##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




---

Form 10-K

|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|           |  | For the fiscal year ended December 31,
    2002                                             
|          
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|           |  | For the transition period
    from           to          .                                  

Commission File Number 000-30715

CoSine Communications, Inc.

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                            
|------------------------------------------------------------------ |  | -------------------------------------------
|Delaware                                                           |  | 94-3280301                                 
|(State or other jurisdiction of
    incorporation or organization) |  | (I.R.S. Employer
    Identification Number)
|                                                                  
|1200 Bridge Parkway, Redwood City,
    CA                          |  | 94065                                      
|(Address of principal executive
    offices)                       |  | (Zip Code)                                 

Registrants telephone number including
area code: (650) 637-4777

Securities Registered Pursuant to
Section 12(b) of the Act: None

Securities Registered Pursuant to
Section 12(g) of the Act:


Common Stock, $.0001 Par Value


(Title of each class)


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

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of
registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this
Form 10-K or any amendment to this
Form 10-K.     o

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

At June 30, 2002, the aggregate market value
of the Common Stock held by non-affiliates of the registrant was
approximately $39,077,130.

The aggregate market value of the Common Stock
held by non-affiliates of the Registrant (based on the closing
price for the Common Stock on the Nasdaq National Market) was
$40,538,630 on March 14, 2003.

As of March 14, 2003, there were
9,916,615 shares of the Registrants Common Stock
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement for
CoSines Annual Meeting of Stockholders to be filed
pursuant to Regulation 14A within 120 days of
CoSines year end are incorporated by reference into
Part III of this Report.



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TABLE OF CONTENTS



|                               |                                                                                               |  |  |  |  |  |  | 
|------------------------------ | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I                        
|                               | Item 1. Business                                                                             
|                               | Item 2. Properties                                                                           
|                               | Item 3. Legal Proceedings                                                                    
|                               | Item 4. Submission of Matters to a Vote of Security Holders                                  
|PART II                       
|                               | Item 5. Market for Registrants Common Stock and Related Stockholder Matters                 
|                               | Item 6. Selected Financial Data                                                              
|                               | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                               | Item 7A. Quantitative and Qualitative Disclosures about Market Risk                          
|                               | Item 8. Financial Statements and Supplementary Data                                          
|REPORT OF INDEPENDENT AUDITORS
|                               | Supplemental Financial Information                                                           
|                               | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 
|PART III                      
|                               | Item 10. Directors and Executive Officers of the Registrant                                  
|                               | Item 11. Executive Compensation                                                              
|                               | Item 12. Security Ownership of Certain Beneficial Owners and Management                      
|                               | Item 13. Certain Relationships and Related Transactions                                      
|                               | Section 16(a) Beneficial Ownership Reporting Compliance                                      
|                               | Item 14. Controls and Procedures                                                             
|                               | Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K                     
|SIGNATURES                    
|CERTIFICATION                 
|EXHIBIT INDEX                 
|EXHIBIT 3.4                   
|EXHIBIT 21.1                  
|EXHIBIT 23.1                  



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##### Table of Contents



COSINE COMMUNICATIONS, INC.

Form 10-K

Year Ended December 31, 2002


TABLE OF CONTENTS

|         |  |                                                                                           |  |      |    | 
|-------- |  | ----------------------------------------------------------------------------------------- |  | ---- | -- | 
|         |  |                                                                                           |  | Page
|         |  |                                                                                           |  |     
|PART I  
|        
|Item 1.  |  | Business                                                                                  |  |      | 2  | 
|         |  | Executive Officers of the Registrant                                                      |  |      | 12 | 
|Item 2.  |  | Properties                                                                                |  |      | 13 | 
|Item 3.  |  | Legal Proceedings                                                                         |  |      | 13 | 
|Item 4.  |  | Submission of Matters to a Vote of Security
    Holders                                   |  |      | 14 | 
|PART II 
|Item 5.  |  | Market for Registrants Common Stock and
    Related Stockholder Matters                  |  |      | 14 | 
|Item 6.  |  | Selected Financial Data                                                                   |  |      | 16 | 
|Item 7.  |  | Managements Discussion and Analysis of
    Financial Condition and Results of Operations |  |      | 17 | 
|Item 7A. |  | Quantitative and Qualitative Disclosures about
    Market Risk                            |  |      | 35 | 
|Item 8.  |  | Financial Statements and Supplementary Data                                               |  |      | 37 | 
|Item 9.  |  | Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosure  |  |      | 66 | 
|PART III
|Item 10. |  | Directors and Executive Officers of the Registrant                                        |  |      | 66 | 
|Item 11. |  | Executive Compensation                                                                    |  |      | 66 | 
|Item 12. |  | Security Ownership of Certain Beneficial Owners
    and Management                        |  |      | 66 | 
|Item 13. |  | Certain Relationships and Related Transactions                                            |  |      | 67 | 
|Item 14. |  | Controls and Procedures                                                                   |  |      | 67 | 
|Item 15. |  | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K                       |  |      | 67 | 
|         |  | Supplemental Financial Information                                                        |  |      | 68 | 
|         |  | Signatures                                                                                |  |      | 70 | 
|         |  | Certifications                                                                            |  |      | 71 | 
|         |  | Exhibit Index                                                                             |  |      | 73 | 

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SAFE HARBOR STATEMENT UNDER

PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995


This report contains forward-looking statements
that are subject to risks and uncertainties. We use words such
as anticipate, believe, plan, expect, future, intend and similar
expressions to identify forward-looking statements. Readers are
cautioned not to place undue reliance on these forward-looking
statements, which reflect managements opinions only as of
the date of this report. Our actual results may vary
significantly from those reflected in these forward-looking
statements. Factors that might cause such a difference include,
but are not limited to, product development, commercialization
and technology difficulties, manufacturing costs, the impact of
competitive products, pricing pressures, changing customer
requirements, timely availability and acceptance of new
products, changes in economic conditions in the various markets
we serve and those factors discussed in the section entitled
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Risk
Factors. We undertake no obligation to revise or publicly
release the results of any revision to these forward-looking
statements. Readers should carefully review the risk factors
described in other documents we file from time to time with the
Securities and Exchange Commission, including the Quarterly
Reports on Form 10-Q to be filed by us in fiscal year 2003.




PART I






|        |         
|------- | --------
|Item 1. | Business

OVERVIEW

We develop, market and sell a communications
platform designed to enable network service providers to rapidly
deliver a portfolio of profitable communication services to
business and consumer customers. Examples include:



| |   |                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------
| |  | virtual private networks, or VPNs, which are
    secure private networks that run on the Internet and other
    communications networks;
|
| |  | firewalls, which are security programs designed
    to prevent unwanted network traffic; and                                            
|
| |  | secure broadband access, which is secure
    high-speed access to the Internet and other communications
    networks.                   

Our Internet Protocol (IP) Service Delivery
Platform consists of hardware elements: a chassis, including our
IPSX 9500TM and IPSX 3500TM Service
Processing Switches (IPSXs), and sub-systems known as our IP
Service Generators (IPSGs) that support various IP services; and
software elements consisting of our InVisionTM
Service Management software for network management and
InGageTM Customer Network Management software.

Our network-based platform is designed to:



| |   |                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------
| |  | allow delivery of applications and services to
    tens of thousands of subscriber networks simultaneously;
|
| |  | help address the cost, management complexity and
    scalability issues of service delivery; and           
|
| |  | reduce the need for equipment on a
    customers premises to provide these applications and
    services. 

INDUSTRY BACKGROUND

Data networks, including the Internet, have
rapidly evolved to become critical for the communications needs
of many businesses and consumers. Despite the downturn within
the telecommunications industry and the overall decrease in
capital spending, service providers who offer high-speed
connectivity services to businesses and consumers are continuing
to invest in high-capacity networks using the latest broadband
access, switching and routing products from both traditional and
emerging communications equipment vendors.

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The delivery of high-speed connectivity is an
intensely competitive industry. This competition has made it
difficult for service providers to differentiate their service
offerings on price alone.

As businesses have become more dependent on the
Internet and other data networks, they are increasingly seeking
other communications services in addition to high-speed
connectivity. To enable these services, a secure and reliable
networking environment is required. The Internet, however,
suffers from an inherent lack of security and dependability,
which businesses have struggled to overcome by using
technologies installed on customer premises equipment, or CPE.
These technologies include firewalls, Denial of Service (DoS)
mitigation, Public Key Infrastructure (PKI), VPNs with IPSec
encryption (which is the coding of data for security purposes,
or Multi-Protocol Label Switching (MPLS)). Businesses use
additional CPE as more services are needed. This equipment can
be costly to install and maintain, requiring large numbers of
expensive networking personnel to manage. We believe that most
businesses are having difficulty implementing these technologies
and that many businesses are increasingly seeking to outsource
IP services.

Network service providers have begun to provide
solutions to address this demand and achieve three important
business objectives:



| |   |                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | attracting subscribers through differentiated
    services that can be layered on top of basic high-speed
    connectivity services;                                                                         
|
| |  | increasing revenue from business subscribers who
    are demanding additional services; and                                                                                                                  
|
| |  | reducing subscriber turnover, because customers
    must consider the total cost of replacing multiple services and
    evaluate the risk of moving critical business services to a new
    service provider.

THE PROBLEMS OF A CPE-BASED APPROACH

Although network service providers have started
to offer additional services through the CPE-based approach,
that approach is subject to a number of limitations.

Each customer site requires multiple pieces of
on-site equipment provided by numerous vendors. This equipment
enables various functions, including routing, firewall
protection and the mitigation of DoS attacks. We believe that
the CPE-based model creates the following challenges that
constrain the delivery of services for both network service
providers and their customers:

High Cost to Install and Manage.Installing and managing equipment
located at dispersed customer sites can result in high costs for
both service providers and their customers. Each new customer
site or service requires new CPE, or the modification of
existing CPE, as well as on-site service calls. This approach is
costly and time consuming and often leads to delays in
establishing service. Both service providers and their
subscribers can incur significant maintenance and monitoring
expenses for the CPE and for expensive personnel needed to
manage these complex networks.

Difficult to Expand.We believe that the CPE-based service
delivery model is difficult to expand because on-site
installation is required for each new site or service.
Implementation challenges increase significantly as new services
and devices are added, since each new network site must be
connected to all existing network sites.

Limited Network Services.In a CPE-based model, a
subscribers data is typically encrypted before entering
the service providers network. This encryption limits the
service provider to simple data transmission because additional
services must be implemented before encryption.

Difficult to Integrate.CPE-based services often involve the
integration of hardware and software from a variety of vendors.
We believe that integrating and ensuring compatibility among a
variety of hardware and software is a significant challenge.

Inconsistent Quality of Service.Service providers may have difficulty
offering consistent quality of service across all of these
disparate network devices and implementing and supporting agreed
levels of service.

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THE NEED FOR A NEW NETWORK-BASED SERVICE
DELIVERY MODEL

We believe that the problems with CPE-based
service delivery models have created a significant need for
service providers to offer network-based services that operate
on equipment located within the service providers
networks. Delivering services in this manner requires the
creation of a new and more intelligent network, through which
services can be delivered quickly and cost-effectively. It also
must serve thousands of customer sites from within a service
providers network, without the need for equipment to be
installed or managed on customers premises. We believe
that this network must be based on an open architecture that
will support network standards and allow for the implementation
of third-party applications.

Limitations of Existing Network-Based
Approaches

Existing network-based approaches to providing IP
services satisfy some needs, but are subject to certain
limitations.

Relocation of Customer Premises Equipment.While reducing the installation and
management costs resulting from broad geographic dispersion of
CPE, relocating this equipment to the service providers
facilities does not fully address the remaining problems of
CPE-based approaches. For example, this approach introduces
costs incurred in requiring large numbers of devices to be
located in the already constrained space of the service
providers facilities.

Carrier Switches and Routers.Switches and routers used by service
providers are specifically designed to forward packets of data
through networks. We believe that this equipment lacks the
flexibility and general-purpose computing capacity necessary to
directly support a wide range of services because the equipment
cannot be adapted to provide other services beyond a private
IP WAN service based upon MPLS VPNs.

Large General-Purpose Computers.Large general-purpose computers,
commonly used in computer data centers, do not have routing
capabilities or network access interfaces and are not designed
specifically for data forwarding. We believe that these
computers do not have the network management and operational
systems required to meet stringent service provider requirements.

THE COSINE COMMUNICATIONS SOLUTION

Our IP Service Delivery Platform provides a
solution that is designed to allow service providers to build
intelligent data networks and deliver a variety of applications
to their end-users. Intelligent data networks are those designed
to deliver applications from within a network without the need
for specialized CPE. Our IP Service Delivery Platform, which is
designed to deliver applications to thousands of subscribers
simultaneously, consists of hardware elements: a chassis,
including our IPSX 9500 and IPSX 3500 Service
Processing Switches, and sub-systems known as our IPSGs; and
software components consisting of our InVision and InGage
software.

We believe our products offer the following
benefits for service providers and their customers:



| |   |                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the ability for service providers to increase
    revenue by delivering a variety of services to their customers;                                                
|
| |  | faster availability of new services for delivery
    by service providers;                                                                                       
|
| |  | reduced operating expenses for service providers
    through automated delivery and customer activation, centralized
    billing and fewer on-site service calls;
|
| |  | the ability of service providers to attract new
    customers and reduce customer turnover;                                                                      
|
| |  | the ability for subscribers to monitor and
    control services;                                                                                                 
|
| |  | reliability and scalability;                                                                                                                                     
|
| |  | software-based network management capabilities
    for service providers and their customers;                                                                    

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| |   |                                                                                             
| | - | --------------------------------------------------------------------------------------------
| |  | a flexible open architecture that can support
    third-party applications and services; and
|
| |  | the ability to support and operate with existing
    network standards and applications.    

STRATEGY

Our objective is to become the leading supplier
of carrier network equipment designed to deliver profitable
applications and services seamlessly from within a service
providers network. The key elements of our strategy are:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Use Our Architecture to Offer Scalable
    Services and Applications.The fully
    distributed and virtualized architecture approach of the IPSX
    enables us to offer service providers the capability of rolling
    out a services that can be added to their data portfolio. CoSine
    either develops these applications in-house or leverages third
    party vendors based on the application type and service provider
    need.
|
| |  | Work Closely with Customers to Facilitate New
    Services.We work closely with our
    customers to develop features to meet their complex and distinct
    needs. We believe that our customers input and cooperation
    are essential to the design of new features for our platform and
    its use in their networks.                                                                                                               
|
| |  | Expand Sales, Distribution, Support and
    Service Capabilities.We have built a
    team of support and service professionals to assist our
    customers with the design, implementation and efficient
    operation of our platform within their networks.                                                                                                                                                                              
|
| |  | Develop New Technologies and
    Products.We have developed a fully
    distributed and virtualized hardware and software architecture
    that we believe will allow us to rapidly develop future products
    and enhancements. We intend to continue our significant
    investment in research and development to create new
    technologies and products.                                                                            
|
| |  | Pursue Strategic
    Partners.We intend to expand our
    products and services through selected partners. We believe that
    working with companies that provide complementary products or
    services for intelligent data networks will assist us in
    bringing greater value to our customers.                                                                                                                                     

PRODUCTS AND TECHNOLOGY

IP Service Delivery Platform

Our products are offered in various
configurations and combinations depending on the size of the
service provider and the specific service offerings. The
IPSX 9500 and IPSX 3500 come with the operating system
software already loaded. A network service provider may buy the
hardware with no additional software applications. However, the
hardware will often be ordered with our InVision Service
Management software. Our InGage Customer Network Management
software is a packaged tool kit that allows a service provider
to develop customer network management capabilities to give
their end-users visibility and control into their managed
services.

As our product is fully functional at the time of
shipment, no significant installation services are necessary
once the product has been received at the customers site.

IPSX Service Processing Switch
Family

Our IPSX family of service processing switches
combines the functionality of high-performance networking
hardware, distributed computing hardware and operating system
software. It is designed to be installed in a service
providers facility and is the platform from which services
are delivered.

Our switch family is based on a computing
architecture that allows distributed computing to occur
simultaneously within a multi-processor system. This approach
combines the computing power of multiple processing engines to
deliver more performance than a single-processor architecture.
This approach, which is designed to be scalable allows
additional processing resources (and thus subscriber service
capacity) to be

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added to the platform as they are needed. This is
in sharp contrast to edge routers with their centralized
architecture which has a fixed ceiling of subscriber capacity
and service processing performance power.


IPSX Hardware Architecture.The IPSX hardware architecture
involves two key design elements, our chassis design and our
service generator design, that create a modular and flexible
platform. We have two chassis designs: 1) the
IPSX 9500, which provides a total of 26 slots, 13 in
the front and 13 in the rear, and 2) the IPSX 3500,
which provides eight slots.

The IPSG is a self-contained subsystem that
delivers computationally intense IP services such as VPNs and
managed firewalls. It operates within CoSines IPSXs
deployed at the edge of a carriers network. Each IPSG is
assembled with a combination of various processing engines and
interface modules to provide specific functionality. The
performance of our IPSGs is enhanced by CoSine-originated
integrated circuits, our processing architecture and our IP
Network Operating System (IPNOSTM).

IPNOS Software.Our
operating system software, or IPNOS, is designed to provide:



| |   |                                                                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | real-time processing, which allows the IPSX to
    perform its functions without significant delay;                                                            
|
| |  | an object-oriented environment, which provides a
    simple framework for multiple instances of the same application
    to operate securely and independently;
|
| |  | fault-tolerance, with the goal that if any
    component fails, a backup will immediately take its place with
    no loss of service; and                      
|
| |  | distributed computing, which spreads applications
    and data over multiple processors at the same time.                                                      

InVision Service Management Software

InVision is a scalable network management
software product designed to allow service providers to manage
our IP Service Delivery Platform and the services being offered
to their customers. It is designed to be installed in the
service providers network operations center and provides a
broad range of management services for each application. It also
enables service providers to develop templates and tools to
facilitate the process of delivering new services.

InVision is designed for scalability to meet the
needs of the largest service provider networks and conforms to
the telecommunication industry network management standards. The
InVision system runs on the Sun Solaris and Microsoft
Windows NT operating systems. InVision also is designed to
operate with other network management systems.

InGage Customer Network Management
Software

InGage is a network management software product
that allows subscribers to manage their services through an
interface that can be securely accessed through the Internet.
InGage enables a subscriber to remotely manage services without
affecting the services of any other subscriber and monitor the
usage of various services. InGage provides subscribers with the
ability to activate various service capabilities directly
without contacting the service provider.

SERVICE OFFERING EXAMPLES

Our IP Service Delivery Platform can support the
following network applications:



| |   |                                                        
| | - | -------------------------------------------------------
| |  | enterprise VPN service;                                
|
| |  | wholesale VPN service;                                 
|
| |  | secure broadband service;                              
|
| |  | combined traditional and IP networking
    service; and

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Enterprise Virtual Private Network
Service

Our platform is designed to enable service
providers with IP backbone networks to offer their enterprise
subscribers VPN services without the need for costly customer
premises equipment. Using traditional connections, enterprise
subscribers can access our IP Service Delivery Platform located
at their service providers closest facility. Each IPSX
acts as a private aggregation point for these connections and
can provide secure routing services between all of a
customers sites within a virtual network.

Service providers can install our platform at the
edge of their networks to reduce the distance that must be
traversed using costly traditional connections from each
enterprise subscriber to the nearest service provider facility.
Once the traffic reaches the IPSX, our IP Service Delivery
Platform can provide encryption and authentication services. The
traffic can then be securely transmitted less expensively over
public IP networks or the Internet. In addition to encrypted VPN
services, CoSine also offers MPLS-based VPNs per the IETF
standard RFC 2547.

Wholesale VPN Service

A wholesale ISP that provides wholesale VPN and
other services to regional ISPs, can use our IP Service Delivery
Platform to offer these regional ISPs services for resale to
their subscribers. ISPs using CPE-based encryption cannot easily
offer network-based services because traffic is encrypted on the
customers premises before being sent to the network. Once
encrypted by the customer, the service provider cannot interpret
the contents of the packet and, as a result, cannot layer on any
services.

When CPE-based encrypted traffic from a customer
site is directed by the regional ISP to our IPSX within the
wholesale ISPs network, the wholesale ISP can decrypt the
traffic and offer services on behalf of regional ISPs. The
wholesale ISP can then re-encrypt the traffic and forward it to
its next destination. This allows the regional ISP to offer a
wide range of services to its customers from the wholesale
ISPs network in a cost-effective, scalable manner.

Secure Broadband Service

Broadband local access carriers installing
digital subscriber line, or DSL, cable modem or broadband
wireless data services control consumer and business access to
the Internet and other data networks. These carriers are very
often in the position of providing wholesale broadband access to
their service provider customers. We believe that wholesale
broadband connectivity is becoming a commodity, and these data
carriers are seeking ways to lower costs of providing this
connectivity and to increase revenues through services. Our
platform is designed to enable broadband data carriers to
provide traffic aggregation and service switching. Additionally,
our platform potentially lowers the cost of operation for
carriers by allowing them to transport the aggregated traffic
over IP networks instead of using traditional connections to
reach their wholesale customers.

Our platform also gives data carriers and their
service provider customers several new revenue-generating
opportunities.

Combined Traditional and IP Networking
Service

Many traditional domestic and international
carriers have invested in frame relay and asynchronous transfer
mode, or ATM, network equipment. Frame relay is a data
communications service that puts data into variable-sized units
for transmission, while ATM is a communications switching
technology that organizes data into standard-sized units for
transmission. We believe that these networks and the enterprises
using them will continue to grow. Large enterprise customers
using these networks generally cannot afford to quickly
transition their entire organization to a new IP-based network.
Our platform is designed to enable traditional service providers
to use their frame relay or ATM networks to emulate IP networks
and offer network-based services. We believe that this will
enable service providers to pursue revenue opportunities from
new services using their significant investments in equipment.

7



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CUSTOMERS

During the year ended December 31, 2002, we
recognized revenue from transactions with 54 customers, of which
Sprint and NEC Corporation accounted for 22% and 15% of our
revenue, respectively. Geographically, our revenue was
distributed as follows: Asia/ Pacific 40%;
United States 36%; and Europe 24% (See
Note 1 of the Notes to the Consolidated Financial
Statements).

Currently a small number of customers account for
a substantial portion of our revenues, and the loss of any one
customer can have a material impact on our operations. In 2001,
two customers, AduroNet and BroadBand Office, became insolvent
and subsequently liquidated their operations. We therefore will
not receive any future orders from either of these companies.
AduroNet accounted for less than 10% of our revenue in 2001 and
35% of our revenue in 2000. BroadBand Office accounted for no
revenue in 2001 and less than 10% of our revenue in 2000.

SALES AND MARKETING

Our products are sold through our direct sales
organization, resellers targeting specific countries and
international partners. At December 31, 2002, we had
39 people in our sales and marketing organization.

We continue to devote a significant portion of
our sales and marketing resources to customer evaluations and
trials. The extensive capabilities of our IP Service Delivery
Platform, the complexity of the networks in which it is
installed and the stability and performance requirements of our
customers frequently result in extended test and trial periods.
Because of the complex nature of the testing process for our
products and the equipment required, our prospective customers
frequently ask for our assistance during the evaluation phase of
our product offering. Therefore, we are continuing to update our
evaluation laboratory to assist prospective customers with test
and trial initiatives, to facilitate our customers
purchase decisions for our products. These evaluations and
trials generally last between three and 12 months,
depending on the size and complexity of the customers
planned deployment of the CoSine platform. Trials and
evaluations may consist of, but are not limited to, the
following:



| |   |                                                                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Customer visits to our sales laboratory in
    Redwood City, California.                                                                                              
|
| |  | Laboratory visits and trials with CoSine systems
    that are shipped to customers laboratory sites and/or
    customer network points of presence for field testing.
|
| |  | Field trials with multiple CoSine systems for
    large carriers to validate CoSines platform in the
    prospective customers global network.                      

Evaluations and trials generally last longer for
larger carriers who have more extensive networks, due to the
rigorous testing they typically perform and the complexity of
integrating any new technology into a large network. In general,
field evaluations also last significantly longer than laboratory
visits and involve greater support from CoSine sales and
services personnel, with marketing and engineering support from
the customer.

CoSine considers an evaluation or trial concluded
when we receive a purchase order from the customer, the customer
returns all field units being tested, or a purchase order is
awarded to a competitor.

Direct Sales

Our direct sales organization is divided into two
regions, North American and International, and concentrates on
network service providers offering IP-based services. Account
managers focus on selling to large individual customers and to
select high-end resellers that specialize in offering solutions
to the carrier market. Account managers work with our customer
services organization and our systems engineering group to
provide customers with network design and build-out proposals.
Account managers are directed by regional Vice Presidents who
report directly to the President and Chief Executive Officer of
CoSine.

As part of our direct sales model, we use our
field sales, engineering and executive personnel to establish
multiple contacts within a potential customers business
organization. We believe that maintaining ongoing

8



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relationships with key individuals in our
customers engineering, operations, marketing and executive
departments is important to our success.


International Sales and Resellers

We have sales offices in a total of eight
countries in Europe, Asia and North America. For customers in
countries in which we have local offices, most of our sales
transactions are conducted directly with the customer. However,
if the customer prefers to make a purchase through a reseller
with which the customer has an established relationship, we may
conduct business through the reseller. In connection with our
May and October 2002 restructurings, we closed sales offices in
eight counties in Europe and Asia. In countries in which we do
not have a local sales office, all of our sales transactions are
conducted through resellers.

CUSTOMER SERVICE AND SUPPORT

Customer service and support play a key role in
ensuring our customers success in using the IP Service
Delivery Platform. The goal of our service organization is to
assist service providers to generate sustainable new revenues in
a short period of time. We seek to achieve this goal by
providing a comprehensive set of service offerings starting with
network architecture, design and installation, through product
support. Our support offerings include hardware and software
warranty services, access to our technical assistance center,
on-site network engineers and technical information and
assistance.

Our professional services include consulting
offerings designed to support service providers from initial
planning through implementation and ongoing operation. Our
network engineers and consultants are skilled in network design
and architecture, VPN technologies, IP security, IP routing
protocols and network performance and availability.

At December 31, 2002, we had
11 employees in our customer service and support
organization.

RESEARCH AND DEVELOPMENT

We have a team of skilled engineers with
extensive experience in designing:



| |   |                                                                                   
| | - | ----------------------------------------------------------------------------------
| |  | scalable Internet software;                                                       
|
| |  | high performance computing platforms;                                             
|
| |  | application specific integrated circuits with
    advanced packaging technologies;
|
| |  | network communications protocols;                                                 
|
| |  | Internet security protocols;                                                      
|
| |  | Internet firewalls;                                                               
|
| |  | managed network services;                                                         
|
| |  | operating system design; and                                                      
|
| |  | network management software.                                                      

Our engineers have come from data networking,
computer systems, computer security and telecommunications
companies. Our research and development group is organized into
teams that work on multiple generations of products. We seek to
offer our customers new products as they are needed, as well as
enhancements to existing products.

We plan to enhance our core technology and
develop additional applications for our IP Service Delivery
Platform. We are dedicating substantial resources to the
development of new features for the IPSX 9500 and 3500. The
design phase of these features is expected to have a minimum
nine to 12 month development cycle.

9



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Our research and development efforts are driven
by market demand, the availability of new technology and
customer feedback. We have invested significant time and
resources to create a structured process for undertaking all
product development projects. Following an assessment of market
demand, our research and development team develops a set of
functional product specifications based on input from our
product management, sales and service organizations. This
process is designed to provide a framework for defining and
addressing the steps, tasks and activities required to bring
product concepts and development projects to market.

We work closely with our customers to determine
the features and functionality they want from our products. We
use their feedback to define and prioritize our product
development efforts. To continue developing additional
applications for our IP Service Delivery Platform, we plan to
continue to work with current and potential customers to develop
products that address the needs of the market.

At December 31, 2002, we had
82 employees in our research and development group.

Our research and development expenses, including
non-cash charges related to equity issuances, totaled
$32.4 million, $66.1 million and $91.2 million
for the years ended December 31, 2002, 2001 and 2000,
respectively.

MANUFACTURING

We outsource manufacturing to two contract
manufacturers. Solectron Corporation procures raw materials for,
assembles and tests all electronic circuit boards used in our
products. Raw materials consist of electronic components and
printed circuit boards from various manufacturers. Prior to our
making new products generally available to customers, we
occasionally purchase electronic components directly from
manufacturers and then transfer the components to Solectron for
assembly into finished circuit boards. Sonic Manufacturing
Corporation procures material for, assembles and tests all
chassis assemblies used in our products. The electronic circuit
boards and chassis assemblies are delivered to our Redwood City,
California facilities, where we perform final configuration,
testing, packaging and shipping. Our manufacturers produce our
products within 30 miles of our Redwood City facilities.
All manufacturing is done on a purchase order basis.

We believe that our use of outsourced
manufacturing minimizes the space and inventory investment
needed for manufacturing operations and enables us to:



| |   |                                                                             
| | - | ----------------------------------------------------------------------------
| |  | adjust manufacturing volumes quickly to meet
    changes in customer demand;
|
| |  | focus on production planning and key commodity
    management; and          
|
| |  | take advantage of the purchasing power of our
    contract manufacturers.   

The use of third-party contract manufacturers
could result in interruptions in our manufacturing operations if
our relationships with these parties are terminated or our
manufacturing subcontractors are unable or unwilling to produce
sufficient quantities of products in a timely manner and at
satisfactory quality levels. Also, we rely on single or limited
sources for various key components, and the loss or delay of
these sources could also interrupt our manufacturing operations.
We have not experienced any interruptions in producing our
products due to a shortage of these key components.

At December 31, 2002, we had 11 employees in
our manufacturing operations group.

BACKLOG

CoSines backlog includes purchase orders
from customers with approved credit status, representing
products and services we plan to deliver within 12 months, plus
our current balance of deferred revenue. At December 31,
2002, 2001 and 2000, our backlog totaled $1.4 million,
$4.4 million and $15.0 million, respectively.

10



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After the successful completion of a customer
evaluation and trial, there is generally a short time between
order and shipment. In addition, customers occasionally change
delivery schedules or cancel orders. As a result, we do not
believe that backlog, as of any particular date, is necessarily
indicative of future revenues for any particular period.
However, we expect that most of our future sales will come from
repeat business from existing customers as well as the
successful completion of customer evaluations and trials.

COMPETITION

The networking equipment business is extremely
competitive, with numerous vendors offering products that
enhance the functionality of a service providers network.
Because our IP Service Delivery Platform enables a broad suite
of services, our capabilities place us in direct competition
with a variety of networking equipment vendors who can offer
specific products each addressing some of a service
providers needs.

In specific service areas, our competitors
include Alcatel, Cisco, Lucent, Nortel, Siemens and Juniper. Our
competitors market and sell products that offer VPN and firewall
capabilities. These competitors and other new entrants are
developing new infrastructure solutions for use within a service
providers network. In general, we are seeing increasing
competition from suppliers of conventional routers who are
attempting to offer value-added services at the network edge.

We also compete with companies that provide
traditional enterprise products, because our IP Service Delivery
Platform may reduce the need for these products. These companies
include SonicWall and NetScreen for firewalls, Avaya and Cisco
for IPSec VPN encryption and Arbor Networks for DoS mitigation.
In addition, as we continue to add functionality through the
addition of third-party applications to the IPSX platform, we
will compete with leading vendors in each new segment we enter.

Many of our competitors, particularly those that
are large public companies, have substantially greater
financial, marketing and development resources. Many of them
have existing relationships with network service providers,
which will make it more difficult for us to sell our products to
those service providers. Some competitors may seek to use
intellectual property rights to limit our ability to compete.

We believe that the principal areas of
competition in these markets are product performance,
reliability, expandability and cost-effectiveness. We believe
that to be competitive in these markets, we must deliver
products that:



| |   |                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------
| |  | provide extremely high network reliability;                                                                    
|
| |  | provide high performance;                                                                                      
|
| |  | scale easily and efficiently through service
    virtualization and unparalleled service processing capability;
|
| |  | operate with existing network designs and
    equipment vendors;                                               
|
| |  | reduce the complexity of the network by
    decreasing the need for multiple layers of equipment;              
|
| |  | provide a cost-effective solution for service
    providers; and                                               
|
| |  | are supported by responsive customer service and
    support.                                                  

We believe that positive factors pertaining to
our competitive position include our technology, the expertise
of our research and development personnel, our service and
support organization and our intellectual property rights. We
believe that negative factors pertaining to our competitive
position include long-standing relationships of our competitors
with key target customers and the fact that some of our
competitors have substantial financial resources available to
promote sales of their products and to develop products more
directly competitive with ours.

INTELLECTUAL PROPERTY

Our IPNOS, InVision and InGage software were
developed internally and are protected by United States and
foreign copyright laws. Our IP Service Delivery Platform system
architecture and hardware were

11



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developed internally, and we own rights to the
core interfaces and protocols between subsystems, which are the
subject of pending United States patent applications. As of
March 14, 2003, we have a total of 20 patent
applications pending in the United States relating to the
design of our products and a patent application pending in each
of Japan and the European Union.


Although we rely on copyright, patent, trade
secret and trademark law to protect our intellectual property,
we believe that the technological and creative skills of our
personnel, new product developments and frequent product
enhancements are essential to maintain our technology leadership.

We license software from network software
application companies for integration into our IP Service
Delivery Platform. These licenses are terminable after a
specified period or upon the occurrence of specified events. If
one or more of these licenses are terminated, we may need to
locate and incorporate alternative software providing comparable
services.

Our success will depend upon our ability to
obtain necessary intellectual property rights and protect our
intellectual property rights. We cannot be certain that we will
be able to obtain necessary intellectual property rights or that
other parties will not contest our intellectual property rights.

EMPLOYEES

As of December 31, 2002, we had
163 full-time employees, 82 of whom were engaged in
research and development, 39 in sales and marketing, 20 in
general corporate, finance and administration, 11 in customer
support and 11 in manufacturing. None of our employees is
represented by a labor union. None of our officers or key
employees is bound by an employment agreement for any specific
term. We have not experienced any work stoppages, and we
consider our relations with our employees to be good.

EXECUTIVE OFFICERS OF THE REGISTRANT

There has been turnover among most of our
executive positions during the past year. Our new executive
management team is comprised of individuals who each bring
substantial career and industry experience.

The names of our executive officers and their
ages, titles and biographies as of March 25, 2003 appear
below.

|                 |  |     |    |          |  |                                                         
|---------------- |  | --- | -- | -------- |  | --------------------------------------------------------
|Name             |  | Age |    | Position
|                 |  |     |    |         
|Stephen Goggiano |  |     | 50 |          |  | President and Chief Executive Officer                   
|Terry Gibson     |  |     | 49 |          |  | Executive Vice President and Chief Financial
    Officer
|Jill Bresnahan   |  |     | 40 |          |  | Senior Vice President, General Counsel and
    Secretary
|Robert Iannucci  |  |     | 47 |          |  | Senior Vice President, Engineering                      

Stephen Goggiano became Chief Executive Officer
on March 3, 2002. Previously, he had served as Chief
Operating Officer since joining CoSine in December 1999 and
assumed the position of President in April 2001. Prior to
joining CoSine, Mr. Goggiano held various positions at SGI,
formerly known as Silicon Graphics, Inc., a provider of
computing systems and software, from 1989 to 1999. These
positions included Senior Vice President and General Manager of
SGIs Server and Supercomputer division, and Senior Vice
President of worldwide manufacturing and customer service.
Mr. Goggiano holds a B.S. in Business from San Jose
State University.

Terry Gibson has served as Executive Vice
President and Chief Financial Officer since joining CoSine in
January 2002. Prior to joining CoSine, Mr. Gibson served as
Chief Financial Officer of Calient Networks, Inc. from May 2000
through December 2001. He served as Chief Financial Officer of
Ramp Networks, Inc. from March 1999 to May 2000 and as Chief
Financial Officer of GaSonics, International from June 1996
through March 1999. He also served as Vice President, Corporate
Controller of Lam Research Corporation from February 1991
through June 1996. Mr. Gibson holds a B.S. in Accounting
from the University of Santa Clara.

12



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Jill Bresnahan has served as Vice President and
General Counsel since joining CoSine in March 2000.
Ms. Bresnahan became Secretary of CoSine in May 2000 and
Senior Vice President in August 2001. Prior to CoSine,
Ms. Bresnahan served 10 years as Senior Division
Counsel for SGI, formerly known as Silicon Graphics, Inc., a
provider of computing systems and software, and Cray Research,
before it was acquired by SGI. Ms. Bresnahan holds a JD
from Hamline University School of Law, and a B.S. in Finance
from St. Cloud State University.

Robert Iannucci has served as Senior Vice
President of Engineering since joining CoSine in January 2002.
From November 1995 until joining CoSine, Dr. Iannucci
worked at Compaq Computer Corporation (and Digital Equipment
Corporation, which was acquired by Compaq in 1998), becoming
Vice President of Research in May 1999. Prior to that
Dr. Iannucci was Director of Compaqs Cambridge
Research Laboratory. Dr. Iannucci holds a Ph.D. in
Electrical Engineering and Computer Science from the
Massachusetts Institute of Technology and has published books
and papers in the field of parallel computation.

ADDITIONAL INFORMATION

We file annual reports, quarterly reports, proxy
statements and other documents with the Securities and Exchange
Commission (SEC) under the Securities exchange Act of 1934
(Exchange Act). The public may read and copy any materials that
we file with the SEC at the SECs Public Reference Room at
450 Fifth Street N.W., Washington, D.C. 20549. The
public may obtain information on the operation of the public
Reference Room by calling the SEC at 1-800-SEC-0330. Also, the
SEC maintains an Internet site that contains reports, proxy and
information statements, and other information regarding issuers,
including CoSine, that file electronically with the SEC. The
public can obtain any documents that we file with the SEC at
HTTP://www.sec.gov.

We also make available free of charge through our
Internet site (http://www.cosinecom.com) our most recent annual
reports, quarterly reports, proxy statements and certain other
documents filed with the SEC. These documents are available as
soon as reasonably practicable after we file them with the SEC.






|        |           
|------- | ----------
|Item 2. | Properties

CoSine leases approximately 48,000 square
feet of office and manufacturing space in Redwood City,
California under an operating lease which expires in December
2011. We believe the space will be sufficient for our current
and anticipated needs through at least December 2003. We have a
service laboratory in Paris utilizing 6,000 square feet of
space with a lease expiring in May 2003. As part of our May 2002
restructuring, we closed a sales and service laboratory in Kuala
Lampur utilizing 3,000 square feet.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

On November 15, 2001, CoSine and seven of
its officers and directors were named as defendants in a
securities class action lawsuit filed in the United States
District Court, Southern District of New York. The complaint
alleges that CoSines September 26, 2000 IPO
prospectus failed to disclose certain alleged actions by the
underwriters for the offering. The complaint alleges claims
against CoSine and its officers and directors under
Section 11 of the Securities Act of 1933. The complaint
also alleges claims against the officers and directors under
Section 15 of the 1933 Act and Section 20(a) of
the Securities Exchange Act of 1934. CoSine and its officers and
directors believe the allegations against them are without merit
and intend to defend the action vigorously.

The complaint generally alleges that various
investment bank underwriters engaged in improper and undisclosed
activities related to the allocation of shares in our initial
public offering. The complaint brings claims for the violation
of several provisions of the federal securities laws against
those underwriters, and also against the Company and certain of
its directors and officers. Various plaintiffs have filed
similar actions asserting virtually identical allegations
against more than 250 other companies. The lawsuit and all other
IPO allocation securities class actions currently
pending in the Southern District of New York have been assigned
to Judge Shira A. Scheindlin for coordinated pretrial
proceedings. In October 2002, the individual defendants

13



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were dismissed without prejudice pursuant to a
stipulation. The issuer defendants recently filed a coordinated
motion to dismiss on common pleading issues, which the Court
granted in part and denied in part in an order dated
February 19, 2002. The Courts order dismissed the
Section 10(b) and Rule 10b-5 claims against the
Company but did not dismiss the Section 11 claims against
the Company. The Company believes that it has meritorious
defenses to the claims against it and intends to defend itself
vigorously.


On December 27, 2002, CoSine and each of its
five directors were named as defendants in a class action
lawsuit filed in the San Mateo County Superior Court on
behalf of CoSine stockholders. The complaint alleges that the
CoSine directors breached their fiduciary duty to the
corporation in rejecting a proposal offered by a private holding
company, Wyndcrest Holdings LLC, to effect a merger of CoSine
into a wholly owned subsidiary of Wyndcrest. Under the proposal,
Wyndcrest would retain a 75% ownership interest in the assets of
CoSine after distributing $95.5 million in cash to the
existing CoSine shareholders, subject to adjustment. On
January 23, 2003, a substantially similar class action
lawsuit was filed in San Mateo County Superior Court. In
March of 2003, the two plaintiffs agreed to consolidate the two
actions. CoSine and its directors believe that the allegations
are without merit and intend to defend the action vigorously.

In the ordinary course of our business, CoSine is
involved in legal proceedings involving contractual obligations,
employment relationships and other matters. Except as described
above, CoSine does not believe there are any pending or
threatened legal proceedings that will have a material impact on
its financial position or results of operations.






|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

There were no matters submitted to a vote of
security holders during the quarter ended December 31, 2002.




PART II






|        |                                                                         
|------- | ------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Stock
    and Related Stockholder Matters

Our common stock has been traded on the Nasdaq
National Market under the symbol COSN since our initial public
offering in September 2000. Prior to that time there was no
public market for the common stock. According to the records of
our transfer agent, at February 27, 2003 we had
approximately 386 shareholders of record. At that date
there were approximately 9,722 beneficial owners of our
common stock.

The following table sets forth the high and low
sales price of our common stock in each fiscal quarter since our
initial public offering, retroactively adjusted for the
September 17, 2002 1-for-10 reverse stock split. All share
and per share information in this Form 10-K have been
restated to reflect this stock split.

|               |  |      |        |     |  |   |        | 
|-------------- |  | ---- | ------ | --- |  | - | ------ | 
|               |  | High |        | Low
|               |  |      |        |    
|2002           |  |      |        |     |  |   |        | 
|First quarter  |  | $    | 21.50  |     |  | $ | 10.10  | 
|Second quarter |  | $    | 11.60  |     |  | $ | 4.00   | 
|Third quarter  |  | $    | 5.40   |     |  | $ | 2.29   | 
|Fourth quarter |  | $    | 7.60   |     |  | $ | 1.91   | 
|2001           |  |      |        |     |  |   |        | 
|First quarter  |  | $    | 197.50 |     |  | $ | 15.63  | 
|Second quarter |  | $    | 35.00  |     |  | $ | 15.00  | 
|Third quarter  |  | $    | 22.70  |     |  | $ | 3.20   | 
|Fourth quarter |  | $    | 16.70  |     |  | $ | 3.30   | 
|2000           |  |      |        |     |  |   |        | 
|Third quarter  |  | $    | 710.00 |     |  | $ | 530.00 | 
|Fourth quarter |  | $    | 560.00 |     |  | $ | 91.25  | 

14



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##### Table of Contents



Equity Compensation Plan Information

The information required under
Section 201(d) of Regulation S-K is set forth in
Item 12 of this report.

Dividend Policy

Our current policy is to retain future earnings,
if any, for use in the operations and expansion of the business,
and we do not anticipate paying any cash dividends in the
foreseeable future.

Use Of Proceeds of Registered
Securities

On September 25, 2000, in connection with
our initial public offering, a Registration Statement on
Form S-1 (File No. 333-35938) was declared effective
by the Securities and Exchange Commission, pursuant to which
1,150,000 shares of our common stock were offered and sold
for our account at a price of $230 per share, generating
gross offering proceeds of $264.5 million. The managing
underwriters were Goldman, Sachs & Co., Chase
Securities Inc., Robertson Stephens, Inc. and JP Morgan
Securities Inc. Our initial public offering closed on
September 29, 2000. The net proceeds of the initial public
offering were approximately $242.5 million after deducting
approximately $18.5 million in underwriting discounts and
approximately $3.5 million in other offering expenses.

We did not pay directly or indirectly any of the
underwriting discounts or other related expenses of the initial
public offering to any of our directors or officers, any person
owning 10% or more of any class of our equity securities, or any
of our affiliates.

We have used approximately $141 million of
the funds from the initial public offering to fund our
operations. We expect to use the remaining net proceeds for
general corporate purposes, including funding our operations,
our working capital needs and capital expenditures. Pending
further use of the net proceeds, we have invested them in
short-term, interest-bearing, investment-grade securities.

15



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##### Table of Contents








|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |       |       |  
|------------------------------------------------------------------------ | ------------------------------------ | ------------------------------------- | ------- | ------ | ------- | ---- | -------- | ------ | ------- | ---- | -------- | ------ | ------- | - | ------- | ------ | ------ | - | ------ | ----- | ----- | -
|                                                                         |                                      |                                      
|                                                                         |                                      | Year Ended December 31,              
|                                                                         |                                      |                                      
|                                                                         |                                      | 2002                                  |         | 2001   |         | 2000 |          | 1999   |         | 1998
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |     
|                                                                         |                                      |                                      
|                                                                         |                                      | (In thousands, except per share data)
|Consolidated Statements of Operations
    Data:                          |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Revenue                                                                  |                                      | $                                     | 23,632  |        |         | $    | 34,293   |        |         | $    | 31,107   |        |         | $ |        |        |        | $ |       |      
|Cost of goods sold                                                       |                                      |                                       | 13,807  |        |         |      | 30,214   |        |         |      | 23,926   |        |         |   |        |        |        |   |       |      
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Gross profit                                                             |                                      |                                       | 9,825   |        |         |      | 4,079    |        |         |      | 7,181    |        |         |   |        |        |        |   |       |      
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Operating expenses:                                                      |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|                                                                         | Research and development             |                                       |         | 32,396 |         |      |          | 66,091 |         |      |          | 91,180 |         |   |         | 27,336 |        |   |        | 7,366 |      
|                                                                         | Sales and marketing                  |                                       |         | 28,271 |         |      |          | 60,000 |         |      |          | 53,625 |         |   |         | 6,077  |        |   |        | 606   |      
|                                                                         | General and administrative           |                                       |         | 10,959 |         |      |          | 23,525 |         |      |          | 24,441 |         |   |         | 4,980  |        |   |        | 1,106 |      
|                                                                         | Restructuring and impairment charges |                                       |         | 34,538 |         |      |          | 8,991  |         |      |          |       |         |   |         |       |        |   |        |      |      
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|                                                                         |                                      | Total operating expenses              |         |        | 106,164 |      |          |        | 158,607 |      |          |        | 169,246 |   |         |        | 38,393 |   |        |       | 9,078 |  
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Loss from operations                                                     |                                      |                                       | (96,339 | )      |         |      | (154,528 | )      |         |      | (162,065 | )      |         |   | (38,393 | )      |        |   | (9,078 | )    
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Other income (expense):                                                  |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|                                                                         | Interest income                      |                                       |         | 3,535  |         |      |          | 11,086 |         |      |          | 8,060  |         |   |         | 1,250  |        |   |        | 55    |      
|                                                                         | Interest expense                     |                                       |         | (966   | )       |      |          | (1,675 | )       |      |          | (1,866 | )       |   |         | (599   | )      |   |        | (267  | )    
|                                                                         | Other                                |                                       |         | 313    |         |      |          | (299   | )       |      |          | 9      |         |   |         | 21     |        |   |        | (3    | )    
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|                                                                         |                                      | Total other income (expense)          |         |        | 2,882   |      |          |        | 9,112   |      |          |        | 6,203   |   |         |        | 672    |   |        |       | (215  | )
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Loss before income tax provision                                         |                                      |                                       | (93,457 | )      |         |      | (145,416 | )      |         |      | (155,862 | )      |         |   | (37,721 | )      |        |   | (9,293 | )    
|                                                                         | Income tax provision                 |                                       |         | 509    |         |      |          | 837    |         |      |          | 264    |         |   |         |       |        |   |        |      |      
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Net loss                                                                 |                                      |                                       | (93,966 | )      |         |      | (146,253 | )      |         |      | (156,126 | )      |         |   | (37,721 | )      |        |   | (9,293 | )    
|Deemed dividend to series D preferred stockholders                       |                                      |                                       |        |        |         |      |         |        |         |      | (2,500   | )      |         |   |        |        |        |   |       |      
|Net loss allocable to common stockholders                                |                                      | $                                     | (93,966 | )      |         | $    | (146,253 | )      |         | $    | (158,626 | )      |         | $ | (37,721 | )      |        | $ | (9,293 | )    
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Basic and diluted net loss per common share                              |                                      | $                                     | (9.72   | )      |         | $    | (15.09   | )      |         | $    | (52.27   | )      |         | $ | (74.99  | )      |        | $ | (45.33 | )    
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      
|Shares used in computing basic and diluted net
    loss per common share |                                      |                                       | 9,670   |        |         |      | 9,695    |        |         |      | 3,035    |        |         |   | 503     |        |        |   | 205    |      
|                                                                         |                                      |                                       |         |        |         |      |          |        |         |      |          |        |         |   |         |        |        |   |        |      

|                                                        |  |                   |         |      |  |      |         |      |  |      |         |  |  |   |         |   |  |   |        |  
|------------------------------------------------------- |  | ----------------- | ------- | ---- |  | ---- | ------- | ---- |  | ---- | ------- |  |  | - | ------- | - |  | - | ------ | -
|                                                        |  |                  
|                                                        |  | December 31, 2002
|                                                        |  |                  
|                                                        |  | 2002              |         | 2001 |  | 2000 |         | 1999 |  | 1998
|                                                        |  |                   |         |      |  |      |         |      |  |     
|                                                        |  |                  
|                                                        |  | (In thousands)   
|Consolidated Balance Sheets Data:                       |  |                   |         |      |  |      |         |      |  |      |         |  |  |   |         |   |  |   |        |  
|Cash, cash equivalents and short-term investments       |  | $                 | 101,467 |      |  | $    | 164,878 |      |  | $    | 288,282 |  |  | $ | 54,586  |   |  | $ | 6,580  |  
|Working capital                                         |  |                   | 91,868  |      |  |      | 163,424 |      |  |      | 283,027 |  |  |   | 49,584  |   |  |   | 2,900  |  
|Total assets                                            |  |                   | 119,561 |      |  |      | 221,203 |      |  |      | 353,928 |  |  |   | 66,070  |   |  |   | 11,099 |  
|Long-term liabilities                                   |  |                   | 2,200   |      |  |      | 6,464   |      |  |      | 12,218  |  |  |   | 7,907   |   |  |   | 2,710  |  
|Redeemable convertible preferred stock                  |  |                   |        |      |  |      |        |      |  |      |        |  |  |   | 89,388  |   |  |   | 9,823  |  
|Total stockholders equity (net capital
    deficiency) |  |                   | 93,481  |      |  |      | 187,065 |      |  |      | 304,763 |  |  |   | (38,374 | ) |  |   | (6,038 | )

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|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

This report contains forward-looking statements
that are subject to risks and uncertainties. We use words such
as anticipate, believe, plan, expect, future, intend and similar
expressions to identify forward-looking statements. Readers are
cautioned not to place undue reliance on these forward-looking
statements, which reflect managements opinions only as of
the date of this report. Our actual results may vary
significantly from those reflected in these forward-looking
statements. Factors that might cause such a difference include,
but are not limited to, product development, commercialization
and technology difficulties, manufacturing costs, the impact of
competitive products, pricing pressures, changing customer
requirements, timely availability and acceptance of new
products, changes in economic conditions in the various markets
we serve and those factors discussed in the section entitled
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Risk
Factors. We undertake no obligation to revise or publicly
release the results of any revision to these forward-looking
statements. Readers should carefully review the risk factors
described in other documents we file from time to time with the
Securities and Exchange Commission, including the Quarterly
Reports on Form 10-Q to be filed by us in fiscal year 2003.

OVERVIEW

We develop, market and sell a communications
platform that we refer to as our IP Service Delivery Platform.
Our product is designed to enable network service providers to
rapidly deliver a portfolio of communication services to
business and consumer customers. We market our IP Service
Delivery Platform through our direct sales force and through
resellers to network service providers in Asia, Europe and North
America. We provide customer service and support for our
products directly and through support partners.

The market for our IP Service Delivery Platform
is new and evolving, and the volume and timing of orders are
difficult to predict. A customers decision to purchase our
platform typically involves a significant commitment of its
resources and a lengthy evaluation, testing and product
qualification process. The long sales cycles and the timing of
our customers rollout of services made possible by our
platform, which affects repeat business, may cause our revenue
and operating results to vary significantly and unexpectedly
from quarter to quarter.

CRITICAL ACCOUNTING POLICIES AND
ESTIMATES

General

Our discussion and analysis of our financial
condition and results of operations are based upon 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 related disclosure of contingent assets and liabilities. On
an ongoing basis, we evaluate our estimates, including those
related to revenue recognition, inventory valuation, warranties
and allowances for doubtful accounts. Additionally, the audit
committee of our board of directors reviews these critical
accounting estimates at least annually. We base our estimates on
historical experience and on various other assumptions that we
believe to be reasonable under the circumstances. These
estimates form the basis for certain judgments about the
carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from
these estimates.

The following accounting policies are
significantly affected by the judgments and estimates we use in
the preparation of our consolidated financial statements.

Revenue Recognition

Most of our sales are generated from complex
arrangements. Recognizing revenue in these arrangements requires
our making significant judgments, particularly in the areas of
collectibility and customer acceptance.

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Assessing the collectibility of amounts invoiced
to customers is particularly critical. To recognize revenue
before we receive payment, we are required to assess that
collection from the customer is probable. If we cannot satisfy
ourselves that collection is probable, we defer recognizing
revenue until we have collected payment.

Certain of our sales arrangements require formal
acceptance by the customer. In such cases, we do not recognize
revenue until we have received formal notification of
acceptance. Although we work closely with our customers to help
them achieve satisfaction with our products prior to and after
acceptance, the timing of customer acceptance can greatly affect
the timing of our revenue.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts in
connection with estimated losses resulting from the inability of
our customers to pay our invoices. In order to estimate the
appropriate level of this allowance, we analyze historical bad
debts, customer concentrations, current customer
credit-worthiness, current economic trends and changes in our
customer payment patterns. In future periods, if the financial
condition of our customers were to deteriorate and affect their
ability to make payments, additional allowances could be
required.

Inventory Valuation

In assessing the value of our inventory, we are
required to make judgments as to future demand and then compare
that demand with current inventory quantities and firm purchase
commitments. If our inventories and firm purchase commitments
are in excess of forecasted demand, we write down the value of
our inventory. We generally use a 12-month forecast to assess
future demand. Inventory write-downs are charged to cost of
sales. During 2002, we charged $1.5 million of inventory
write-downs to cost of sales primarily as the result of reduced
forecasted demand for our product. If actual demand for our
products is less than our forecasts, additional inventory
write-downs may be required.

Long-lived assets

We evaluate the carrying value of long-lived
assets, consisting primarily of property, plant and equipment,
whenever certain events or changes in circumstances indicate
that the carrying amount of these assets may not be recoverable.
In assessing the recoverability of long-lived assets, we compare
the carrying value to the undiscounted future cash flows the
assets are expected to generate. If the total of the
undiscounted future cash flows is less than the carrying amount
of the assets, the assets will be written down to their
estimated fair value. Fair value is generally determined by
calculating the discounted future cash flows using a discount
rate based upon our weighted average cost of capital or specific
appraisal, as appropriate. Significant judgments and assumptions
are required in the forecast of future operating results used in
the preparation of the estimated future cash flows, including
long-term forecasts of overall market conditions and our
participation in the market. Changes in these estimates could
have a material adverse effect on the assessment of the
long-lived assets, thereby requiring us to record further asset
write-downs in the future. During 2002, we charged
$18.8 million to operating expenses as a result of
impairments.

Warranties

We provide a basic limited warranty, including
repair or replacement of parts, and technical support. The
specific terms and conditions of those warranties vary depending
on the customer or region in which we do business. We estimate
the costs that may be incurred under its basic limited warranty
and record a liability in the amount of such costs at the time
product revenue is recognized. Our warranty obligation is
affected by the number of installed units, product failure
rates, materials usage and service delivery costs incurred in
correcting product failures. We periodically assess the adequacy
of our recorded warranty liabilities and adjust the amounts as
necessary. In future periods, if actual product failure rates,
materials usage or service delivery costs differ from our
estimates, adjustments to cost of sales could result.

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Impact of Equity Issuances on Operating
Results

Equity issuances have a material impact on our
operating results. The equity issuances that have affected
operating results to date include warrants granted to customers
and suppliers, stock options granted to employees and
consultants and stock issued in lieu of cash compensation to
suppliers.

Our revenue in 2001 and 2000 was affected
significantly by warrants issued to our first three customers,
Qwest Communications International, Inc., AduroNet Limited and
Broadband Office, Inc. These warrants were issued upon receipt
of substantial purchase orders which were preceded by a period
of cooperation with us in the marketing, development and
refinement of our products. Our revenue from these customers
consisted of receipts from sales, including equity issued in
connection with sales, less receipts for equity issued in
connection with sales. As of December 31, 2001, the value
of the warrants granted to these customers was fully amortized
and as a result, our revenue in 2002 was not affected by the
value of warrants granted to customers.

Our costs of goods sold and operating expenses
are also affected significantly by charges related to warrants
and options issued for services. Furthermore, some of our
employee stock option transactions have resulted in deferred
compensation, which is presented as a reduction of
stockholders equity on our balance sheet and is amortized
over the vesting period of the applicable options using the
graded vesting method.

The compensation associated with shares and
options relating to the following transactions is required to be
remeasured at the end of each accounting period. The
remeasurement at the end of each accounting period will result
in unpredictable charges or credits in future periods, depending
on future fluctuations in the market prices of our common stock:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Non-recourse promissory notes
    receivable:During the fourth quarter
    of 2000, we converted full-recourse promissory notes received
    from employees upon the early exercise of unvested employee
    stock options to non-recourse obligations. Accordingly, we are
    required to remeasure the compensation associated with these
    shares until the earlier of the shares vesting or the note being
    repaid. Deferred compensation expense, which is recorded at each
    remeasurement, is amortized over the remaining vesting period of
    the underlying options.                                                                                                                                                                                                                          
|
| |  | Repriced stock
    options:In November 2002, we repriced
    1,091,453 outstanding employee stock options to purchase
    shares of our common stock with original exercise prices ranging
    from $5.45 per share to $159.38 per share. These
    options were repriced to $5.00 per share, which was higher
    than the fair market value of the underlying shares on the
    repricing date. In July 2001, we repriced
    722,071 unexercised employee stock options to
    $15.50 per share, the fair market value of the underlying
    shares on the repricing date. These options had previously been
    granted at prices ranging from $40.00 to $400.00 per share.
    The repricing requires that compensation be remeasured for these
    options until they are exercised or canceled, or expire.

Some of the stock options granted to our
employees have resulted in deferred compensation as a result of
stock options having an exercise price below their fair value.
Deferred compensation is presented as a reduction to
stockholders equity on the balance sheet and is then
amortized using an accelerated method over the vesting period of
the applicable options. When an employee terminates, an expense
credit is recorded for any amortization that has been previously
recorded as an expense in excess of vesting.

RESULTS OF OPERATIONS

For the year ended December 31, 2002, we
reported a basic and diluted net loss per common share of $9.72.
For the year ended December 31, 2001, we reported a basic
and diluted net loss per common share of $15.09. For the year
ended December 31, 2000, the first year in which we
recognized revenue, basic and diluted loss per common share was
$52.27. The effects of equity issuances to customers, suppliers,
employees and consultants decreased net loss per common share by
$0.03 for the year ended December 31, 2002 and increased
net loss per common share by $3.62 and $26.15 for the years
ended December 31, 2001 and 2000,

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respectively. All per share amounts have been
restated to reflect our 1-for-10 reverse stock split, which
occurred in September 2002.


Revenue

We recognize product revenue at the time of
shipment, assuming that persuasive evidence of an arrangement
exists, the sales price is fixed or determinable and
collectibility is probable, unless we have future obligations
for installation or require customer acceptance, in which case
revenue is deferred until these obligations are met. Our product
incorporates software that is not incidental to the related
hardware and, accordingly, we recognize revenue in accordance
with the American Institute of Certified Public Accountants
issued Statement of Position 97-2 Software Revenue
Recognition. For arrangements that include the delivery of
multiple products, the revenue is allocated to the various
products based on vendor-specific objective evidence of
fair value (VSOE). We establish VSOE based on either the
price charged for the product when the same product is sold
separately or for products not yet sold separately, based on the
list prices of such products individually established by
management with the relevant authority to do so. Revenue from
post-contract support obligations for specified future periods
is deferred and recognized on a straight-line basis over the
service period. Revenue from consulting services is recognized
as the services are provided. Amounts billed in excess of
revenue recognized are included as deferred revenue in the
accompanying consolidated balance sheets. We record estimated
warranty costs based on our projections of the costs of
fulfilling our warranty obligations.

For the year ended December 31, 2002,
revenue was $23.6 million, of which 79% was from hardware
sales, 8% was from software sales and 13% was from sales of
services. For the year ended December 31, 2001, revenue was
$34.3 million, of which 63% was from hardware sales, 9% was
from software sales and 28% was from sales of services. Receipts
from sales, including equity issued in connection with sales,
were $37.3 million. For the year ended December 31,
2000, revenue was $31.1 million, of which 86% was from
hardware sales, 8% was from software sales and 6% was from sales
of services. Receipts from sales, including equity issued in
connection with sales, were $41.6 million.

Below is a reconciliation of revenue for the
years ended December 31, 2002, 2001 and 2000 as presented
in our statement of operations to show the separate components
as indicated (in thousands):

|                                                                          |  |      |        |      |  |      |        |  |  |   |        | 
|------------------------------------------------------------------------- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|                                                                          |  | 2002 |        | 2001 |  | 2000
|                                                                          |  |      |        |      |  |     
|Receipts from sales, including equity issued in
    connection with sales |  | $    | 23,632 |      |  | $    | 37,296 |  |  | $ | 41,618 | 
|Less: Receipts for equity issued in connection
    with sales             |  |      |       |      |  |      | 3,003  |  |  |   | 10,511 | 
|                                                                          |  |      |        |      |  |      |        |  |  |   |        | 
|Revenue                                                                   |  | $    | 23,632 |      |  | $    | 34,293 |  |  | $ | 31,107 | 
|                                                                          |  |      |        |      |  |      |        |  |  |   |        | 

We issued no warrants to customers during the
years ended December 31, 2002 and 2001.

We issued the following warrants to customers
during the year ended December 31, 2000:

A warrant exercisable for 123,350 shares of
our Series C preferred stock at an exercise price of
$8.10 per share issued to Qwest upon receipt of a purchase
order from Qwest for $18.3 million of our products and
services;

A warrant exercisable for 20,000 shares of
our common stock at an exercise price of $40.00 per share
issued to AduroNet upon receipt of a purchase order from
AduroNet for $20.7 million of our products and
services; and

A warrant exercisable for 46,885 shares of
our common stock at an exercise price of $37.30 per share
issued to BroadBand Office upon receipt of a purchase order from
BroadBand Office for $20.0 million of our products and
services. BroadBand Office filed for bankruptcy in May 2001 and
subsequently we wrote off the remaining unamortized portion of
this warrant.

We calculated the fair value of these
customer-related warrants to be $16.3 million
($10.3 million in the case of Qwest, $1.9 million in
the case of AduroNet and $4.1 million in the case of
BroadBand Office). These

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values were calculated using the Black-Scholes
option pricing model, using volatility of 0.6, a risk-free
interest rate of 5% and an expected life of four years. Of these
amounts, $3.0 million ($1.4 million related to Qwest,
$0.5 million related to AduroNet and $1.1 million
related to revenue recognized in 2000 for BroadBand Office, as a
result of BroadBand Offices bankruptcy in 2001) was
recognized as offsets to receipts from sales, including equity
issued in connection with sales in determination of revenue for
the year ended December 31, 2001, and $10.5 million
($8.9 million related to Qwest, $1.3 million related
to AduroNet and $0.3 million related to BroadBand Office)
was recognized as offsets to receipts from sales, including
equity issued in connection with sales in determination of
revenue for the year ended December 31, 2000. Our revenue
in 2002 is no longer affected by the value of warrants granted
to customers.


In the second quarter of 2001, one of our
customers filed for bankruptcy. As a result, the
$3.8 million of previously unamortized fair value of the
warrants issued to that customer was written off. Approximately
$1.1 million was charged against revenue representing the
amount of revenue previously recognized for this customer and
approximately $2.7 million was charged to sales and
marketing expense.

As of December 31, 2002, 2001 and 2000, we
deferred $1.4 million, $2.7 million and
$7.6 million, respectively, of revenue from contracts that
we immediately invoiced but which provide for subsequent
customer acceptance, consulting services and post-contract
support services. At December 31, 2002 and 2001, there were
no unamortized non-cash charges relating to customer-related
warrants and at December 31, 2000, the unamortized portion
of non-cash charges related to warrants issued to customers was
$5.7 million.

Non-Cash Charges and Credits Related to Equity
Issuances

During 2002, we benefited from $0.3 million
of non-cash credits related to equity issuances to cost of goods
sold, operating expenses and interest expense. During 2001 and
2000, we amortized $32.1 million and $68.8 million of
non-cash charges related to equity issuances, respectively, to
cost of goods sold, operating expenses and interest expense.
During the second quarter of 2001, $2.7 million was
included in sales and marketing expense for the write off of the
unamortized portion of BroadBand Offices warrants due to
their bankruptcy.

During 2002, in relation to non-recourse
promissory notes, we recorded a reversal of deferred stock
compensation of $4,916,000 due to employee terminations, a
reduction of deferred compensation of $282,000 due to the
remeasurement of compensation associated with these unvested
shares and amortization of $173,000. During 2001, we recorded a
reduction deferred stock compensation due to the remeasurement
of compensation associated with these unvested shares amounting
to $31,586,000 and a reversal of amortization of $526,000.
During 2001, we recorded additional deferred stock compensation
of $39,718,000 and amortization of $8,217,000 relating to the
remeasurement of compensation associated with these unvested
shares.

During 2002, we recorded deferred stock
compensation in relation to repriced stock options amounting to
$1,111,000 and amortization of $514,000, as the price of our
stock at the end of the quarter after the November 2002
repricing was higher than the repriced amount. During 2001, we
recorded no deferred stock compensation in relation to repriced
stock options, as the price of our stock at the end of each
quarter after the July 2001 repricing was not higher than the
repriced amount.

We recorded amortization of deferred compensation
related to stock options granted to employees prior to our
initial public offering having an exercise price below fair
market value of $7,273,000, $29,687,000 and $51,563,000 during
2002, 2001 and 2000, respectively.

During 2002, we recorded credits of $8,466,000
related to the reversal of deferred stock compensation
amortization in excess of vesting for terminated employees.

During 2002, we recorded a charge of $27,000
related to options with accelerated vesting.

In connection with warrants or stock options
issued to non-employees and in conjunction with lease and debt
agreements, we recorded amortization charges of $195,000,
$218,000 and $8,984,000 during 2002, 2001 and 2000, respectively.

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Cost of Goods Sold

Cost of goods sold includes all costs of
producing our sold products, including the costs of outsourced
manufacturing, software royalties, shipping, warranties, related
manufacturing overhead costs and the costs of providing our
service offerings, including personnel engaged in providing
maintenance and consulting services to our customers. To the
extent that the value of inventory is written down, this will be
reflected in cost of goods sold. We have also incurred non-cash
charges and credits related to equity issuances. We have
outsourced the majority of our manufacturing and repair
operations. A significant portion of our cost of goods sold
consists of payments to our contract manufacturers. We conduct
manufacturing engineering, final assembly, configuration testing
and documentation control at our facilities in Redwood City,
California.

For the year ended December 31, 2002, cost
of goods sold was $13.8 million, of which
$12.6 million or 92% represented materials, labor,
production overhead and warranties, $1.5 million or 11%
represented inventory write-downs, $1.0 million or 7%
represented software royalties, ($0.1) million or (1%)
represented non-cash credits related to equity issuances in
manufacturing operations and ($1.2) million or (9%)
represented fully reserved inventory sold. For the year ended
December 31, 2001, cost of goods sold was
$30.2 million, of which $12.7 million or 41%
represented materials, labor, production overhead and
warranties, $12.3 million or 42% represented inventory
write-downs, $2.3 million or 8% represented non-cash
charges related to equity issuances in manufacturing operations
and $2.9 million or 9% represented software royalties. For
the year ended December 31, 2000, cost of goods sold was
$23.9 million, of which $16.6 million or 69%
represented materials, labor and production overhead,
$4.3 million or 18% represented warranty costs,
$3.1 million or 13% represented non-cash charges related to
equity issuances in manufacturing operations and
$1.1 million or 4% represented software royalties.

Gross Profit

For the years ended December 31, 2002, 2001
and 2000, gross profit was $9.8 million, or 42% of revenue,
$4.1 million, or 12% of revenue and $7.2 million, or
23% of revenue, respectively.

The components of the change in the gross margin
for the years ended December 31, 2002 and 2001,
respectively, were as follows:

|                                             |  |         |     |         |  |  |     |   
|-------------------------------------------- |  | ------- | --- | ------- |  |  | --- | --
|                                             |  | 2002    |     | 2001   
|                                             |  | % of    |     | % of   
|                                             |  | Revenue |     | Revenue
|                                             |  |         |     |        
|Inventory write-downs                        |  |         | 30  |         |  |  | (27 | ) 
|Non-cash charges related to equity issuances |  |         | 7   |         |  |  | 3   |   
|Credits for fully reserved inventory sold    |  |         | 5   |         |  |  |    |   
|Software royalty expense                     |  |         | 4   |         |  |  | (5  | ) 
|Warranty expense                             |  |         |    |         |  |  | 13  |   
|Materials, labor and production overhead     |  |         | (16 | )       |  |  | 5   |   
|                                             |  |         |     |         |  |  |     |   
|                                             |  |         | 30  | %       |  |  | (11 | )%
|                                             |  |         |     |         |  |  |     |   

Research and Development Expenses

Research and development expenses consist
primarily of salaries and related personnel costs, fees paid to
contractors and outside service providers, and the costs of
laboratory equipment and prototypes related to the design,
development and testing of our products. We have also incurred
non-cash charges and credits related to equity issuances. We
expense our research and development costs as they are incurred.
Several components of our research and development effort
require significant expenditures, the timing of which can cause
significant quarterly variability in our expenses. The number of
prototypes required to build and test a complex product such as
the IP Service Delivery Platform is large, and this building and
testing process occurs over a short period of time.

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Research and development expenses were
$32.4 million, $66.1 million and $91.2 million
for the years ended December 31, 2002, 2001 and 2000,
respectively. The decrease for the year ended December 31,
2002 was $33.7 million or 51% when compared with the year
ended 2001. This resulted partly from a $14.9 million
reduction in salary and employee-related expenses reflecting
lower headcount in the current period. Non-cash charges related
to equity issuances were lower by $11.2 million due to the
reversal of amortization of deferred compensation in excess of
vesting for employees who were terminated and our use of an
accelerated amortization method for employee stock compensation,
which results in lower charges in each subsequent period.
Facilities and information technology infrastructure costs were
$3.6 million lower as a result of reductions in personnel
and square footage occupied. Depreciation expense was
$2.9 million lower due to the reduced carrying value of
assets resulting from impairment charges recorded in the second
and third quarters of 2002 (See Note 9 of the Notes to the
Consolidated Financial Statements for further details). The
decrease for the year ended December 31, 2001 was
$25.1 million or 28% when compared with the year ended
2000. This decrease resulted from decreased non-cash charges
related to equity issuances.

Non-cash credits related to equity issuances were
$0.4 million for the year ended December 31, 2002, and
non-cash charges related to equity issuances were
$10.8 million and $34.7 million for the years ended
December 31, 2001 and 2000, respectively.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of
salaries and related expenses for personnel engaged in sales,
marketing and customer evaluations, as well as the costs
associated with customer evaluations and trials and other
promotional and marketing expenses. We devote substantial sales
and marketing resources to customer evaluations and trials. The
complexity of our IP Service Delivery Platform and the networks
in which it is installed and integrated may often require
extensive evaluation periods and trials. These trials are
conducted by our customers at customer-designated locations or
within our sales laboratories and require support from our
highly trained systems engineers and service and support
personnel. These evaluations and trials generally take
approximately three to 12 months. We anticipate that
customer evaluations and trials will continue to require a
substantial amount of our sales and marketing resources. We have
also incurred non-cash charges related to equity issuances.

Sales and marketing expenses were
$28.3 million, $60.0 million and $53.6 million
for the years ended December 31, 2002, 2001 and 2000,
respectively. The decrease for the year ended December 31,
2002 was $31.7 million or 53% when compared with the year
ended 2001. This resulted partly from a $13.6 million
decrease in non-cash charges related to equity issuances due to
the reversal of amortization of deferred compensation in excess
of vesting for employees who were terminated and our use of an
accelerated amortization method for employee stock compensation,
which results in lower charges in each subsequent period. Salary
and employee-related expenses were reduced by $9.2 million
reflecting lower headcount in the current period and lower
commission expense. Marketing program expense declined by
$3.5 million due to cost saving measures. Travel expense
declined by $2.2 million due to lower headcount and the
implementation of cost saving measures. Evaluation unit and lab
amortization expense declined by $1.8 million due to
reduced trials and the reduced carrying value of assets
resulting from impairment charges recorded in the second and
third quarters of 2002 (See Note 9 of the Notes to the
Consolidated Financial Statements for further details). Finally,
facilities and information technology infrastructure expense
declined by $1.7 million. The increase in sales and
marketing expense was $6.4 million or 12% for the year
ended December 31, 2001 when compared with the same period
of 2000. This increase resulted from increased salary and
related employee expenses, facilities costs, depreciation and
marketing programs offset by a decrease in non-cash charges
related to equity issuances.

Non-cash credits related to equity issuances were
$0.9 million for the year ended December 31, 2002, and
non-cash charges related to equity issuances were
$12.7 million and $17.9 million for the years ended
December 31, 2001 and 2000, respectively.

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General and Administrative Expenses

General and administrative expenses consist
primarily of salaries and related expenses for executive,
finance, legal, accounting and human resources personnel as well
as other corporate expenses, including non-cash charges related
to equity issuances.

General and administrative expenses were
$11.0 million, $23.5 million and $24.4 million
for the years ended December 31, 2002, 2001 and 2000,
respectively. The decrease for the year ended December 31,
2002 was $12.5 million or 53% when compared with the year
ended 2001. This resulted partly from a $5.3 million
decrease in non-cash charges related to equity issuances due to
the reversal of amortization of deferred compensation in excess
of vesting for employees who were terminated and our use of an
accelerated amortization method for employee stock compensation,
which results in lower charges in each subsequent period. Salary
and employee-related expenses declined by $3.4 million
reflecting lower headcount in the current period. Depreciation
expense was lower by $1.8 million due to the reduced
carrying value of assets resulting from impairment charges
recorded in the second and third quarters of 2002 (See
Note 9 of the Notes to the Consolidated Financial
Statements for further details). Reduced use of outside
professional services resulted in a decrease of
$0.8 million. General and administrative expenses decreased
$0.9 million or 4% in 2001 when compared with 2000. This
decrease resulted from a decrease in non-cash charges related to
equity issuances offset by increases in salary and related
employee expenses, insurance and other office costs and
depreciation.

General and administrative non-cash charges
related to equity issuances were $0.9 million,
$6.2 million and $12.9 million for the years ended
December 31, 2002, 2001 and 2000, respectively.

Restructuring and Impairment Charges



| |                           
| | --------------------------
| | October 2002 Restructuring

In October 2002, our senior management approved a
restructuring plan to reduce its worldwide workforce. In
addition, based on ongoing negotiations, we estimate that we
will be able to settle our obligations associated with Redwood
City, California leased facilities we exited during the year for
$8.1 million. Employees were notified in October 2002 that
certain job functions would be eliminated and that particular
termination benefits would be paid to affected employees. As a
result of the workforce reduction, 73 employees were
designated for termination in the restructuring program. Most of
the terminations took place in the fourth quarter of 2002. The
employees affected by the workforce reduction were from all
functional groups and were located in offices in the United
States, Europe and Asia. Amounts related to the worldwide
workforce reduction and lease commitment will be paid out
through March of 2002.

The restructuring program was implemented to
reduce operating expenses and conserve cash and is expected to
reduce quarterly operating expenses, excluding non-cash charges
or credits related to equity issuances, by approximately
$3.9 million by the first quarter of 2003, a 26% reduction
as compared to the third quarter of 2002.

Details of the October 2002 restructuring charges
for the year ended December 31, 2002 are as follows, (in
thousands):

|                                           |  |           |        |             |  |       |       |  |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ----------- |  | ----- | ----- |  |  | - | ------ | -
|                                           |  | Worldwide |        | Lease       |  |      
|                                           |  | Workforce |        | Termination |  |      
|                                           |  | Reduction |        | and Other   |  | Total
|                                           |  |           |        |             |  |      
|Charges                                    |  | $         | 1,945  |             |  | $     | 7,854 |  |  | $ | 9,799  |  
|Cash payments                              |  |           | (1,628 | )           |  |       |      |  |  |   | (1,628 | )
|Deposit forfeiture and deferred rent       |  |           |       |             |  |       | 305   |  |  |   | 305    |  
|                                           |  |           |        |             |  |       |       |  |  |   |        |  
|Provision balance at December 31,
    2002 |  | $         | 317    |             |  | $     | 8,159 |  |  | $ | 8,476  |  
|                                           |  |           |        |             |  |       |       |  |  |   |        |  

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| |                       
| | ----------------------
| | May 2002 Restructuring

In May 2002, our senior management approved a
restructuring plan to reduce its worldwide workforce, close
certain sales offices, exit certain facilities and dispose of or
abandon certain property and equipment. Employees were notified
in May 2002 that certain job functions would be eliminated and
that particular termination benefits would be paid to affected
employees. As a result of the workforce reduction,
146 employees were designated for termination in the
restructuring program. Most of the terminations took place in
the second quarter of 2002, with the remainder taken in the
third quarter of 2002. The employees affected by the workforce
reduction were from all functional groups and were located in
our offices in the United States, Europe and Asia. Amounts
related to the worldwide workforce reduction were paid out
through December of 2002, and lease commitments and
non-cancelable commitments are being paid out over their
respective terms through 2003. We also wrote down certain
property and equipment to its expected realizable value as the
assets have been either sold, disposed of or otherwise abandoned.

The restructuring program was implemented to
reduce operating expenses and conserve cash. Due to this
restructuring we realized a cost savings, excluding non-cash
charges related to equity issuances, of approximately
$10.0 million per quarter, starting in the third quarter of
2002, as compared to the first quarter of 2002.

Details of the May 2002 restructuring charges for
the year ended December 31, 2002 are as follows, (in
thousands):

|                                           |  |           |        |             |  |             |        |       |  |   |        |   |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ----------- |  | ----------- | ------ | ----- |  | - | ------ | - |  | - | ------ | -
|                                           |  |           |        | Write-down  |  |             |        |      
|                                           |  | Worldwide |        | of Property |  | Lease       |        |      
|                                           |  | Workforce |        | and         |  | Commitments |        |      
|                                           |  | Reduction |        | Equipment   |  | and Other   |        | Total
|                                           |  |           |        |             |  |             |        |      
|Charges                                    |  | $         | 3,660  |             |  | $           | 3,248  |       |  | $ | 2,318  |   |  | $ | 9,226  |  
|Cash payments                              |  |           | (3,660 | )           |  |             |       |       |  |   | (1,503 | ) |  |   | (5,163 | )
|Non-cash charges                           |  |           |       |             |  |             | (3,248 | )     |  |   |       |   |  |   | (3,248 | )
|                                           |  |           |        |             |  |             |        |       |  |   |        |   |  |   |        |  
|Provision balance at December 31,
    2002 |  | $         |       |             |  | $           |       |       |  | $ | 815    |   |  | $ | 815    |  
|                                           |  |           |        |             |  |             |        |       |  |   |        |   |  |   |        |  



| |                                    
| | -----------------------------------
| | Impairment of Long-lived
    Assets

As a result of our assessment of market
conditions and the related effect on our business plan, we
concluded that indicators of impairment of its long-lived assets
were present during the second and third quarters of 2002.
Accordingly, we performed an impairment test of the carrying
value of our long-lived assets, consisting primarily of property
and equipment in accordance with Financial Accounting Standards
Board Statement Number 144, Accounting for the
Impairment or Disposal of Long-Lived Assets
(SFAS 144). Based on an undiscounted cash flow analysis,
the cash flows expected to be generated by our long-lived assets
during their estimated remaining useful lives were not
sufficient to recover the net book value of the assets.
Consequently, we obtained a valuation report outlining the
estimated fair value of the assets, based on quoted market
prices, from an independent appraiser and recorded an impairment
charge of approximately $15.5 million to write the carrying
value of our long-lived assets held for use down to their fair
values in the second and third quarters of 2002. In addition,
property and equipment that was idled or abandoned was written
down by approximately $3.2 million to its estimated net
realizable value.



| |                                           
| | ------------------------------------------
| | April and September 2001
    Restructuring

In April and September of 2001, our senior
management approved restructuring plans to reduce its worldwide
workforce, close certain sales offices, exit certain facilities
and idle certain property and equipment. Employees affected by
the April 2001 program were notified and terminated in April
2001. With respect to the September 2001 program, notification
was given to employees on September 28, 2001 that certain
job functions would be eliminated and that particular
termination benefits would be paid to affected employees. The
restructuring programs were implemented to reduce operating
expenses and conserve cash.

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Details of the April and September 2001
restructuring charges for the years ended December 31, 2002
and 2001 are as follows (in thousands):

|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ----------- |  | ----------- | ------ | ----- |  | - | ---- | - |  | - | ------ | -
|                                           |  |           |        | Write-down  |  |             |        |      
|                                           |  | Worldwide |        | of Property |  | Lease       |        |      
|                                           |  | Workforce |        | and         |  | Commitments |        |      
|                                           |  | Reduction |        | Equipment   |  | and Other   |        | Total
|                                           |  |           |        |             |  |             |        |      
|Charges                                    |  | $         | 3,496  |             |  | $           | 4,593  |       |  | $ | 902  |   |  | $ | 8,991  |  
|Cash payments                              |  |           | (3,155 | )           |  |             |       |       |  |   | (135 | ) |  |   | (3,290 | )
|Non-cash charges                           |  |           |       |             |  |             | (4,593 | )     |  |   |     |   |  |   | (4,593 | )
|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  
|Provision balance at December 31,
    2001 |  | $         | 341    |             |  | $           |       |       |  | $ | 767  |   |  | $ | 1,108  |  
|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  
|Cash payments                              |  |           | (341   | )           |  |             |       |       |  |   | (767 | ) |  |   | 1,108  |  
|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  
|Provision balance at December 31,
    2002 |  | $         |       |             |  | $           |       |       |  | $ |     |   |  | $ |       |  
|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  

As a result of the workforce reductions,
approximately 55 employees were terminated in the second
quarter of 2001, and approximately 50 employees were
designated for termination in the third quarter of 2001
restructuring program and were then terminated in the fourth
quarter of 2001. The employees in both workforce reductions were
from all functional groups and were primarily located in the
Redwood City, California offices. Certain property and equipment
has been written down to its expected realizable value. Due to
these restructurings we realized a cost savings, excluding
non-cash charges related to equity issuances, of approximately
$5.9 million per quarter, starting in the first quarter of
2002, as compared to the first quarter of 2001.

Amounts related to the worldwide workforce
reduction were paid out through mid-2002, and lease commitments
were paid out over the respective lease terms through mid-2002.

Interest and Other Income (Expense)

For the year ended December 31, 2002,
interest and other income (expense) was $3.8 million, a
decrease of $7.0 million when compared with 2001. This
reflects decreased interest income due to lower levels of cash
and short-term investments and lower interest rates on invested
amounts. For the year ended December 31, 2001, interest and
other income (expense) was $10.8 million, an increase
of $2.7 million when compared with 2000. The increase
reflects increased investment activity, which was the result of
larger cash balances and short-term investments.

Interest Expense

For the year ended December 31, 2002,
interest expense was $1.0 million, a decrease of
$0.7 million when compared with 2001. For the year ended
December 31, 2001, interest expense was $1.7 million,
a decrease of $0.2 million when compared with 2000. The
decreases reflect reduced equipment loans and capital leases.

Income Tax Provision

Provisions for income taxes of $0.5 million,
$0.8 million and $0.3 million for the years ended
December 31, 2002, 2001 and 2000, respectively, were
comprised entirely of foreign corporate income taxes, which are
a function of our operations in subsidiaries in various
countries. The provision for income taxes is based on income
taxes on minimum profits the foreign operations generated for
services they provided to us. Our tax expense for fiscal 2003
will continue to depend on the amount and mix of income derived
from sources subject to corporate income taxes of foreign taxing
jurisdictions.

As of December 31, 2002, we had federal and
state net operating loss carryforwards of approximately
$232.0 million and $101.0 million, respectively. As of
December 31, 2002, we also had federal and state research
and development tax credit carryforwards of approximately
$3.1 million and $3.5 million, respectively. The net
operating loss and tax credit carryforwards will expire at
various dates beginning in 2005, if not utilized.

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As of December 31, 2001, we had federal and
state net operating loss carryforwards of approximately
$153.0 million and $110.0 million, respectively. As of
December 31, 2001, we also had federal and state research
and development tax credit carryforwards of approximately
$2.6 million and $2.5 million, respectively.

We have not recognized any benefit from the
future use of net operating loss carryforwards for these
periods, or for any other periods, since our incorporation. We
are not recognizing the potential tax benefits of our net
operating loss carryforwards because we do not have sufficient
evidence that we will generate adequate profits to use them.

Use of the net operating loss and tax credit
carryforwards may be subject to substantial annual limitation
due to the ownership change limitations provided by the Internal
Revenue Code of 1986, and similar state provisions. The annual
limitation may result in the expiration of net operating loss
and tax credit carryforwards before utilization.

Deemed Dividend

In 2000, we sold 62,500 shares of
series D redeemable convertible preferred stock at
$80.00 per share for which we received proceeds of
$5.0 million. At the date of issuance, we believed that the
per share price of $80.00 represented the fair value of the
preferred stock. After our initial public offering process
began, we reevaluated and increased the fair value of our common
stock at March 2000. The increase in fair value resulted in a
beneficial conversion feature of $2.5 million, which we
recorded as a deemed dividend to preferred stockholders in 2000.
We recorded the deemed dividend at the date of issuance by
offsetting charges and credits to stockholders equity. The
preferred stock dividend increased the net loss allocable to
common stockholders in the calculation of basic and diluted net
loss per common share for the year ended December 31, 2000.

LIQUIDITY AND CAPITAL RESOURCES

Prior to our initial public offering in September
2000, we financed our operations primarily through sales of
convertible preferred stock for net proceeds of
$166.6 million, plus equipment and working capital loans
and capital leases. Upon the closing of our initial public
offering on September 29, 2000, we received cash proceeds,
net of underwriters discount and offering expenses,
totaling $242.5 million, and all of our convertible
preferred stock was converted into 7.0 million shares of
common stock.

Cash, Cash Equivalents and Short-Term
Investments

At December 31, 2002, cash, cash equivalents
and short-term investments were $101.5 million. This
compares with $164.9 million at December 31, 2001.

Operating Activities

We used $54.7 million in cash for operations
for the year ended December 31, 2002, a decrease of
$45.4 million from the amount used in 2001. The decrease in
use of cash in 2002 was primarily the result of an improvement
in working capital and a lower net loss. The working capital
improvement was primarily due to reductions in accounts
receivable, inventory and deferred revenue. We used
$100.0 million in cash for operations for the year ended
December 31, 2001, an increase of $43.2 million from
the amount used in 2000. The increase in use of cash in 2001 was
primarily the result of a higher net loss and cash used for
working capital. The cash used for working capital was primarily
due to reduction in deferred revenue

Investing Activities

For the year ended December 31, 2002, we
used $4.7 million in cash for investing activities, a
decrease of $57.2 million over 2001. The decrease in cash
provided in 2002 represents a reduction in proceeds from the
sales and maturities of short-term investments partially offset
by a reduction in capital expenditures. For the year ended
December 31, 2001, we provided $52.4 million in cash
for investing activities, an increase of

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$219.7 million over 2000. The increase in
cash provided in 2001 primarily represents sales and maturities
of short-term investments.


Financing Activities

For the year ended December 31, 2002, we
used $5.2 million in cash from financing activities, an
increase of $0.6 million from 2001. The increase in cash
used resulted from reduced proceeds from issuances of common
stock. For the year ended December 31, 2001, we used
$4.6 million in cash from financing activities, a decrease
of $334.7 million from 2000. The increase in cash used in
2001 primarily reflects decreased proceeds from issuance of
common stock.

Contractual Obligations

Our contractual obligations as of
December 31, 2002 are as follows (in thousands):

|                                                |       |       |        |        |  |             |        |             |  |            |       |       |  |   |       |       |  |   |       |       | 
|----------------------------------------------- | ----- | ----- | ------ | ------ |  | ----------- | ------ | ----------- |  | ---------- | ----- | ----- |  | - | ----- | ----- |  | - | ----- | ----- | 
|                                                |       |       |        | Due in |  | Due in 2004 |        | Due in 2006 |  | Due       
|                                                |       | Total |        | 2003   |  | and 2005    |        | and 2007    |  | Thereafter
|                                                |       |       |        |        |  |             |        |             |  |           
|Equipment and working capital loans             |       | $     | 2,135  |        |  | $           | 2,002  |             |  | $          | 133   |       |  | $ |      |       |  | $ |      |      
|Capital lease obligations                       |       |       | 1,965  |        |  |             | 1,965  |             |  |            |      |       |  |   |      |       |  |   |      |      
|Operating lease obligations                     |       |       | 28,736 |        |  |             | 10,401 |             |  |            | 4,255 |       |  |   | 4,461 |       |  |   | 9,619 |      
|Raw material components                         |       |       | 2,131  |        |  |             | 2,131  |             |  |            |      |       |  |   |      |       |  |   |      |      
|Accrued severance-related restructuring charges |       |       | 317    |        |  |             | 317    |             |  |            |      |       |  |   |      |       |  |   |      |      
|                                                |       |       |        |        |  |             |        |             |  |            |       |       |  |   |       |       |  |   |       |      
|                                                | Total |       | $      | 35,284 |  |             | $      | 16,816      |  |            | $     | 4,388 |  |   | $     | 4,461 |  |   | $     | 9,619 | 
|                                                |       |       |        |        |  |             |        |             |  |            |       |       |  |   |       |       |  |   |       |      

Approximately $79,000 of the operating lease
payments due in 2003 was accrued as part of our May 2002
restructuring program. As part of our October 2002 restructuring
program, $8,104,000 was accrued for an expected Redwood City,
California leased facility settlement.

We believe that we possess sufficient liquidity
and capital resources to fund our operating and working capital
requirements for at least the next 12 months. We may
require additional funds to support other purposes and may seek
to raise these additional funds through debt or equity financing
or from other sources. There can be no assurances that
additional funding will be available at all, or that if
available, such financing will be obtainable on terms favorable
to us.

OUTLOOK

We believe that capital spending in the
telecommunications industry will recover in the long-term (two
to five years). However, due to reductions in capital spending
plans by our customers and uncertainty within the
telecommunications industry, the outlook for growth in 2003 is
not favorable and the outlook for 2004 cannot be determined with
certainty at this time. The lack of capital availability for
many emerging service providers combined with the emphasis of
larger service providers on reducing operating expenses, has
caused a significant reduction in capital spending in the
industry as a whole. While we believe this is a short-term (up
to two years) phenomenon, it has had a direct impact on our
operations. We anticipate that this capital spending trend will
continue to have a substantial, adverse effect on our revenue
growth for at least the remainder of the 2003 fiscal year.
Because capital continues to be scarce, we believe that pricing
will continue to be under pressure as each potential customer
attempts to improve returns on invested capital. Until capital
spending levels within the telecommunications industry begin to
recover, we will focus our efforts on controlling costs and
increasing our market share. However, there can be no assurance
that we will succeed in meeting these objectives.

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Recent Accounting Pronouncements

In June 2002, the Financial Accounting Standards
Board (FASB) issued Statement Number 146,
Accounting for Costs Associated with Exit or Disposal
Activities, (SFAS 146) which addresses accounting for
restructuring and similar costs. SFAS 146 supersedes
previous accounting guidance, principally Emerging Issues Task
Force (EITF) Issue No. 94-3 Liability
Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring). SFAS 146 requires recognition of the
liability for costs associated with an exit or disposal activity
when we exit the facility, whereas under EITF Issue
No. 94-3, a liability for an exit cost is recognized at the
date a company commits to an exit plan. In addition,
SFAS 146 establishes that the liability should initially be
measured and recorded at fair value. Accordingly, SFAS 146
may affect the timing of recognizing future restructuring costs,
as well as the amounts recognized. Application of SFAS 146
is required for restructuring activities initiated after
December 31, 2002. The effect of the adoption of
SFAS 146 is dependent on our related activities subsequent
to the date of adoption.

In November 2002, the FASB issued FASB
Interpretation No. 45, Guarantors Accounting
and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others  an
Interpretation of FASB Statements No. 5, 57, and 107 and
Rescission of FASB Interpretation No. 34. The
Interpretation elaborates on the disclosures to be made by a
guarantor in its interim and annual financial statements about
its obligations under certain guarantees that it has issued. It
also requires a guarantor to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. The initial recognition and
measurement provisions of the Interpretation apply to guarantees
issued or modified after December 31, 2002 and we are still
assessing the potential impact of that adoption on our financial
statements. We have adopted the disclosure provisions of FASB
Interpretation No. 45 for the year ended December 31,
2002.

In December 2002, the FASB issued Statement
Number 148, Accounting for Stock-Based
Compensation  Transition and Disclosure
(SFAS 148). SFAS 148 amends Statement Number 123,
Accounting for Stock-Based Compensation,
(SFAS 123) to provide alternative methods of transition to
the SFAS 123 fair value method of accounting for
stock-based employee compensation. In addition, SFAS 148
requires disclosure of the effects of an entitys
accounting policy with respect to stock-based employee
compensation on reported net income and earnings per share in
annual and interim financial statements. As permitted under
SFAS 148, we are adopting only the disclosure provisions of
that accounting standard effective for the year ended
December 31, 2002.

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RISK FACTORS

The following discussion describes certain risk
factors related to our business as well as to our industry in
general.



| |                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------
| | We have a history of losses that we expect
    will continue, and if we never achieve profitability we may
    cease operations.

At December 31, 2002, we had an accumulated
deficit of $443.5 million. We have incurred net losses
since our incorporation. We cannot be certain that our revenue
will grow or that we will generate sufficient revenue to become
profitable. If we do not achieve profitability, we may cease
operations.



| |                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Due to our loss-making activity we could
    lose major opportunities with large service providers who are
    concerned with our long-term financial viability.

Many large telecommunications service providers
purchase capital equipment from vendors with a history of
successful operations including positive cash flow. Our history
of losses and use of cash in operations may cause certain
service providers to decide not to purchase our equipment
because of concerns regarding our long-term financial viability
and our ability to support their businesses. Unless we can
generate positive cash flows by either increasing revenues
and/or decreasing costs, concerns regarding our long-term
financial viability may cause some potential customers to
purchase product from other larger, more established suppliers
including Cisco Systems, Lucent Technologies, Nortel Networks,
Alcatel, Ericsson, Siemens and Juniper Networks.



| |                                                                                                           
| | ----------------------------------------------------------------------------------------------------------
| | The outlook for capital spending in the
    telecommunications industry directly impacts our
    business.

Due to reductions in capital spending plans by
our customers and uncertainty within the telecommunications
industry, the outlook for growth in 2003 is not favorable.
Capital spending in the industry as a whole has slowed as a
result of a lack of available capital for many emerging service
providers and a generally cautious approach to capital spending
within the industry.

While we believe this is a short-term (up to two
years) phenomenon, we anticipate that this trend will continue
to have a substantial, adverse effect on our revenue growth for
at least the remainder of the 2003 fiscal year.



| |                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We participate in a competitive
    marketplace, and our failure to compete successfully would limit
    our ability to increase our market share and harm our
    business.

Competition in the network infrastructure market
is intense, and we expect that competition in the market for IP
networking services will also be intense. If we are unable to
compete effectively, our revenue and market share will be
negatively affected.

We face competition from companies in the network
infrastructure market, including Cisco Systems, Lucent
Technologies, Nortel Networks, Alcatel, Ericsson, Siemens and
Juniper Networks.

We believe that there is likely to be
consolidation in our industry. We expect to face increased
competition from larger companies with significantly greater
resources than we have.

Some of these larger competitors have
pre-existing relationships involving a range of product lines
with the network service providers who are the principal
potential customers for our IP Service Delivery Platform. These
competitors may offer vendor financing, which we generally do
not offer, undercut our prices or use their pre-existing
relationships with our customers to induce them not to use our
IP Service Delivery Platform.

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| |                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The limited sales history of our IP Service
    Delivery Platform makes forecasting our revenue difficult, which
    may impair our ability to manage our business.

We were founded in April 1997, shipped our first
test IP Service Delivery Platform product in March 1999 and sold
our first IP Service Delivery Platform product in March 2000. We
have limited meaningful historical financial data upon which to
forecast our revenue.



| |                                                                                                                                                                                             
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our customers are unable to generate
    sales of services using our products and to manage delivery of
    these services to their customers, we may be unable to sell our
    products.

Our future success depends on network service
providers, who are our customers, generating revenue from the
sale of services delivered using our products. Sales of our
products may decline or be delayed if our customers do not
successfully introduce commercial services derived from our IP
Service Delivery Platform or if our customers do not generate
revenue from these services sufficient to realize an attractive
return on their investment in our IP Service Delivery Platform.
In addition, the long cycle for service providers to introduce
new services made possible by our platform may cause our revenue
and operating results to vary significantly from quarter to
quarter.

Our ability to generate future revenue also
depends on whether network service providers successfully
forecast market trends and identify customer demand for the
services and features that our products would enable network
service providers to offer their customers.



| |                                                                                        
| | ---------------------------------------------------------------------------------------
| | Fluctuations in demand can lead to
    impairment of the value of our long-lived assets

Fluctuations in demand can also lead to the
consideration of asset impairment charges. The carrying value of
property, plant and equipment is reviewed if the facts and
circumstances suggest that property, plant and equipment may be
impaired. An impairment review requires management to make
certain estimates and judgments regarding future cash flows that
management expects to be generated by groups of assets.

We evaluate the carrying value of our long-lived
assets, consisting primarily of property, plant and equipment,
whenever certain events or changes in circumstances indicate
that the carrying amount of these assets may not be recoverable.
In assessing the recoverability of long-lived assets, we compare
the carrying value to the undiscounted future cash flows the
assets are expected to generate. If the total of the
undiscounted future cash flows is less than the carrying amount
of the assets, the assets will be written down to their
estimated fair value. Significant judgments and assumptions are
required in the forecast of future operating results used in the
preparation of the estimated future cash flows, including
long-term forecasts of overall market conditions and our
participation in the market. Changes in these estimates could
have a material adverse effect on the assessment of the
long-lived assets, thereby requiring us to record further asset
write-downs in the future.



| |                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------
| | If our IP Service Delivery Platform does
    not rapidly achieve market acceptance, we may be unable to
    achieve profitability.

Our products offer a new approach for delivering
services by network service providers, who may perceive our
products as being more expensive than the other technologies and
products they purchase. If network service providers do not
accept our IP Service Delivery Platform as a method for
delivering services to their customers, our ability to increase
our revenue, achieve profitability and continue operations would
be harmed. Our success also depends on third-party software
providers recognizing the advantages of our service delivery
method and on our ability to effectively support their software
development efforts.



| |                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------
| | Our IP Service Delivery Platform is our
    only product line, and our future revenue depends on its
    commercial success.

Our IP Service Delivery Platform, which is
comprised of hardware and software, is the only product that we
currently offer to our customers. Our future revenue depends on
the commercial success of our IP Service

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Delivery Platform. If customers do not adopt,
purchase and successfully implement our IP Service Delivery
Platform in large numbers, our revenue will not grow.




| |                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our products are technically complex and
    may contain errors or defects that are not found until our
    customers put our products to full use. Errors or defects in our
    products could seriously harm our reputation and our ability to
    sell our products.

Our products are more complicated than most
networking products. They can be adequately tested only when put
to full use in large and diverse networks with high amounts of
traffic. Errors or defects in our products could result in the
loss of current customers, the inability to attract new
customers and increased service and warranty costs.



| |                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The long sales cycle for our platform may
    cause our revenue and operating results to vary significantly
    from quarter to quarter, and the price of our stock to
    decline.

A customers decision to purchase our IP
Service Delivery Platform involves a significant commitment of
its resources and a lengthy evaluation, testing and product
qualification process. Network service providers and other
customers with complex networks usually expand their networks in
increments on a periodic basis. We may receive purchase orders
for significant dollar amounts on an irregular and unpredictable
basis. These events may cause our revenue and operating results
to vary significantly and unexpectedly from quarter to quarter,
which could cause our stock price to decline.



| |                                                                                                      
| | -----------------------------------------------------------------------------------------------------
| | If we fail to develop new products or
    features, we will have difficulty attracting
    customers.

Based on our prior experience, we expect that our
customers will require product features that our current IP
Service Delivery Platform does not have. Our products are
technically complex, and the development of new products or
features is an uncertain, time-consuming and labor-intensive
process. We may experience design, manufacturing or marketing
problems with new products. If we fail to develop new or
enhanced products that meet customer requirements, our ability
to attract and retain customers will be hindered.

If we fail to execute new product introductions
in a timely manner we may experience erratic revenue growth,
which could negatively affect profitability and in turn have a
negative impact on our stock price. In addition, such a failure
could result in additional costs such as excess inventory,
customer conversion costs, higher than expected product costs
and higher than expected operating expenses in research and
development and in sales and marketing.



| |                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We rely upon a limited number of customers,
    and any decrease in revenue from these customers or failure to
    increase our customer base could harm our operating
    results.

The loss of one or more of our customers, a
reduction in purchases of our products by our customers or the
decline of our customers business may limit our revenue
growth and harm our operating results. Our customers may reduce
or discontinue purchases of our products at any time.

Our future success will depend on attracting
additional customers. Failure to increase our customer base
would hinder our growth and harm our operating results.



| |                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------
| | If we fail to retain key personnel, our
    operations could suffer and our stock price could be negatively
    impacted.

Maintaining key personnel may be difficult for a
number of reasons, including but not limited to market demand,
stock price, growth opportunities, management philosophy,
company performance and competitive activity. If we lose key
personnel we may find it difficult and costly to recruit new
management and other personnel and this may have a negative
affect on our performance and in turn on our stock price.

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| |                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | A failure of our contract manufacturers or
    our sole source and limited source suppliers to meet our needs
    would seriously harm our ability to timely fill customer
    orders.

If any of our manufacturers terminates its
relationship with us or is unable to produce sufficient
quantities of our products in a timely manner and at
satisfactory quality levels, our ability to fill customer orders
on time, our reputation and our operating results will suffer.
Our contract manufacturers do not have a long-term obligation to
supply products to us. Qualifying new contract manufacturers and
starting volume production is expensive and time consuming and
would disrupt our business.

We purchase several key components, including
field programmable gate arrays, some integrated circuits and
memory devices, and power supplies from a single source or a
limited number of sources. We do not have long-term supply
contracts for these components. If our supply of these
components is interrupted, we may be unable to locate an
alternate source in a timely manner or at favorable prices.
Interruption or delay in the supply of these components could
cause us to lose sales to existing and potential customers.



| |                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If any of our significant suppliers were to
    terminate their relationships with us or compete against us, our
    revenue and market share would likely be reduced.

Many of our suppliers also have significant
development and marketing relationships with our competitors and
have significantly greater financial and marketing resources
than we do. If they develop and market products in the future in
competition with us, or form or strengthen arrangements with our
competitors, our revenue and market share will likely be reduced.



| |                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------
| | If we fail to predict our manufacturing
    requirements accurately, we could incur additional costs or
    manufacturing delays.

We provide forecasts of our demand to our
contract manufacturers up to twelve months before scheduled
delivery of products to our customers. If we overestimate our
manufacturing requirements, we may have excess or obsolete
inventory, which could harm our operating results. If we
underestimate our requirements, our contract manufacturers may
have an insufficient inventory, which could interrupt
manufacturing of our products and result in delays in shipments
and revenue. If we do not accurately anticipate lead times for
components, we may experience component shortages.



| |                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If necessary licenses of third-party
    technology are terminated or become unavailable or too
    expensive, our competitive position and our product offering
    will suffer.

We license from third-party suppliers certain
software applications incorporated in our IP Service
Delivery Platform. Also, we may need to license technology from
other third-party suppliers to enable us to develop new products
or features. Our inability to renew or obtain any third-party
license that we need could require us to obtain substitute
technology of lower quality or at greater cost. Either of these
outcomes could seriously impair our ability to sell our products
and could harm our operating results.



| |                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Insiders continue to have substantial
    control over us and they could delay or prevent a change in our
    corporate control even if our other stockholders wanted it to
    occur.

Our executive officers, directors and principal
stockholders who hold 5% or more of the outstanding common stock
and their affiliates beneficially own a significant portion of
our outstanding common stock. These stockholders will be able to
exercise significant control over all matters requiring
stockholder approval, including the election of directors and
approval of significant corporate transactions. This could delay
or prevent an outside party from acquiring or merging with us
even if our other stockholders wanted it to occur.



| |                                                                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we become subject to unfair hiring
    claims, we could be prevented from hiring needed personnel, or
    from pursuing or implementing our research, and could incur
    substantial liabilities or costs.

Companies in our industry whose employees accept
positions with competitors frequently claim that these
competitors have engaged in unfair hiring practices or that the
employment of these persons would

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involve the disclosure or use of trade secrets or
information subject to an obligation of confidentiality. We have
been threatened with claims like these in the past and may
receive claims of this kind in the future. These claims could
prevent us from hiring personnel or from using the knowledge and
experience brought to us by the personnel whom we hire. We could
also incur substantial costs and damages in defending ourselves
or our employees against these claims, regardless of their
merits. Defending ourselves against such claims could divert the
attention of our management away from our operations.




| |                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our products do not work the way our
    customers expect, orders for our products may be cancelled and
    the market perception of our products could be
    harmed.

If our products do not work with our
customers or their end-users networks, the market
perception of our products could be harmed and orders for our
products could be cancelled. In particular, if an actual or
perceived breach of network security occurs in a customers
or its end-users network that uses our products, we may be
subject to lawsuits for losses suffered by customers or their
end-users.

If we have to redesign or modify our products to
make them compatible with a customers or end-users
network, our sales cycle could be extended, our research and
development costs may increase and profit margins on our
products may decline.



| |                                                                                                                                                                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because the markets in which we compete are
    prone to rapid technological change and the adoption of
    standards different from those that we use, our products could
    become obsolete, and we could be required to incur substantial
    costs to modify our products to remain
    competitive.

The market for our IP Service Delivery
Platform is prone to rapid technological change, the adoption of
new standards, frequent new product introductions and changes in
customer and end-user requirements. We may be unable to respond
quickly or effectively to these developments. We may experience
difficulties that could prevent our development of new products
and features. The introduction of new products or technologies
by competitors, or the emergence of new industry standards,
could render our products obsolete or could require us to incur
costs to redesign our products.



| |                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------
| | We rely on our intellectual property rights
    to be competitive, and if we are unable to protect these rights,
    we may never become profitable.

We rely on a combination of copyright, trademark,
patent and trade secret laws and restrictions on disclosure to
protect our intellectual property rights. Monitoring
unauthorized use of our products is difficult, and we cannot be
certain that the steps we have taken will prevent unauthorized
use of our technology. If we are unable to protect our
intellectual property rights, our ability to supply our products
as they have been designed could suffer, and our ability to
become profitable could be harmed.



| |                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we become involved in an intellectual
    property dispute, we could be subject to significant liability,
    the time and attention of our management could be diverted and
    we could be prevented from selling our products.

We may become a party to litigation in the future
to protect our intellectual property or because others may
allege infringement of their intellectual property. These claims
and any resulting lawsuit could subject us to significant
liability for damages or invalidate our proprietary rights.
These lawsuits, regardless of their merits, likely would be
time-consuming and expensive to resolve and would divert
management time and attention. Any potential intellectual
property litigation alleging our infringement of a
third-partys intellectual property also could force us to:



| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | stop selling products or services that use the
    challenged intellectual property;                                                                                                           
|
| |  | obtain from the owner of the infringed
    intellectual property right a license to sell the relevant
    technology, which license may not be available on reasonable
    terms, or at all; or
|
| |  | redesign those products or services that use the
    infringed technology.                                                                                                                     

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| |                                                                                      
| | -------------------------------------------------------------------------------------
| | If our stock price declines to below $1.00,
    we could be delisted from the Nasdaq.

If our stock price were to drop below $1.00, our
common stock could be delisted from the Nasdaq National market.

A low stock price could also cause some of our
potential customers to be reluctant to purchase our products.



| |                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------
| | Acts of war, terrorist activity, and
    bio-terrorism can have a negative effect on the demand for our
    products.

The terrorist activity on September 11,
2001, the ensuing declaration of war on terrorism, and the war
against Iraq may result in reduced demand for networking
products. Capital spending in the telecommunications industry
was already depressed prior to the tragedy, and additional news
regarding war and terrorism may negatively impact the demand for
our products. These circumstances may result in delayed
purchases, cancelled orders and new technology requirements,
which could lead to reduced revenues or increased costs, which
in turn could negatively affect our stock price.



| |                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------
| | We may have difficulty obtaining director
    and officer liability insurance in acceptable amounts for
    acceptable rates.

Like most other public companies, we carry
insurance protecting our officers and directors against claims
relating to the conduct of our business. This insurance covers,
among other things, the costs incurred by companies and their
management to defend against and resolve claims relating to
management conduct and results of operations, such as securities
class action claims. These claims typically are expensive to
defend against and resolve. We pay significant premiums to
acquire and maintain this insurance, which is provided by
third-party insurers, and we agree to underwrite a portion of
such exposures under the terms of the insurance coverage. One
consequence of the current economic downturn and decline in
stock prices has been a substantial increase in the number of
securities class actions and similar claims brought against
public corporations and their management, including our company
and certain of our current and former officers and directors.
Consequently, insurers providing director and officer liability
insurance have in recent periods sharply increased the premiums
they charge for this insurance, raised retentions (that is, the
amount of liability that a company is required to pay to defend
and resolve a claim before any applicable insurance is
provided), and limited the amount of insurance they will
provide. Moreover, insurers typically provide only one-year
policies. The insurance policies that may cover the current
securities lawsuits against us have a $250,000 retention. As a
result, the costs we incur in defending the current securities
lawsuits against us will not be reimbursed until they exceed
$250,000. The policies that would cover any future lawsuits may
not provide any coverage to us and may cover the directors and
officers only in the event we are unwilling or unable to cover
their costs in defending against and resolving any future
claims. As a result, our costs in defending any future lawsuits
could increase significantly. Particularly in the current
economic environment, we cannot assure you that in the future we
will be able to obtain sufficient director and officer liability
insurance coverage at acceptable rates and with acceptable
deductibles and other limitations. Failure to obtain such
insurance could materially harm our financial condition in the
event that we are required to defend against and resolve any
future or existing securities class actions or other claims made
against us or our management arising from the conduct of our
operations. Further, the inability to obtain such insurance in
adequate amounts may impair our future ability to retain and
recruit qualified officers and directors.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    about Market Risk

Interest Rate Sensitivity

We do not currently use derivative financial
instruments for speculative trading or hedging purposes. In
addition, we maintain our cash equivalents in government and
agency securities, debt instruments of financial institutions
and corporations and money market funds. Our exposure to market
risks from changes in interest rates relates primarily to
corporate debt securities. We place our investments with high
credit quality issuers and, by policy, limit the amount of the
credit exposure to any one issuer.

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Our general policy is to limit the risk of
principal loss and ensure the safety of invested funds by
limiting market and credit risk. All highly-liquid investments
with a maturity of less than three months at the date of
purchase are considered to be cash equivalents, and all
investments with maturities of three months or greater are
classified as available-for-sale and considered to be short-term
investments.

Exchange Rate Sensitivity

Currently, all of our sales and most of our
expenses are denominated in United States dollars. Therefore, we
have not engaged in any foreign exchange hedging activities to
date.

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|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

STATEMENT OF MANAGEMENT
RESPONSIBILITY

Cosines management is responsible for the
preparation, integrity and objectivity of the consolidated
financial statements and other financial information presented
in this report. The accompanying consolidated financial
statements have been prepared in conformity with accounting
principles generally accepted in the United States and reflect
the effects of certain estimates and judgments made by
management.

Management maintains an effective system of
internal control that is designed to provide reasonable
assurance that assets are safeguarded and transactions are
properly recorded and executed in accordance with
managements authorization. The system is continuously
monitored by direct management review. We select and train
qualified people who are provided with and expected to adhere to
our standards of business conduct. These standards, which set
forth the highest principles of business ethics and conduct, are
a key element of our control system.

Our consolidated financial statements have been
audited by Ernst & Young LLP, independent accountants.
Their audits were conducted in accordance with auditing
standards generally accepted in the United States, and included
such tests and related procedures, as they considered necessary
in the circumstances.

The Audit Committee of the Board of Directors,
which consists of outside directors, meets regularly with
management and the independent auditors to review accounting,
reporting and auditing and internal control matters. The
committee has direct and private access to the external auditors.

|                                                          |  |                                                                     
|--------------------------------------------------------- |  | --------------------------------------------------------------------
|STEPHEN GOGGIANOPresident and Chief
    Executive Officer |  | TERRY GIBSONExecutive Vice President and
    Chief Financial Officer

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REPORT OF INDEPENDENT AUDITORS

The Board of Directors and Stockholders CoSine
Communications, Inc.

We have audited the accompanying consolidated
balance sheets of CoSine Communications, Inc. as of
December 31, 2002 and 2001, and the related consolidated
statements of operations, redeemable convertible preferred stock
and stockholders equity (net capital deficiency), and cash
flows for each of the three years in the period ended
December 31, 2002. Our audits also included the financial
statement schedule listed at Item 15(a). These consolidated
financial statements and schedule are the responsibility of the
Companys management. Our responsibility is to express an
opinion on these consolidated financial statements and schedule
based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the consolidated financial position of CoSine
Communications, Inc. at December 31, 2002 and 2001, and the
consolidated results of its operations and its cash flows for
each of the three years in the period ended December 31,
2002, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related
financial statement schedule, when considered in relation to the
basic financial statements taken as a whole, presents fairly in
all material respects the information stated therein.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

San Jose, California

January 25, 2003


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COSINE COMMUNICATIONS, INC.

CONSOLIDATED BALANCE SHEETS

|                                                             |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |          |         | 
|------------------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ------- | -------- | ------- | - | ------- | -------- | ------- | 
|                                                             |                                                                                                                                                                               |                                                                                   
|                                                             |                                                                                                                                                                               | December 31,                                                                      
|                                                             |                                                                                                                                                                               |                                                                                   
|                                                             |                                                                                                                                                                               | 2002                                                                               |         | 2001    
|                                                             |                                                                                                                                                                               |                                                                                    |         |         
|                                                             |                                                                                                                                                                               |                                                                                   
|                                                             |                                                                                                                                                                               | (In thousands, except                                                             
|                                                             |                                                                                                                                                                               | for share data)                                                                   
|ASSETS                                                      
|Current assets:                                              |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                             | Cash and cash equivalents                                                                                                                                                     |                                                                                    | $       | 9,230    |         |   | $       | 73,868   |        
|                                                             | Short-term investments                                                                                                                                                        |                                                                                    |         | 92,237   |         |   |         | 91,010   |        
|                                                             | Accounts receivable:                                                                                                                                                          |                                                                                    |         |          |         |   |         |          |        
|                                                             |                                                                                                                                                                               | Trade (net of allowances for doubtful accounts of
    $233 and $700, respectively) |         |          | 6,373   |   |         |          | 13,978  | 
|                                                             |                                                                                                                                                                               | Other                                                                              |         |          | 679     |   |         |          | 1,277   | 
|                                                             | Inventory                                                                                                                                                                     |                                                                                    |         | 3,175    |         |   |         | 5,229    |        
|                                                             | Prepaid expenses and other current assets                                                                                                                                     |                                                                                    |         | 4,054    |         |   |         | 5,736    |        
|                                                             |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                             |                                                                                                                                                                               | Total current assets                                                               |         |          | 115,748 |   |         |          | 191,098 | 
|Property and equipment, net                                  |                                                                                                                                                                               |                                                                                    | 2,816   |          |         |   | 28,724  |         
|Long-term deposits                                           |                                                                                                                                                                               |                                                                                    | 997     |          |         |   | 1,136   |         
|Other assets                                                 |                                                                                                                                                                               |                                                                                    |        |          |         |   | 245     |         
|                                                             |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                             |                                                                                                                                                                               | $                                                                                  | 119,561 |          |         | $ | 221,203 |         
|                                                             |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                            
|LIABILITIES AND STOCKHOLDERS
    EQUITY                    
|                                                            
|Current liabilities:                                         |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                             | Accounts payable                                                                                                                                                              |                                                                                    | $       | 2,493    |         |   | $       | 3,210    |        
|                                                             | Provision for warranty claims                                                                                                                                                 |                                                                                    |         | 1,103    |         |   |         | 2,505    |        
|                                                             | Accrued other liabilities                                                                                                                                                     |                                                                                    |         | 13,362   |         |   |         | 8,989    |        
|                                                             | Accrued compensation                                                                                                                                                          |                                                                                    |         | 1,708    |         |   |         | 4,221    |        
|                                                             | Deferred revenue                                                                                                                                                              |                                                                                    |         | 1,444    |         |   |         | 2,713    |        
|                                                             | Current portion of equipment and working capital
    loans                                                                                                                    |                                                                                    |         | 1,865    |         |   |         | 2,549    |        
|                                                             | Current portion of obligations under capital lease                                                                                                                            |                                                                                    |         | 1,905    |         |   |         | 3,487    |        
|                                                             |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                             |                                                                                                                                                                               | Total current liabilities                                                          |         |          | 23,880  |   |         |          | 27,674  | 
|Long-term portion of equipment and working
    capital loans |                                                                                                                                                                               |                                                                                    | 131     |          |         |   | 1,992   |         
|Long-term portion of obligations under capital
    lease     |                                                                                                                                                                               |                                                                                    |        |          |         |   | 1,905   |         
|Accrued rent                                                 |                                                                                                                                                                               |                                                                                    | 2,069   |          |         |   | 2,556   |         
|Other long-term liabilities                                  |                                                                                                                                                                               |                                                                                    |        |          |         |   | 11      |         
|Commitments and contingencies Stockholders
    equity:      |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                             | Preferred stock, 3,000,000 shares
    authorized; none issued and outstanding                                                                                                 |                                                                                    |         |         |         |   |         |         |        
|                                                             | Common stock, $.0001 par value,
    300,000,000 shares authorized; 9,959,092 and
    10,199,686 shares issued and outstanding at
    December 31, 2002 and 2001, respectively |                                                                                    |         | 1        |         |   |         | 1        |        
|                                                             | Additional paid-in capital                                                                                                                                                    |                                                                                    |         | 549,243  |         |   |         | 575,894  |        
|                                                             | Notes receivable from stockholders                                                                                                                                            |                                                                                    |         | (10,531  | )       |   |         | (25,466  | )      
|                                                             | Accumulated other comprehensive income                                                                                                                                        |                                                                                    |         | 532      |         |   |         | 481      |        
|                                                             | Deferred compensation                                                                                                                                                         |                                                                                    |         | (2,274   | )       |   |         | (14,321  | )      
|                                                             | Accumulated deficit                                                                                                                                                           |                                                                                    |         | (443,490 | )       |   |         | (349,524 | )      
|                                                             |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                             |                                                                                                                                                                               | Total stockholders equity                                                         |         |          | 93,481  |   |         |          | 187,065 | 
|                                                             |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         
|                                                             |                                                                                                                                                                               | $                                                                                  | 119,561 |          |         | $ | 221,203 |         
|                                                             |                                                                                                                                                                               |                                                                                    |         |          |         |   |         |         

See accompanying notes.

39



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##### Table of Contents



COSINE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |        |         | 
|------------------------------------------------------------------------ | ------------------------------------ | ---------------------------- | ------- | ------ | ------- | ---- | -------- | ------ | ------- | - | -------- | ------ | ------- | 
|                                                                         |                                      |                             
|                                                                         |                                      | Year Ended December 31,     
|                                                                         |                                      |                             
|                                                                         |                                      | 2002                         |         | 2001   |         | 2000
|                                                                         |                                      |                              |         |        |         |     
|                                                                         |                                      |                             
|                                                                         |                                      | (In thousands, except       
|                                                                         |                                      | for per share data)         
|Revenue                                                                  |                                      | $                            | 23,632  |        |         | $    | 34,293   |        |         | $ | 31,107   |       
|                                                                         | Cost of goods sold(1)                |                              |         | 13,807 |         |      |          | 30,214 |         |   |          | 23,926 |        
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Gross profit                                                             |                                      |                              | 9,825   |        |         |      | 4,079    |        |         |   | 7,181    |       
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Operating expenses:                                                      |                                      |                              |         |        |         |      |          |        |         |   |          |       
|                                                                         | Research and development(2)          |                              |         | 32,396 |         |      |          | 66,091 |         |   |          | 91,180 |        
|                                                                         | Sales and marketing(3)               |                              |         | 28,271 |         |      |          | 60,000 |         |   |          | 53,625 |        
|                                                                         | General and administrative(4)        |                              |         | 10,959 |         |      |          | 23,525 |         |   |          | 24,441 |        
|                                                                         | Restructuring and impairment charges |                              |         | 34,538 |         |      |          | 8,991  |         |   |          |       |        
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|                                                                         |                                      | Total operating expenses     |         |        | 106,164 |      |          |        | 158,607 |   |          |        | 169,246 | 
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Loss from operations                                                     |                                      |                              | (96,339 | )      |         |      | (154,528 | )      |         |   | (162,065 | )     
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Other income (expense):                                                  |                                      |                              |         |        |         |      |          |        |         |   |          |       
|                                                                         | Interest income                      |                              |         | 3,535  |         |      |          | 11,086 |         |   |          | 8,060  |        
|                                                                         | Interest expense(5)                  |                              |         | (966   | )       |      |          | (1,675 | )       |   |          | (1,866 | )      
|                                                                         | Other                                |                              |         | 313    |         |      |          | (299   | )       |   |          | 9      |        
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|                                                                         |                                      | Total other income (expense) |         |        | 2,882   |      |          |        | 9,112   |   |          |        | 6,203   | 
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Loss before income tax provision                                         |                                      |                              | (93,457 | )      |         |      | (145,416 | )      |         |   | (155,862 | )     
|                                                                         | Income tax provision                 |                              |         | 509    |         |      |          | 837    |         |   |          | 264    |        
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Net loss                                                                 |                                      |                              | (93,966 | )      |         |      | (146,253 | )      |         |   | (156,126 | )     
|Deemed dividend to series D preferred stockholders                       |                                      |                              |        |        |         |      |         |        |         |   | (2,500   | )     
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Net loss allocable to common stockholders                                |                                      | $                            | (93,966 | )      |         | $    | (146,253 | )      |         | $ | (158,626 | )     
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Basic and diluted net loss per common share                              |                                      | $                            | (9.72   | )      |         | $    | (15.09   | )      |         | $ | (52.27   | )     
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       
|Shares used in computing basic and diluted net
    loss per common share |                                      |                              | 9,670   |        |         |      | 9,695    |        |         |   | 3,035    |       
|                                                                         |                                      |                              |         |        |         |      |          |        |         |   |          |       



---



|    |                                                                                                                                                                                                                            
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Cost of goods sold includes $101 in 2002 of
    non-cash credits related to equity issuances and $2,283 and
    $3,072 in 2001 and 2000, respectively, of non-cash charges
    related to equity issuances.                
|   
|(2) | Research and development expenses include $385 in
    2002 of non-cash credits related to equity issuances and $10,818
    and $34,726 in 2001 and 2000, respectively, of non-cash charges
    related to equity issuances.
|   
|(3) | Sales and marketing expenses include $854 in 2002
    of non-cash credits related to equity issuances and $12,685 and
    $17,901 in 2001 and 2000, respectively, of non-cash charges
    related to equity issuances.     
|   
|(4) | General and administrative expenses include $925
    in 2002, $6,177 in 2001 and $12,928 in 2000 of non-cash charges
    related to equity issuances.                                                                      
|   
|(5) | Interest expense includes $131 in 2002, $154 in
    2001 and $137 in 2000 of non-cash charges related to equity
    issuances.                                                                                             

See accompanying notes.

40



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##### Table of Contents



COSINE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE
CONVERTIBLE PREFERRED STOCK

AND STOCKHOLDERS EQUITY (NET CAPITAL
DEFICIENCY)


|                                                                                                                                                                        |  |                                                  |            |              |  |            |         |            |  |               |           |              |  |             |   |               |  |         |         |             |  |   |         |   |  |   |    |  |  |   |          |   |  |   |         |   |  |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------ | ---------- | ------------ |  | ---------- | ------- | ---------- |  | ------------- | --------- | ------------ |  | ----------- | - | ------------- |  | ------- | ------- | ----------- |  | - | ------- | - |  | - | -- |  |  | - | -------- | - |  | - | ------- | - |  | - | ------- | -
|                                                                                                                                                                        |  |                                                  |            |              |  |            |         |            |  |               |           |              |  |             |   |               |  |        
|                                                                                                                                                                        |  | Redeemable                                       |            |              |  |            |         |            |  |               |           |              |  |             |   |               |  | Total  
|                                                                                                                                                                        |  | Convertible Preferred                            |            |              |  |            |         | Notes      |  | Accumulated   |           |              |  |             |   | Stockholders
|                                                                                                                                                                        |  | Stock                                            |            | Common Stock |  | Additional |         | Receivable |  | Other         |           |              |  |             |   | Equity (Net  
|                                                                                                                                                                        |  |                                                  |            |              |  | Paid-in    |         | from       |  | Comprehensive |           | Deferred     |  | Accumulated |   | Capital      
|                                                                                                                                                                        |  | Shares                                           |            |              |  | Shares     |         |            |  | Capital       |           | Stockholders |  | Income      |   | Compensation  |  | Deficit |         | Deficiency)
|                                                                                                                                                                        |  |                                                  |            |              |  |            |         |            |  |               |           |              |  |             |   |               |  |         |         |            
|                                                                                                                                                                        |  |                                                 
|                                                                                                                                                                        |  | (In thousands, except shares and per share data)
|Balance at December 31, 1999                                                                                                                                            |  |                                                  | 5,638,114  |              |  | $          | 8,939   |            |  |               | 1,074,095 |              |  | $           |  |               |  | $       | 40,049  |             |  | $ | (903    | ) |  | $ | 11 |  |  | $ | (30,386  | ) |  | $ | (47,145 | ) |  | $ | (38,374 | )
|Issuance of common stock for services at $40.00
    and $95.00 per share                                                                                                |  |                                                  |           |              |  |            |        |            |  |               | 1,920     |              |  |             |  |               |  |         | 96      |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 96      |  
|Issuance of warrants to
    purchase 123,350 shares of series C preferred
    stock to a customer upon issuance of a purchase order                                     |  |                                                  |           |              |  |            | 1,030   |            |  |               |          |              |  |             |  |               |  |         |        |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   |        |  
|Issuance of warrants to
    purchase 66,885 shares of common stock to customers
    upon issuance of purchase orders                                                    |  |                                                  |           |              |  |            |        |            |  |               |          |              |  |             |  |               |  |         | 5,952   |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 5,952   |  
|Issuance of warrants to
    purchase 3,750 shares of common stock in connection
    with lease agreement                                                                |  |                                                  |           |              |  |            |        |            |  |               |          |              |  |             |  |               |  |         | 357     |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 357     |  
|Issuance of series D preferred stock to
    investors at $80.00 per share, net of issuance costs of $39                                                                 |  |                                                  | 62,500     |              |  |            | 496     |            |  |               |          |              |  |             |  |               |  |         |        |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   |        |  
|Issuance of series E preferred stock to investors
    at $150.00 per share, net of issuance costs of $5                                                                 |  |                                                  | 466,667    |              |  |            | 6,999   |            |  |               |          |              |  |             |  |               |  |         |        |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   |        |  
|Issuance of common stock in connection with stock
    options for cash and notes                                                                                        |  |                                                  |           |              |  |            |        |            |  |               | 1,106,113 |              |  |             |  |               |  |         | 37,756  |             |  |   | (35,847 | ) |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 1,909   |  
|Increase in value of variable award warrants of
    common stock in connection with services                                                                            |  |                                                  |           |              |  |            |        |            |  |               |          |              |  |             |  |               |  |         | 429     |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 429     |  
|Exercise of warrants to purchase series A
    convertible preferred stock                                                                                               |  |                                                  | 15,911     |              |  |            |        |            |  |               |          |              |  |             |  |               |  |         | 10      |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 10      |  
|Conversion of series A convertible preferred stock                                                                                                                      |  |                                                  | (15,911    | )            |  |            |        |            |  |               | 63,642    |              |  |             |  |               |  |         |        |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   |        |  
|Exercise of warrants to purchase series B
    convertible preferred stock                                                                                               |  |                                                  | 30,488     |              |  |            | 23      |            |  |               |          |              |  |             |  |               |  |         |        |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   |        |  
|Exercise of warrants to purchase series C
    convertible preferred stock                                                                                               |  |                                                  | 187,540    |              |  |            | 170     |            |  |               |          |              |  |             |  |               |  |         |        |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   |        |  
|Exercise of warrants to purchase series D
    convertible preferred stock                                                                                               |  |                                                  | 15,406     |              |  |            | 54      |            |  |               |          |              |  |             |  |               |  |         |        |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   |        |  
|Exercise of warrants to purchase common stock                                                                                                                           |  |                                                  |           |              |  |            |        |            |  |               | 32,596    |              |  |             |  |               |  |         | 806     |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 806     |  
|Automatic conversion of series A through E
    convertible preferred stock in connection with the initial
    public offering                                           |  |                                                  | (6,400,715 | )            |  |            | (17,711 | )          |  |               | 6,963,215 |              |  |             | 1 |               |  |         | 177,109 |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 177,110 |  
|Issuance of common stock at $230.00 per
    share, net of underwriting discounts of $18,500 and issuance
    costs of $3,514 in connection with initial public offering |  |                                                  |           |              |  |            |        |            |  |               | 1,150,000 |              |  |             |  |               |  |         | 242,471 |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 242,471 |  
|Repayment of notes receivable from stockholders                                                                                                                         |  |                                                  |           |              |  |            |        |            |  |               |          |              |  |             |  |               |  |         |        |             |  |   | 98      |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 98      |  
|Deferred stock- based compensation                                                                                                                                      |  |                                                  |           |              |  |            |        |            |  |               |          |              |  |             |  |               |  |         | 121,396 |             |  |   |        |   |  |   |   |  |  |   | (121,396 | ) |  |   |        |   |  |   |        |  
|Amortization of deferred stock-based compensation                                                                                                                       |  |                                                  |           |              |  |            |        |            |  |               |          |              |  |             |  |               |  |         |        |             |  |   |        |   |  |   |   |  |  |   | 59,780   |   |  |   |        |   |  |   | 59,780  |  
|Issuance and remeasurement of options to non-
    employees to purchase common stock                                                                                    |  |                                                  |           |              |  |            |        |            |  |               |          |              |  |             |  |               |  |         | 8,035   |             |  |   |        |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | 8,035   |  
|Repurchase of unvested shares                                                                                                                                           |  |                                                  |           |              |  |            |        |            |  |               | (24,118   | )            |  |             |  |               |  |         | (196    | )           |  |   | 131     |   |  |   |   |  |  |   |         |   |  |   |        |   |  |   | (65     | )

41



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##### Table of Contents



|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |          |  
|-------------------------------------------------------------------------------- | ------------------------------- | ------------------------------------------------ | - | ------------ |  | ---------- | - | ---------- |  | ------------- | ---------- | ------------ |  | ----------- | - | ------------- |  | ------- | ------- | ----------- |  |  | ------- | - |  |  | ------ | ------ | - |  | ------- | - |  |  | -------- | -------- | - |  | -------- | -------- | -
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |        
|                                                                                 |                                 | Redeemable                                       |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  | Total  
|                                                                                 |                                 | Convertible Preferred                            |   |              |  |            |   | Notes      |  | Accumulated   |            |              |  |             |   | Stockholders
|                                                                                 |                                 | Stock                                            |   | Common Stock |  | Additional |   | Receivable |  | Other         |            |              |  |             |   | Equity (Net  
|                                                                                 |                                 |                                                  |   |              |  | Paid-in    |   | from       |  | Comprehensive |            | Deferred     |  | Accumulated |   | Capital      
|                                                                                 |                                 | Shares                                           |   |              |  | Shares     |   |            |  | Capital       |            | Stockholders |  | Income      |   | Compensation  |  | Deficit |         | Deficiency)
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |            
|                                                                                 |                                 |                                                 
|                                                                                 |                                 | (In thousands, except shares and per share data)
|Components of comprehensive loss:                                                |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|                                                                                 | Net loss                        |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        |       |   |  |         |  |  |  |          | (156,126 | ) |  |          | (156,126 | )
|                                                                                 | Unrealized gains on investments |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        | 2,327  |   |  |         |  |  |  |          |         |   |  |          | 2,327    |  
|                                                                                 | Translation adjustment          |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        | (52    | ) |  |         |  |  |  |          |         |   |  |          | (52      | )
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Total comprehensive loss                                                         |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         |        |             |  |  |        |   |  |  | 2,275  |        |   |  |        |   |  |  | (156,126 | )        |   |  | (153,851 | )       
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Balance at December 31, 2000                                                     |                                 |                                                  |  |              |  |            |  |            |  |               | 10,367,463 |              |  |             | 1 |               |  |         | 634,270 |             |  |  | (36,521 | ) |  |  | 2,286  |        |   |  | (92,002 | ) |  |  | (203,271 | )        |   |  | 304,763  |         
|Issuance of common stock in connection with stock
    options                    |                                 |                                                  |  |              |  |            |  |            |  |               | 49,374     |              |  |             |  |               |  |         | 214     |             |  |  |        |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 214      |         
|Issuance of common stock in connection with the
    Employee Stock Purchase Plan |                                 |                                                  |  |              |  |            |  |            |  |               | 78,772     |              |  |             |  |               |  |         | 940     |             |  |  |        |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 940      |         
|Repayment of notes receivable from stockholders                                  |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         |        |             |  |  | 404     |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 404      |         
|Repurchase of unvested shares                                                    |                                 |                                                  |  |              |  |            |  |            |  |               | (295,923   | )            |  |             |  |               |  |         | (11,014 | )           |  |  | 10,651  |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | (363     | )       
|Remeasurement of deferred stock-based compensation                               |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         | (29,541 | )           |  |  |        |   |  |  |       |        |   |  | 29,541  |   |  |  |         |          |   |  |         |         
|Cancellation of options with deferred stock
    compensation charges             |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         | (18,979 | )           |  |  |        |   |  |  |       |        |   |  | 18,979  |   |  |  |         |          |   |  |         |         
|Amortization of deferred stock-based compensation                                |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         |        |             |  |  |        |   |  |  |       |        |   |  | 29,161  |   |  |  |         |          |   |  | 29,161   |         
|Remeasurement of options to non- employees                                       |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         | 4       |             |  |  |        |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 4        |         
|Components of comprehensive loss:                                                |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|                                                                                 | Net loss                        |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        |       |   |  |         |  |  |  |          | (146,253 | ) |  |          | (146,253 | )
|                                                                                 | Unrealized gains on investments |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        | (1,803 | ) |  |         |  |  |  |          |         |   |  |          | (1,803   | )
|                                                                                 | Translation adjustment          |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        | (2     | ) |  |         |  |  |  |          |         |   |  |          | (2       | )
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Total comprehensive loss                                                         |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         |        |             |  |  |        |   |  |  | (1,805 | )      |   |  |        |   |  |  | (146,253 | )        |   |  | (148,058 | )       
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Balance at December 31, 2001                                                     |                                 |                                                  |  |              |  | $          |  |            |  |               | 10,199,686 |              |  |             | 1 |               |  |         | 575,894 |             |  |  | (25,466 | ) |  |  | 481    |        |   |  | (14,321 | ) |  |  | (349,524 | )        |   |  | 187,065  |         
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Issuance of common stock in connection with stock
    options                    |                                 |                                                  |  |              |  |            |  |            |  |               | 29,239     |              |  |             |  |               |  |         | 262     |             |  |  |        |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 262      |         
|Issuance of common stock in connection with the
    Employee Stock Purchase Plan |                                 |                                                  |  |              |  |            |  |            |  |               | 62,230     |              |  |             |  |               |  |         | 454     |             |  |  |        |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 454      |         
|Repayment of notes receivable from stockholders                                  |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         |        |             |  |  | 234     |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 234      |         
|Repurchase of unvested shares                                                    |                                 |                                                  |  |              |  |            |  |            |  |               | (332,063   | )            |  |             |  |               |  |         | (14,841 | )           |  |  | 14,701  |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | (140     | )       
|Remeasurement of deferred stock-based compensation                               |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         | 829     |             |  |  |        |   |  |  |       |        |   |  | (829    | ) |  |  |         |          |   |  |         |         
|Cancellation of options with deferred stock
    compensation charges             |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         | (4,916  | )           |  |  |        |   |  |  |       |        |   |  | 4,916   |   |  |  |         |          |   |  |         |         
|Amortization of deferred stock-based compensation                                |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         |        |             |  |  |        |   |  |  |       |        |   |  | 7,960   |   |  |  |         |          |   |  | 7,960    |         
|Reversal of amortization in excess of vesting                                    |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         | (8,466  | )           |  |  |        |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | (8,466   | )       
|Options with vesting accelerated or exercise
    deadline extended               |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         | 27      |             |  |  |        |   |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 27       |         
|Components of comprehensive loss:                                                |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|                                                                                 | Net loss                        |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        |       |   |  |         |  |  |  |          | (93,966  | ) |  |          | (93,966  | )
|                                                                                 | Unrealized gains on investments |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        | (209   | ) |  |         |  |  |  |          |         |   |  |          | (209     | )
|                                                                                 | Translation adjustment          |                                                  |   |             |  |            |   |           |  |               |            |             |  |             |   |              |  |         |         |            |  |  |         |  |  |  |        | 260    |   |  |         |  |  |  |          |         |   |  |          | 260      |  
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Total comprehensive loss                                                         |                                 |                                                  |  |              |  |            |  |            |  |               |           |              |  |             |  |               |  |         |        |             |  |  |        |   |  |  | 51     |        |   |  |        |   |  |  | (93,966  | )        |   |  | (93,915  | )       
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Balance at December 31, 2002                                                     |                                 |                                                  |  |              |  | $          |  |            |  |               | 9,959,092  |              |  |             | 1 |               |  |         | 549,243 |             |  |  | (10,531 | ) |  |  | 532    |        |   |  | (2,274  | ) |  |  | (443,490 | )        |   |  | 93,481   |         
|                                                                                 |                                 |                                                  |   |              |  |            |   |            |  |               |            |              |  |             |   |               |  |         |         |             |  |  |         |   |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         

See accompanying notes.

42



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##### Table of Contents



COSINE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |        |         |  
|------------------------------------------------------------------------------------------- | --------------------------------------------------------------------- | ----------------------------------------- | ------- | ------ | ------ | ---- | -------- | ------ | ------ | - | -------- | ------ | ------- | -
|                                                                                            |                                                                       |                                          
|                                                                                            |                                                                       | Year Ended December 31,                  
|                                                                                            |                                                                       |                                          
|                                                                                            |                                                                       | 2002                                      |         | 2001   |        | 2000
|                                                                                            |                                                                       |                                           |         |        |        |     
|                                                                                            |                                                                       |                                          
|                                                                                            |                                                                       | (In thousands)                           
|Operating activities:                                                                       |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Net loss                                                                                    |                                                                       | $                                         | (93,966 | )      |        | $    | (146,253 | )      |        | $ | (156,126 | )     
|Adjustments to reconcile net loss to net cash
    used in operating activities:             |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|                                                                                            | Depreciation                                                          |                                           |         | 10,448 |        |      |          | 16,000 |        |   |          | 16,872 |        
|                                                                                            | Allowance for doubtful accounts                                       |                                           |         | 296    |        |      |          | 1,385  |        |   |          | 631    |        
|                                                                                            | Non-cash charges related to inventory write down                      |                                           |         | 1,465  |        |      |          | 12,356 |        |   |          | 2,768  |        
|                                                                                            | Write-down of property and capital equipment                          |                                           |         | 18,761 |        |      |          | 4,593  |        |   |          |       |        
|                                                                                            |                                                                       | Non-cash restructuring charges            |         |        | (305   | )    |          |        |       |   |          |        |        |  
|                                                                                            | Amortization of deferred stock compensation, net                      |                                           |         | 7,987  |        |      |          | 29,165 |        |   |          | 59,780 |        
|                                                                                            | Reversal of amortization in excess of vesting                         |                                           |         | (8,466 | )      |      |          |       |        |   |          |       |        
|                                                                                            | Amortization of warrants issued for services                          |                                           |         | 195    |        |      |          | 5,955  |        |   |          | 11,370 |        
|                                                                                            | Non-cash charges on options granted to acquire
    goods and services |                                           |         |       |        |      |          |       |        |   |          | 8,029  |        
|                                                                                            | Common stock issued for services                                      |                                           |         |       |        |      |          |       |        |   |          | 96     |        
|                                                                                            | Other                                                                 |                                           |         | 263    |        |      |          | 338    |        |   |          | (52    | )      
|                                                                                            | Change in operating assets and liabilities:                           |                                           |         |        |        |      |          |        |        |   |          |        |        
|                                                                                            |                                                                       | Accounts receivable (trade)               |         |        | 7,309  |      |          |        | (9,270 | ) |          |        | (6,724  | )
|                                                                                            |                                                                       | Other receivables                         |         |        | 598    |      |          |        | (486   | ) |          |        | (791    | )
|                                                                                            |                                                                       | Inventory                                 |         |        | 589    |      |          |        | (6,951 | ) |          |        | (13,075 | )
|                                                                                            |                                                                       | Prepaid expenses and other current assets |         |        | 1,487  |      |          |        | 4,394  |   |          |        | (8,420  | )
|                                                                                            |                                                                       | Long-term deposits                        |         |        | (306   | )    |          |        |       |   |          |        |        |  
|                                                                                            |                                                                       | Other assets                              |         |        | 245    |      |          |        | (166   | ) |          |        | 491     |  
|                                                                                            |                                                                       | Accounts payable                          |         |        | (717   | )    |          |        | (3,924 | ) |          |        | 4,629   |  
|                                                                                            |                                                                       | Provision for warranty claims             |         |        | (1,402 | )    |          |        | (1,236 | ) |          |        | 3,741   |  
|                                                                                            |                                                                       | Accrued other liabilities                 |         |        | 4,373  |      |          |        | 1,511  |   |          |        | 6,010   |  
|                                                                                            |                                                                       | Accrued compensation                      |         |        | (2,513 | )    |          |        | (589   | ) |          |        | 3,998   |  
|                                                                                            |                                                                       | Note payable                              |         |        |       |      |          |        | (223   | ) |          |        | 223     |  
|                                                                                            |                                                                       | Deferred revenue                          |         |        | (1,269 | )    |          |        | (6,841 | ) |          |        | 9,353   |  
|                                                                                            |                                                                       | Accrued rent                              |         |        | 263    |      |          |        | 402    |   |          |        | 506     |  
|                                                                                            |                                                                       | Other liabilities                         |         |        | (11    | )    |          |        | (205   | ) |          |        | (66     | )
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Net cash used in operating activities                                                       |                                                                       |                                           | (54,676 | )      |        |      | (100,045 | )      |        |   | (56,757  | )     
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Investing activities:                                                                       |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Capital expenditures                                                                        |                                                                       |                                           | (3,304  | )      |        |      | (16,916  | )      |        |   | (41,980  | )     
|Purchase of short-term investments                                                          |                                                                       |                                           | (89,253 | )      |        |      | (116,374 | )      |        |   | (182,494 | )     
|Proceeds from sales and maturities of short-term
    investments                            |                                                                       |                                           | 87,817  |        |        |      | 185,702  |        |        |   | 57,175   |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Net cash provided by (used in) investing
    activities                                     |                                                                       |                                           | (4,740  | )      |        |      | 52,412   |        |        |   | (167,299 | )     
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Financing activities:                                                                       |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Proceeds from equipment and working capital loans
    and capital leases                    |                                                                       |                                           |        |        |        |      |         |        |        |   | 11,482   |       
|Principal payments of equipment and working
    capital loans and capital leases            |                                                                       |                                           | (6,032  | )      |        |      | (5,833   | )      |        |   | (4,027   | )     
|Proceeds from issuance of preferred stock, net                                              |                                                                       |                                           |        |        |        |      |         |        |        |   | 77,432   |       
|Proceeds from issuance of common stock, net                                                 |                                                                       |                                           | 716     |        |        |      | 1,154    |        |        |   | 245,186  |       
|Proceeds from notes receivable from stockholders                                            |                                                                       |                                           | 234     |        |        |      | 404      |        |        |   | 98       |       
|Repurchase of common stock                                                                  |                                                                       |                                           | (140    | )      |        |      | (363     | )      |        |   | (65      | )     
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Net cash (used in) provided by financing
    activities                                     |                                                                       |                                           | (5,222  | )      |        |      | (4,638   | )      |        |   | 330,106  |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Net (decrease) increase in cash and cash
    equivalents                                    |                                                                       |                                           | (64,638 | )      |        |      | (52,271  | )      |        |   | 106,050  |       
|Cash and cash equivalents at the beginning of the
    period                                |                                                                       |                                           | 73,868  |        |        |      | 126,139  |        |        |   | 20,089   |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Cash and cash equivalents at the end of the period                                          |                                                                       | $                                         | 9,230   |        |        | $    | 73,868   |        |        | $ | 126,139  |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Supplemental information:                                                                   |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Cash paid for interest                                                                      |                                                                       | $                                         | 835     |        |        | $    | 1,521    |        |        | $ | 1,729    |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Income taxes paid                                                                           |                                                                       | $                                         | 509     |        |        | $    | 837      |        |        | $ | 264      |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Capital lease obligations incurred                                                          |                                                                       |                                           |        |        |        |      |         |        |        | $ | 9,996    |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Conversion of redeemable convertible preferred
    stock                                    |                                                                       |                                           |        |        |        |      |         |        |        | $ | 177,120  |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Issuance and remeasurement of warrants                                                      |                                                                       |                                           |        |        |        |      |         |        |        | $ | 17,038   |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Notes receivable collected from stockholders (in
    exchange for issuance of common stock) |                                                                       |                                           |        |        |        |      |         |        |        | $ | 35,847   |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       
|Cancellation of notes receivable due to
    repurchase of unvested stock                    |                                                                       | $                                         | 14,701  |        |        | $    | 10,651   |        |        | $ | 131      |       
|                                                                                            |                                                                       |                                           |         |        |        |      |          |        |        |   |          |       

See accompanying notes.

43



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##### Table of Contents



COSINE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

1.     Summary of
Significant Accounting Policies



| |                        
| | -----------------------
| | Description of Business

CoSine Communications, Inc. (the
Company or CoSine) was incorporated in
California on April 14, 1997 and in August 2000 was
reincorporated in the State of Delaware. CoSine is engaged in
the development of network-based, high-performance Internet
service delivery platforms for the global business Internet
Protocol Service Provider market.



| |                      
| | ---------------------
| | Basis of Presentation

The consolidated financial statements include all
of the accounts of CoSine and its wholly owned subsidiaries. All
significant intercompany balances and transactions have been
eliminated.

In September 2002, CoSine completed a stockholder
approved reverse stock split. The ratio of the reverse stock
split was one-for-ten and reduced the number of shares of issued
and outstanding stock from approximately 100 million shares
to approximately 10 million shares. All share and per share
data has been restated to reflect this reverse stock split.



| |                        
| | -----------------------
| | Initial Public Offering

In September 2000, CoSine completed its initial
public offering in which it sold 1,150,000 shares of common
stock, including 150,000 shares upon the exercise of the
underwriters over-allotment option, at $230 per
share. The net proceeds of the initial public offering, after
deducting the underwriters discount and other offering
expenses, were approximately $242,471,000. Upon the completion
of the initial public offering all outstanding convertible
preferred stock converted into an aggregate of
6,963,215 shares of common stock. Prior to the initial
public offering, there were warrants for 258,241 shares of
preferred and common stock that were subject to cashless
automatic exercise upon the initial public offering; however,
all of these warrants were exercised in cash for approximately
$3,514,000 prior to the initial public offering.



| |                 
| | ----------------
| | Use of Estimates

The preparation of consolidated financial
statements in conformity with accounting principles generally
accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in
the consolidated financial statements and the accompanying
notes. Actual results could differ from these estimates.



| |                                    
| | -----------------------------------
| | Impairment of Long-Lived
    Assets

The Company evaluates the carrying value of
long-lived assets, consisting primarily of property, plant and
equipment, whenever certain events or changes in circumstances
indicate that the carrying amount of these assets may not be
recoverable. In assessing the recoverability of long-lived
assets, the Company compares the carrying value to the
undiscounted future cash flows the assets are expected to
generate. If the total of the undiscounted future cash flows is
less than the carrying amount of the assets, the assets will be
written down to their estimated fair value. Fair value is
generally determined by calculating the discounted future cash
flows using a discount rate based upon the Companys
weighted average cost of capital or specific appraisal, as
appropriate. Significant judgments and assumptions are required
in the forecast of future operating results used in the
preparation of the estimated future cash flows, including
long-term forecasts of overall market conditions and the
Companys participation in the market. Changes in these
estimates could have a material adverse effect on the assessment
of the long-lived assets, thereby requiring the Company to
record further asset write-downs in the future.

44



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                           
| | --------------------------
| | Significant Concentrations

Financial instruments that potentially subject
CoSine to concentrations of credit risk primarily consist of
cash equivalents and short-term investments. CoSine mitigates
investment risk by investing only in government and high quality
corporate securities and by limiting the amount of exposure to
any one issuer.

CoSine relies on a few companies as the sole
source of various materials in the production process. CoSine
also utilizes third-party subcontractors to manufacture its
product. If these suppliers were unable to satisfy the material
and production requirements, CoSine may be unable to meet
customer demand. Alternatively, if CoSine overestimates
manufacturing requirements, CoSine or its contract manufacturers
may have excess or obsolete inventory, which could result in
CoSine recording charges in connection with those materials.

For the year ended December 31, 2002, CoSine
recognized revenue from two customers which accounted for 22%
and 15% of total revenue, respectively. At December 31,
2002, CoSine had two customers who accounted for 33% and 15%,
respectively, of total accounts receivable. For the year ended
December 31, 2001, CoSine recognized revenue from
transactions with a total of 36 customers, of which two each
accounted for 11% of total revenue. At December 31, 2001,
CoSine had four customers who accounted for 14%, 14%, 10% and
10%, respectively, of total accounts receivable. For the year
ended December 31, 2000, CoSine had three customers who
accounted for 41%, 35% and 19%, respectively, of total revenue.



| |           
| | ----------
| | Guarantees

In November 2002, the FASB issued Interpretation
No. 45, Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, which requires certain guarantees
to be recorded at fair value. The Company from time to time
enters into certain types of contracts that contingently require
the Company to indemnify parties against third party claims.
These contracts primarily relate to: (i) certain real
estate leases, under which the Company may be required to
indemnify property owners for environmental and other
liabilities, and other claims arising from the Companys
use of the applicable premises, (ii) certain agreements
with the Companys officers, directors and employees, under
which the Company may be required to indemnify such persons for
liabilities arising out of their employment relationship and
(iii) contracts that additionally indemnify customers
against loss or damage to property or persons as a result of
willful or negligent conduct by CoSine employees or
sub-contractors.

Generally, a maximum obligation is not explicitly
stated. Because the obligated amounts associated with this type
of agreement are not explicitly stated, the overall maximum
amount of the obligation cannot be reasonably estimated.
Historically, CoSine has not been obligated to make payments for
these obligations, and no liabilities have therefore been
recorded for these obligations on its balance sheet as of
December 31, 2002.



| |                                                      
| | -----------------------------------------------------
| | Cash, Cash Equivalents and Short-Term
    Investments

CoSine considers all highly-liquid investments
purchased with original maturities of three months or less from
the date of purchase to be cash equivalents. Investments with
maturities in excess of three months and less than one year are
considered to be short-term investments. Management determines
the appropriate classification of cash equivalents and
investment securities at the time of purchase and reevaluates
the determination as of each balance sheet date. Management has
classified CoSines marketable securities as
available-for-sale securities in the accompanying consolidated
financial statements. Available-for-sale securities are carried
at fair value, with unrealized gains and losses reported in a
separate component of stockholders equity. Realized gains
and losses and declines in value judged to be
other-than-temporary on available-for-sale securities are
included in interest income. Interest on securities classified
as available-for-sale is also included in interest income. The
cost of securities sold is based on the specific identification
method.

45



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

CoSine invests excess cash in
U.S. government and agency securities, debt instruments of
financial institutions and corporations, and money market funds
with strong credit ratings. CoSine has established guidelines
about the diversification of its investments and their
maturities.

Short-term investments at each year end,
including cash equivalents and short-term investments, were as
follows (in thousands):

|                                       |  |      |        |      |  |   |         |  
|-------------------------------------- |  | ---- | ------ | ---- |  | - | ------- | -
|                                       |  | 2002 |        | 2001
|                                       |  |      |        |     
|Money market funds                     |  | $    | 10,075 |      |  | $ | 64,105  |  
|Commercial paper                       |  |      | 62,546 |      |  |   | 4,998   |  
|Corporate bonds                        |  |      | 22,506 |      |  |   | 86,012  |  
|                                       |  |      |        |      |  |   |         |  
|                                       |  |      | 95,127 |      |  |   | 155,115 |  
|Amounts classified as cash equivalents |  |      | (2,890 | )    |  |   | (64,105 | )
|                                       |  |      |        |      |  |   |         |  
|                                       |  | $    | 92,237 |      |  | $ | 91,010  |  
|                                       |  |      |        |      |  |   |         |  

As of December 31, 2002 and 2001, the fair
value approximated the amortized cost of available-for-sale
securities. All available-for-sale securities have contractual
maturities of one year or less.

As of December 31, 2002 and 2001, $500,000
and $300,000, respectively, of restricted cash was included in
long-term deposits. The amount represents a security deposit for
corporate bank credit cards.



| |                                    
| | -----------------------------------
| | Allowance for Doubtful
    Accounts

CoSine maintains allowances for doubtful accounts
for estimated losses resulting from the inability of its
customers to pay their invoices. In order to estimate the
appropriate level of this allowance, the Company analyzes
historical bad debts, customer concentrations, current customer
credit-worthiness, current economic trends and changes in
customer payment patterns.



| |            
| | -----------
| | Inventories

Net inventories at each year end, stated at the
lower of cost (first-in, first-out) or market, consisted of the
following (in thousands):

|                    |  |      |       |      |  |   |       | 
|------------------- |  | ---- | ----- | ---- |  | - | ----- | 
|                    |  | 2002 |       | 2001
|                    |  |      |       |     
|Raw materials       |  | $    | 312   |      |  | $ | 1,170 | 
|Semi-finished goods |  |      | 1,951 |      |  |   | 2,952 | 
|Finished goods      |  |      | 912   |      |  |   | 1,107 | 
|                    |  |      |       |      |  |   |       | 
|                    |  | $    | 3,175 |      |  | $ | 5,229 | 
|                    |  |      |       |      |  |   |       | 

Included in net semi-finished goods at
December 31, 2002 and 2001 was $289,000 and $591,000,
respectively, of goods used for customer evaluation purposes.
Included in net finished goods inventory at December 31,
2001 was $516,000 of goods awaiting customer acceptance. There
was no finished goods inventory awaiting customer acceptance at
December 31, 2002.

In assessing the value of inventory, CoSine is
required to make judgments as to future demand and then compare
that demand with current inventory quantities and firm purchase
commitments. If inventories and firm purchase commitments are in
excess of forecasted demand, the value of inventory is written
down. CoSine generally uses a 12-month forecast to assess future
demand. Inventory write-downs are charged to cost of sales.
During 2002, $1,236,000 of fully reserved inventory was sold and
$646,000 of inventory was written down. In addition, a charge of
$819,000 was recorded in 2002 in connection with excess purchase

46



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

commitments at CoSines contract
manufacturers. During 2001, inventory was written down by
$9,908,000. In addition, a charge of $2,448,000 was recorded in
2001 in connection with excess purchase commitments with one of
CoSines contract manufacturers.



| |                       
| | ----------------------
| | Property and Equipment

Property and equipment at December 31, 2002
are stated estimated fair value, net of accumulated
depreciation. Property and equipment at December 31, 2001
are stated at cost, net of accumulated depreciation. Property
and equipment are depreciated using the straight-line method
over estimated useful lives of the assets (ranging from three to
five years) or the related lease term.

In 2002, an impairment charge of $15,512,000 was
recorded against property and equipment. In addition, assets
that were either sold, disposed of or otherwise abandoned were
written down by $3,248,000 to their estimated net realizable
value. In 2001, $4,593,000 of property and equipment was written
down to its net realizable value as part of the restructuring
program approved and recorded in September 2001. (See
Note 9)

Property and equipment at each year end consisted
of the following (in thousands):

|                                       |  |      |        |      |  |   |         |  
|-------------------------------------- |  | ---- | ------ | ---- |  | - | ------- | -
|                                       |  | 2002 |        | 2001
|                                       |  |      |        |     
|Computer equipment                     |  | $    | 1,147  |      |  | $ | 11,167  |  
|Furniture and fixtures                 |  |      | 210    |      |  |   | 2,798   |  
|Leasehold improvements                 |  |      | 8      |      |  |   | 3,261   |  
|Computer software                      |  |      | 6      |      |  |   | 6,688   |  
|Manufacturing and laboratory equipment |  |      | 3,218  |      |  |   | 33,390  |  
|                                       |  |      |        |      |  |   |         |  
|                                       |  |      | 4,589  |      |  |   | 57,304  |  
|Accumulated depreciation               |  |      | (1,773 | )    |  |   | (28,580 | )
|                                       |  |      |        |      |  |   |         |  
|                                       |  | $    | 2,816  |      |  | $ | 28,724  |  
|                                       |  |      |        |      |  |   |         |  



| |           
| | ----------
| | Warranties

CoSine provides a basic limited warranty,
including repair or replacement of parts, and technical support.
The specific terms and conditions of those warranties vary
depending on the customer or region in which CoSine does
business. CoSine estimates the costs that may be incurred under
its basic limited warranty and records a liability in the amount
of such costs at the time product revenue is recognized.
CoSines warranty obligation is affected by the number of
installed units, product failure rates, materials usage and
service delivery costs incurred in correcting product failures.
CoSine periodically assesses the adequacy of its recorded
warranty liabilities and adjusts the amounts as necessary.

Changes in CoSines warranty liability were
as follows (in thousands):

|                                                   |  |      |        |      |  |      |        |   |  |   |       |  
|-------------------------------------------------- |  | ---- | ------ | ---- |  | ---- | ------ | - |  | - | ----- | -
|                                                   |  | 2002 |        | 2001 |  | 2000
|                                                   |  |      |        |      |  |     
|Beginning balance                                  |  | $    | 2,505  |      |  | $    | 3,741  |   |  | $ |      |  
|Warranty charged to cost of goods sold             |  |      | 351    |      |  |      | 2,355  |   |  |   | 4,292 |  
|Utilization of warranties                          |  |      | (1,568 | )    |  |      | (1,491 | ) |  |   | (551  | )
|Changes in estimated liability based on experience |  |      | (185   | )    |  |      | (2,100 | ) |  |   |      |  
|                                                   |  |      |        |      |  |      |        |   |  |   |       |  
|Ending balance                                     |  | $    | 1,103  |      |  | $    | 2,505  |   |  | $ | 3,741 |  
|                                                   |  |      |        |      |  |      |        |   |  |   |       |  

47



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                         
| | ------------------------
| | Stock-Based Compensation

CoSine accounts for employee and director stock
option grants using the intrinsic value method in accordance
with Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees,
(APB 25) and related interpretations as described in FASB
Interpretation No. 44, Accounting for Certain
Transactions involving Stock Compensation, (FIN 44).
The fair value disclosures required by Statement of Financial
Accounting Standards Board Statement No. 123,
Accounting for Stock-Based Compensation,
(SFAS 123) are included below and in Note 6.
SFAS 123 requires the disclosure of pro forma information
regarding net loss and net loss per share as if CoSine had
accounted for its stock options under the fair value method.

In connection with CoSines initial public
offering, the fair value of its common stock was reevaluated and
deferred stock compensation for option grants to employees was
recorded, representing the difference between the fair value of
the common stock for financial reporting purposes and the
exercise price of the underlying options. Cosine is also
required to remeasure compensation associated with the unvested
shares issued upon exercise of unvested employee stock options
for full recourse promissory notes that were subsequently
converted to non-recourse obligations. The amount of deferred
stock-based compensation is amortized over the vesting period of
the individual options, using the graded vesting method.

In November 2002, CoSine repriced 1,091,453
outstanding employee stock options to purchase shares of
CoSines common stock with original exercise prices ranging
from $5.45 per share to $159.38 per share. These
options were repriced to $5.00 per share, which was above
the fair market value of the underlying shares on the repricing
date. CoSine recorded deferred stock compensation in connection
with these repriced options, as the price of CoSines stock
was higher than the repriced amount at December 31, 2002.
In July 2001, CoSine repriced 722,071 unexercised employee stock
options to $15.50 per share, the fair market value of the
underlying shares on the repricing date. These options had
previously been granted at prices ranging from $40.00 to
$400.00 per share. The repricing requires that compensation
associated with these options be remeasured until they are
exercised or canceled, or expire. During the years ended
December 31, 2002 and 2001, CoSine did not record any
deferred stock compensation in connection with these repriced
options as the price of CoSines stock was not higher than
the repriced amount at any quarter-end during those periods (See
Note 6).

Stock options granted to non-employees are
accounted for in accordance with SFAS 123 and the Emerging
Issues Task Force Consensus No. 96-18, Accounting for
Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling Goods or
Services, which requires the value of such options to be
periodically remeasured as they vest over a performance period.
The fair value of such options is determined using the
Black-Scholes model.



| |                      
| | ---------------------
| | Pro Forma Information

CoSine has elected to continue to follow
APB 25 to account for employee stock options because the
alternative fair value method of accounting prescribed by
SFAS 123 requires the use of option valuation models that
were not developed for use in valuing employee stock options.
Under APB 25, no compensation expense is recognized when
the exercise price of employee stock options equals the market
price of the underlying stock on the date of grant.

For purposes of estimating the effect of
SFAS 123 on CoSines net loss, the fair value of
CoSines options was estimated at the grant date using the
Black-Scholes option pricing model with the following
assumptions: volatility of 0.67 for 2002, 1.15 for 2001 and 0.6
for 2000, risk-free interest rate of 3% for 2002 and 5% for 2001
and 2000, an expected life of four years, and a dividend yield
of zero. The weighted-average fair values of options granted
during 2002, 2001 and 2000 were $2.73, $23.10 and $47.90,
respectively. The estimated weighted-average fair value of
shares granted under the Purchase Plan in 2002 was $1.60, using
a volatility of

48



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

0.67, risk-free interest rate of 1% and an
expected life of six months. The estimated weighted-average fair
value of shares granted under the Purchase Plan in 2001 was
$5.20, using a volatility of 1.15, risk-free interest rate of 2%
and an expected life of six months.

The following table illustrates the effect on
CoSines net loss and net loss per share if CoSine had
applied the fair value recognition provisions of SFAS 123
to stock-based employee compensation (in thousands, except per
share data):

|                                                                                                                                            |  |      |         |      |  |      |          |   |  |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | ---- |  | ---- | -------- | - |  | - | -------- | -
|                                                                                                                                            |  | 2002 |         | 2001 |  | 2000
|                                                                                                                                            |  |      |         |      |  |     
|Net loss, as reported                                                                                                                       |  | $    | (93,966 | )    |  | $    | (146,253 | ) |  | $ | (156,126 | )
|Add: Stock-based employee compensation expense
    included in reported net loss                                                            |  |      | 7,987   |      |  |      | 29,161   |   |  |   | 59,780   |  
|Deduct: Reversal of amortization in excess of
    vesting                                                                                   |  |      | (8,466  | )    |  |      |         |   |  |   |         |  
|                                                                                                                                            |  |      |         |      |  |      |          |   |  |   |          |  
|Deduct: Stock-based employee compensation expense
    determined under fair value method for all stock option grants
    (SFAS 123 expense) |  |      | 5,202   |      |  |      | (7,864   | ) |  |   | (55,264  | )
|                                                                                                                                            |  |      |         |      |  |      |          |   |  |   |          |  
|Pro forma net loss                                                                                                                          |  | $    | (89,243 | )    |  | $    | (124,956 | ) |  | $ | (151,610 | )
|                                                                                                                                            |  |      |         |      |  |      |          |   |  |   |          |  
|Basic and diluted net loss per share, as reported                                                                                           |  | $    | (9.72   | )    |  | $    | (15.09   | ) |  | $ | (52.27   | )
|                                                                                                                                            |  |      |         |      |  |      |          |   |  |   |          |  
|Pro forma basic and diluted net loss per share                                                                                              |  | $    | (9.23   | )    |  | $    | (12.89   | ) |  | $ | (49.95   | )
|                                                                                                                                            |  |      |         |      |  |      |          |   |  |   |          |  



| |                    
| | -------------------
| | Revenue Recognition

CoSine recognizes product revenue at the time of
shipment, assuming that persuasive evidence of an arrangement
exists, the sales price is fixed or determinable and
collectibility is probable, unless CoSine has future obligations
for installation or requires customer acceptance, in which case
revenue is deferred until these obligations are met.
CoSines product incorporates software that is not
incidental to the related hardware and, accordingly, CoSine
recognizes revenue in accordance with the American Institute of
Certified Public Accountants issued Statement of Position 97-2
Software Revenue Recognition. For arrangements that
include the delivery of multiple products, the revenue is
allocated to the various products based on vendor-specific
objective evidence of fair value (VSOE). CoSine
establishes VSOE based on either the price charged for the
product when the same product is sold separately or for products
not yet sold separately, based on the list prices of such
products individually established by management with the
relevant authority to do so. Revenue from post-contract support
obligations for specified future periods is deferred and
recognized on a straight-line basis over the service period.
Revenue from consulting services is recognized as the services
are provided. Amounts billed in excess of revenue recognized are
included as deferred revenue in the accompanying consolidated
balance sheets.

During 2000, CoSine issued warrants to its
initial customers. The warrants were issued upon receipt of
substantial purchase orders that were preceded by a period of
cooperation with CoSine in the marketing, development and
refinement of its product. The fair value of these
customer-related warrants was calculated to be $16,252,000. For
the year ended December 31, 2001 and 2000, $3,003,000 and
$10,511,000, respectively, were recognized as offsets to
receipts from sales, including equity issued in connection with
sales in the determination of revenue. CoSines revenue in
2002 was not affected by the value of warrants granted to
customers.

49



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Below is a reconciliation of revenue for the
years ended December 31, 2002, 2001 and 2000 as presented
in the statement of operations to show the separate components
as indicated (in thousands):

|                                                                          |  |      |        |      |  |      |        |  |  |   |        | 
|------------------------------------------------------------------------- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|                                                                          |  | 2002 |        | 2001 |  | 2000
|                                                                          |  |      |        |      |  |     
|Receipts from sales, including equity issued in
    connection with sales |  | $    | 23,632 |      |  | $    | 37,296 |  |  | $ | 41,618 | 
|Less: Receipts for equity issued in connection
    with sales             |  |      |       |      |  |      | 3,003  |  |  |   | 10,511 | 
|                                                                          |  |      |        |      |  |      |        |  |  |   |        | 
|Revenue                                                                   |  | $    | 23,632 |      |  | $    | 34,293 |  |  | $ | 31,107 | 
|                                                                          |  |      |        |      |  |      |        |  |  |   |        | 



| |                   
| | ------------------
| | Cost of Goods Sold

Cost of goods sold is comprised primarily of
material, labor, overhead, shipping costs, warranty costs and
inventory write-downs. In addition, cost of goods sold includes
non-cash charges or credits related to equity issuances.



| |                         
| | ------------------------
| | Research and Development

Research and development expenditures, consisting
primarily of materials, labor and overhead costs for the
development and testing of prototypes and salaries and related
personnel costs associated with independent research, are
generally charged to operations as incurred.

Statement of Financial Accounting Standards
No. 86, Accounting for the Costs of Computer Software
to be Sold, Leased or Otherwise Marketed, requires the
capitalization of certain software development costs subsequent
to the establishment of technological feasibility. Based on
CoSines product development process, technological
feasibility is established upon the completion of a working
model. Through December 31, 2002, capitalizable costs
incurred after achieving technological feasibility have not been
significant for any development project. Accordingly, CoSine has
charged all such costs to research and development expense in
the periods they were incurred.



| |                    
| | -------------------
| | Advertising Expense

Advertising costs are expensed as incurred and
amounted to $105,000, $437,000 and $532,000 for the years ended
December 31, 2002, 2001 and 2000, respectively.



| |                          
| | -------------------------
| | Net Loss Per Common Share

Basic net loss per common share is calculated
based on the weighted-average number of common shares
outstanding during the periods presented, less the
weighted-average shares outstanding that are subject to
CoSines right of repurchase. Diluted net loss per common
share would give effect to the dilutive effect of common stock
equivalents consisting of stock options and warrants (calculated
using the treasury stock method) and convertible preferred stock.

50



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table presents the calculation of
basic and diluted net loss per share for each year end (in
thousands, except per share data):

|                                            |                                                                                 |      |         |        |  |      |          |        |  |   |          |       | 
|------------------------------------------- | ------------------------------------------------------------------------------- | ---- | ------- | ------ |  | ---- | -------- | ------ |  | - | -------- | ----- | 
|                                            |                                                                                 | 2002 |         | 2001   |  | 2000
|                                            |                                                                                 |      |         |        |  |     
|Net loss allocable to common stockholders   |                                                                                 | $    | (93,966 | )      |  | $    | (146,253 | )      |  | $ | (158,626 | )    
|Basic and diluted:                          |                                                                                 |      |         |        |  |      |          |        |  |   |          |      
|                                            | Weighted-average shares of common stock
    outstanding                         |      |         | 10,095 |  |      |          | 10,269 |  |   |          | 4,038 | 
|                                            | Less: weighted-average shares subject to
    repurchase                         |      |         | 425    |  |      |          | 574    |  |   |          | 1,003 | 
|                                            |                                                                                 |      |         |        |  |      |          |        |  |   |          |      
|                                            | Weighted-average shares used in basic and diluted
    net loss per common share |      |         | 9,670  |  |      |          | 9,695  |  |   |          | 3,035 | 
|                                            |                                                                                 |      |         |        |  |      |          |        |  |   |          |      
|Basic and diluted net loss per common share |                                                                                 | $    | (9.72   | )      |  | $    | (15.09   | )      |  | $ | (52.27   | )    
|                                            |                                                                                 |      |         |        |  |      |          |        |  |   |          |      

During all periods presented, CoSine had
securities outstanding that could potentially dilute earnings
per share in the future, but were excluded from the computation
of diluted net loss per common share, as their effect would have
been antidilutive. These shares amounted to 1,332,000, 1,696,000
and 1,438,000 for the years ended December 31, 2002, 2001
and 2000, respectively.



| |                  
| | -----------------
| | Segment Reporting

CoSine operates in only one segment, and
substantially all of CoSines assets are located in the
United States.

Revenues from customers by geographic region for
the years ended December 31, 2002, 2001 and 2000 were as
follows (in thousands):

|              |  |                  |        |               |  |         |        |  |  |   |        | 
|------------- |  | ---------------- | ------ | ------------- |  | ------- | ------ |  |  | - | ------ | 
|              |  | Receipts from    |        |               |  |        
|              |  | Sales, Including |        | Receipts for  |  |        
|              |  | Equity Issued    |        | Equity Issued |  |        
|              |  | in Connection    |        | in Connection |  |        
|Region        |  | with Sales       |        | with Sales    |  | Revenue
|              |  |                  |        |               |  |        
|2002          |  |                  |        |               |  |         |        |  |  |   |        | 
|Europe        |  | $                | 5,726  |               |  | $       |       |  |  | $ | 5,726  | 
|Asia/ Pacific |  |                  | 9,483  |               |  |         |       |  |  |   | 9,483  | 
|United States |  |                  | 8,423  |               |  |         |       |  |  |   | 8,423  | 
|              |  |                  |        |               |  |         |        |  |  |   |        | 
|              |  | $                | 23,632 |               |  | $       |        |  |  | $ | 23,632 | 
|              |  |                  |        |               |  |         |        |  |  |   |        | 
|2001          |  |                  |        |               |  |         |        |  |  |   |        | 
|Europe        |  | $                | 15,757 |               |  | $       | 544    |  |  | $ | 15,213 | 
|Asia/ Pacific |  |                  | 11,623 |               |  |         |       |  |  |   | 11,623 | 
|United States |  |                  | 9,916  |               |  |         | 2,459  |  |  |   | 7,457  | 
|              |  |                  |        |               |  |         |        |  |  |   |        | 
|              |  | $                | 37,296 |               |  | $       | 3,003  |  |  | $ | 34,293 | 
|              |  |                  |        |               |  |         |        |  |  |   |        | 
|2000          |  |                  |        |               |  |         |        |  |  |   |        | 
|Europe        |  | $                | 14,608 |               |  | $       | 1,296  |  |  | $ | 13,312 | 
|Japan         |  |                  | 7,787  |               |  |         |       |  |  |   | 7,787  | 
|United States |  |                  | 19,223 |               |  |         | 9,215  |  |  |   | 10,008 | 
|              |  |                  |        |               |  |         |        |  |  |   |        | 
|              |  | $                | 41,618 |               |  | $       | 10,511 |  |  | $ | 31,107 | 
|              |  |                  |        |               |  |         |        |  |  |   |        | 

51



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

In June 2002, the Financial Accounting Standards
Board (FASB) issued Statement Number 146, Accounting
for Costs Associated with Exit or Disposal Activities,
(SFAS 146) which addresses accounting for restructuring and
similar costs. SFAS 146 supersedes previous accounting
guidance, principally Emerging Issues Task Force
(EITF) Issue No. 94-3 Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a
Restructuring). SFAS 146 requires recognition of the
liability for costs associated with an exit or disposal activity
when the Company exits the facility, whereas under EITF Issue
No. 94-3, a liability for an exit cost is recognized at the
date a company commits to an exit plan. In addition,
SFAS 146 establishes that the liability should initially be
measured and recorded at fair value. Accordingly, SFAS 146
may affect the timing of recognizing future restructuring costs,
as well as the amounts recognized. Application of SFAS 146
is required for restructuring activities initiated after
December 31, 2002. The effect of the adoption of
SFAS 146 is dependent on the Companys related
activities subsequent to the date of adoption.

In November 2002, the FASB issued FASB
Interpretation No. 45, Guarantors Accounting
and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others  an
Interpretation of FASB Statements No. 5, 57, and 107 and
Rescission of FASB Interpretation No. 34. The
Interpretation elaborates on the disclosures to be made by a
guarantor in its interim and annual financial statements about
its obligations under certain guarantees that it has issued. It
also requires a guarantor to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. The initial recognition and
measurement provisions of the Interpretation apply to guarantees
issued or modified after December 31, 2002 and CoSine is
still assessing the potential impact of that adoption on its
financial statements. CoSine has adopted the disclosure
provisions of FASB Interpretation No. 45 for the year ended
December 31, 2002.

In December 2002, the FASB issued Statement
Number 148, Accounting for Stock-Based
Compensation  Transition and Disclosure
(SFAS 148). SFAS 148 amends SFAS 123,
Accounting for Stock-Based Compensation, to provide
alternative methods of transition to the SFAS 123 fair
value method of accounting for stock-based employee
compensation. In addition, SFAS 148 requires disclosure of
the effects of an entitys accounting policy with respect
to stock-based employee compensation on reported net income and
earnings per share in annual and interim financial statements.
As permitted under SFAS 148, CoSine is adopting only the
disclosure provisions of that accounting standard effective for
the year ended December 31, 2002.

2.     Equipment and
Working Capital Loans

CoSine has entered into equipment and working
capital loan agreements that are secured by the assets purchased
using the loans. Principal and interest are due in monthly
installments through 2004. Interest accrues at annual rates
between 12.9% and 14.3%. As of December 31, 2002 and 2001,
total principal payments due under these agreements were
$1,996,000 and $4,541,000, respectively. The fair value of the
loans is estimated based on current interest rates available to
CoSine for debt instruments with similar terms, degrees of risk
and remaining maturities. The carrying value of the loans
approximates their fair value.

52



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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Future minimum payments under equipment and
working capital loans at December 31, 2002 are as follows
(in thousands):

|                             |                   |   |        |     | 
|---------------------------- | ----------------- | - | ------ | --- | 
|2003                         |                   | $ | 2,002  |    
|2004                         |                   |   | 133    |    
|                             |                   |   |        |    
|Total minimum payments       |                   |   | 2,135  |    
|Amount representing interest |                   |   | (139   | )  
|                             |                   |   |        |    
|Total principal              |                   |   | 1,996  |    
|Current portion              |                   |   | (1,865 | )  
|                             |                   |   |        |    
|                             | Long-term portion |   | $      | 131 | 
|                             |                   |   |        |    

3.     Leases

CoSine entered into various capital leases under
sale and leaseback agreements to finance the purchase of
computer and other equipment. Capitalized costs of $1,480,000
and $9,996,000 and accumulated amortization of $1,231,000 and
$4,987,000 are included in property and equipment at
December 31, 2002 and 2001, respectively. CoSine leases its
facilities under operating leases, with terms ranging from
August 1998 through December 2011.

Future minimum payments for all leases and the
present value of the net minimum lease payments for capital
leases are as follows (in thousands):

|                                            |                   |         |        |           |  |   |        |  | 
|------------------------------------------- | ----------------- | ------- | ------ | --------- |  | - | ------ |  | 
|                                            |                   | Capital |        | Operating
|                                            |                   | Leases  |        | Leases   
|                                            |                   |         |        |          
|2003                                        |                   | $       | 1,965  |           |  | $ | 10,401 | 
|2004                                        |                   |         |       |           |  |   | 2,112  | 
|2005                                        |                   |         |       |           |  |   | 2,143  | 
|2006                                        |                   |         |       |           |  |   | 2,201  | 
|2007                                        |                   |         |       |           |  |   | 2,260  | 
|Later years                                 |                   |         |       |           |  |   | 9,619  | 
|                                            |                   |         |        |           |  |   |        | 
|Total minimum lease payments                |                   |         | 1,965  |           |  | $ | 28,736 | 
|                                            |                   |         |        |           |  |   |        | 
|Amount representing interest                |                   |         | (60    | )         |  |   |        | 
|                                            |                   |         |        |           |  |   |        | 
|Present value of net minimum lease payments |                   |         | 1,905  |           |  |   |        | 
|Current portion                             |                   |         | (1,905 | )         |  |   |        | 
|                                            |                   |         |        |           |  |   |        | 
|                                            | Long-term portion |         | $      |          |  |   |        |  | 
|                                            |                   |         |        |           |  |   |        | 

Rent expense was $6,056,000, $8,337,000 and
$7,259,000 for the years ended December 31, 2002, 2001 and
2000, respectively, and is calculated on a straight-line basis.

CoSine had subleased a portion of the space at
one of its facilities. Rental income relating to the sublease
was $182,000 and $719,000 for the years ended December 31,
2001 and 2000, respectively. The sublease arrangements expired
on June 30, 2001.

At December 31, 2002, $79,000 of the
remaining operating lease payments was accrued as part of
CoSines May 2002 restructuring program. As part of
CoSines October 2002 restructuring program, $8,104,000 was
accrued for an expected Redwood City, California leased facility
settlement.

53



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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

4.     Commitments
and Contingencies

As of December 31, 2002, CoSine had
commitments of approximately $2,131,000 relating to purchases of
raw materials and semi-finished goods. Of that amount, $819,000
related to excess inventory was accrued at December 31,
2002.

On November 15, 2001, CoSine and seven of
its officers and directors were named as defendants in a
securities class action lawsuit filed in the United States
District Court, Southern District of New York. The complaint
alleges that CoSines September 26, 2000 IPO
prospectus failed to disclose certain alleged actions by the
underwriters for the offering. The complaint alleges claims
against CoSine and its officers and directors under
Section 11 of the Securities Act of 1933. The complaint
also alleges claims against the officers and directors under
Section 15 of the 1933 Act and Section 20(a) of
the Securities Exchange Act of 1934. CoSine and its officers and
directors believe the allegations against them are without merit
and intend to defend the action vigorously.

The complaint generally alleges that various
investment bank underwriters engaged in improper and undisclosed
activities related to the allocation of shares in CoSines
initial public offering. The complaint brings claims for the
violation of several provisions of the federal securities laws
against those underwriters, and also against the Company and
certain of its directors and officers. Various plaintiffs have
filed similar actions asserting virtually identical allegations
against more than 250 other companies. The lawsuit and all other
IPO allocation securities class actions currently
pending in the Southern District of New York have been assigned
to Judge Shira A. Scheindlin for coordinated pretrial
proceedings. In October 2002, the individual defendants were
dismissed without prejudice pursuant to a stipulation. The
issuer defendants recently filed a coordinated motion to dismiss
on common pleading issues, which the Court granted in part and
denied in part in an order dated February 19, 2002. The
Courts order dismissed the Section 10(b) and
Rule 10b-5 claims against the Company but did not dismiss
the Section 11 claims against the Company. The Company
believes that it has meritorious defenses to the claims against
it and intends to defend itself vigorously.

On December 27, 2002, CoSine and each of its
five directors were named as defendants in a class action
lawsuit filed in the San Mateo County Superior Court on
behalf of CoSine stockholders. The complaint alleges that the
CoSine directors breached their fiduciary duty to the
corporation in rejecting a proposal offered by a private holding
company, Wyndcrest Holdings LLC, to effect a merger of CoSine
into a wholly owned subsidiary of Wyndcrest. Under the proposal,
Wyndcrest would retain a 75% ownership interest in the assets of
CoSine after distributing $95.5 million in cash to the
existing CoSine shareholders, subject to adjustment. On
January 23, 2003, a substantially similar class action
lawsuit was filed in San Mateo County Superior Court. In
March of 2003, the two plaintiffs agreed to consolidate the two
actions. CoSine and its directors believe that the allegations
are without merit and intend to defend the action vigorously.

In the ordinary course of business, CoSine is
involved in legal proceedings involving contractual obligations,
employment relationships and other matters. Except as described
above, CoSine does not believe there are any pending or
threatened legal proceedings that will have a material impact on
its financial position or results of operations.

5.     401(k)
Plan

CoSine has a defined contribution benefit plan
established under the provisions of Section 401(k) of the
Internal Revenue Code. All employees may elect to contribute up
to 20% of their compensation to the plan through salary
deferrals, subject to IRS limits. CoSine may contribute a
discretionary matching contribution. Since inception CoSine has
made no matching contributions to the plan.

54



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

6.     Stockholders
Equity



| |                
| | ---------------
| | Deemed Dividend

In March 2000, CoSine consummated the sale of an
additional 62,500 shares of series D redeemable convertible
preferred stock from which CoSine received proceeds of
approximately $5,000,000 or $80.00 per share. At the date
of issuance, CoSine believed the per share price of $80.00
represented the fair value of the preferred stock. After
CoSines initial public offering process began, CoSine
reevaluated the fair value of its common stock as of March 2000.
Accordingly, an increase in fair value has resulted in a
beneficial conversion feature of $2,500,000, which has been
recorded as a deemed dividend to preferred stockholders in 2000.
CoSine recorded the deemed dividend at the date of issuance by
offsetting charges and credits to stockholders equity. The
preferred stock dividend increases the net loss allocable to
common stockholders in the calculation of basic and diluted net
loss per common share for the year ended December 31, 2000.



| |             
| | ------------
| | Common Stock

CoSine has reserved shares of common stock for
future issuance at each year end as follows (in thousands):

|                     |                            |      |       |       |  |  |       |       | 
|-------------------- | -------------------------- | ---- | ----- | ----- |  |  | ----- | ----- | 
|                     |                            | 2002 |       | 2001 
|                     |                            |      |       |      
|Stock options:       |                            |      |       |       |  |  |       |      
|                     | Options outstanding        |      |       | 1,298 |  |  |       | 1,680 | 
|                     | Reserved for future grants |      |       | 1,856 |  |  |       | 862   | 
|Warrants outstanding |                            |      | 34    |       |  |  | 34    |      
|                     |                            |      |       |       |  |  |       |      
|                     |                            |      | 3,188 |       |  |  | 2,576 |      
|                     |                            |      |       |       |  |  |       |      



| |                       
| | ----------------------
| | 1997 Stock Option Plan

In October 1997, the board of directors adopted
the 1997 Stock Plan (1997 Plan) for issuance of common stock and
grants of options for common stock to employees, consultants and
directors. Incentive stock options granted under the plan are at
prices not less than the fair value of stock at the date of
grant, except in the case of a sale to a person who owns stock
representing more than 10% of all the voting power of all
classes of stock of CoSine, in which case the purchase price
will be 110% of the fair market value of the common stock on the
date of grant. Nonstatutory stock options granted under the 1997
Plan are at prices not less than 85% of the fair value of stock
at the date of grant, except in the case of a sale to a person
who owns stock representing more than 10% of all the voting
power of all classes of stock of CoSine, in which case the
purchase price will be 110% of the fair market value of the
common stock on the date of grant. Options granted under the
1997 Plan generally vest over four years at a rate of 25% one
year from the grant date and ratably monthly thereafter and
expire 10 years after the grant, or earlier upon
termination. Options may be granted with different vesting terms.

The 1997 Plan also allowed for the exercise of
options before vesting and the related issuance of restricted
stock that is subject to right of repurchase by CoSine. The
rights of repurchase generally lapse at the rate noted above. At
December 31, 2002 and 2001, 45,952 and 277,290 shares
of common stock were subject to repurchase at an aggregate
repurchase price of $1,930,000 and $11,830,000, respectively.
During 2002 and 2001, employees defaulted on notes receivable in
the amounts of $14,701,000 and $10,651,000, respectively,
secured by 332,063 shares and 221,455 shares of common
stock, respectively. The shares were returned to the Company.

Effective upon the initial public offering, the
1997 Plan was terminated and the shares reserved and unissued
under the 1997 Plan were reserved for issuance under the 2000
Plan.

55



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                       
| | ----------------------
| | 2000 Stock Option Plan

In May 2000, the board of directors adopted the
2000 Stock Plan (2000 Plan). The 2000 Plan was approved by the
stockholders before the completion of the initial public
offering. The 2000 Plan provides for the grant of incentive
stock options to employees, and for the grant of nonstatutory
stock options and stock purchase rights to employees, directors
and consultants. Incentive stock options granted under the 2000
Plan will be at prices not less than the fair value of the
common stock at the date of grant. The term of each option will
be determined by the administrator of the plan, generally
10 years or less.

At December 31, 2002 and 2001, a total of
3,122,303 and 2,483,173 common shares of CoSine have been
reserved for issuance under the 2000 Plan, respectively.



| |                       
| | ----------------------
| | 2002 Stock Option Plan

In January 2002, the board of directors adopted
the 2002 Stock Plan (2002 Plan). The purpose of the 2002 Plan is
to make available for issuance certain shares of Common Stock
that have been (i) previously issued pursuant to the
exercise of stock options granted under the 1997 Plan and
(ii) subsequently reacquired by CoSine pursuant to
repurchase rights contained in restricted stock purchase
agreements or pursuant to optionee defaults on promissory notes
issued in connection with the exercise of such options
(Reacquired Shares). Under the terms of the 1997 Plan and the
2000 Plan, these Reacquired Shares would not otherwise have been
available for reissuance. No shares that were not previously
issued under the 1997 Plan and subsequently reacquired by CoSine
have been or will be reserved for issuance under the 2002 Plan.

A maximum of 1,000,000 shares may be
reserved for issuance under the 2002 Plan. An aggregate of
335,791 shares were initially reserved for issuance under
the 2002 Plan upon its adoption. These shares consisted of
Reacquired Shares as of the date of adoption. Additional shares
that become Reacquired Shares after the date of adoption of the
2002 Plan, up to a maximum of 664,209 additional shares, will
also become available for issuance under the 2002 Plan. As of
February 28, 2003, an aggregate of 685,009 Reacquired
Shares have been reserved for issuance under the 2002 Plan.

The provisions of the 2002 Plan are substantially
similar to those of the 2000 Plan, except that the 2002 Plan
does not permit the grant of awards to officers or directors and
does not permit the grant of Incentive Stock Options. The 2002
Plan provides for the grant of nonstatutory stock options to
employees (excluding officers) and consultants. Stock options
granted under the 2002 Plan will be at prices not less than the
fair value of the common stock at the date of grant. The term of
each option, generally 10 years or less, will be determined
by the administrator of the Plan.



| |                          
| | -------------------------
| | 2000 Director Option Plan

In May 2000, the board of directors adopted the
2000 Director Option Plan (Directors Plan), which was
effective upon the closing of the initial public offering. At
December 31, 2002 and 2001 a total of 40,000 shares of
common stock have been reserved for issuance under the
Directors Plan.

The Directors Plan will automatically grant
an option to purchase 8,000 shares of common stock to
each non-employee director when he or she is first elected to
CoSines board of directors following the initial public
offering. The Directors Plan also provided that each
non-employee director who had been a member of the board of
directors for at least six months before the date of each annual
stockholders meeting would receive an automatic annual
grant of options to acquire 2,000 shares of common stock.

The options have an exercise price per share
equal to the fair market value of common stock at the date of
grant and have a term of 10 years. Initial options vest and
become exercisable in four equal annual increments immediately
following the date of grant. Later additional options granted
vest and become exercisable on the fourth anniversary of the
date of grant.

56



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                       
| | --------------------------------------
| | Summary Stock Option Plan
    Activity

Stock activity under the Stock Option Plans was
as follows (in thousands, except per share data):

|                                |  |               |        |                     |  |           |        |   |  |   |       | 
|------------------------------- |  | ------------- | ------ | ------------------- |  | --------- | ------ | - |  | - | ----- | 
|                                |  |               |        |                    
|                                |  |               |        | Options Outstanding
|                                |  |               |        |                    
|                                |  |               |        |                     |  | Weighted-
|                                |  | Shares        |        |                     |  | Average  
|                                |  | Available for |        |                     |  | Price per
|                                |  | Grant         |        | Shares              |  | Share    
|                                |  |               |        |                     |  |          
|Balance as of December 31, 1999 |  |               | 688    |                     |  |           | 1,080  |   |  | $ | 6.89  | 
|Authorized                      |  |               | 1,409  |                     |  |           |       |   |  |   |      | 
|Granted                         |  |               | (1,552 | )                   |  |           | 1,552  |   |  |   | 99.42 | 
|Exercised                       |  |               |       |                     |  |           | (1,106 | ) |  |   | 34.16 | 
|Canceled                        |  |               | 117    |                     |  |           | (117   | ) |  |   | 57.90 | 
|                                |  |               |        |                     |  |           |        |   |  |   |       | 
|Balance as of December 31, 2000 |  |               | 662    |                     |  |           | 1,417  |   |  |   | 82.89 | 
|Authorized                      |  |               | 510    |                     |  |           |       |   |  |   |      | 
|Granted                         |  |               | (1,656 | )                   |  |           | 1,656  |   |  |   | 23.16 | 
|Exercised                       |  |               |       |                     |  |           | (50    | ) |  |   | 3.79  | 
|Canceled                        |  |               | 1,343  |                     |  |           | (1,343 | ) |  |   | 86.83 | 
|                                |  |               |        |                     |  |           |        |   |  |   |       | 
|Balance as of December 31, 2001 |  |               | 859    |                     |  |           | 1,680  |   |  |   | 23.57 | 
|Repurchased                     |  |               | 645    |                     |  |           |       |   |  |   |      | 
|Granted                         |  |               | (1,884 | )                   |  |           | 1,884  |   |  |   | 9.26  | 
|Exercised                       |  |               |       |                     |  |           | (30    | ) |  |   | 9.73  | 
|Canceled                        |  |               | 2,236  |                     |  |           | (2,236 | ) |  |   | 20.05 | 
|                                |  |               |        |                     |  |           |        |   |  |   |       | 
|Balance as of December 31, 2002 |  |               | 1,856  |                     |  |           | 1,298  |   |  |   | 9.18  | 
|                                |  |               |        |                     |  |           |        |   |  |   |       | 

The following table summarizes information
concerning options outstanding and exercisable at
December 31, 2002 (in thousands, except per share data):

|                |  |                     |       |                     |  |           |     |        |  |           |        |  |  |  |     |  |  |   |        | 
|--------------- |  | ------------------- | ----- | ------------------- |  | --------- | --- | ------ |  | --------- | ------ |  |  |  | --- |  |  | - | ------ | 
|                |  |                     |       |                    
|                |  | Options Outstanding |       | Options Exercisable
|                |  |                     |       |                    
|                |  |                     |       | Weighted-           |  |           |     |       
|                |  |                     |       | Average             |  | Weighted- |     |        |  | Weighted-
|                |  |                     |       | Remaining           |  | Average   |     |        |  | Average  
|Range of        |  |                     |       | Contractual         |  | Exercise  |     |        |  | Exercise 
|Exercise Prices |  | Shares              |       | Life                |  | Price     |     | Shares |  | Price    
|                |  |                     |       |                     |  |           |     |        |  |          
|$0.38-$4.10     |  |                     | 50    |                     |  |           | 6.6 |        |  | $         | 2.40   |  |  |  | 44  |  |  | $ | 2.18   | 
|5.00            |  |                     | 1,027 |                     |  |           | 8.4 |        |  |           | 5.00   |  |  |  | 542 |  |  |   | 5.00   | 
|8.80-12.20      |  |                     | 51    |                     |  |           | 8.7 |        |  |           | 10.91  |  |  |  | 42  |  |  |   | 11.30  | 
|15.00-15.50     |  |                     | 58    |                     |  |           | 8.1 |        |  |           | 15.47  |  |  |  | 54  |  |  |   | 15.50  | 
|15.70-22.40     |  |                     | 33    |                     |  |           | 8.7 |        |  |           | 18.31  |  |  |  | 10  |  |  |   | 17.87  | 
|22.50-26.20     |  |                     | 45    |                     |  |           | 8.2 |        |  |           | 22.53  |  |  |  | 45  |  |  |   | 22.53  | 
|32.70-162.50    |  |                     | 34    |                     |  |           | 7.6 |        |  |           | 107.12 |  |  |  | 33  |  |  |   | 108.49 | 
|                |  |                     |       |                     |  |           |     |        |  |           |        |  |  |  |     |  |  |   |        | 
|$0.38-$162.50   |  |                     | 1,298 |                     |  |           | 8.3 |        |  | $         | 9.18   |  |  |  | 770 |  |  | $ | 11.53  | 
|                |  |                     |       |                     |  |           |     |        |  |           |        |  |  |  |     |  |  |   |        | 



| |                                      
| | -------------------------------------
| | 2000 Employee Stock Purchase
    Plan

In May 2000, the board of directors adopted the
2000 Employee Stock Purchase Plan (Purchase Plan), which was
effective upon the closing of the initial public offering. The
Purchase Plan qualifies under the

57



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

provisions of section 423 of the 1986
Internal Revenue Code of the United States. A total of
654,000 shares are reserved for issuance under the Purchase
Plan. Under the terms of the Purchase Plan, employees may
contribute through payroll deductions up to 10% of their
compensation to purchase shares at a price equal to 85% of the
lower of the fair market value of the common stock at the
beginning of the offering period or at the end of the offering
period.



| |                         
| | ------------------------
| | Stock-Based Compensation

During the year ended December 31, 2000,
CoSine issued stock options to employees with exercise prices
that it believed represented the fair value of the stock. In
March 2000, after CoSine began the initial public offering
process, CoSine reevaluated the fair value of its common stock.
In connection with the reevaluation, CoSine recorded deferred
stock compensation for these stock option grants of $81,029,000
in the year ended December 31, 2000, representing the
difference between the fair value of the common stock for
financial reporting purposes and the exercise price of the
underlying options. This amount is recorded as a reduction of
stockholders equity and is being amortized over the
vesting period of the individual options, generally four years,
using the graded vesting method. CoSine recorded amortization of
deferred stock compensation of $7,273,000, $29,687,000 and
$51,563,000 for the years ended December 31, 2002, 2001 and
2000, respectively. When an employee terminates, an expense
credit is recorded for any amortization that has been previously
recorded as an expense in excess of vesting. For the year ended
December 31, 2002, credits of $8,466,000 were recorded to
reverse deferred stock compensation amortization in excess of
vesting.

During the year ended December 31, 2000,
CoSine granted common stock options to non-employees at exercise
prices that range from $40.00 to $95.00 per share for
services provided to CoSine. These options are included in the
option tables disclosed above. The options generally vest over
four years at a rate of 25% one year from the grant date and
ratably monthly thereafter and expire 10 years after the
grant date. CoSine recognized expense of $4,000 and $8,029,000
in 2001 and 2000, respectively, for these transactions, and no
expense in 2002. The fair value of these options was
periodically remeasured as they vested over the performance
period and was estimated using the Black-Scholes model with the
following assumptions: risk-free interest rate of 5%, expected
life of 10 years, a dividend yield of zero, and an expected
volatility of CoSines common stock of 0.6.

During the year ended December 31, 2000,
CoSine converted full-recourse promissory notes received from
employees upon the early exercise of unvested employee stock
options to non-recourse obligations. Accordingly, CoSine is
required to remeasure the compensation associated with these
shares until the earlier of the shares vesting, or the note
being repaid or defaulted. The result of each remeasurement is
deferred compensation expense, which is amortized over the
remaining vesting period of the underlying options. In 2002,
CoSine recorded a reversal of deferred stock compensation of
$4,916,000 due to employee terminations, a reduction of deferred
compensation of $282,000 due to the remeasurement of
compensation associated with these unvested shares and
amortization of $173,000. In 2001, CoSine recorded a reduction
deferred stock compensation due to the remeasurement of
compensation associated with these unvested shares amounting to
$31,586,000 and a reversal of amortization of $526,000. In 2000,
Cosine recorded amortization of deferred compensation of
$8,217,000.

On November 1, 2002, CoSine repriced
1,091,453 outstanding employee stock options to purchase shares
of CoSines common stock with original exercise prices
ranging from $5.45 per share to $159.38 per share.
These options were repriced to $5.00 per share, $1.00 more
than the fair market value of the underlying shares on the
repricing date. The repricing requires that compensation
associated with these options be remeasured until they are
exercised, canceled, or expire. During 2002, CoSine recorded
deferred stock compensation in relation to repriced stock
options amounting to $1,111,000 and amortization of $514,000, as
the price of CoSines stock at the end of the quarter after
the November 2002 repricing was higher than the repriced amount.

58



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

On July 10, 2001, CoSine repriced 722,071
outstanding employee stock options to purchase shares of
CoSines common stock with original exercise prices ranging
from $40.00 per share to $400.00 per share. These
options were repriced to $15.50 per share, the fair market
value of the underlying shares on the repricing date. The
repricing requires that compensation associated with these
options be remeasured until they are exercised, canceled, or
expire. During the years ended December 31, 2002 and
December 31, 2001, CoSine did not record any deferred stock
compensation in connection with these repriced options, as the
price of CoSines stock was not higher than the repriced
amount at any quarter-end during those periods.



| |         
| | --------
| | Warrants

In November 1998, in connection with consulting
services, CoSine issued warrants to
purchase 4,307 shares of common stock. The warrants
were exercisable at any time at $1.50 per share and expired
on the earlier of 10 years following the issue date or a
corporate reorganization. The warrants were exercised in
September 2000 and converted into 4,307 common shares upon
completion of the initial public offering. The warrants had a
variable measurement date and accordingly they were periodically
revalued based on the guidance of Emerging Issues Task Force
Consensus No. 96-18 (EITF No. 96-18). The warrants
were to vest over a period of four years and their fair value
was calculated to be $260,000 at December 31, 1999, using
the Black-Scholes valuation method, utilizing a volatility
factor of 0.6, risk-free interest rate of 5%, and an initial
expected life of 10 years. Prior to their exercise, the
fair value of the warrants was being amortized over the expected
life of the warrants.

In August 1998, in connection with a facilities
lease arrangement, CoSine issued warrants to
purchase 15,792 shares of series A preferred stock.
The warrants were exercisable at any time at no cost to the
holder and expired on the earlier of five years following the
issue date or a corporate reorganization. The warrants had a
variable measurement date and accordingly they are periodically
revalued based on the guidance of EITF No. 96-18. The
warrants vested over a period of one year and their fair value
was calculated to be $767,000 at December 31, 1999 using
the Black-Scholes valuation method, utilizing a volatility
factor of 0.6, risk-free interest rate of 5%, and an initial
expected life of five years. The fair value of the warrants is
being amortized over the term of the lease. These warrants were
exercised in June 2000 and converted into 63,642 shares of
common stock upon the completion of the initial public offering
in September of 2000.

In May 1998, in connection with a loan and
security agreement, CoSine issued warrants to
purchase 8,469 shares of series B preferred
stock. Upon the closing of the initial public offering, these
warrants became warrants to purchase an equivalent number of
shares of common stock. The warrants were fully vested
immediately upon issuance and exercisable at any time at
$7.38 per share and expired five years following the issue
date. There are no forfeiture rights. As there were no future
performance obligations, the measurement date of the warrants
was fixed at the issuance date. The fair value of the warrants
was calculated to be $35,000 using the Black-Scholes valuation
method, utilizing a volatility factor of 0.6, risk-free interest
rate of 5%, and an expected life of five years, and was expensed
in full during 1998. In October 2000, these warrants were
exercised in a cashless exercise, which resulted in
8,289 shares of common stock being issued net of
180 shares delivered in payment of the warrant exercise
price.

In October 1998, in connection with an equipment
and working capital loan arrangement, CoSine issued warrants to
purchase 30,488 shares of series B preferred
stock. Upon the closing of the initial public offering, these
warrants became warrants to purchase an equivalent number of
shares of common stock. The warrants were fully vested
immediately upon issuance and exercisable at any time at
$7.38 per share and expire eight years following the issue
date. The fair value of the warrants was calculated to be
$152,000 using the Black-Scholes valuation method, utilizing a
volatility factor of 0.6, risk-free interest rate of 5%, and an
expected life of eight years. The fair value of the warrants is
being amortized over the term of the loan.

In November 1998, in connection with a bridge
note agreement, CoSine issued warrants to
purchase 30,488 shares of series B preferred stock.
The warrants were fully vested immediately upon issuance

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

and exercisable at any time at $7.38 per
share and expired on the earlier of 10 years following the
issue date and a corporate reorganization. As there were no
future performance obligations, the measurement date of the
warrants was fixed at the issuance date. The fair value of the
warrants was calculated to be $165,000 using the Black-Scholes
valuation method, utilizing a volatility factor of 0.6,
risk-free interest rate of 5%, and an expected life of
10 years, and was expensed in full during 1998. These
warrants were exercised at various dates between May 2000 and
completion of the initial public offering in September and the
shares of series B preferred stock issued were converted to
common stock upon completion of the initial public offering.

In May 1999, for technical, marketing and
market-related product development services, CoSine issued
warrants to a customer to purchase 64,190 shares of
series C preferred stock. The warrants were fully vested
immediately upon issuance and exercisable at any time at
$10.91 per share and expired five years following the issue
date. The warrants were exercised in July 2000 and converted
into 64,190 shares of common stock upon completion of the
initial public offering. As there were no future performance
obligations, the measurement date of the warrants was fixed at
the issuance date. The fair value of the warrants was calculated
to be $392,000 using the Black-Scholes valuation method,
utilizing a volatility factor of 0.6, risk-free interest rate of
5%, and an expected life of five years, and was expensed in full
during 1999.

In September 1999, in connection with placement
services for the first round of series D issuance, CoSine
issued warrants to purchase 14,893 shares of series D
preferred stock. The warrants were fully vested immediately upon
issuance and exercisable at any time at $35.05 per share
and expired five years following the issue date. The warrants
were exercised in July 2000 and converted into
14,893 shares of common stock upon completion of the
initial public offering. As there were no future performance
obligations, the measurement date of the warrants was fixed at
the issuance date. The fair value of the warrants was calculated
to be $292,000 using the Black-Scholes valuation method,
utilizing a volatility factor of 0.6, risk-free interest rate of
5%, and an expected life of five years, and was recorded as
series D first round issuance costs.

In October 1999, in connection with placement
services for the second round of series D issuance, CoSine
issued warrants to purchase 514 shares of
series D preferred stock. The warrants were fully vested
immediately upon issuance and exercisable at any time at
$35.05 per share and expired five years following the issue
date. The warrants were exercised in July 2000 and converted
into 514 shares of common stock upon the completion of the
initial public offering. As there were no future performance
obligations, the measurement date of the warrants was fixed at
the issuance date. The fair value of the warrants was calculated
to be $16,000 using the Black-Scholes valuation method,
utilizing a volatility factor of 0.6, risk-free interest rate of
5%, and an expected life of five years, and was recorded as
series D second round issuance costs.

In January 2000, upon receipt of a purchase order
from a customer, CoSine issued warrants to the customer to
purchase 123,350 shares of series C preferred
stock at $8.10 per share, subject to adjustment. The
warrants had a life of four years. They were fully vested and
exercisable immediately and were exercised in July 2000 and
converted into 123,350 shares of common stock upon
completion of the initial public offering. As there were no
future performance obligations, the measurement date of the
warrants was fixed at the issuance date. The fair value of the
warrants was calculated to be $10,300,000 using the
Black-Scholes valuation method, utilizing a volatility factor of
0.6, risk-free interest rate of 5% and an expected life of four
years. The fair value of the warrants was deferred and has since
been fully amortized as an offset to receipts from sales,
including equity issued in connection with sales as the revenue
associated with this order has been recognized.

In February 2000, upon receipt of a purchase
order from a customer, CoSine issued warrants to the customer to
purchase 20,000 shares of common stock at
$40.00 per share, subject to adjustment. The warrants had a
life of four years. They were fully vested and exercisable
immediately and were exercised in September 2000. As there were
no future performance obligations, the measurement date of the
warrants was fixed at the issuance date. The fair value of the
warrants was calculated to be $1,840,000 using the Black-Scholes
valuation method, utilizing a volatility factor of 0.6,
risk-free interest rate of 5% and an expected life of four

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

years. Prior to their exercise, the fair value of
the warrants was deferred and has since been fully amortized as
an offset to receipts from sales, including equity issued in
connection with sales as the revenue associated with this order
has been recognized.

In March 2000, upon receipt of a purchase order
from a customer, CoSine issued warrants to the customer to
purchase 46,885 shares of common stock at
$37.30 per share, subject to adjustment. The warrants had a
life of four years. They were fully vested and exercisable
immediately. As there were no future performance obligations,
the measurement date of the warrants was fixed at the assumed
issuance date. The fair value of the warrants was calculated to
be $4,112,000 using the Black-Scholes valuation method,
utilizing a volatility factor of 0.6, risk-free interest rate of
5% and an expected life of four years. Prior to their exercise,
the fair value of the warrants was deferred, and a portion of
the fair value was amortized in 2000 as an offset to receipts
from sales, including equity issued in connection with sales.
This customer, however, ceased operations during 2001 and
therefore the remaining $3,830,000 of unamortized fair value of
these warrants was written off. Of the amount written off,
approximately $1,092,000 was charged as an offset to receipts
from sales, including equity issued in connection with sales,
and the remaining balance of $2,738,000 was charged to sales and
marketing expense.

In March 2000, in connection with an equipment
lease, CoSine issued warrants for the purchase of
3,750 shares of its common stock at $80.00 per share
to a leasing company. The warrants may be exercised at any time
before the earlier of 10 years from the date of the warrant
or the fifth anniversary of the initial public offering. As
there are no future performance obligations, the measurement
date of the warrants was fixed at the issuance date. The fair
value of the warrant was calculated to be $357,000 using the
Black-Scholes valuation method utilizing a volatility factor of
0.6, risk-free interest rate of 5% and an expected life of
10 years. This amount was deferred as prepaid interest and
is being amortized over the lease term of three years.

In April 2000, for assistance with specific
marketing activities CoSine agreed to issue a warrant to a
customer for the purchase of 7,500 shares of common stock
at $150.00 per share, subject to adjustment. The issuance
of the warrant was contingent upon the customer obtaining
financing for its purchase order. The customer subsequently
sought protection under Chapter 11 of the United States
federal bankruptcy code, and accordingly the warrants were not
issued.

At December 31, 2002 and 2001, warrants to
purchase 30,488 and 3,750 shares of common stock at
$7.38 per share and $80.00 per share, respectively,
were outstanding.

7.     Related
Parties

As of December 31, 2002 and 2001, CoSine had
non-recourse promissory notes receivable of $775,000 and
$3,360,000, respectively, from officers of CoSine for the
payment of stock option exercises. The notes are secured by a
pledge of CoSines common stock and have annual interest
rates ranging from 6.09% to 6.77%. The notes and interest
accrued but unpaid are due and payable during 2008. During 2002,
four officers, whose employment with CoSine terminated,
defaulted on the payment of non-recourse loans amounting to
$2,485,000 secured by 67,156 shares of common stock. During
2001, one officer, whose employment with CoSine terminated,
defaulted on the payment of a non-recourse loan amounting to
$2,019,000 secured by 21,250 shares of common stock.

As of December 31, 2002 and 2001, CoSine had
non-recourse promissory notes receivable secured by a pledge of
CoSines common stock totaling $9,756,000 and $22,106,000,
respectively, from non-officer employees of CoSine for the
payment of stock option exercises. Yearly interest on the notes
ranges from 6.09% to 6.77%. The notes are due and payable at the
earliest of 10 years from the date of loan, the date of the
employees termination or the date the shares are sold.
During 2002 and 2001, non-officer employees defaulted

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

on notes receivable in the amounts of $12,216,000
and $8,632,000, respectively, secured by 264,907 shares and
200,205 shares of common stock, respectively.

During 2000, certain CoSine officers purchased
stock in AduroNet Limited. The officers total holdings
represented less than 1% of AduroNets total outstanding
shares. For the year ended December 31, 2000, CoSine
recognized revenue of $13,267,000 from AduroNet. In February
2001, AduroNet became insolvent and subsequently filed for
provisional liquidation under British law.

8.     Income
Taxes

The provisions for income taxes of $509,000,
$837,000 and $264,000 for the years ended December 31,
2002, 2001 and 2000, respectively, are comprised entirely of
foreign corporate income taxes. The difference between the
provisions for income taxes and the amounts computed by applying
the federal statutory income tax rate to the losses before
income taxes are explained below (in thousands):

|                                                            |                 |      |         |      |  |      |         |     |  |   |         |     | 
|----------------------------------------------------------- | --------------- | ---- | ------- | ---- |  | ---- | ------- | --- |  | - | ------- | --- | 
|                                                            |                 | 2002 |         | 2001 |  | 2000
|                                                            |                 |      |         |      |  |     
|U.S. federal tax benefit at federal
    statutory rate      |                 | $    | (32,888 | )    |  | $    | (50,896 | )   |  | $ | (54,552 | )  
|Loss for which no tax benefit is currently
    recognizable |                 |      | 30,828  |      |  |      | 46,030  |     |  |   | 42,785  |    
|Non-cash charges related to equity issuances                |                 |      | 2,569   |      |  |      | 5,703   |     |  |   | 12,031  |    
|                                                            |                 |      |         |      |  |      |         |     |  |   |         |    
|                                                            | Total provision |      | $       | 509  |  |      | $       | 837 |  |   | $       | 264 | 
|                                                            |                 |      |         |      |  |      |         |     |  |   |         |    

Deferred income taxes reflect the net tax effects
of temporary differences between the carrying amounts of assets
and liabilities for financial reporting purposes and the amounts
used for income tax purposes. Significant components of
CoSines deferred tax assets are as follows (in thousands):

|                          |                                                |      |          |        |  |  |          |        | 
|------------------------- | ---------------------------------------------- | ---- | -------- | ------ |  |  | -------- | ------ | 
|                          |                                                | 2002 |          | 2001  
|                          |                                                |      |          |       
|Deferred tax assets:      |                                                |      |          |        |  |  |          |       
|                          | Net operating loss carryforwards               |      | $        | 85,000 |  |  | $        | 60,003 | 
|                          | Equity related charges                         |      |          | 13,719 |  |  |          | 17,190 | 
|                          | Tax credit carryforwards                       |      |          | 5,496  |  |  |          | 4,266  | 
|                          | Deferred revenue                               |      |          | 592    |  |  |          | 954    | 
|                          | Inventory reserve                              |      |          | 2,905  |  |  |          | 6,094  | 
|                          | Capitalized research and development           |      |          | 6,685  |  |  |          | 5,608  | 
|                          | Accruals and reserves not currently deductible |      |          | 6,760  |  |  |          | 6,594  | 
|                          |                                                |      |          |        |  |  |          |       
|Total deferred tax assets |                                                |      | 121,157  |        |  |  | 100,709  |       
|Valuation allowance       |                                                |      | (121,157 | )      |  |  | (100,709 | )     
|                          |                                                |      |          |        |  |  |          |       
|                          | Net deferred tax assets                        |      | $        |       |  |  | $        |       | 
|                          |                                                |      |          |        |  |  |          |       

Financial Accounting Standards Board Statement
Number 109, Accounting for Income Taxes provides for
the recognition of deferred tax assets if realization of the
deferred tax assets is more likely than not. Based upon the
weight of available evidence, which includes CoSines
historical operating performance and the reported cumulative net
losses in all prior years, CoSine has provided a full valuation
allowance against its net deferred tax assets. The valuation
allowance increased by $20,448,000 in 2002 and by $44,138,000 in
2001. The valuation allowance at December 31, 2002 includes
approximately $13,719,000 relating to equity issuances, which
will be credited to stockholders equity when realized.
December 31, 2001 includes approximately $17,190,000
relating to equity issuances, which will be credited to
stockholders equity when realized.

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

As of December 31, 2002, CoSine had federal
and state net operating loss carryforwards of approximately
$232,000,000 and $101,000,000, respectively. As of
December 31, 2001, CoSine had federal and state net
operating loss carryforwards of approximately $153,000,000 and
$110,000,000, respectively. As of December 31, 2002, CoSine
also had federal and state research and development tax credit
carryforwards of approximately $3,100,000 and $3,490,000,
respectively. As of December 31, 2001, CoSine also had
federal and state research and development tax credit
carryforwards of approximately $2,600,000 and $2,500,000,
respectively. The net operating loss and tax credit
carryforwards will expire at various dates beginning in 2005, if
not utilized.

Use of the net operating loss and tax credit
carryforwards may be subject to substantial annual limitation
due to the ownership change limitations provided by the Internal
Revenue Code of 1986, and similar state provisions. The annual
limitation may result in the expiration of net operating loss
and tax credit carryforwards before utilization.

9.     Restructuring
and Impairment Charges



| |                           
| | --------------------------
| | October 2002 Restructuring

In October 2002, CoSines senior management
approved a restructuring plan to reduce its worldwide workforce.
In addition, based on ongoing negotiations, CoSine estimates
that it will be able to settle its obligations associated with
Redwood City, California leased facilities it exited during the
year for $8,104,000. Employees were notified in October 2002
that certain job functions would be eliminated and that
particular termination benefits would be paid to affected
employees. As a result of the workforce reduction,
73 employees were designated for termination in the
restructuring program. Most of the terminations took place in
the fourth quarter of 2002. The employees affected by the
workforce reduction were from all functional groups and were
located in offices in the United States, Europe and Asia.
Amounts related to the worldwide workforce reduction and lease
commitment will be paid out through March of 2003. The
restructuring program was implemented to reduce operating
expenses and conserve cash.

Details of the October 2002 restructuring charges
for the year ended December 31, 2002 are as follows, (in
thousands):

|                                           |  |           |        |             |  |       |       |  |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ----------- |  | ----- | ----- |  |  | - | ------ | -
|                                           |  | Worldwide |        | Lease       |  |      
|                                           |  | Workforce |        | Termination |  |      
|                                           |  | Reduction |        | and Other   |  | Total
|                                           |  |           |        |             |  |      
|Charges                                    |  | $         | 1,945  |             |  | $     | 7,854 |  |  | $ | 9,799  |  
|Cash payments                              |  |           | (1,628 | )           |  |       |      |  |  |   | (1,628 | )
|Deposit forfeiture and deferred rent       |  |           |       |             |  |       | 305   |  |  |   | 305    |  
|                                           |  |           |        |             |  |       |       |  |  |   |        |  
|Provision balance at December 31,
    2002 |  | $         | 317    |             |  | $     | 8,159 |  |  | $ | 8,476  |  
|                                           |  |           |        |             |  |       |       |  |  |   |        |  



| |                       
| | ----------------------
| | May 2002 Restructuring

In May 2002, CoSines senior management
approved a restructuring plan to reduce its worldwide workforce,
close certain sales offices, exit certain facilities and dispose
of or abandon certain property and equipment. Employees were
notified in May 2002 that certain job functions would be
eliminated and that particular termination benefits would be
paid to affected employees. As a result of the workforce
reduction, 146 employees were designated for termination in the
restructuring program. Most of the terminations took place in
the second quarter of 2002, with the remainder taken in the
third quarter of 2002. The employees in the workforce reduction
were from all functional groups and were located in offices in
the United States, Europe and Asia. Amounts related to the
worldwide workforce reduction were paid out through December of
2002, and lease commitments and non-cancelable commitments are
being paid out over their respective terms

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

through 2003. The Company also wrote down certain
property and equipment to its expected realizable value as the
assets have been either sold, disposed of or otherwise
abandoned. The restructuring program was implemented to reduce
operating expenses and conserve cash.

Details of the May 2002 restructuring charges for
the year ended December 31, 2002 are as follows, (in
thousands):

|                                           |  |           |        |             |  |             |        |       |  |   |        |   |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ----------- |  | ----------- | ------ | ----- |  | - | ------ | - |  | - | ------ | -
|                                           |  |           |        | Write-down  |  |             |        |      
|                                           |  | Worldwide |        | of Property |  | Lease       |        |      
|                                           |  | Workforce |        | and         |  | commitments |        |      
|                                           |  | Reduction |        | Equipment   |  | and Other   |        | Total
|                                           |  |           |        |             |  |             |        |      
|Charges                                    |  | $         | 3,660  |             |  | $           | 3,248  |       |  | $ | 2,318  |   |  | $ | 9,226  |  
|Cash payments                              |  |           | (3,660 | )           |  |             |       |       |  |   | (1,503 | ) |  |   | (5,163 | )
|Non-cash charges                           |  |           |       |             |  |             | (3,248 | )     |  |   |       |   |  |   | (3,248 | )
|                                           |  |           |        |             |  |             |        |       |  |   |        |   |  |   |        |  
|Provision balance at December 31,
    2002 |  | $         |       |             |  | $           |       |       |  | $ | 815    |   |  | $ | 815    |  
|                                           |  |           |        |             |  |             |        |       |  |   |        |   |  |   |        |  



| |                                    
| | -----------------------------------
| | Impairment of Long-lived
    Assets

As a result of CoSines assessment of market
conditions and the related effect on its business plan, the
Company concluded that indicators of impairment of its
long-lived assets were present during the second and third
quarters of 2002. Accordingly, the Company performed an
impairment test of the carrying value of its long-lived assets,
consisting primarily of property and equipment in accordance
with SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. Based on an undiscounted
cash flow analysis, the cash flows expected to be generated by
CoSines long-lived assets during their estimated remaining
useful lives are not sufficient to recover the net book value of
the assets. Consequently, the Company obtained a valuation
report outlining the estimated fair value of the assets, based
on quoted market prices, from an independent appraiser and
recorded an impairment charge of $15,512,000 to write the
carrying value of its long-lived assets held for use down to
their fair values in the second and third quarters of 2002. In
addition, property and equipment that was idled or abandoned was
written down by approximately $3,248,000 to its estimated net
realizable value.



| |                                           
| | ------------------------------------------
| | April and September 2001
    Restructuring

In April and September of 2001, CoSines
senior management approved restructuring plans to reduce its
worldwide workforce, close certain sales offices, exit certain
facilities and idle certain property and equipment. Employees
affected by the April 2001 program were notified and terminated
in April 2001. With respect to the September 2001 program,
notification was given to employees on September 28, 2001
that certain job functions would be eliminated and that
particular termination benefits would be paid to affected
employees. The restructuring programs were implemented to reduce
operating expenses and conserve cash.

64



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Details of the April and September 2001
restructuring charges for the year ended December 31, 2002
and 2001 are as follows (in thousands):

|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ----------- |  | ----------- | ------ | ----- |  | - | ---- | - |  | - | ------ | -
|                                           |  |           |        | Write-down  |  |             |        |      
|                                           |  | Worldwide |        | of Property |  | Lease       |        |      
|                                           |  | Workforce |        | and         |  | Commitments |        |      
|                                           |  | Reduction |        | Equipment   |  | and Other   |        | Total
|                                           |  |           |        |             |  |             |        |      
|Charges                                    |  | $         | 3,496  |             |  | $           | 4,593  |       |  | $ | 902  |   |  | $ | 8,991  |  
|Cash payments                              |  |           | (3,155 | )           |  |             |       |       |  |   | (135 | ) |  |   | (3,290 | )
|Non-cash charges                           |  |           |       |             |  |             | (4,593 | )     |  |   |     |   |  |   | (4,593 | )
|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  
|Provision balance at December 31,
    2001 |  | $         | 341    |             |  | $           |       |       |  | $ | 767  |   |  | $ | 1,108  |  
|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  
|Cash payments                              |  |           | (341   | )           |  |             |       |       |  |   | (767 | ) |  |   | 1,108  |  
|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  
|Provision balance at December 31,
    2002 |  | $         |       |             |  | $           |       |       |  | $ |     |   |  | $ |       |  
|                                           |  |           |        |             |  |             |        |       |  |   |      |   |  |   |        |  

As a result of the workforce reductions,
approximately 55 employees were terminated in the second quarter
of 2001, and approximately 50 employees were designated for
termination in the third quarter of 2001 restructuring program
and were then terminated in the fourth quarter of 2001. The
employees in both workforce reductions were from all functional
groups and were primarily located in the Redwood City,
California offices. Certain property and equipment has been
written down to its expected realizable value.

Amounts related to the worldwide workforce
reduction were paid out through mid-2002, and lease commitments
were paid out over the respective lease terms through mid-2002.

65



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##### Table of Contents






Supplemental Financial Information

The supplemental financial information required
to be set forth in this Item 8 is located in Part III
Item 15.






|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

Not applicable.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management



| |                                         
| | ----------------------------------------
| | Equity Compensation Plan
    Information

The following table summarizes equity
compensation plans approved by shareholders and equity
compensation plans that were not approved by the shareholders as
of December 31, 2002:

|                                                              |  |                         |           |                      |  |                         |      |     |  |  |           |    
|------------------------------------------------------------- |  | ----------------------- | --------- | -------------------- |  | ----------------------- | ---- | --- |  |  | --------- | ---
|                                                              |  |                         |           |                      |  | (c)                    
|                                                              |  |                         |           |                      |  | Number of Securities   
|                                                              |  | (a)                     |           |                      |  | Remaining Available for
|                                                              |  | Number of Securities    |           | (b)                  |  | Future Issuance Under  
|                                                              |  | to be Issued upon       |           | Weighted-Average     |  | Equity Compensation    
|                                                              |  | Exercise of Outstanding |           | Exercise Price of    |  | Plans (Excluding       
|                                                              |  | Options, Warrants       |           | Outstanding Options, |  | Securities Reflected in
|Plan category                                                 |  | and Rights              |           | Warrants and Rights  |  | Column (a))            
|                                                              |  |                         |           |                      |  |                        
|Equity compensation plans approved by stockholders            |  |                         | 1,211,941 | (1)                  |  | $                       | 9.48 | (1) |  |  | 2,119,726 | (2)
|Equity compensation plans not approved by
    stockholders(3) |  |                         | 86,150    |                      |  | $                       | 5.00 |     |  |  | 249,641   |    
|Total                                                         |  |                         | 1,298,091 |                      |  | $                       | 9.18 |     |  |  | 2,369,367 |    



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes 359,854 shares subject to
    outstanding options under the 1997 Stock Plan,
    836,087 shares subject to outstanding options under the
    2000 Stock Plan, and 16,000 shares subject to outstanding
    options under the Director Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   
|(2) | Includes 525,787 shares available for future
    issuance under the 1997 Stock Plan, 1,048,784 shares
    available for future issuance under the 2000 Stock Plan,
    32,000 shares available for future issuance under the
    Director Plan, and 513,155 shares available for future
    issuance under the Employee Stock Purchase Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   
|(3) | The only equity compensation plan not approved by
    stockholders is the 2002 Stock Plan (the 2002 Plan). The board
    of directors adopted the 2002 Plan in January 2002. The purpose
    of the 2002 Plan is to make available for issuance certain
    shares of Common Stock that have been (i) previously issued
    pursuant to the exercise of stock options granted under the 1997
    Plan and (ii) subsequently reacquired by CoSine pursuant to
    repurchase rights contained in restricted stock purchase
    agreements or pursuant to optionee defaults on promissory notes
    issued in connection with the exercise of such options
    (Reacquired Shares). Under the terms of the 1997 Plan and the
    2000 Plan, these Reacquired Shares would not otherwise have been
    available for reissuance. No shares that were not previously
    issued under the 1997 Plan and subsequently reacquired by CoSine
    have been or will be reserved for issuance under the 2002 Plan.
    A maximum of 1,000,000 shares may be reserved for issuance
    under the 2002 Plan. An aggregate of 335,791 shares were
    initially reserved for issuance under the 2002 Plan upon its
    adoption. These shares consisted of Reacquired Shares as of the
    date of adoption. Additional shares that become Reacquired
    Shares after the date of adoption of the 2002 Plan, up to a
    maximum of 664,209 additional shares, will also become available
    for issuance under the 2002 Plan. The provisions of the 2002
    Plan are substantially similar to those of the 2000 Plan, except
    that the 2002 Plan does not permit the grant of awards to
    officers

66



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##### Table of Contents



| |                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | or directors and does not permit the grant of
    Incentive Stock Options. The 2002 Plan provides for the grant of
    nonstatutory stock options to employees (excluding officers) and
    consultants. Stock options granted under the 2002 Plan will be
    at prices not less than the fair value of the common stock at
    the date of grant. The term of each option, generally
    10 years or less, will be determined by CoSine.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required by these Part III,
Items 10, 11, 12 and 13 are omitted and incorporated herein
by reference to CoSines definitive Proxy Statement for its
2003 Annual Meeting of Stockholders to be filed within
120 days of the end of CoSines fiscal year ended
December 31, 2002. However, no information set forth in the
Proxy Statement regarding the Report of the Compensation
Committee on Executive Compensation or the performance graph, or
the Report of the Audit Committee shall be deemed incorporated
by reference into this Form 10-K.




Section 16(a) Beneficial Ownership
Reporting Compliance

Information about compliance with
section 16(a) of the Securities and Exchange Act is
incorporated by reference to CoSines definitive Proxy
Statement for its 2003 Annual Meeting of Stockholders to be
filed within 120 days of the end of CoSines fiscal
year ended December 31, 2002.






|         |                        
|-------- | -----------------------
|Item 14. | Controls and Procedures

(a) Our President and Chief Executive
Officer and our Executive Vice President and Chief Financial
Officer have evaluated our disclosure controls and procedures as
of a date (the Evaluation Date) within the 90 days prior to
the filing date of this report on Form 10-K, and have
concluded that such controls and procedures are effective.

(b) There were no significant changes in our
internal controls or in other factors that could significantly
affect our internal controls subsequent to the Evaluation Date,
including any corrective actions with regard to significant
deficiencies or material weaknesses.






|         |                                                                    
|-------- | -------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K

(a) The following documents are filed as
part of this Annual Report on Form 10-K:



| |                         
| | ------------------------
| | (1) Financial Statements

|                                                                                                                                                                                                   |  |      |    | 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                                                                                                                                                                                   |  | Page
|                                                                                                                                                                                                   |  |     
|Statement of Management Responsibility                                                                                                                                                             |  |      | 37 | 
|Report of Independent Auditors                                                                                                                                                                     |  |      | 38 | 
|Consolidated Balance Sheets 
    December 31, 2002 and 2001                                                                                                                                       |  |      | 39 | 
|Consolidated Statements of Operations 
    Years ended December 31, 2002, 2001 and 2000                                                                                                           |  |      | 40 | 
|Consolidated Statements of Redeemable Convertible
    Preferred Stock, Stockholders Equity (Net Capital
    Deficiency) and Comprehensive Loss  Years ended
    December 31, 2002, 2001 and 2000 |  |      | 41 | 
|Consolidated Statements of Cash Flows 
    Years ended December 31, 2002, 2001 and 2000                                                                                                           |  |      | 43 | 
|Notes to Consolidated Financial Statements                                                                                                                                                         |  |      | 44 | 



| |                                  
| | ---------------------------------
| | (2) Financial Statement Schedules

|                                                    |  |  |    | 
|--------------------------------------------------- |  |  | -- | 
|Schedule II  Valuation and
    Qualifying Accounts |  |  | 69 | 

All other schedules are omitted as they are not
applicable or the required information is shown in the Financial
Statements or the notes thereto.



| |             
| | ------------
| | (3) Exhibits

See Exhibit Index on page 73. The Exhibits
listed in the accompanying Exhibit Index are filed as part
of this Annual Report on Form 10-K.

67



---



##### Table of Contents



(b) Reports on Form 8-K

On March 26, 2003, Stephen Goggiano,
President and Chief Executive Officer of the Company, and Terry
Gibson, Executive Vice President and Chief Financial Officer of
the Company, each executed certifications in connection with the
Form 10-K of the Company for the fiscal year ending
December 31, 2002, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002. Copies of such certifications
were included in the Form 8-K as Exhibits 99.1 and
99.2.

COSINE COMMUNICATIONS, INC.

SUPPLEMENTAL FINANCIAL INFORMATION
(unaudited)

|                                            |  |                                       |         |            |  |            |         |         |  |         |         |            |  |            |         |            |  |   |         |   |  |   |         |   |  |   |        |   |  |   |         |  
|------------------------------------------- |  | ------------------------------------- | ------- | ---------- |  | ---------- | ------- | ------- |  | ------- | ------- | ---------- |  | ---------- | ------- | ---------- |  | - | ------- | - |  | - | ------- | - |  | - | ------ | - |  | - | ------- | -
|                                            |  |                                       |         |           
|                                            |  | 2001                                  |         | 2002      
|                                            |  |                                       |         |           
|                                            |  | 1st                                   |         | 2nd        |  | 3rd        |         | 4th     |  | 1st     |         | 2nd        |  | 3rd        |         | 4th       
|                                            |  | Quarter                               |         | Quarter(1) |  | Quarter(1) |         | Quarter |  | Quarter |         | Quarter(2) |  | Quarter(2) |         | Quarter(2)
|                                            |  |                                       |         |            |  |            |         |         |  |         |         |            |  |            |         |           
|                                            |  |                                      
|                                            |  | (In thousands, except per share data)
|Revenue                                     |  | $                                     | 6,055   |            |  | $          | 7,127   |         |  | $       | 9,826   |            |  | $          | 11,285  |            |  | $ | 7,093   |   |  | $ | 6,066   |   |  | $ | 5,245  |   |  | $ | 5,228   |  
|Gross profit (loss)                         |  |                                       | (2,790  | )          |  |            | 2,685   |         |  |         | (1,941  | )          |  |            | 6,125   |            |  |   | 3,726   |   |  |   | 78      |   |  |   | 3,014  |   |  |   | 3,007   |  
|Net loss                                    |  |                                       | (41,846 | )          |  |            | (39,094 | )       |  |         | (41,926 | )          |  |            | (23,387 | )          |  |   | (22,955 | ) |  |   | (44,748 | ) |  |   | (9,014 | ) |  |   | (17,249 | )
|Basic and diluted net loss per common share |  | $                                     | (4.41   | )          |  | $          | (4.06   | )       |  | $       | (4.29   | )          |  | $          | (2.37   | )          |  | $ | (2.31   | ) |  | $ | (4.63   | ) |  | $ | (0.93  | ) |  | $ | (1.78   | )



---



|    |                                                                                                                                                                                                                                                          
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes restructuring charges of
    $2.0 million in the second quarter of 2001 and
    $7.0 million in the third quarter of 2001.                                                                                                                      
|   
|(2) | Includes restructuring and impairment charges of
    $24.0 million in the second quarter of 2002, restructuring
    charges of $0.7 million in the third quarter of 2002 and
    restructuring charges of $9.8 million in the fourth quarter
    of 2002.

68



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##### Table of Contents



COSINE COMMUNICATIONS, INC.

SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

|                              |                                  |                |   |            |  |                 |     |                |  |   |   |        |   |   |     |     | 
|----------------------------- | -------------------------------- | -------------- | - | ---------- |  | --------------- | --- | -------------- |  | - | - | ------ | - | - | --- | --- | 
|                              |                                  | Balance at     |   |            |  |                 |     |               
|                              |                                  | Beginning      |   | Charged to |  | Additions       |     | Balance at End
|Classification                |                                  | of Year        |   | Expenses   |  | (Deductions)(1) |     | of Year       
|                              |                                  |                |   |            |  |                 |     |               
|                              |                                  |               
|                              |                                  | (In thousands)
|Year ended December 31, 2002: |                                  |                |   |            |  |                 |     |                |  |   |   |        |   |   |     |    
|                              | Reserves for accounts receivable |                | $ | 700        |  |                 | $   | 296            |  |   | $ | (763   | ) |   | $   | 233 | 
|                              |                                  |                |   |            |  |                 |     |                |  |   |   |        |   |   |     |    
|Year ended December 31, 2001: |                                  |                |   |            |  |                 |     |                |  |   |   |        |   |   |     |    
|                              | Reserves for accounts receivable |                | $ | 631        |  |                 | $   | 1,385          |  |   | $ | (1,316 | ) |   | $   | 700 | 
|                              |                                  |                |   |            |  |                 |     |                |  |   |   |        |   |   |     |    
|Year ended December 31, 2000  |                                  | $              |  |            |  | $               | 631 |                |  | $ |  |        |   | $ | 631 |    
|                              |                                  |                |   |            |  |                 |     |                |  |   |   |        |   |   |     |    



---



|    |                                              
|--- | ---------------------------------------------
|(1) | Represents write offs of accounts receivable.

69



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the Registrant
has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized, on March 25, 2003.



| |                            
| | ---------------------------
| | COSINE COMMUNICATIONS, INC.



| |     |                     
| | --- | --------------------
| | By: | /s/ STEPHEN GOGGIANO

| |                                          
| | -----------------------------------------
| |                                          
| | Stephen Goggiano                         
| | President and Chief Executive
    Officer

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints
Stephen Goggiano, Jill Bresnahan and Terry Gibson, and each of
them acting individually, his true and lawful attorneys-in-fact
and agents, each with full power of substitution, for him in any
and all capacities, to sign any and all amendments to this
report, and to file the same, with all exhibits thereto and all
other documents in connection therewith, with the Securities and
Exchange Commission, granting unto each of said
attorneys-in-fact, or his substitute or substitutes, and each of
them, hereby ratifying and confirming all that such
attorneys-in-fact, or any substitutes, may do or cause to be
done by virtue hereof.

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed on
March 25, 2003 by the following persons in the capacities
indicated.

|                                     |  |                                                                                                       |  | 
|------------------------------------ |  | ----------------------------------------------------------------------------------------------------- |  | 
|                                     |  |                                                                                                      
|Signature                            |  | Title                                                                                                
|                                     |  |                                                                                                      
|                                    
|/s/ STEPHEN GOGGIANOStephen Goggiano |  | President, Chief Executive Officer and
    Director
    (Principal Executive Officer)                
|                                    
|/s/ TERRY GIBSONTerry Gibson         |  | Executive Vice President and Chief Financial
    Officer (Principal Financial and Accounting Officer)
|                                    
|/s/ DONALD GREENDonald Green         |  | Chairman of the Board and Director                                                                   
|                                    
|/s/ CHARLES J. ABBECharles J. Abbe   |  | Director                                                                                             
|                                    
|/s/ VINTON CERFVinton Cerf           |  | Director                                                                                             
|                                    
|/s/ R. DAVID SPRENGR. David Spreng   |  | Director                                                                                             

70



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##### Table of Contents



CERTIFICATION

1. I have reviewed this annual report on
Form 10-K of CoSine Communications, Inc.;

2. Based on my knowledge, this annual report
does not contain any untrue statement of a material fact or omit
to state a material fact necessary to make the statements made,
in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this
annual report;

3. Based on my knowledge, the financial
statements, and other financial information included in this
annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual
report;

4. The registrants other certifying
officer and I are responsible for establishing and
maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5. The registrants other certifying
officer and I have disclosed, based on our most recent
evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons
performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6. The registrants other certifying
officer and I have indicated in this annual report whether
there were significant changes in internal controls or in other
factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies
and material weaknesses.



| |                                                    
| | ---------------------------------------------------
| | /s/ STEPHEN GOGGIANO                               
| |                                                    
| | Stephen Goggiano                                   
| | Director, President and Chief Executive
    Officer

March 25, 2003

71



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##### Table of Contents






CERTIFICATION

1. I have reviewed this annual report on
Form 10-K of CoSine Communications, Inc.;

2. Based on my knowledge, this annual report
does not contain any untrue statement of a material fact or omit
to state a material fact necessary to make the statements made,
in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this
annual report;

3. Based on my knowledge, the financial
statements, and other financial information included in this
annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual
report;

4. The registrants other certifying
officer and I are responsible for establishing and
maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5. The registrants other certifying
officer and I have disclosed, based on our most recent
evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons
performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6. The registrants other certifying
officer and I have indicated in this annual report whether
there were significant changes in internal controls or in other
factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies
and material weaknesses.



| |                                                         
| | --------------------------------------------------------
| | /s/ TERRY GIBSON                                        
| |                                                         
| | Terry Gibson                                            
| | Executive Vice President and Chief Financial
    Officer

March 25, 2003

72



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EXHIBIT INDEX

|        |    |             |  |                                                                                                                                                                                                                                                                  
|------- | -- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 3  | .1*         |  | Second Amended and Restated Certificate of
    Incorporation, as amended (incorporated by reference to
    Exhibit 3.1 to Form 10-Q filed November 14, 2000).                                                                                                    
|        | 3  | .2*         |  | Bylaws (incorporated by reference to
    Exhibit 3.3 to Form 8A (file no. 000-30715) filed
    May 26, 2000). First Amendment to Bylaws dated
    April 30, 2001 (incorporated by reference to
    Exhibit 3.3 to Form                                           
|        | 3  | .3*         |  | 10-Q filed August 13, 2001).                                                                                                                                                                                                                                     
|        | 3  | .4          |  | Second Amendment to Bylaws dated January 28,
    2003.                                                                                                                                                                                                           
|        | 10 | .1*         |  | Form of Indemnification Agreement entered into by
    the Registrant with each of its directors and officers
    (incorporated by reference to Exhibit 10.1 of Amendment
    No. 1 to Registration Statement on Form S-1 filed
    June 6, 2000).                
|        | 10 | .2*         |  | 2000 Stock Plan and forms of agreements
    thereunder (incorporated by reference to Exhibit 10.2 of
    Amendment No. 1 to Registration Statement on Form S-1
    filed June 6, 2000).                                                                          
|        | 10 | .3*         |  | 2000 Employee Stock Purchase Plan and forms of
    agreements thereunder (incorporated by reference to
    Exhibit 10.3 of Amendment No. 1 to Registration
    Statement on Form S-1 filed June 6, 2000).                                                        
|        | 10 | .4*         |  | 2000 Director Option Plan and forms of agreements
    thereunder (incorporated by reference to Exhibit 10.4 of
    Amendment No. 1 to Registration Statement on Form S-1
    filed June 6, 2000).                                                                
|        | 10 | .5*         |  | 1997 Stock Plan (as amended and restated) and
    forms of agreements thereunder (incorporated by reference to
    Exhibit 10.5 of Registration Statement on Form S-1
    filed April 28, 2000).                                                                 
|        | 10 | .6*         |  | Third Amended and Restated Investors Rights
    Agreement (incorporated by reference to Exhibit 10.6 of
    Amendment No. 1 to Registration Statement on Form S-1
    filed June 6, 2000).                                                                      
|        | 10 | .7*         |  | Master Equipment Lease Agreement between the
    Registrant and Relational Funding Corporation dated as of
    February 1, 2000 (incorporated by reference to
    Exhibit 10.7 of Amendment No. 1 to Registration
    Statement on Form S-1 filed June 6, 2000). 
|        | 10 | .8*         |  | Loan and Security Agreement between Registrant
    and Venture Lending and Leasing II, Inc. dated as of
    September 21, 1998 (incorporated by reference to
    Exhibit 10.8 of Amendment No. 1 to Registration
    Statement on Form S-1 filed June 6, 2000).  
|        | 10 | .9*         |  | Amended and Restated Supplement between
    Registrant and Venture Lending and Leasing II, Inc. dated
    as of October 21, 1998 (incorporated by reference to
    Exhibit 10.9 of Amendment No. 1 to Registration
    Statement on Form S-1 filed June 6, 2000).
|        | 10 | .10*        |  | Master Loan and Security Agreement between
    Registrant and Finova Capital Corporation date as of
    May 19, 1999 (incorporated by reference to
    Exhibit 10.10 of Amendment No. 1 to Registration
    Statement on Form S-1 filed June 6, 2000).           
|        | 10 | .11*        |  | Loan and Security Agreement between Registrant
    and Silicon Valley Bank dated as of May 29, 1998
    (incorporated by reference to Exhibit 10.11 of Amendment
    No. 1 to Registration Statement on Form S-1 filed
    June 6, 2000).                        
|        | 10 | .12*        |  | Loan Modification Agreement between Registrant
    and Silicon Valley Bank dated as of June 22, 1998
    (incorporated by reference to Exhibit 10.12 of Registration
    Statement on Form S-1 filed April 28, 2000).                                            
|        | 10 | .13*        |  | Loan and Security Agreement between Registrant
    and Silicon Valley Bank dated as of September 30, 1999
    (incorporated by reference to Exhibit 10.13 of Amendment
    No. 1 to Registration Statement on Form S-1 filed
    June 6, 2000).                  
|        | 10 | .14*        |  | Building Lease Agreement between Registrant and
    Westport Joint Venture dated as of May 26, 1998
    (incorporated by reference to Exhibit 10.14 of Amendment
    No. 1 to Registration Statement on Form S-1 filed
    June 6, 2000).                        
|        | 10 | .15*        |  | Amendment No. 1 to Lease between Registrant
    and Westport Joint Venture dated as of September 9, 1999
    (incorporated by reference to Exhibit 10.15 of Registration
    Statement on Form S-1 filed April 28, 2000).                                        

73



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##### Table of Contents



|        |    |             |  |                                                                                                                                                                                                                                                
|------- | -- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 10 | .16*        |  | Building Lease Agreement between Registrant and
    Westport Joint Venture dated as of September 20, 1999
    (incorporated by reference to Exhibit 10.16 of Amendment
    No. 1 to Registration Statement on Form S-1 filed
    June 6, 2000).
|        | 10 | .17*        |  | 2002 Stock Plan and forms of agreements
    thereunder (incorporated by reference to Exhibit 10.17 to
    Form 10-K filed March 15, 2002).                                                                                                     
|        | 21 | .1          |  | Subsidiaries of the Registrant.                                                                                                                                                                                                                
|        | 23 | .1          |  | Consent of Independent Auditors.                                                                                                                                                                                                               



---



|  |                  
|- | -----------------
|* | Previously filed.

74