##### 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,
    2003            
|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



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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

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 on June 30, 2003) was
approximately $60,571,528.

As of
March 19, 2004, there were 10,173,879 shares of the
Registrants Common Stock outstanding.



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COSINE COMMUNICATIONS, INC.

FORM 10-K

Year Ended December 31, 2003


TABLE OF CONTENTS

|              |  |                                                                                           |  |      |    | 
|------------- |  | ----------------------------------------------------------------------------------------- |  | ---- | -- | 
|              |  |                                                                                           |  | Page
|              |  |                                                                                           |  |     
|Part I       
|Item 1.       |  | Business                                                                                  |  |      | 1  | 
|              |  | Executive Officers of the
    Registrant                                                  |  |      | 11 | 
|Item 2.       |  | Properties                                                                                |  |      | 11 | 
|Item 3.       |  | Legal Proceedings                                                                         |  |      | 12 | 
|Item 4.       |  | Submission of Matters to a
    Vote of Security Holders                                   |  |      | 12 | 
|Part II      
|Item 5.       |  | Market for Registrants
    Common Stock and Related Stockholder Matters                  |  |      | 12 | 
|Item 6.       |  | Selected Financial Data                                                                   |  |      | 13 | 
|Item 7.       |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations |  |      | 15 | 
|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  |  |      | 62 | 
|Item 9A.      |  | Controls and Procedures                                                                   |  |      | 62 | 
|Part III     
|Item 10.      |  | Directors and Executive
    Officers of the Registrant                                    |  |      | 63 | 
|Item 11.      |  | Executive Compensation                                                                    |  |      | 64 | 
|Item 12.      |  | Security Ownership of
    Certain Beneficial Owners and Management                        |  |      | 68 | 
|Item 13.      |  | Certain Relationships and
    Related Transactions                                        |  |      | 70 | 
|Item 14.      |  | Principal Accountant Fees
    and Services                                                |  |      | 71 | 
|Part IV      
|Item 15.      |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                       |  |      | 71 | 
|              |  | Signatures                                                                                |  |      | 73 | 
|              |  | Exhibit Index                                                                             |  |      | 74 | 
|EXHIBIT 3.5  
|EXHIBIT 10.11
|EXHIBIT 21.1 
|EXHIBIT 23.1 
|EXHIBIT 31.1 
|EXHIBIT 31.2 
|EXHIBIT 32.1 
|EXHIBIT 32.2 





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SAFE HARBOR STATEMENT UNDER

PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995


This annual report on Form 10-K contains
forward-looking statements. We use words such as
anticipate, believe, plan,
expect, future, intend and
similar expressions to identify forward-looking statements.
These forward-looking statements are subject to certain risks
and uncertainties that could cause actual results to differ
materially from those reflected in the forward-looking
statements. Factors that might cause such a difference include,
but are not limited to, the continued downturn in the
telecommunications industry and slow development of the market
for network-based IP services, failure to achieve revenue growth
and profitability, product development, commercialization and
technology difficulties, manufacturing costs, the impact of
competitive products, pricing, changing customer requirements,
timely availability and acceptance of new products, and changes
in economic conditions in the various markets that we serve, all
as are discussed in more detail in the section entitled
Risk Factors on pages 29 through 35 of this
report, as well as the other risk factors discussed in that
section. Readers are cautioned not to place undue reliance on
these forward-looking statements, which reflect
managements opinions only as of the date hereof. 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 that we file from time to time with the
Securities and Exchange Commission, including the Quarterly
Reports on Form 10-Q that we file in fiscal year 2004.




PART I






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

OVERVIEW

CoSine Communications, Inc. (CoSine) was
incorporated in California on April 14, 1997 and in August
2000 was reincorporated in the State of Delaware. 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 9500 and IPSX 3500 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 InVision Service Management software for
network management and InGage 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

1



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access, switching and routing products from both
traditional and emerging communications equipment vendors.


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 masking 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.



| |                                                     
| | ----------------------------------------------------
| | 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 associated with the need for 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 of 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 of subscribers to monitor and control
    their outsourced services;                                                                                 
|
| |  | reliability and scalability;                                                                                                                                     
|
| |  | software-based network management capabilities
    for service providers and their customers; and                                                                
|
| |  | the ability to support and operate with existing
    network standards and applications.                                                                         

3



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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:



| |   |                                                                                                                                                                                                                                                                                                                                                                               
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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. We intend to
    expand this capability by seeking additional reseller partners.                                
|
| |  | 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
    existing marketing, sales service and support capabilities
    through strategic relationships, mergers or acquisitions. 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 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

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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 (IPNOS).


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 server and Microsoft
Windows NT operating 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.

SERVICE OFFERING EXAMPLES

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



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



| |                                               
| | ----------------------------------------------
| | 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. 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, we also
offer 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

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##### Table of Contents



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 positioned to provide 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 with the utilization of a network-based firewall
to secure any kind of broadband access connection.



| |                                                   
| | --------------------------------------------------
| | 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 obtain the benefit
of IP services. We believe that this will enable service
providers to pursue revenue opportunities from new services
using their significant investments in equipment.

CUSTOMERS

During the year ended December 31, 2003, we
recognized revenue from 38 customers, of which Sprint and Nissho
Corporation accounted for 41% and 12% of our revenue,
respectively. Geographically, our revenue was distributed as
follows: Asia/ Pacific 35%; United States 47%; and Europe 18%
(See Note 1 of the Notes to the Consolidated Financial
Statements). Japan and Korea accounted for 20% and 12% of our
revenue, respectively.

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 results of operations.

SALES AND MARKETING

We sell our products through our direct sales
organization and resellers targeting specific countries. At
December 31, 2003, we had 30 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

6



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equipment required, we often assist prospective
customers with test and trial initiatives in order to facilitate
their 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; and
|
| |  | 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.



| |             
| | ------------
| | Direct Sales

Our direct sales organization is divided into
three regions  North America, Asia Pacific and
Europe  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, or General Managers, who report
directly to the Senior Vice President of Worldwide Sales.

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 developing and maintaining ongoing
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 five
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 countries in which we
do not have a local sales office, our sales transactions are
typically 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 revenue 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, 2003, we had 11 employees in
our customer service and support organization.

7



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##### Table of Contents



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.

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, 2003, we had 78 employees in
our research and development group. Since April of 2001, we have
had several restructurings in order to reduce our operating
expenses. These restructurings involved significant reductions
in our workforce, including our research and development group.
These reductions have required us to prioritize our research and
development objectives and to focus on enhancement of the
performance of our platform and the development of features that
are most important to our core customer base.

Our research and development expenses, including
non-cash charges related to equity issuances, totaled
$21.8 million, $32.4 million and $66.1 million
for the years ended December 31, 2003, 2002 and 2001,
respectively.

MANUFACTURING

We outsource the manufacture of our IPSG,
interface modules and chassis to two contract manufacturers. Our
primary contract manufacturer  Solectron
Corporation  procures raw materials, assembles our
printed circuit boards, and builds and test the IPSGs and
interface configurations used in our products. Raw materials
consist of electronic components 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 and test into finished products. Sonic

8



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##### Table of Contents



Manufacturing Corporation procures raw materials
and assembles and tests all chassis used in our products. The
IPSGs, interface modules and chassis assemblies are delivered to
our Redwood City, California facility, where we perform system
build, system test, packing and shipment. Our contract
manufacturers produce our products within 30 miles of our
Redwood City facility. All contract manufacturing is done
pursuant to a rolling 4-quarter forecast submitted by CoSine.


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, 2003, we had 10 employees in
our manufacturing operations group.

BACKLOG

Our 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, 2003,
2002 and 2001, our backlog totaled $3.5 million,
$1.4 million and $4.4 million, respectively. We expect
most of the orders in our backlog as of December 31, 2003
to be filled in 2004.

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. We do not believe that
backlog as of a 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, Redback 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.

9



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##### Table of Contents



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 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, 2004, we have a total of 21
patent applications pending in the United States relating to the
design of our products, four PCT patent applications pending 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, 2003, we had 148
full-time employees, 78 of whom were engaged in research and
development, 30 in sales and marketing, 19 in general corporate,
finance and administration, 11 in customer support and 10 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.

In addition we utilize contractors based in India
for certain software development and maintenance functions.

10



---



##### Table of Contents






EXECUTIVE OFFICERS

The names of our executive officers and their
ages, titles and biographies as of March 25, 2004 appear
below.

|                 |  |     |    |          |  |                                                         
|---------------- |  | --- | -- | -------- |  | --------------------------------------------------------
|Name             |  | Age |    | Position
|                 |  |     |    |         
|Stephen Goggiano |  |     | 51 |          |  | President and Chief Executive Officer                   
|Terry Gibson     |  |     | 50 |          |  | Executive Vice President and Chief Financial
    Officer
|Jerry Jalaba     |  |     | 48 |          |  | Senior Vice President of Worldwide Sales                

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 and
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.

Jerry Jalaba has served as Senior Vice President
of Sales since joining CoSine in August 2003. Prior to joining
CoSine, Mr. Jalaba served as Vice President, Worldwide
Sales and Support of Filanet/ Uroam from September 2001 to June
2003. From November 2000 to July 2001, he served as Vice
President, Enterprise Solutions Group of Palm. From January 2000
to October 2000, he served as Senior Vice President, Worldwide
Sales, Service and Marketing of Ramp Networks. From June 1998 to
November 1999, he served as Vice President, Sales and Service of
Vertical Networks. From April 1993 to June 1998 he worked at
3Com Corporation, where he served in various senior sales
positions, including Vice President of Worldwide Sales
Operations and Vice President of Enterprise Sales, North
America. Prior to 3Com Corporation, he spent 13 years at
IBM where he held several sales, marketing and network
consulting roles. Mr. Jalaba holds a B.S. from the
Massachusetts Institute of Technology and an MBA from the
University of Southern California.

AVAILABLE 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 that expires in December 2011. Additionally,
CoSine maintains sales offices in France, the United Kingdom,
Japan, Korea and other regions of the United States. We believe
the space will be sufficient for our current and anticipated
needs through at least December 2004.

11



---



##### Table of Contents








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

On November 15, 2001, CoSine and certain 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
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 each of the
directors and officers who signed the registration statement
relating to the initial public offering. 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 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, 2003. 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.

In June 2003, the plaintiffs in all of the cases
presented a settlement proposal to all of the issuer defendants.
Under the proposed settlement, the plaintiffs will dismiss and
release all claims against participating issuer defendants in
exchange for a contingent payment guaranty by the insurance
companies collectively responsible for insuring the issuer
defendants in all of the related cases, and the assignment or
surrender to the plaintiffs of certain claims the issuer
defendants may have against the underwriters. Under the
guaranty, the insurers will be required to pay the amount, if
any, by which $1 billion exceeds the aggregate amount ultimately
collected by the plaintiffs from the underwriter defendants in
all the cases, up to the limits of the applicable insurance
policies. The Company will not be required to make any cash
payments under the settlement, unless the Companys insurer
is required to pay on the Companys behalf an amount that
exceeds the Companys insurance coverage. The Company does
not believe that this circumstance will occur. In July 2003, a
special committee of the Companys Board of Directors
approved the proposed settlement. The settlement is subject to
acceptance by a substantial majority of the issuer defendants,
and execution of a definitive settlement agreement. The
settlement is also subject to approval of the court, which
cannot be assured. If the settlement is not consummated, the
Company intends to defend the lawsuit vigorously. However, we
cannot predict its outcome with certainty. If we are not
successful in our defense of this lawsuit, we could be forced to
make significant payments to the plaintiffs and their lawyers,
and such payments could have a material adverse effect on our
business, financial condition and results of operations if not
covered by our insurance carrier. Even if these claims are not
successful, the litigation could result in substantial costs and
divert managements attention and resources, which could
adversely affect our business, results of operations and
financial position.

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.






|        |                                                        
|------- | -------------------------------------------------------
|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, 2003.




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 our common stock. According to the records of
our transfer agent, at March 18, 2004 we had approximately
302 shareholders of record. At that date there were
approximately 7,707 beneficial owners of our common stock.

12



---



##### Table of Contents



The following table sets forth the high and low
sales price of our common stock in the years ended
December 31, 2003 and 2002, 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 reverse stock split.

|               |  |      |       |     |  |   |       | 
|-------------- |  | ---- | ----- | --- |  | - | ----- | 
|               |  | High |       | Low
|               |  |      |       |    
|2003           |  |      |       |     |  |   |       | 
|First quarter  |  | $    | 5.98  |     |  | $ | 4.23  | 
|Second quarter |  | $    | 6.50  |     |  | $ | 4.21  | 
|Third quarter  |  | $    | 7.07  |     |  | $ | 5.50  | 
|Fourth quarter |  | $    | 8.11  |     |  | $ | 6.14  | 
|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  | 



| |                                         
| | ----------------------------------------
| | 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

To date we have not declared or paid any cash
dividends on our common stock. 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 $185 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.






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

The selected consolidated financial data below
should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of
Operations and our consolidated financial statements and
the related notes. The selected consolidated statements of
operations data for the years ended December 31, 2003, 2002
and 2001 and the selected consolidated balance sheet data as of
December 31, 2003 and 2002, are derived from, and are
qualified by reference to, the audited consolidated financial
statements included elsewhere in this Form 10-K. The
selected consolidated statement of operations data for the
fiscal years ending prior to December 31, 2001, and the
selected consolidated balance sheet data prior to
December 31, 2002, are derived from our audited
consolidated financial statements that are not included in

13



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##### Table of Contents



this Annual Report on Form 10-K. The
historical results presented below are not necessarily
indicative of future results.


|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |        |        | 
|------------------------------------------------------------------------ | ------------------------------------ | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------- | ---- | -------- | ------ | ------- | - | -------- | ------ | ------- | - | ------- | ------ | ------ | 
|                                                                         |                                      |                                      
|                                                                         |                                      | Year Ended December 31,              
|                                                                         |                                      |                                      
|                                                                         |                                      | 2003                                  |         | 2002   |        | 2001 |         | 2000   |         | 1999
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |     
|                                                                         |                                      |                                      
|                                                                         |                                      | (In thousands, except per share data)
|Consolidated Statements of Operations
    Data:                          |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Revenue                                                                  |                                      | $                                     | 14,621  |        |        | $    | 23,632  |        |         | $    | 34,293   |        |         | $ | 31,107   |        |         | $ |        |       
|Cost of goods sold                                                       |                                      |                                       | 6,765   |        |        |      | 13,807  |        |         |      | 30,214   |        |         |   | 23,926   |        |         |   |        |       
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Gross profit                                                             |                                      |                                       | 7,856   |        |        |      | 9,825   |        |         |      | 4,079    |        |         |   | 7,181    |        |         |   |        |       
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Operating expenses:                                                      |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|                                                                         | Research and development             |                                       |         | 21,756 |        |      |         | 32,396 |         |      |          | 66,091 |         |   |          | 91,180 |         |   |         | 27,336 |       
|                                                                         | Sales and marketing                  |                                       |         | 13,808 |        |      |         | 28,271 |         |      |          | 60,000 |         |   |          | 53,625 |         |   |         | 6,077  |       
|                                                                         | General and administrative           |                                       |         | 7,226  |        |      |         | 10,959 |         |      |          | 23,525 |         |   |          | 24,441 |         |   |         | 4,980  |       
|                                                                         | Restructuring and impairment charges |                                       |         | 336    |        |      |         | 34,538 |         |      |          | 8,991  |         |   |          |       |         |   |         |       |       
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|                                                                         |                                      | Total operating expenses              |         |        | 43,126 |      |         |        | 106,164 |      |          |        | 158,607 |   |          |        | 169,246 |   |         |        | 38,393 | 
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Loss from operations                                                     |                                      |                                       | (35,270 | )      |        |      | (96,339 | )      |         |      | (154,528 | )      |         |   | (162,065 | )      |         |   | (38,393 | )     
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Other income (expense):                                                  |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|                                                                         | Interest income                      |                                       |         | 1,296  |        |      |         | 3,535  |         |      |          | 11,086 |         |   |          | 8,060  |         |   |         | 1,250  |       
|                                                                         | Interest expense                     |                                       |         | (224   | )      |      |         | (966   | )       |      |          | (1,675 | )       |   |          | (1,866 | )       |   |         | (599   | )     
|                                                                         | Other                                |                                       |         | (447   | )      |      |         | 313    |         |      |          | (299   | )       |   |          | 9      |         |   |         | 21     |       
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|                                                                         |                                      | Total other income (expense)          |         |        | 625    |      |         |        | 2,882   |      |          |        | 9,112   |   |          |        | 6,203   |   |         |        | 672    | 
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Loss before income tax provision                                         |                                      |                                       | (34,645 | )      |        |      | (93,457 | )      |         |      | (145,416 | )      |         |   | (155,862 | )      |         |   | (37,721 | )     
|                                                                         | Income tax provision                 |                                       |         | 287    |        |      |         | 509    |         |      |          | 837    |         |   |          | 264    |         |   |         |       |       
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Net loss                                                                 |                                      |                                       | (34,932 | )      |        |      | (93,966 | )      |         |      | (146,253 | )      |         |   | (156,126 | )      |         |   | (37,721 | )     
|Deemed dividend to series D preferred
    stockholders                   |                                      |                                       |        |        |        |      |        |        |         |      |         |        |         |   | (2,500   | )      |         |   |        |       
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Net loss allocable to common stockholders                                |                                      | $                                     | (34,932 | )      |        | $    | (93,966 | )      |         | $    | (146,253 | )      |         | $ | (158,626 | )      |         | $ | (37,721 | )     
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Basic and diluted net loss per common share                              |                                      | $                                     | (3.57   | )      |        | $    | (9.72   | )      |         | $    | (15.09   | )      |         | $ | (52.27   | )      |         | $ | (74.99  | )     
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       
|Shares used in computing basic and diluted net
    loss per common share |                                      |                                       | 9,791   |        |        |      | 9,670   |        |         |      | 9,695    |        |         |   | 3,035    |        |         |   | 503     |       
|                                                                         |                                      |                                       |         |        |        |      |         |        |         |      |          |        |         |   |          |        |         |   |         |       

14



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##### Table of Contents



|                                                        |  |                |        |      |  |      |         |      |  |      |         |  |  |   |         |  |  |   |         |  
|------------------------------------------------------- |  | -------------- | ------ | ---- |  | ---- | ------- | ---- |  | ---- | ------- |  |  | - | ------- |  |  | - | ------- | -
|                                                        |  |               
|                                                        |  | December 31,  
|                                                        |  |               
|                                                        |  | 2003           |        | 2002 |  | 2001 |         | 2000 |  | 1999
|                                                        |  |                |        |      |  |      |         |      |  |     
|                                                        |  |               
|                                                        |  | (In thousands)
|Consolidated Balance Sheets Data:                       |  |                |        |      |  |      |         |      |  |      |         |  |  |   |         |  |  |   |         |  
|Cash, cash equivalents and short-term investments       |  | $              | 57,752 |      |  | $    | 101,467 |      |  | $    | 164,878 |  |  | $ | 288,282 |  |  | $ | 54,586  |  
|Working capital                                         |  |                | 59,705 |      |  |      | 91,868  |      |  |      | 163,424 |  |  |   | 283,027 |  |  |   | 49,584  |  
|Total assets                                            |  |                | 73,426 |      |  |      | 119,561 |      |  |      | 221,203 |  |  |   | 353,928 |  |  |   | 66,070  |  
|Working capital loans                                   |  |                |       |      |  |      | 131     |      |  |      | 1,992   |  |  |   | 4,541   |  |  |   | 6,037   |  
|Accrued rent                                            |  |                | 2,078  |      |  |      | 2,069   |      |  |      | 2,556   |  |  |   | 2,154   |  |  |   | 1,648   |  
|Long-term capital lease obligations                     |  |                |       |      |  |      |        |      |  |      | 1,905   |  |  |   | 5,391   |  |  |   |        |  
|Other long-term liabilities                             |  |                |       |      |  |      |        |      |  |      | 11      |  |  |   | 132     |  |  |   | 222     |  
|Redeemable convertible preferred stock                  |  |                |       |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   | 89,388  |  
|Total stockholders equity (net capital
    deficiency) |  |                | 61,174 |      |  |      | 93,481  |      |  |      | 187,065 |  |  |   | 304,763 |  |  |   | (38,374 | )



| |                                                 
| | ------------------------------------------------
| | Quarterly financial information
    (unaudited):

|                                     |  |                                       |         |            |  |            |         |            |  |         |        |         |  |         |         |         |  |   |        |   |  |   |        |   |  |   |        |   |  |   |         |  
|------------------------------------ |  | ------------------------------------- | ------- | ---------- |  | ---------- | ------- | ---------- |  | ------- | ------ | ------- |  | ------- | ------- | ------- |  | - | ------ | - |  | - | ------ | - |  | - | ------ | - |  | - | ------- | -
|                                     |  |                                       |         |           
|                                     |  | 2002                                  |         | 2003      
|                                     |  |                                       |         |           
|                                     |  | 1st                                   |         | 2nd        |  | 3rd        |         | 4th        |  | 1st     |        | 2nd     |  | 3rd     |         | 4th    
|                                     |  | Quarter                               |         | Quarter(1) |  | Quarter(1) |         | Quarter(1) |  | Quarter |        | Quarter |  | Quarter |         | Quarter
|                                     |  |                                       |         |            |  |            |         |            |  |         |        |         |  |         |         |        
|                                     |  |                                      
|                                     |  | (In thousands, except per share data)
|Revenue                              |  | $                                     | 7,093   |            |  | $          | 6,066   |            |  | $       | 5,245  |         |  | $       | 5,228   |         |  | $ | 2,206  |   |  | $ | 6,014  |   |  | $ | 4,024  |   |  | $ | 2,377   |  
|Gross profit                         |  |                                       | 3,726   |            |  |            | 78      |            |  |         | 3,014  |         |  |         | 3,007   |         |  |   | 715    |   |  |   | 2,822  |   |  |   | 1,798  |   |  |   | 1,430   |  
|Net loss                             |  |                                       | (22,955 | )          |  |            | (44,748 | )          |  |         | (9,014 | )       |  |         | (17,249 | )       |  |   | (8,864 | ) |  |   | (7,716 | ) |  |   | (8,184 | ) |  |   | (10,168 | )
|Basic and diluted net loss per share |  | $                                     | (2.31   | )          |  | $          | (4.63   | )          |  | $       | (0.93  | )       |  | $       | (1.78   | )       |  | $ | (0.91  | ) |  | $ | (0.79  | ) |  | $ | (0.84  | ) |  | $ | (1.03   | )



---



|    |                                                                                                                                                                                                                                                          
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | 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.






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

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 still in the early stages of development, 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. While we
believe that the market for network-based IP services will
continue to grow and represents a significant opportunity, we
have not generated sufficient revenue to fund our operations. We
believe that we have a technically strong product that can
deliver IP services at a lower cost than competing products.
However, we must increase our revenue in the short term in order
to reduce our cash consumption and remain a viable and
competitive supplier.

15



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##### Table of Contents



Managements overview of the Companys
position is discussed in more detail in the Outlook
section on page 28 and the Liquidity section on
page 26.

CRITICAL ACCOUNTING POLICIES AND
ESTIMATES



| |        
| | -------
| | General

Our discussion and analysis of our financial
condition and results of operations are based on our
consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the
United States. The preparation of these consolidated financial
statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenue and
expenses, and related disclosure of contingent assets and
liabilities. On an ongoing basis, we evaluate our estimates,
including those related to revenue recognition, allowance for
doubtful accounts, inventory valuation, long-lived assets,
warranties and equity issuances. 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
customer acceptance and collectibility.

Certain of our sales arrangements require formal
acceptance by our customers. 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.

While the end user of our product is normally a
large network service provider, we also sell product and
services through small resellers and to small network service
providers in Asia, Europe and North America. 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 revenue
recognition until we have collected payment.



| |                                    
| | -----------------------------------
| | 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 may be required.



| |                    
| | -------------------
| | Inventory Valuation

In assessing the value of our inventory, we are
required to make judgments about 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 2003, we charged $0.2 million of inventory
write-downs and $0.1 million of excess purchase commitments
to cost of sales primarily as the result of reduced forecasted
demand for certain of our components and we sold
$0.9 million of previously written-down inventory. If
actual demand for our products is less than our forecasts,
additional inventory write-downs may be required.

16



---



##### Table of Contents





| |                  
| | -----------------
| | 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 on 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 such that we may be required to record further
asset write-downs in the future. We had no impairment charges in
2003 or 2001. 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 our 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. Each quarter, we 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 may result.



| |                                                    
| | ---------------------------------------------------
| | 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, stock issued in lieu of cash compensation to
suppliers and re-priced stock options.

Our revenue in 2001 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 in 2000 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 2003 and 2002 was not affected
by the value of warrants granted to customers.

Our cost of goods sold, operating expenses and
interest expense were also affected significantly in 2001 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 deferred compensation and amortization
associated with shares and options relating to the following
transactions is required to be re-measured at the end of each
accounting period, based on the current stock price. The
re-measurement 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 re-measure the compensation associated with these
    shares until the earlier of repayment of the note or default.
    Deferred compensa-

17



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##### Table of Contents



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | tion expense, which is recorded at each
    re-measurement, is amortized over the remaining vesting period
    of the underlying options.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  | Re-priced stock
    options:In November 2002, we
    re-priced 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 re-priced to $5.00 per share, which was higher than
    the fair market value of the underlying shares on the re-pricing
    date. In July 2001, we re-priced 722,071 unexercised employee
    stock options to $15.50 per share, the fair market value of the
    underlying shares on the re-pricing date. These options had
    previously been granted at prices ranging from $40.00 to $400.00
    per share. Compensation will be re-measured for these options
    until they are exercised, canceled, or expire. At
    December 31, 2003, 603,411 stock options re-priced in
    November 2002 were still outstanding.

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 estimated
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 years ended December 31, 2003, 2002
and 2001, we reported basic and diluted net losses per share of
$3.57, $9.72 and $15.09, respectively. Charges related to equity
issuances to customers, suppliers, employees and consultants
increased net loss per share by $0.13 for the year ended
December 31, 2003, decreased net loss per share by $0.03
for the year ended December 31, 2002 and increased net loss
per share by $3.62 for the year ended December 31, 2001.
All per share amounts have been restated to reflect our 1-for-10
reverse stock split, effected in September 2002.



| |        
| | -------
| | Revenue

The majority of our revenue is recognized from
the sale of our IP Service Delivery Platform and subsequent
service support arrangements. 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
collection 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 elements, 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 perpetual software licenses is
recognized upon shipment or acceptance, if required. Revenue
from one-year term licenses is recognized on a straight-line
basis over the one-year license term. Post-delivery technical
support, such as on-site service, phone support, parts and
access to software upgrades, when and if available, is provided
under separate support services agreements. In cases where the
support services are sold as part of an arrangement including
multiple elements, we allocate revenue to the support service
based on the VSOE of the service and recognize it on a
straight-line basis over the service period. Revenue from
consulting and training 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.

18



---



##### Table of Contents



Revenue from customers by geographic region for
the years ended December 31, 2003, 2002 and 2001 was as follows,
in thousands:

|              |               |      |       |        |  |      |    |     |   |      |       |        |  |  |    |     |   |   |        |        |  |  |    |     |  
|------------- | ------------- | ---- | ----- | ------ |  | ---- | -- | --- | - | ---- | ----- | ------ |  |  | -- | --- | - | - | ------ | ------ |  |  | -- | --- | -
|              |               | 2003 |       | %      |  | 2002 |    | %   |   | 2001 |       | %     
|              |               |      |       |        |  |      |    |     |   |      |       |       
|United States |               | $    | 6,808 |        |  |      | 47 | %   |   | $    | 8,423 |        |  |  | 36 | %   |   | $ | 7,457  |        |  |  | 22 | %  
|Asia/ Pacific |               |      | 5,137 |        |  |      | 35 |     |   |      | 9,483 |        |  |  | 40 |     |   |   | 11,623 |        |  |  | 34 |    
|Europe        |               |      | 2,676 |        |  |      | 18 |     |   |      | 5,726 |        |  |  | 24 |     |   |   | 15,213 |        |  |  | 44 |    
|              |               |      |       |        |  |      |    |     |   |      |       |        |  |  |    |     |   |   |        |        |  |  |    |    
|              | Total revenue |      | $     | 14,621 |  |      |    | 100 | % |      | $     | 23,632 |  |  |    | 100 | % |   | $      | 34,293 |  |  |    | 100 | %
|              |               |      |       |        |  |      |    |     |   |      |       |        |  |  |    |     |   |   |        |        |  |  |    |    

Hardware, software and service revenue for the
years ended December 31, 2003, 2002 and 2001 was as
follows, in thousands:

|                                                                                            |               |      |        |        |  |      |     |   |  |      |        |        |  |  |     |   |  |   |        |        |  |  |     |   | 
|------------------------------------------------------------------------------------------- | ------------- | ---- | ------ | ------ |  | ---- | --- | - |  | ---- | ------ | ------ |  |  | --- | - |  | - | ------ | ------ |  |  | --- | - | 
|                                                                                            |               | 2003 |        | %      |  | 2002 |     | % |  | 2001 |        | %     
|                                                                                            |               |      |        |        |  |      |     |   |  |      |        |       
|Hardware                                                                                    |               | $    | 11,352 |        |  |      | 78  | % |  | $    | 18,753 |        |  |  | 79  | % |  | $ | 23,699 |        |  |  | 63  | %
|Software                                                                                    |               |      | 451    |        |  |      | 3   |   |  |      | 1,870  |        |  |  | 8   |   |  |   | 3,299  |        |  |  | 9   |  
|Services                                                                                    |               |      | 2,818  |        |  |      | 19  |   |  |      | 3,009  |        |  |  | 13  |   |  |   | 10,298 |        |  |  | 28  |  
|                                                                                            |               |      |        |        |  |      |     |   |  |      |        |        |  |  |     |   |  |   |        |        |  |  |     |  
|Receipts from sales, including equity issued in
    2000 in connection with purchase orders |               |      | 14,621 |        |  |      | 100 | % |  |      | 23,632 |        |  |  | 100 | % |  |   | 37,296 |        |  |  | 100 | %
|                                                                                            |               |      |        |        |  |      |     |   |  |      |        |        |  |  |     |   |  |   |        |        |  |  |     |  
|Less: receipts for equity issued in 2000 in
    connection with purchase orders             |               |      |       |        |  |      |     |   |  |      |       |        |  |  |     |   |  |   | 3,003  |        |  |  |     |  
|                                                                                            |               |      |        |        |  |      |     |   |  |      |        |        |  |  |     |   |  |   |        |        |  |  |     |  
|                                                                                            | Total revenue |      | $      | 14,621 |  |      |     |   |  |      | $      | 23,632 |  |  |     |   |  |   | $      | 34,293 |  |  |     |   | 
|                                                                                            |               |      |        |        |  |      |     |   |  |      |        |        |  |  |     |   |  |   |        |        |  |  |     |  

In 2003, unit shipments declined. The decline
reflects sales to fewer customers, as we have focused our sales
efforts on certain large service providers. The decline also
reflects lower sales to existing customers, due in part to the
timing of their expansion plans. Partially offsetting this
decline, our average selling price improved in 2003 as compared
to 2002 due to a favorable product and regional mix. Software
revenue declined $1.4 million due to fewer new customers.
We generally sell our primary software product, InVision, in our
initial sale to new customers.

Because the market for network-based IP services
is in the early stages of development, service provider demand
for our products may fluctuate until service providers are able
to further develop enterprise demand for such services and
accelerate revenue growth from the sale of such services. See
Outlook section on page 28 and Risk
Factors section on pages 29 to 35.

We issued no warrants to customers during the
years ended December 31, 2003, 2002 and 2001. At
December 31, 2003, 2002 and 2001, there were no unamortized
non-cash charges related to warrants issued to customers.

As of December 31, 2003, 2002 and 2001, we
deferred $3.5 million, $1.4 million and $2.7 million,
respectively, of revenue from contracts that we immediately
invoiced but which provide for subsequent customer acceptance,
consulting services and post-contract support services.



| |                                                             
| | ------------------------------------------------------------
| | Non-Cash Charges and Credits Related to
    Equity Issuances

We amortized (benefited from) $1.3 million,
($0.3) million and $32.1 million of non-cash charges
related to equity issuances to cost of goods sold, operating
expenses and interest expense, for the years ended
December 31, 2003, 2002 and 2001, respectively.

19



---



##### Table of Contents



Below is a reconciliation of non-cash charges
related to equity issuances for the years ended
December 31, 2003, 2002 and 2001, affecting our cost of
goods sold, operating expenses and interest expense, in
thousands:

|                                                                                                                                                                                  |  |                         |       |      |  |      |        |   |  |   |        |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ----- | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                                                                                                                                                  |  |                        
|                                                                                                                                                                                  |  | Year ended December 31,
|                                                                                                                                                                                  |  |                        
|                                                                                                                                                                                  |  | 2003                    |       | 2002 |  | 2001
|                                                                                                                                                                                  |  |                         |       |      |  |     
|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 |  | $                       | 1,377 |      |  | $    | 7,273  |   |  | $ | 29,691 |  
|Credits related to the reversal of deferred stock
    compensation amortization in excess of vesting for terminated
    employees                                                 |  |                         | (956  | )    |  |      | (8,466 | ) |  |   | (526   | )
|Amortization of deferred compensation associated
    with non-recourse promissory notes                                                                                           |  |                         |      |      |  |      | 173    |   |  |   |       |  
|Amortization of deferred compensation associated
    with re-pricing                                                                                                              |  |                         | 797   |      |  |      | 514    |   |  |   |        |  
|Charges related to options with accelerated
    vesting                                                                                                                           |  |                         | 1     |      |  |      | 27     |   |  |   |        |  
|Write-off of unamortized portion of BroadBand
    Offices warrants due to their bankruptcy                                                                                       |  |                         |      |      |  |      |       |   |  |   | 2,738  |  
|Amortization of charges related to warrants or
    stock options issued to non-employees in conjunction with lease
    and debt agreements                                        |  |                         | 92    |      |  |      | 195    |   |  |   | 212    |  
|                                                                                                                                                                                  |  |                         |       |      |  |      |        |   |  |   |        |  
|Net non-cash charges related to equity issuances                                                                                                                                  |  | $                       | 1,311 |      |  | $    | (284   | ) |  | $ | 32,117 |  
|                                                                                                                                                                                  |  |                         |       |      |  |      |        |   |  |   |        |  

Equity-related charges, which are largely
dependent on our quarterly stock price, may cause our expenses
to materially fluctuate from quarter-to-quarter and year-to-year.



| |                   
| | ------------------
| | 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, 2003, cost
of goods sold was $6.8 million, of which $6.1 million
or 90% represented materials, labor, production overhead and
warranties, $0.7 million or 10% represented software
royalties, $0.5 million or 7% represented reductions in
overhead absorption rate for raw materials and semi-finished
goods, $0.2 million or 3% represented inventory
write-downs, $0.1 million or 2% represented non-cash
charges related to equity issuances and ($0.9) million or
(13%) represented the sale of previously written down inventory.
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 the sale of
previously written down inventory. 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.



| |             
| | ------------
| | Gross Profit

For the years ended December 31, 2003, 2002
and 2001, gross profit was $7.9 million, or 54% of revenue,
$9.8 million, or 42% of revenue and $4.1 million, or
12% of revenue, respectively.

20



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The twelve percentage point improvement in gross
margin for the year ended December 31, 2003 compared to the
year ended December 31, 2002 was primarily the result of a
ten percentage point reduction in materials, labor and product
overhead costs as a percentage of sales. A lower provision for
inventory write-downs additionally improved gross margin by five
percentage points. The improvements were partially offset by a
reduction in the inventory overhead rate on raw materials and
semi-finished goods, which accounted for a three percentage
point reduction in gross margin. Primarily accounting for the
reduction in materials, labor and overhead cost as a percentage
of sales were an increase in average selling price due to the
regional mix of sales, more favorable product configurations and
reductions in maintenance contract support costs due to
headcount and overhead reductions.

We expect our gross margin to be primarily
affected by regional product mix and configurations, the volume
of product sold and pricing pressures, the amount of excess
inventory reserve charges and the amount of written-down
inventory sold. The mix of products that our customers purchase
is unpredictable and, because of lead times required to buy
certain components and the timing of our customers orders,
we purchase inventory based on forecasted demand. The amount of
excess inventory purchase commitments and excess inventory
charges related to on-hand inventory is dependent on us
purchasing the correct mix of inventory. In addition, if our
unit sales volumes are significantly lower than forecasted
demand, excess inventory charges will result.



| |                                      
| | -------------------------------------
| | 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.

Research and development expenses were
$21.8 million, $32.4 million and $66.1 million
for the years ended December 31, 2003, 2002 and 2001,
respectively.

Research and development expense decreased
$10.6 million or 33% in the year ended December 31,
2003, compared to the year ended December 31, 2002. This
resulted partly from a $4.8 million reduction in salary and
employee-related expenses reflecting a full year of lower
headcount in 2003 following our May and October 2002
restructurings. Depreciation expense was $3.7 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). Facilities and information
technology infrastructure costs were $2.6 million lower as
a result of reductions in personnel and square footage occupied.
Non-cash charges related to equity issuances were
$1.0 million higher due to credits taken in 2002 for the
reversal of amortization of deferred compensation in excess of
vesting for employees who were terminated that year.

Research and development expense decreased
$33.7 million or 51% in the year ended December 31,
2002, compared to the year ended December 31, 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).

Non-cash charges related to equity issuances were
$0.6 million for the year ended December 31, 2003.
Non-cash credits related to equity issuances were
$0.4 million for the year ended December 31, 2002.
Non-cash charges related to equity issuances were
$10.8 million for the year ended December 31, 2001.

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| |                             
| | ----------------------------
| | 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.
Since April of 2001, we have had several restructurings in order
to reduce our operating expenses. These restructurings involved
significant reductions in our workforce, including our sales and
marketing group. We will attempt to partially offset the effect
of these reductions by establishing relationships with resellers
in selected markets.

Sales and marketing expenses were
$13.8 million, $28.3 million and $60.0 million for the
years ended December 31, 2003, 2002 and 2001, respectively.

Sales and marketing expense decreased
$14.5 million or 51% in the year ended December 31,
2003, compared to the year ended December 31, 2002. This
resulted partly from an $8.7 million reduction in salary
and employee-related expenses reflecting a full year of lower
headcount in the 2003 following our May and October 2002
restructurings and lower commission expense. Depreciation
expense and expense related to CoSine product used in labs
declined $2.8 million due primarily to the reduced carrying
value of assets resulting from impairment charges recorded in
the second and third quarters of 2002 and some assets becoming
fully depreciated. Facilities and information technology
infrastructure expense declined by $2.7 million as a result
of reductions in personnel, square footage occupied and sales
office rents. Travel expense declined $1.6 million due to
cost saving measures and associated reductions in headcount.
Marketing spending on events and market development declined
$1.4 million due to attending fewer tradeshows and cost saving
measures. Partially offsetting those savings, non-cash charges
related to equity issuances increased $1.0 million due to
credits for the reversal of amortization of deferred
compensation expense in excess of vesting in 2002 for employees
who were terminated during that year. Absorption to cost of
goods sold of spending to support maintenance contracts and
warranty declined $1.8 million. Such support costs are
initially charged to Sales and Marketing expense and
subsequently reclassified to either cost of sales or the
provision for warranty claims based on associated activity such
as product return levels and technical support case data. Due
primarily to a smaller customer installed base, activity
associated with maintenance and warranty was less than in the
prior year.

Sales and marketing expense decreased
$31.7 million or 53% in the year ended December 31,
2002, compared to the year ended December 31, 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.

Non-cash charges related to equity issuances were
$0.1 million for the year ended December 31, 2003.
Non-cash credits related to equity issuances were
$0.9 million for the year ended December 31, 2002.
Non-cash charges related to equity issuances were
$12.7 million for the year ended December 31, 2001.

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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
$7.2 million, $11.0 million and $23.5 million for
the years ended December 31, 2003, 2002 and 2001,
respectively.

General and administrative expense decreased
$3.8 million or 35% in the year ended December 31,
2003, compared to the year ended December 31, 2002. This
resulted partly from payroll-related expense, which declined
$1.8 million, reflecting a full year of lower headcount in
the 2003 following our May and October 2002 restructurings.
Depreciation expense declined $0.5 million due to the
reduced carrying value of the underlying fixed assets resulting
from impairment charges recorded in the second and third
quarters of 2002. Legal, accounting and audit services declined
$0.5 million as a result of cost-saving measures. Non-cash
charges related to equity issuances declined $0.5 million
due to lower headcount and our use of an accelerated
amortization method, which results in lower charges in each
subsequent period. Bad debt expense declined $0.4 million
as a result of lower revenue and lower actual bad debt
experience.

General and administrative expense decreased
$12.5 million or 53% in the year ended December 31,
2002, compared to the year ended December 31, 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 non-cash charges
related to equity issuances were $0.5 million,
$0.9 million and $6.2 million for the years ended
December 31, 2003, 2002 and 2001, respectively.

General and administrative expenses in 2004 may
significantly increase due to costs related to the
implementation of Section 404 of the Sarbanes-Oxley Act of
2002, which requires management to report on, and our auditors
to attest to, our internal controls.



| |                                         
| | ----------------------------------------
| | Restructuring and Impairment
    Charges



| |                                 
| | --------------------------------
| | May and March 2003 Restructuring

In May and March 2003, our senior management
communicated additional reductions in our workforce related to
employees in our European region and the closure of a sales
office in the Asia/ Pacific Rim region. The employees were
notified in May and March 2003 that their job functions would be
eliminated and that termination benefits would be paid to them.
As a result of the workforce reduction, five employees were
designated for termination. Amounts related to the workforce
reduction and the other items are expected to be paid through
June of 2004. The restructuring programs were an extension of
the October 2002 restructuring, which was implemented to reduce
operating expenses and conserve cash.

23



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Activity related to the May and March 2003
restructuring for the year ended December 31, 2003 was as
follows, (in thousands):

|                                           |  |           |      |             |  |       |     |   |  |   |      |  
|------------------------------------------ |  | --------- | ---- | ----------- |  | ----- | --- | - |  | - | ---- | -
|                                           |  | Worldwide |      | Lease       |  |      
|                                           |  | workforce |      | termination |  |      
|                                           |  | reduction |      | and other   |  | Total
|                                           |  |           |      |             |  |      
|Charges                                    |  | $         | 277  |             |  | $     | 17  |   |  | $ | 294  |  
|Cash payments                              |  |           | (284 | )           |  |       | (12 | ) |  |   | (296 | )
|Non-cash items                             |  |           | (20  | )           |  |       | (4  | ) |  |   | (24  | )
|Accrual adjustment                         |  |           | 75   |             |  |       | (1  | ) |  |   | 74   |  
|                                           |  |           |      |             |  |       |     |   |  |   |      |  
|Provision balance at December 31,
    2003 |  | $         | 48   |             |  | $     |    |   |  | $ | 48   |  
|                                           |  |           |      |             |  |       |     |   |  |   |      |  



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

In October 2002, our senior management approved a
restructuring program to reduce our worldwide workforce.
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 were paid out through September of 2003. In
addition, during the first quarter of 2003, we settled
obligations associated with as leased facility in Redwood City,
California that we exited during 2002 and made a payment of
$8,104,000. The restructuring program was implemented to reduce
operating expenses and conserve cash.

Activity related to the October 2002
restructuring for the years ended December 31, 2003 and
2002 was 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  |  
|                                           |  |           |        |             |  |       |        |   |  |   |        |  
|Cash payments                              |  |           | (310   | )           |  |       | (8,112 | ) |  |   | (8,422 | )
|Accrual adjustment                         |  |           | (7     | )           |  |       | (47    | ) |  |   | (54    | )
|                                           |  |           |        |             |  |       |        |   |  |   |        |  
|Provision balance at December 31,
    2003 |  | $         |       |             |  | $     |       |   |  | $ |       |  
|                                           |  |           |        |             |  |       |        |   |  |   |        |  



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

In May 2002, our senior management approved a
restructuring plan to reduce our 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 taking place 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 through March 2004. 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.

24



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##### Table of Contents



Activity related to the May 2002 restructuring
for the years ended December 31, 2003 and 2002 was as
follows, (in thousands):

|                                           |  |           |        |               |  |             |        |       |  |   |        |   |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ------------- |  | ----------- | ------ | ----- |  | - | ------ | - |  | - | ------ | -
|                                           |  | Worldwide |        | Write-down of |  | Lease       |        |      
|                                           |  | workforce |        | property 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    |  
|                                           |  |           |        |               |  |             |        |       |  |   |        |   |  |   |        |  
|Cash payments                              |  |           |        |               |  |             |        |       |  |   | (677   | ) |  |   | (677   | )
|Non-cash charges                           |  |           |       |               |  |             |       |       |  |   | (42    | ) |  |   | (42    | )
|Accrual adjustment                         |  |           |        |               |  |             |        |       |  |   | 22     |   |  |   | 22     |  
|                                           |  |           |        |               |  |             |        |       |  |   |        |   |  |   |        |  
|Provision balance at December 31,
    2003 |  | $         |       |               |  | $           |       |       |  |   | 118    |   |  |   | 118    |  
|                                           |  |           |        |               |  |             |        |       |  |   |        |   |  |   |        |  



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

As a result of our assessment of market
conditions and the related effect on its 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 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 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 $15,512,000 to write down the carrying value of our
long-lived assets held for use 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, our senior
management approved restructuring programs to reduce our
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 in September 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.

Activity related to the April and September 2001
restructuring for the year ended December 31, 2002 and 2001
was as follows (in thousands):

|                                           |  |           |        |               |  |             |        |       |  |   |      |   |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ------------- |  | ----------- | ------ | ----- |  | - | ---- | - |  | - | ------ | -
|                                           |  | Worldwide |        | Write-down of |  | Lease       |        |      
|                                           |  | workforce |        | property 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

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##### Table of Contents



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.



| |                                               
| | ----------------------------------------------
| | Interest Income and Other Income
    (Expense)

For the year ended December 31, 2003,
interest income and other income (expense) was
$0.8 million, a decrease of $3.0 million when compared
with the year ended December 31, 2002. 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. The year over year
decreases reflect decreased interest income due to lower levels
of cash and short-term investments and lower interest rates on
invested amounts.



| |                 
| | ----------------
| | Interest Expense

For the year ended December 31, 2003,
interest expense was $0.2 million, a decrease of
$0.8 million when compared with the year ended
December 31, 2002. For the year ended December 31,
2002, interest expense was $1.0 million, a decrease of
$0.7 million when compared with the year ended
December 31, 2001. The year over year decreases reflect
reduced equipment loans and capital leases.



| |                     
| | --------------------
| | Income Tax Provision

Provisions for income taxes of $0.3 million,
$0.5 million and $0.8 million for the years ended
December 31, 2003, 2002 and 2001, 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 2004
will continue to depend on the amount and mix of income derived
from sources subject to corporate income taxes of foreign taxing
jurisdictions.

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.

LIQUIDITY AND CAPITAL RESOURCES

Currently, we are not generating sufficient
revenue to fund our operations. We expect our operating losses
and net operating cash outflows to continue unless we are able
to significantly increase our revenues, reduce our operating
expenses or both. In April and September 2001, May and October
2002 and, to a lesser extent, in March and May 2003, we
announced that we had adopted business plans to reduce our
operating expenses to reflect current and expected business
conditions. We cannot assure you that we will be able to
decrease our operating expenses significantly below current
levels and still remain a viable and competitive supplier.

Based on our rate of quarterly cash consumption
in 2003 of approximately $9 million (which excludes
$8.1 million paid to settle a lease obligation related to
facilities we exited in Redwood City, California), we believe
that we possess sufficient liquidity and capital resources to
fund our operations and working capital requirements for at
least the next 12 months. However, because of our history
of losses and use of cash in operations, certain of our existing
and prospective customers may have concerns regarding our
long-term financial viability and our ability to support their
businesses, and as a result may choose to purchase equipment
from other larger and more established suppliers. See Risk
Factors on pages 29  35.

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

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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.


We may seek to raise 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.



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

At December 31, 2003, cash, cash equivalents
and short-term investments were $57.8 million. This
compares with $101.5 million at December 31, 2002.



| |                     
| | --------------------
| | Operating Activities

We used $38.4 million in cash for operations
for the year ended December 31, 2003, a decrease of
$16.3 million from the amount used in 2002. Our $59.0
million decrease in net loss was partially offset by an increase
in accrued expenses, a less favorable decrease in accounts
receivable and lower non-cash expenses in 2003 compared to 2002.
Items primarily contributing to the increase in accrued expense
and lower non-cash charges include the following:



| |   |                                                                                                                                                                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Accrued other liabilities declined
    $10.8 million, primarily as a result of paying down
    $9.4 million of restructuring expenses accrued in the 2002.                                                                                                            
|
| |  | The net loss for the year ended December 31,
    2002 included a non-cash write-down of $18.8 million for
    the impairment of fixed assets.                                                                                                                         
|
| |  | Depreciation expense declined $7.7 million
    due to the reduced carrying value of property and equipment
    resulting from impairment charges recorded in the second and
    third quarters of 2002 and some property and equipment becoming
    fully depreciated.

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.

Investing Activities

For the year ended December 31, 2003,
investing activities provided $51.2 million in cash, an
increase of $56.0 million over 2002. The increase in cash
provided in 2003 was the result of an increase in proceeds from
the sales and maturities of short-term investments compared over
investment purchases.

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.



| |                     
| | --------------------
| | Financing Activities

For the year ended December 31, 2003, we
used $2.4 million in cash from financing activities, or
$2.9 million less than 2002. The reduction in cash used was
primarily the result of lower principal payments on working
capital loans and leases and higher proceeds from stock option
exercises.

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.

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| |                        
| | -----------------------
| | Contractual Obligations

Our contractual obligations as of
December 31, 2003 are as follows (in thousands):

|                                                |       |       |        |        |  |             |       |             |  |            |       |       |  |   |       |       |  |   |       |       | 
|----------------------------------------------- | ----- | ----- | ------ | ------ |  | ----------- | ----- | ----------- |  | ---------- | ----- | ----- |  | - | ----- | ----- |  | - | ----- | ----- | 
|                                                |       |       |        | Due in |  | Due in 2005 |       | Due in 2007 |  | Due       
|                                                |       | Total |        | 2004   |  | and 2006    |       | and 2008    |  | Thereafter
|                                                |       |       |        |        |  |             |       |             |  |           
|Equipment and working capital loans             |       | $     | 129    |        |  | $           | 129   |             |  | $          |      |       |  | $ |      |       |  | $ |      |      
|Operating lease obligations                     |       |       | 19,548 |        |  |             | 2,647 |             |  |            | 4,667 |       |  |   | 4,714 |       |  |   | 7,520 |      
|Raw material components                         |       |       | 1,390  |        |  |             | 1,390 |             |  |            |      |       |  |   |      |       |  |   |      |      
|Accrued severance-related restructuring charges |       |       | 166    |        |  |             | 166   |             |  |            |      |       |  |   |      |       |  |   |      |      
|Royalty obligations                             |       |       | 1,150  |        |  |             | 350   |             |  |            | 800   |       |  |   |      |       |  |   |      |      
|                                                |       |       |        |        |  |             |       |             |  |            |       |       |  |   |       |       |  |   |       |      
|                                                | Total |       | $      | 22,383 |  |             | $     | 4,682       |  |            | $     | 5,467 |  |   | $     | 4,714 |  |   | $     | 7,520 | 
|                                                |       |       |        |        |  |             |       |             |  |            |       |       |  |   |       |       |  |   |       |      

OUTLOOK

Fourth Quarter 2003 revenue of $2.4 million
marked a disappointing end to a challenging year. While our cost
management and cash flow improvement actions yielded
improvements from 2002 to 2003, we must drive significant,
near-term revenue growth. Although capital spending in the
telecommunications industry has begun to recover, the market for
network-based IP services has continued to develop slowly. We
see evidence that a number of major carriers will move to a
network-based approach to IP services delivery. This trend is
reflected in the expansion plans of our existing customers, as
well as those of prospective customers. Our research and
interaction with our carrier customers indicates that enterprise
customers large and small are increasingly demanding low cost,
secure, communications capabilities, along with value-added IP
services such as IP Sec and MPLS VPN, Firewall and Dos Shield.
Carriers, at the same time, are looking for ways to provide and
scale such capabilities to serve hundreds or thousands of
geographically dispersed users in a profitable manner. We
believe that we have a strong, differentiated product that can
deliver network-based IP services at a lower cost than the
competitive alternatives.

While we believe that the market for
network-based IP services represents a significant opportunity,
we recognize the need to increase revenues and decrease cash
consumption in the short term. As of the filing date of this
report, we believe that we cannot make further significant
reductions in our operating expenses, and at the same time
continue to win new business, support our existing customers and
continue with the research and development necessary to compete
effectively in our market. Therefore, we must achieve revenue
growth in the near term by winning repeat business as our
customers seek to expand their network-based IP service
offerings and capturing new customers as they begin to enter
this market. However, there can be no assurance that we will
succeed in meeting these objectives. Our ability to achieve such
revenue growth will depend, in part, on the rate of growth in
enterprise adoption of the network-based IP services delivery
model.

Our ability to pursue new customers is
constrained by the relatively small size of our sales force and
the long sales cycle involved in the purchase of our products.
Accordingly, the establishment of strategic reseller
relationships is an important part of our strategy for 2004. By
establishing these relationships, we can leverage the sales and
support capabilities of these partners and thereby expand our
potential market. In addition, we have evaluated a variety of
different business scenarios and possible means for facilitating
CoSines long-term success. We have explored, and will
continue to explore, OEM relationships, strategic partner
relationships, mergers and acquisitions as possible ways to
facilitate CoSines long-term success and build shareholder
value, and we use industry and financial experts to assist us in
seeking and evaluating such opportunities.



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

In January 2003, the Financial Accounting
Standards Board (FASB) issued Interpretation No. 46
(FIN 46), Consolidation of Variable Interest
Entities. FIN 46 addresses consolidation by business
enterprises of variable interest entities. Under that
interpretation, certain entities known as Variable Interest
Entities (VIEs) must be consolidated by the primary
beneficiary of the entity. The primary beneficiary is generally
defined as having the majority of the risks and rewards arising
from the VIE. For VIEs in which a significant (but not majority)
variable interest is held, certain disclosures are required. We
have not entered

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into any arrangements or made any investments
which qualify as a VIE in the period after January 31, 2003
and therefore the initial implementation of FIN 46 had no impact
on our financial statements. For VIEs acquired before
February 1, 2003, we are required to apply the accounting
and disclosure rules set forth in FIN 46 in the first quarter of
2004. We have determined that the adoption of FIN 46 will not
have any impact on our financial statements.


In December 2003, the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 104
(SAB 104), Revenue Recognition.
SAB 104 revises or rescinds portions of the interpretive
guidance included in Topic 13 of the codification of staff
accounting bulletins in order to make this interpretive guidance
consistent with current authoritative accounting and auditing
guidance and SEC rules and regulations. The adoption of SAB 104
did not have a material effect on our financial statements for
the period ending December 31, 2003.

RISK FACTORS

This report (including the Outlook
section above) contains forward-looking statements. We use words
such as anticipate, believe,
plan, expect, future,
intend and similar expressions to identify
forward-looking statements. These forward-looking statements are
subject to certain risks and uncertainties that could cause
actual results to differ materially from those reflected in the
forward-looking statements. Factors that might cause such a
difference include, but are not limited to, the continued
downturn in the telecommunications industry and slow development
of the market for network-based IP services, failure to achieve
revenue growth and profitability, product development,
commercialization and technology difficulties, manufacturing
costs, the impact of competitive products, pricing, changing
customer requirements, timely availability and acceptance of new
products, and changes in economic conditions in the various
markets that we serve, all as are discussed in more detail below
in this section, as well as the other risk factors discussed
below. Readers are cautioned not to place undue reliance on
these forward-looking statements, which reflect
managements opinions only as of the date hereof. 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 that we file from time to time with the
Securities and Exchange Commission, including the Quarterly
Reports on Form 10-Q that we file in fiscal year 2004.

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 do not achieve profitability we may
    cease operations.

At December 31, 2003, we had an accumulated
deficit of $478.4 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 and are unable to
obtain additional financing, we may run out of cash and cease
operations.



| |                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------
| | Due to our losses, 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 equipment from us
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 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.

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| |                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------
| | The market for managed network-based IP
    services is still in the early stages of growth. As a result,
    demand may fluctuate.

The market for managed network-based IP services
is still in the early stages of growth. We believe that the
market for these services will grow, but the timing of this
growth is linked to the development of this market by service
providers and the growth of enterprise demand. Until the market
develops further, demand may not increase significantly and may
continue to fluctuate. If our quarterly or annual operating
results do not meet the expectations of securities analysts or
investors, the trading price of our common stock could decline.



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

Our business depends on capital expenditures
within the telecommunications industry, which has experienced a
significant downturn since 2001. 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 the industry in general appears to be
recovering, the ultimate duration of this downturn is unknown.
Due to reductions in capital spending plans by our customers and
uncertainty within the telecommunications industry, we
anticipate that this trend will continue to have a substantial,
adverse effect on our revenue growth for at least the remainder
of the current fiscal year. No assurance can be given that the
Companys net revenue and operating results will not be
further adversely affected by the current downturn or any future
downturns.



| |                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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 that may run from three to twelve months.
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.



| |                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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. Many of our competitors are larger companies
with significantly greater resources than we have, and we expect
to face increased competition from larger companies in the
future. 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.



| |                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------
| | Future consolidation in the
    telecommunications equipment industry may increase competition
    that could harm our business

The markets in which we compete are characterized
by increasing consolidation both within the data communications
sector and by companies combining or acquiring data
communications assets and assets for delivering voice-related
services. We cannot predict with certainty how industry
consolidation will affect our competitors. We may not be able to
compete successfully in an increasingly consolidated industry.
Increased competition and consolidation in our industry could
require that we reduce the prices of our products and result in
our loss of market share, which would materially adversely
affect our business, financial condition and

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results of operations. Because we may be
dependent on certain strategic relationships with third parties
in our industry, any additional consolidation involving these
parties could reduce the demand for our products and otherwise
harm our business prospects.




| |                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our ability to sustain or grow our business
    may be harmed if we are unable to develop and maintain certain
    strategic relationships with third parties to market and sell
    our products.

Because we are a relatively small company with
correspondingly small sales and support groups, our success will
depend in part upon our ability to form and maintain
distribution partnerships, including agreements under which we
agree to sell our products to certain service provider customers
through distribution partners. We may not be able to establish
sufficient reseller relationships to enable us to expand our
potential market and achieve revenue growth. The amount and
timing of resources that our distribution partners devote to our
business, if any, is not within our control. Our distribution
partners may not perform their obligations as expected. In some
cases, agreements with our distribution partners may be
relatively new, and we cannot be certain that we will be able to
achieve expected revenues from such partners or sustain the
level of revenue generated thus far under similar arrangements.
If any of our distribution partners chooses not to renew,
breaches or terminates its agreement or fails to perform its
obligations under its agreement, we may not be able to sustain
or grow our business. In the event that such relationships are
terminated, we may not be able to continue to maintain or
develop similar relationships or to replace distribution
partners. In addition, any such agreements we enter into in the
future may not be successful.



| |                                                                                                                                                                                             
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.



| |                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------
| | If our IP Service Delivery Platform does
    not 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 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 line
that we currently offer to our customers. Our future revenue
depends on the commercial success of our IP Service Delivery
Platform. If customers do not adopt, purchase and successfully
implement our IP Service Delivery Platform in large numbers, our
revenue will not grow.



| |                                                                                                                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our products contain defects, we may be
    subject to significant liability claims from our customers,
    distribution partners and the end-users of our products and
    incur significant unexpected expenses and lost
    sales

Our products are technically complex and can be
adequately tested only when put to full use in large and diverse
networks with high amounts of traffic. They have in the past
contained, and may in the future contain,

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undetected or unresolved errors or defects.
Despite extensive testing, errors, defects or failures may be
found in our current or future products or enhancements after
commencement of commercial shipments. If this happens, we may
experience delay in or loss of market acceptance and sales,
product returns, diversion of development resources, injury to
our reputation, inability to attract new customers, or increased
service and warranty costs, any of which could have a material
adverse effect on our business, financial condition and results
of operations. Moreover, because our products are designed to
provide critical communications services, we may receive
significant liability claims. We attempt to include in our
agreements with customers and distribution partners provisions
intended to limit our exposure to liability claims. However, our
customers and distribution partners may not be willing to agree
to such provisions, and in any event such provisions may not be
effective in any or all cases or under any or all scenarios, and
they may not preclude all potential claims resulting from a
defect in one of our products or from a defect related to the
installation or operation of one of our products. Although we
maintain product liability and errors and omissions insurance
covering certain damages arising from implementation and use of
our products, our insurance may not cover all claims sought
against us. Liability claims could require us to spend
significant time and money in litigation or to pay significant
damages. As a result, any such claims, whether or not
successful, could seriously damage our reputation and our
business.




| |                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------
| | If we fail to develop and market 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 our 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 introduce new products 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.



| |                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.

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| |                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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 certain of our
customers or the decline of a key customers business may
limit our revenue growth and harm our operating results. Our
customers may reduce or discontinue purchases of our products at
any time. In 2003, we generated 53 percent of our revenue
from two customers.

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



| |                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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. These outcomes
could seriously impair our ability to sell our products and
could harm our operating results.



| |                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------
| | 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

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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.                                                                                                                     



| |                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------
| | 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.



| |                                                                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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 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 against these claims, regardless of
their merits. Defending ourselves against such claims could
divert the attention of our management away from our operations.



| |                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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 cannot obtain director and officer
    liability insurance in acceptable amounts for acceptable rates,
    we may have difficulty recruiting and retaining qualified
    directors and officers.

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

34



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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 lawsuit against us have a $250,000
retention. As a result, the costs we incur in defending this
lawsuit 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.




| |                                                                                        
| | ---------------------------------------------------------------------------------------
| | 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. For example, we recorded a
write-down of $15.5 million in fiscal year 2002. 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.






|         |                                                               
|-------- | --------------------------------------------------------------
|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.

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.

A sensitivity analysis was performed on our
December 31, 2003 investment portfolio based on a modeling
technique that measures hypothetical fair market value changes
that would result from a parallel shift in the yield curve of
plus 100 basis points. Based on this analysis, a hypothetical
100 basis point increase in interest rates would result in a
$123,000 decrease in the fair value of our investments in debt
securities as of December 31, 2003.

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Exchange Rate Sensitivity

Currently, all of our revenue and most of our
expenses are denominated in U.S. dollars. However, since a
portion of our operations sales and service activities are
outside of the U.S., we have entered into transactions in other
currencies. We are primarily exposed to changes in exchange
rates for the Euro, Japanese yen, and British pound. Because we
transact expenses only in foreign currency, we are adversely
affected by a weaker U.S. dollar relative to major currencies
worldwide. Additionally, because some of our obligations are
denominated in foreign currencies, a weaker U.S. dollar creates
foreign exchange losses. We have not engaged in any foreign
exchange hedging activities to date.

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

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, 2003 and 2002, and the related consolidated
statements of operations, stockholders equity and cash
flows for each of the three years in the period ended
December 31, 2003. 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, 2003 and 2002, and the
consolidated results of its operations and its cash flows for
each of the three years in the period ended December 31,
2003, 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

February 6, 2004


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COSINE COMMUNICATIONS, INC.

CONSOLIDATED BALANCE SHEETS

|                                                             |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |          |         | 
|------------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ------ | -------- | ------ | - | ------- | -------- | ------- | 
|                                                             |                                                                                                                                                                           |                                                                                   
|                                                             |                                                                                                                                                                           | December 31,                                                                      
|                                                             |                                                                                                                                                                           |                                                                                   
|                                                             |                                                                                                                                                                           | 2003                                                                               |        | 2002    
|                                                             |                                                                                                                                                                           |                                                                                    |        |         
|                                                             |                                                                                                                                                                           |                                                                                   
|                                                             |                                                                                                                                                                           | (In thousands, except for                                                         
|                                                             |                                                                                                                                                                           | share and per share data)                                                         
|ASSETS                                                      
|Current assets:                                              |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         
|                                                             | Cash and cash equivalents                                                                                                                                                 |                                                                                    | $      | 19,719   |        |   | $       | 9,230    |        
|                                                             | Short-term investments                                                                                                                                                    |                                                                                    |        | 38,033   |        |   |         | 92,237   |        
|                                                             | Accounts receivable:                                                                                                                                                      |                                                                                    |        |          |        |   |         |          |        
|                                                             |                                                                                                                                                                           | Trade (net of allowances for doubtful accounts of
    $150 and $233, respectively) |        |          | 4,962  |   |         |          | 6,373   | 
|                                                             |                                                                                                                                                                           | Other                                                                              |        |          | 494    |   |         |          | 679     | 
|                                                             | Inventory                                                                                                                                                                 |                                                                                    |        | 4,003    |        |   |         | 3,175    |        
|                                                             | Prepaid expenses and other current assets                                                                                                                                 |                                                                                    |        | 2,668    |        |   |         | 4,054    |        
|                                                             |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         
|                                                             |                                                                                                                                                                           | Total current assets                                                               |        |          | 69,879 |   |         |          | 115,748 | 
|Property and equipment, net                                  |                                                                                                                                                                           |                                                                                    | 2,900  |          |        |   | 2,816   |         
|Long-term deposits                                           |                                                                                                                                                                           |                                                                                    | 647    |          |        |   | 997     |         
|                                                             |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         
|                                                             |                                                                                                                                                                           | $                                                                                  | 73,426 |          |        | $ | 119,561 |         
|                                                             |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         
|                                                            
|LIABILITIES AND STOCKHOLDERS
    EQUITY                    
|Current liabilities:                                         |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         
|                                                             | Accounts payable                                                                                                                                                          |                                                                                    | $      | 1,657    |        |   | $       | 2,493    |        
|                                                             | Provision for warranty claims                                                                                                                                             |                                                                                    |        | 464      |        |   |         | 1,103    |        
|                                                             | Accrued other liabilities                                                                                                                                                 |                                                                                    |        | 2,560    |        |   |         | 13,362   |        
|                                                             | Accrued compensation                                                                                                                                                      |                                                                                    |        | 1,821    |        |   |         | 1,708    |        
|                                                             | Deferred revenue                                                                                                                                                          |                                                                                    |        | 3,543    |        |   |         | 1,444    |        
|                                                             | Current portion of equipment and working capital
    loans                                                                                                                |                                                                                    |        | 129      |        |   |         | 1,865    |        
|                                                             | Current portion of obligations under capital lease                                                                                                                        |                                                                                    |        |         |        |   |         | 1,905    |        
|                                                             |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         
|                                                             |                                                                                                                                                                           | Total current liabilities                                                          |        |          | 10,174 |   |         |          | 23,880  | 
|Long-term portion of equipment and working
    capital loans |                                                                                                                                                                           |                                                                                    |       |          |        |   | 131     |         
|Accrued rent                                                 |                                                                                                                                                                           |                                                                                    | 2,078  |          |        |   | 2,069   |         
|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; 10,176,845 and 9,959,092 shares issued and
    outstanding at December 31, 2003 and 2002, respectively |                                                                                    |        | 1        |        |   |         | 1        |        
|                                                             | Additional paid-in capital                                                                                                                                                |                                                                                    |        | 546,176  |        |   |         | 549,243  |        
|                                                             | Notes receivable from stockholders                                                                                                                                        |                                                                                    |        | (6,659   | )      |   |         | (10,531  | )      
|                                                             | Accumulated other comprehensive income                                                                                                                                    |                                                                                    |        | 533      |        |   |         | 532      |        
|                                                             | Deferred compensation                                                                                                                                                     |                                                                                    |        | (455     | )      |   |         | (2,274   | )      
|                                                             | Accumulated deficit                                                                                                                                                       |                                                                                    |        | (478,422 | )      |   |         | (443,490 | )      
|                                                             |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         
|Total stockholders equity                                   |                                                                                                                                                                           |                                                                                    | 61,174 |          |        |   | 93,481  |         
|                                                             |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         
|                                                             |                                                                                                                                                                           | $                                                                                  | 73,426 |          |        | $ | 119,561 |         
|                                                             |                                                                                                                                                                           |                                                                                    |        |          |        |   |         |         

See accompanying notes.

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COSINE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |        |         | 
|----------------------------------------------------------------- | ------------------------------------ | ----------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------- | - | -------- | ------ | ------- | 
|                                                                  |                                      |                                          
|                                                                  |                                      | Year Ended December 31,                  
|                                                                  |                                      |                                          
|                                                                  |                                      | 2003                                      |         | 2002   |        | 2001
|                                                                  |                                      |                                           |         |        |        |     
|                                                                  |                                      |                                          
|                                                                  |                                      | (In thousands, except for per share data)
|Revenue                                                           |                                      | $                                         | 14,621  |        |        | $    | 23,632  |        |         | $ | 34,293   |       
|                                                                  | Cost of goods sold(1)                |                                           |         | 6,765  |        |      |         | 13,807 |         |   |          | 30,214 |        
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|Gross profit                                                      |                                      |                                           | 7,856   |        |        |      | 9,825   |        |         |   | 4,079    |       
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|Operating expenses:                                               |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|                                                                  | Research and development(2)          |                                           |         | 21,756 |        |      |         | 32,396 |         |   |          | 66,091 |        
|                                                                  | Sales and marketing(3)               |                                           |         | 13,808 |        |      |         | 28,271 |         |   |          | 60,000 |        
|                                                                  | General and administrative(4)        |                                           |         | 7,226  |        |      |         | 10,959 |         |   |          | 23,525 |        
|                                                                  | Restructuring and impairment charges |                                           |         | 336    |        |      |         | 34,538 |         |   |          | 8,991  |        
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|                                                                  |                                      | Total operating expenses                  |         |        | 43,126 |      |         |        | 106,164 |   |          |        | 158,607 | 
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|Loss from operations                                              |                                      |                                           | (35,270 | )      |        |      | (96,339 | )      |         |   | (154,528 | )     
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|Other income (expense):                                           |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|                                                                  | Interest income                      |                                           |         | 1,296  |        |      |         | 3,535  |         |   |          | 11,086 |        
|                                                                  | Interest expense(5)                  |                                           |         | (224   | )      |      |         | (966   | )       |   |          | (1,675 | )      
|                                                                  | Other(6)                             |                                           |         | (447   | )      |      |         | 313    |         |   |          | (299   | )      
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|                                                                  |                                      | Total other income (expense)              |         |        | 625    |      |         |        | 2,882   |   |          |        | 9,112   | 
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|Loss before income tax provision                                  |                                      |                                           | (34,645 | )      |        |      | (93,457 | )      |         |   | (145,416 | )     
|                                                                  | Income tax provision                 |                                           |         | 287    |        |      |         | 509    |         |   |          | 837    |        
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|Net loss                                                          |                                      | $                                         | (34,932 | )      |        | $    | (93,966 | )      |         | $ | (146,253 | )     
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|Basic and diluted net loss per share                              |                                      | $                                         | (3.57   | )      |        | $    | (9.72   | )      |         | $ | (15.09   | )     
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       
|Shares used in computing basic and diluted net
    loss per share |                                      |                                           | 9,791   |        |        |      | 9,670   |        |         |   | 9,695    |       
|                                                                  |                                      |                                           |         |        |        |      |         |        |         |   |          |       



---



|    |                                                                                                                                                                                                                                                      
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Cost of goods sold includes $130 of non-cash
    charges related to equity issuances in 2003, $101 of non-cash
    credits related to equity issuances in 2002 and $2,283 of
    non-cash charges related to equity issuances in 2001.               
|   
|(2) | Research and development expenses include $568 of
    non-cash charges related to equity issuances in 2003, $385 of
    non-cash credits related to equity issuances in 2002 and $10,818
    of non-cash charges related to equity issuances in 2001.
|   
|(3) | Sales and marketing expenses include $124 of
    non-cash charges related to equity issuances in 2003, $854 of
    non-cash credits related to equity issuances in 2002 and $12,685
    of non-cash charges related to equity issuances in 2001.     
|   
|(4) | General and administrative expenses include $459,
    $925 and $6,177 of non-cash charges related to equity issuances
    in 2003, 2002 and 2001, respectively.                                                                                      
|   
|(5) | Interest expense includes $30, $131 and $154 of
    non-cash charges related to equity issuances in 2003, 2002 and
    2001, respectively.                                                                                                           
|   
|(6) | Other includes foreign exchange losses of $432,
    $281 and $302 in 2003, 2002 and 2001, respectively.                                                                                                                                              

See accompanying notes.

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COSINE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

(In thousands, except share data)


|                                                                                 |                                            |                                   |            |            |  |            |   |               |  |          |         |              |  |               |         |        |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |          |  
|-------------------------------------------------------------------------------- | ------------------------------------------ | --------------------------------- | ---------- | ---------- |  | ---------- | - | ------------- |  | -------- | ------- | ------------ |  | ------------- | ------- | ------ |  |  | ------ | ------ | - |  | ------- | - |  |  | -------- | -------- | - |  | -------- | -------- | -
|                                                                                 |                                            |                                   |            |            |  | Notes      |   | Accumulated   |  |          |         |              |  |              
|                                                                                 |                                            | Common Stock                      |            | Additional |  | Receivable |   | Other         |  |          |         |              |  | Total        
|                                                                                 |                                            |                                   |            | Paid-in    |  | from       |   | Comprehensive |  | Deferred |         | Accumulated  |  | Stockholders
|                                                                                 |                                            | Shares                            |            | Amount     |  | Capital    |   | Stockholders  |  | Income   |         | Compensation |  | Deficit       |         | Equity
|                                                                                 |                                            |                                   |            |            |  |            |   |               |  |          |         |              |  |               |         |       
|                                                                                 |                                            |                                  
|                                                                                 |                                            | (In thousands, except share data)
|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 loss on investments, net of tax |                                   |            |           |  |            |   |              |  |          |         |             |  |               |         |       |  |  |        | (1,803 | ) |  |         |  |  |  |          |         |   |  |          | (1,803   | )
|                                                                                 | Translation adjustment, net of tax         |                                   |            |           |  |            |   |              |  |          |         |             |  |               |         |       |  |  |        | (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 loss on investments, net of tax |                                   |            |           |  |            |   |              |  |          |         |             |  |               |         |       |  |  |        | (209   | ) |  |         |  |  |  |          |         |   |  |          | (209     | )
|                                                                                 | Translation adjustment, net of tax         |                                   |            |           |  |            |   |              |  |          |         |             |  |               |         |       |  |  |        | 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   |         
|                                                                                 |                                            |                                   |            |            |  |            |   |               |  |          |         |              |  |               |         |        |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Issuance of common stock in connection with stock
    options                    |                                            |                                   | 245,629    |            |  |            |  |               |  |          | 1,207   |              |  |               |        |        |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 1,207    |         
|Issuance of common stock in connection with the
    Employee Stock Purchase Plan |                                            |                                   | 57,480     |            |  |            |  |               |  |          | 231     |              |  |               |        |        |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 231      |         
|Repayment of notes receivable from stockholders                                  |                                            |                                   |           |            |  |            |  |               |  |          |        |              |  |               | 32      |        |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 32       |         
|Repurchase of unvested shares                                                    |                                            |                                   | (85,356    | )          |  |            |  |               |  |          | (3,905  | )            |  |               | 3,840   |        |  |  |       |        |   |  |        |   |  |  |         |          |   |  | (65      | )       
|Remeasurement of deferred stock-based compensation                               |                                            |                                   |           |            |  |            |  |               |  |          | 619     |              |  |               |        |        |  |  |       |        |   |  | (619    | ) |  |  |         |          |   |  |         |         
|Cancellation of options with deferred stock
    compensation charges             |                                            |                                   |           |            |  |            |  |               |  |          | (264    | )            |  |               |        |        |  |  |       |        |   |  | 264     |   |  |  |         |          |   |  |         |         
|Amortization of deferred stock-based compensation                                |                                            |                                   |           |            |  |            |  |               |  |          |        |              |  |               |        |        |  |  |       |        |   |  | 2,174   |   |  |  |         |          |   |  | 2,174    |         
|Reversal of amortization in excess of vesting                                    |                                            |                                   |           |            |  |            |  |               |  |          | (956    | )            |  |               |        |        |  |  |       |        |   |  |        |   |  |  |         |          |   |  | (956     | )       
|Options with vesting accelerated or exercise
    deadline extended               |                                            |                                   |           |            |  |            |  |               |  |          | 1       |              |  |               |        |        |  |  |       |        |   |  |        |   |  |  |         |          |   |  | 1        |         
|Components of comprehensive loss:                                                |                                            |                                   |            |            |  |            |   |               |  |          |         |              |  |               |         |        |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|                                                                                 | Net loss                                   |                                   |            |           |  |            |   |              |  |          |         |             |  |               |         |       |  |  |        |       |   |  |         |  |  |  |          | (34,932  | ) |  |          | (34,932  | )
|                                                                                 | Unrealized loss on investments, net of tax |                                   |            |           |  |            |   |              |  |          |         |             |  |               |         |       |  |  |        | (315   | ) |  |         |  |  |  |          |         |   |  |          | (315     | )
|                                                                                 | Translation adjustment, net of tax         |                                   |            |           |  |            |   |              |  |          |         |             |  |               |         |       |  |  |        | 316    |   |  |         |  |  |  |          |         |   |  |          | 316      |  
|                                                                                 |                                            |                                   |            |            |  |            |   |               |  |          |         |              |  |               |         |        |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Total comprehensive loss                                                         |                                            |                                   |           |            |  |            |  |               |  |          |        |              |  |               |        |        |  |  | 1      |        |   |  |        |   |  |  | (34,932  | )        |   |  | (34,931  | )       
|                                                                                 |                                            |                                   |            |            |  |            |   |               |  |          |         |              |  |               |         |        |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         
|Balance at December 31, 2003                                                     |                                            |                                   | 10,176,845 |            |  |            | 1 |               |  |          | 546,176 |              |  |               | (6,659  | )      |  |  | 533    |        |   |  | (455    | ) |  |  | (478,422 | )        |   |  | 61,174   |         
|                                                                                 |                                            |                                   |            |            |  |            |   |               |  |          |         |              |  |               |         |        |  |  |        |        |   |  |         |   |  |  |          |          |   |  |          |         

See accompanying notes.

40



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##### Table of Contents



COSINE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |        |        |  
|-------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------- | ----------------------------------------- | ------- | ----- | ------- | ---- | ------- | ------ | ------ | - | -------- | ------ | ------ | -
|                                                                                 |                                                                                             |                                          
|                                                                                 |                                                                                             | Year Ended December 31,                  
|                                                                                 |                                                                                             |                                          
|                                                                                 |                                                                                             | 2003                                      |         | 2002  |         | 2001
|                                                                                 |                                                                                             |                                           |         |       |         |     
|                                                                                 |                                                                                             |                                          
|                                                                                 |                                                                                             | (In thousands)                           
|Operating activities:                                                            |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Net loss                                                                         |                                                                                             | $                                         | (34,932 | )     |         | $    | (93,966 | )      |        | $ | (146,253 | )     
|Adjustments to reconcile net loss to net cash
    used in operating activities:  |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|                                                                                 | Depreciation                                                                                |                                           |         | 2,715 |         |      |         | 10,448 |        |   |          | 16,000 |       
|                                                                                 | Allowance for doubtful accounts                                                             |                                           |         | (113  | )       |      |         | 296    |        |   |          | 1,385  |       
|                                                                                 | Non-cash charges related to inventory write down                                            |                                           |         | 193   |         |      |         | 1,465  |        |   |          | 12,356 |       
|                                                                                 | Write-down of property and capital equipment                                                |                                           |         |      |         |      |         | 18,761 |        |   |          | 4,593  |       
|                                                                                 | Non-cash restructuring charges                                                              |                                           |         | 66    |         |      |         | (305   | )      |   |          |       |       
|                                                                                 | Amortization of deferred stock compensation and
    charges related to vesting acceleration |                                           |         | 2,175 |         |      |         | 7,987  |        |   |          | 29,165 |       
|                                                                                 | Reversal of amortization in excess of vesting                                               |                                           |         | (956  | )       |      |         | (8,466 | )      |   |          |       |       
|                                                                                 | Amortization of warrants issued for services                                                |                                           |         | 92    |         |      |         | 195    |        |   |          | 5,955  |       
|                                                                                 | Other                                                                                       |                                           |         | (11   | )       |      |         | 263    |        |   |          | 338    |       
|                                                                                 | Change in operating assets and liabilities:                                                 |                                           |         |       |         |      |         |        |        |   |          |        |       
|                                                                                 |                                                                                             | Accounts receivable (trade)               |         |       | 1,524   |      |         |        | 7,309  |   |          |        | (9,270 | )
|                                                                                 |                                                                                             | Other receivables                         |         |       | 185     |      |         |        | 598    |   |          |        | (486   | )
|                                                                                 |                                                                                             | Inventory                                 |         |       | (841    | )    |         |        | 589    |   |          |        | (6,951 | )
|                                                                                 |                                                                                             | Prepaid expenses and other current assets |         |       | 1,294   |      |         |        | 1,487  |   |          |        | 4,394  |  
|                                                                                 |                                                                                             | Long-term deposits                        |         |       | 333     |      |         |        | (306   | ) |          |        |       |  
|                                                                                 |                                                                                             | Other assets                              |         |       |        |      |         |        | 245    |   |          |        | (166   | )
|                                                                                 |                                                                                             | Accounts payable                          |         |       | (836    | )    |         |        | (717   | ) |          |        | (3,924 | )
|                                                                                 |                                                                                             | Provision for warranty claims             |         |       | (639    | )    |         |        | (1,402 | ) |          |        | (1,236 | )
|                                                                                 |                                                                                             | Accrued other liabilities                 |         |       | (10,847 | )    |         |        | 4,373  |   |          |        | 1,511  |  
|                                                                                 |                                                                                             | Accrued compensation                      |         |       | 113     |      |         |        | (2,513 | ) |          |        | (589   | )
|                                                                                 |                                                                                             | Note payable                              |         |       |        |      |         |        |       |   |          |        | (223   | )
|                                                                                 |                                                                                             | Deferred revenue                          |         |       | 2,099   |      |         |        | (1,269 | ) |          |        | (6,841 | )
|                                                                                 |                                                                                             | Accrued rent                              |         |       | 9       |      |         |        | 263    |   |          |        | 402    |  
|                                                                                 |                                                                                             | Other liabilities                         |         |       |        |      |         |        | (11    | ) |          |        | (205   | )
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Net cash used in operating activities                                            |                                                                                             |                                           | (38,377 | )     |         |      | (54,676 | )      |        |   | (100,045 | )     
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Investing activities:                                                            |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Capital expenditures                                                             |                                                                                             |                                           | (2,983  | )     |         |      | (3,304  | )      |        |   | (16,916  | )     
|Purchase of short-term investments                                               |                                                                                             |                                           | (76,849 | )     |         |      | (89,253 | )      |        |   | (116,374 | )     
|Proceeds from sales and maturities of short-term
    investments                 |                                                                                             |                                           | 131,065 |       |         |      | 87,817  |        |        |   | 185,702  |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Net cash provided by (used in) investing
    activities                          |                                                                                             |                                           | 51,233  |       |         |      | (4,740  | )      |        |   | 52,412   |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Financing activities:                                                            |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Principal payments of equipment and working
    capital loans and capital leases |                                                                                             |                                           | (3,772  | )     |         |      | (6,032  | )      |        |   | (5,833   | )     
|Proceeds from issuance of common stock, net                                      |                                                                                             |                                           | 1,438   |       |         |      | 716     |        |        |   | 1,154    |       
|Proceeds from notes receivable from stockholders                                 |                                                                                             |                                           | 32      |       |         |      | 234     |        |        |   | 404      |       
|Repurchase of common stock                                                       |                                                                                             |                                           | (65     | )     |         |      | (140    | )      |        |   | (363     | )     
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Net cash used in financing activities                                            |                                                                                             |                                           | (2,367  | )     |         |      | (5,222  | )      |        |   | (4,638   | )     
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Net (decrease) increase in cash and cash
    equivalents                         |                                                                                             |                                           | 10,489  |       |         |      | (64,638 | )      |        |   | (52,271  | )     
|Cash and cash equivalents at the beginning of the
    period                     |                                                                                             |                                           | 9,230   |       |         |      | 73,868  |        |        |   | 126,139  |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Cash and cash equivalents at the end of the period                               |                                                                                             | $                                         | 19,719  |       |         | $    | 9,230   |        |        | $ | 73,868   |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Supplemental information:                                                        |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Cash paid for interest                                                           |                                                                                             | $                                         | 195     |       |         | $    | 835     |        |        | $ | 1,521    |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Income taxes paid                                                                |                                                                                             | $                                         | 110     |       |         | $    | 509     |        |        | $ | 837      |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Cancellation of notes receivable due to
    repurchase of unvested stock         |                                                                                             | $                                         | 3,840   |       |         | $    | 14,701  |        |        | $ | 10,651   |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Net transfer from inventory to property and
    equipment                        |                                                                                             | $                                         | 180     |       |         | $    | 191     |        |        | $ |         |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       
|Net transfer from property and equipment to
    inventory                        |                                                                                             | $                                         |        |       |         | $    |        |        |        | $ | 1,645    |       
|                                                                                 |                                                                                             |                                           |         |       |         |      |         |        |        |   |          |       

See accompanying notes.

41



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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 and sale 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 inter-company 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 common 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.



| |                 
| | ----------------
| | 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.
Estimates are used in accounting for, but not limited to,
revenue recognition, allowance for doubtful accounts, inventory
valuations, long-lived asset valuations, accrued liabilities
including warranties, and equity issuances. Estimates and
assumptions are reviewed periodically and the effects of
revisions are reflected in the consolidated financial statements
in the period of determination.



| |                                    
| | -----------------------------------
| | 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.



| |                           
| | --------------------------
| | 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. The Company is exposed to credit risks in the
event of default by these institutions to the extent of the
amount recorded on the balance sheet.

42



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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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, 2003, CoSine
recognized revenue from two customers who accounted for 41% and
12% of total revenue, respectively. At December 31, 2003,
CoSine had two customers who accounted for 52% and 19%,
respectively, of total accounts receivable. For the year ended
December 31, 2002, CoSine recognized revenue from two
customers who 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 two customers
which each accounted for 11% of total revenue. The Company
generally does not require collateral and maintains adequate
reserves for potential credit losses.



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

CoSine from time to time enters into certain
types of contracts that require the Company to indemnify parties
against certain third party claims that may arise. These
contracts primarily relate to: (i) certain real estate
leases under which the Company may be required to indemnify
property owners for environmental 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, (iii) contracts under which the
Company may be required to indemnify customers against loss or
damage to property or persons as a result of willful or
negligent conduct by CoSine employees or sub-contractors,
(iv) contracts under which the Company may be required to
indemnify customers against third party claims that a CoSine
product infringes a patent, copyright or other intellectual
property right and (v) procurement or license agreements
under which the Company may be required to indemnify licensors
or vendors for certain claims that may be brought against them
arising from the Companys acts or omissions with respect
to the supplied products or technology.

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, 2003.



| |                                                      
| | -----------------------------------------------------
| | 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, if any, 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.

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.

43



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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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

|                                       |  |              |         |      |  |   |        |  
|-------------------------------------- |  | ------------ | ------- | ---- |  | - | ------ | -
|                                       |  |             
|                                       |  | December 31,
|                                       |  |             
|                                       |  | 2003         |         | 2002
|                                       |  |              |         |     
|Money market funds                     |  | $            | 44,700  |      |  | $ | 10,075 |  
|Commercial paper                       |  |              | 11,065  |      |  |   | 62,546 |  
|Corporate bonds                        |  |              |        |      |  |   | 22,506 |  
|                                       |  |              |         |      |  |   |        |  
|                                       |  |              | 55,765  |      |  |   | 95,127 |  
|Amounts classified as cash equivalents |  |              | (17,732 | )    |  |   | (2,890 | )
|                                       |  |              |         |      |  |   |        |  
|                                       |  | $            | 38,033  |      |  | $ | 92,237 |  
|                                       |  |              |         |      |  |   |        |  

As of December 31, 2003 and 2002, 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, 2003 and 2002, $150,000
and $500,000, 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 stated at the lower of cost
(first-in, first-out) or market, consisted of the following (in
thousands):

|                    |  |              |       |      |  |   |       | 
|------------------- |  | ------------ | ----- | ---- |  | - | ----- | 
|                    |  |             
|                    |  | December 31,
|                    |  |             
|                    |  | 2003         |       | 2002
|                    |  |              |       |     
|Raw materials       |  | $            | 160   |      |  | $ | 312   | 
|Semi-finished goods |  |              | 3,466 |      |  |   | 1,951 | 
|Finished goods      |  |              | 377   |      |  |   | 912   | 
|                    |  |              |       |      |  |   |       | 
|                    |  | $            | 4,003 |      |  | $ | 3,175 | 
|                    |  |              |       |      |  |   |       | 

Included in net semi-finished goods at
December 31, 2003 and 2002 was $126,000 and $289,000,
respectively, of goods used for customer evaluation purposes.
Included in net finished goods inventory at December 31,
2003 was $160,000 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 2003, CoSine sold $891,000 of previously written-down
inventory and $193,000 of inventory was written down. During
2002, CoSine sold $1,236,000 of previously written-down
inventory and $646,000 of inventory was written down. In
addition, charges of $113,000 and $819,000 were recorded in 2003
and 2002, respectively, in connection with excess purchase
commitments at CoSines contract manufacturers.

44



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

CoSine periodically reviews the rates used to
determine overhead capitalization applied to inventory. As a
result of restructuring activity and refinements in its business
model, the Company adjusted the overhead absorption rate for raw
materials and semi-finished goods downward during the year ended
December 31, 2003. This change in estimate increased cost
of goods sold by $527,000 for the year ended December 31,
2003.



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

Property and equipment at December 31, 2003
and 2002 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
one to five years) or the related lease term, if shorter.

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 initiated in September 2001. (See Note 9)

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

|                                       |  |              |        |      |  |   |        |  
|-------------------------------------- |  | ------------ | ------ | ---- |  | - | ------ | -
|                                       |  |             
|                                       |  | December 31,
|                                       |  |             
|                                       |  | 2003         |        | 2002
|                                       |  |              |        |     
|Computer equipment                     |  | $            | 1,412  |      |  | $ | 1,147  |  
|Furniture and fixtures                 |  |              | 211    |      |  |   | 210    |  
|Leasehold improvements                 |  |              | 30     |      |  |   | 8      |  
|Computer software                      |  |              | 312    |      |  |   | 6      |  
|Manufacturing and laboratory equipment |  |              | 5,423  |      |  |   | 3,218  |  
|                                       |  |              |        |      |  |   |        |  
|                                       |  |              | 7,388  |      |  |   | 4,589  |  
|Accumulated depreciation               |  |              | (4,488 | )    |  |   | (1,773 | )
|                                       |  |              |        |      |  |   |        |  
|                                       |  | $            | 2,900  |      |  | $ | 2,816  |  
|                                       |  |              |        |      |  |   |        |  



| |           
| | ----------
| | 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):

|                                                   |  |      |       |      |  |      |        |   |  |   |        |  
|-------------------------------------------------- |  | ---- | ----- | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                   |  | 2003 |       | 2002 |  | 2001
|                                                   |  |      |       |      |  |     
|Beginning balance                                  |  | $    | 1,103 |      |  | $    | 2,505  |   |  | $ | 3,741  |  
|Warranty charged to cost of goods sold             |  |      | 352   |      |  |      | 351    |   |  |   | 2,355  |  
|Utilization of warranties                          |  |      | (894  | )    |  |      | (1,568 | ) |  |   | (1,491 | )
|Changes in estimated liability based on experience |  |      | (97   | )    |  |      | (185   | ) |  |   | (2,100 | )
|                                                   |  |      |       |      |  |      |        |   |  |   |        |  
|Ending balance                                     |  | $    | 464   |      |  | $    | 1,103  |   |  | $ | 2,505  |  
|                                                   |  |      |       |      |  |      |        |   |  |   |        |  

45



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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 and compensation charges in
connection with these repriced options, as the price of
CoSines stock was higher than the repriced amount at
December 31, 2002 and during certain quarters of 2003. 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. 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).
Compensation associated with re-priced options will be
remeasured until they are exercised, canceled or expire.

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.

46



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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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):

|                                                                                                                                            |  |      |         |      |  |      |         |   |  |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | ---- |  | ---- | ------- | - |  | - | -------- | -
|                                                                                                                                            |  | 2003 |         | 2002 |  | 2001
|                                                                                                                                            |  |      |         |      |  |     
|Net loss, as reported                                                                                                                       |  | $    | (34,932 | )    |  | $    | (93,966 | ) |  | $ | (146,253 | )
|Add: Stock-based employee compensation expense
    included in reported net loss                                                            |  |      | 2,175   |      |  |      | 7,987   |   |  |   | 29,161   |  
|Deduct: Reversal of amortization in excess of
    vesting                                                                                   |  |      | (956    | )    |  |      | (8,466  | ) |  |   |         |  
|Deduct: Stock-based employee compensation expense
    determined under fair value method for all stock option grants
    (SFAS 123 expense) |  |      | (2,556  | )    |  |      | 5,202   |   |  |   | (7,864   | )
|                                                                                                                                            |  |      |         |      |  |      |         |   |  |   |          |  
|Pro forma net loss                                                                                                                          |  | $    | (36,269 | )    |  | $    | (89,243 | ) |  | $ | (124,956 | )
|                                                                                                                                            |  |      |         |      |  |      |         |   |  |   |          |  
|Basic and diluted net loss per share, as reported                                                                                           |  | $    | (3.57   | )    |  | $    | (9.72   | ) |  | $ | (15.09   | )
|                                                                                                                                            |  |      |         |      |  |      |         |   |  |   |          |  
|Pro forma basic and diluted net loss per share                                                                                              |  | $    | (3.70   | )    |  | $    | (9.23   | ) |  | $ | (12.89   | )
|                                                                                                                                            |  |      |         |      |  |      |         |   |  |   |          |  

The fair value of CoSines options was
estimated at the grant date using the Black-Scholes option
pricing model with the following weighted average assumptions:

|                                              |  |                   |         |                   |  |                   |         |   |  |   |         |  
|--------------------------------------------- |  | ----------------- | ------- | ----------------- |  | ----------------- | ------- | - |  | - | ------- | -
|                                              |  | Fiscal Year Ended |         | Fiscal Year Ended |  | Fiscal Year Ended
|                                              |  | December 31,      |         | December 31,      |  | December 31,     
|                                              |  | 2003              |         | 2002              |  | 2001             
|                                              |  |                   |         |                   |  |                  
|Weighted average fair value of shares granted |  | $                 | 3.23    |                   |  | $                 | 2.73    |   |  | $ | 23.10   |  
|Dividend yield                                |  |                   | 0.0     | %                 |  |                   | 0.0     | % |  |   | 0.0     | %
|Volatility                                    |  |                   | 0.82    |                   |  |                   | 0.67    |   |  |   | 1.15    |  
|Risk free interest rate                       |  |                   | 2.2     | %                 |  |                   | 3.0     | % |  |   | 5.0     | %
|Expected life                                 |  |                   | 4 years |                   |  |                   | 4 years |   |  |   | 4 years |  

The estimated weighted-average fair value of
shares granted under the Purchase Plan in 2003 was $2.22, using
a volatility of 0.47, risk-free interest rate of 1.3% and an
expected life of one year. The estimated weighted-average fair
value of shares granted under the Purchase Plan in 2002 was
$1.60, using a volatility of 0.67, risk-free interest rate of 1%
and an expected life of one year. 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.



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

The majority of CoSines revenue is
recognized from the sale of its IP Service Delivery Platforms
and subsequent service support arrangements. 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 collection 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 elements, 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

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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 perpetual software licenses is
recognized upon shipment or acceptance, if required. Revenue
from one-year term licenses is recognized on a straight-line
basis over the one-year license term. Post delivery technical
support, such as on-site service, phone support, parts and
access to software upgrades, when and if available, is provided
by CoSine under separate support services agreements. In cases
where the support service is sold as part of an arrangement
including multiple elements, CoSine allocates revenue to the
support service based on the VSOE of the services and recognizes
it on a straight-line basis over the service period. Revenue
from consulting and training 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, $3,003,000 was recognized
as an offset to receipts from sales in the determination of
revenue. CoSines revenue in 2003 and 2002 was not affected
by the value of warrants granted to customers.

Below is a reconciliation of revenue for the
years ended December 31, 2003, 2002 and 2001 as presented
in the statement of operations to show the separate components
as indicated (in thousands):

|                                                                                            |  |      |        |      |  |      |        |  |  |   |        | 
|------------------------------------------------------------------------------------------- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|                                                                                            |  | 2003 |        | 2002 |  | 2001
|                                                                                            |  |      |        |      |  |     
|Receipts from sales, including equity issued in
    2000 in connection with purchase orders |  | $    | 14,621 |      |  | $    | 23,632 |  |  | $ | 37,296 | 
|Less: Receipts for equity issued in 2000 in
    connection with purchase orders             |  |      |       |      |  |      |       |  |  |   | 3,003  | 
|                                                                                            |  |      |        |      |  |      |        |  |  |   |        | 
|Revenue                                                                                     |  | $    | 14,621 |      |  | $    | 23,632 |  |  | $ | 34,293 | 
|                                                                                            |  |      |        |      |  |      |        |  |  |   |        | 



| |                   
| | ------------------
| | 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, 2003, 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.

48



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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



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

Advertising costs are expensed as incurred. For
the year ended December 31, 2003, the Company incurred no
expense for advertising. Advertising costs amounted to $105,000
and $437,000 for the years ended December 31, 2002 and
2001, respectively.



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

Basic net loss per 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 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.

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

|                                     |                                                                          |                         |         |       |  |      |         |        |  |   |          |        | 
|------------------------------------ | ------------------------------------------------------------------------ | ----------------------- | ------- | ----- |  | ---- | ------- | ------ |  | - | -------- | ------ | 
|                                     |                                                                          |                        
|                                     |                                                                          | Year Ended December 31,
|                                     |                                                                          |                        
|                                     |                                                                          | 2003                    |         | 2002  |  | 2001
|                                     |                                                                          |                         |         |       |  |     
|Net loss                             |                                                                          | $                       | (34,932 | )     |  | $    | (93,966 | )      |  | $ | (146,253 | )     
|Basic and diluted:                   |                                                                          |                         |         |       |  |      |         |        |  |   |          |       
|                                     | Weighted-average shares of common stock
    outstanding                  |                         |         | 9,999 |  |      |         | 10,095 |  |   |          | 10,269 | 
|                                     | Less: weighted-average shares subject to
    repurchase                  |                         |         | 208   |  |      |         | 425    |  |   |          | 574    | 
|                                     |                                                                          |                         |         |       |  |      |         |        |  |   |          |       
|                                     | Weighted-average shares used in basic and diluted
    net loss per share |                         |         | 9,791 |  |      |         | 9,670  |  |   |          | 9,695  | 
|                                     |                                                                          |                         |         |       |  |      |         |        |  |   |          |       
|Basic and diluted net loss per share |                                                                          | $                       | (3.57   | )     |  | $    | (9.72   | )      |  | $ | (15.09   | )     
|                                     |                                                                          |                         |         |       |  |      |         |        |  |   |          |       

During all periods presented, CoSine had stock
options and warrants outstanding that could potentially dilute
earnings per share in the future, but were excluded from the
computation of diluted net loss per share, as their effect would
have been antidilutive. These shares amounted to 1,280,000,
1,332,000 and 1,696,000 for the years ended December 31,
2003, 2002 and 2001, respectively.



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

CoSine operates in only one segment: IP Service
Delivery Platforms. Substantially all of CoSines assets
are located in the United States.

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Revenues from customers by geographic region for
the years ended December 31, 2003, 2002 and 2001 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
|                      |  |               |        |               |  |        
|2003                  |  |               |        |               |  |         |       |  |  |   |        | 
|Europe                |  | $             | 2,676  |               |  | $       |      |  |  | $ | 2,676  | 
|Japan                 |  |               | 2,957  |               |  |         |      |  |  |   | 2,957  | 
|Korea                 |  |               | 1,717  |               |  |         |      |  |  |   | 1,717  | 
|Rest of Asia/ Pacific |  |               | 463    |               |  |         |      |  |  |   | 463    | 
|United States         |  |               | 6,808  |               |  |         |      |  |  |   | 6,808  | 
|                      |  |               |        |               |  |         |       |  |  |   |        | 
|                      |  | $             | 14,621 |               |  | $       |       |  |  | $ | 14,621 | 
|                      |  |               |        |               |  |         |       |  |  |   |        | 
|2002                  |  |               |        |               |  |         |       |  |  |   |        | 
|Europe                |  | $             | 5,726  |               |  | $       |      |  |  | $ | 5,726  | 
|Japan                 |  |               | 4,726  |               |  |         |      |  |  |   | 4,726  | 
|Korea                 |  |               | 2,911  |               |  |         |      |  |  |   | 2,911  | 
|Rest of Asia/ Pacific |  |               | 1,846  |               |  |         |      |  |  |   | 1,846  | 
|United States         |  |               | 8,423  |               |  |         |      |  |  |   | 8,423  | 
|                      |  |               |        |               |  |         |       |  |  |   |        | 
|                      |  | $             | 23,632 |               |  | $       |       |  |  | $ | 23,632 | 
|                      |  |               |        |               |  |         |       |  |  |   |        | 
|2001                  |  |               |        |               |  |         |       |  |  |   |        | 
|Europe                |  | $             | 15,757 |               |  | $       | 544   |  |  | $ | 15,213 | 
|Japan                 |  |               | 11,623 |               |  |         |      |  |  |   | 11,623 | 
|United States         |  |               | 9,916  |               |  |         | 2,459 |  |  |   | 7,457  | 
|                      |  |               |        |               |  |         |       |  |  |   |        | 
|                      |  | $             | 37,296 |               |  | $       | 3,003 |  |  | $ | 34,293 | 
|                      |  |               |        |               |  |         |       |  |  |   |        | 



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

In January 2003, the Financial Accounting
Standards Board (FASB) issued Interpretation No. 46
(FIN 46), Consolidation of Variable Interest
Entities. FIN 46 addresses consolidation by business
enterprises of variable interest entities. Under that
interpretation, certain entities known as Variable Interest
Entities (VIEs) must be consolidated by the primary
beneficiary of the entity. The primary beneficiary is generally
defined as having the majority of the risks and rewards arising
from the VIE. For VIEs in which a significant (but not majority)
variable interest is held, certain disclosures are required. The
Company has not entered into any arrangements or made any
investments which qualify as a VIE in the period after
January 31, 2003 and therefore the initial implementation
of FIN 46 had no impact on its financial statements. For VIEs
acquired before February 1, 2003, the Company is required
to apply the accounting and disclosure rules set forth in FIN 46
in the first quarter of 2004. The Company has determined that
the adoption of FIN 46 will not have any impact on the
Companys financial statements.

In December 2003, the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 104
(SAB 104), Revenue Recognition.
SAB 104 revises or rescinds portions of the interpretive
guidance included in Topic 13 of the codification of staff
accounting bulletins in order to make this interpretive guidance
consistent with current authoritative accounting and auditing
guidance and SEC rules and regulations. The

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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

adoption of SAB 104 did not have a material
effect on the Companys financial statements for the period
ending December 31, 2003.



|   |                                    
|-- | -----------------------------------
|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 March 2004. Interest accrues at an annual
rate of 14.3%. As of December 31, 2003 and 2002, total
principal payments due under these agreements were $129,000 and
$1,996,000 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.

Future minimum payments under equipment and
working capital loans at December 31, 2003 are as follows
(in thousands):

|                             |                   |  |      |   | 
|---------------------------- | ----------------- |  | ---- | - | 
|2004 minimum payments        |                   |  | 132  |  
|                             |                   |  |      |  
|Amount representing interest |                   |  | (3   | )
|                             |                   |  |      |  
|Total principal              |                   |  | 129  |  
|Current portion              |                   |  | (129 | )
|                             |                   |  |      |  
|                             | Long-term portion |  | $    |  | 
|                             |                   |  |      |  



|   |       
|-- | ------
|3. | Leases

CoSine leases its facilities under operating
leases, with terms ranging from August 1998 through December
2011.

Future minimum payments for all operating leases
are as follows (in thousands):

|                             |  |           |        | 
|---------------------------- |  | --------- | ------ | 
|                             |  | Operating
|                             |  | Leases   
|                             |  |          
|2004                         |  | $         | 2,647  | 
|2005                         |  |           | 2,392  | 
|2006                         |  |           | 2,275  | 
|2007                         |  |           | 2,327  | 
|2008                         |  |           | 2,387  | 
|Thereafter                   |  |           | 7,520  | 
|                             |  |           |        | 
|Total minimum lease payments |  | $         | 19,548 | 
|                             |  |           |        | 

Rent expense was $3,126,000, $6,056,000 and
$8,337,000 for the years ended December 31, 2003, 2002 and
2001, respectively, and is calculated on a straight-line basis.

CoSine subleased a portion of the space at one of
its facilities in 2001, from which it recognized rental income
of $182,000 during that year. The sublease arrangement expired
on June 30, 2001.



|   |                              
|-- | -----------------------------
|4. | Commitments and Contingencies

As of December 31, 2003, CoSine had
commitments of approximately $1,390,000 relating to purchases of
raw materials and semi-finished goods. Of that amount, $329,000
related to excess inventory was accrued at December 31,
2003.

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

On November 15, 2001, CoSine and certain 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
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 each of the
directors and officers who signed the registration statement
relating to the initial public offering. 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 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, 2003. 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.

In June 2003, the plaintiffs in all of the cases
presented a settlement proposal to all of the issuer defendants.
Under the proposed settlement, the plaintiffs will dismiss and
release all claims against participating issuer defendants in
exchange for a contingent payment guaranty by the insurance
companies collectively responsible for insuring the issuer
defendants in all of the related cases, and the assignment or
surrender to the plaintiffs of certain claims the issuer
defendants may have against the underwriters. Under the
guaranty, the insurers will be required to pay the amount, if
any, by which $1 billion exceeds the aggregate amount ultimately
collected by the plaintiffs from the underwriter defendants in
all the cases, up to the limits of the applicable insurance
policies. The Company will not be required to make any cash
payments under the settlement, unless the Companys insurer
is required to pay on the Companys behalf an amount that
exceeds the Companys insurance coverage. The Company does
not believe that this circumstance will occur. In July 2003, a
special committee of the Companys Board of Directors
approved the proposed settlement. The settlement is subject to
acceptance by a substantial majority of the issuer defendants,
and execution of a definitive settlement agreement. The
settlement is also subject to approval of the court, which
cannot be assured. If the settlement is not consummated, the
Company intends to defend the lawsuit vigorously. However, the
Company cannot predict its outcome with certainty. If the
Company is not successful in its defense of this lawsuit, it
could be forced to make significant payments to the plaintiffs
and their lawyers, and such payments could have a material
adverse effect on the Companys business, financial
condition and results of operations if not covered by the
Companys insurance carrier. Even if these claims are not
successful, the litigation could result in substantial costs and
divert managements attention and resources, which could
adversely affect the Companys business, results of
operations and financial position.

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.

52



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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|   |                     
|-- | --------------------
|6. | Stockholders Equity



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

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

|                     |                             |      |       |       |  |  |       |       | 
|-------------------- | --------------------------- | ---- | ----- | ----- |  |  | ----- | ----- | 
|                     |                             | 2003 |       | 2002 
|                     |                             |      |       |      
|Stock options:       |                             |      |       |       |  |  |       |      
|                     | Options outstanding         |      |       | 1,246 |  |  |       | 1,298 | 
|                     | Available for future grants |      |       | 1,747 |  |  |       | 1,856 | 
|Warrants outstanding |                             |      | 34    |       |  |  | 34    |      
|                     |                             |      |       |       |  |  |       |      
|                     |                             |      | 3,027 |       |  |  | 3,188 |      
|                     |                             |      |       |       |  |  |       |      



| |                       
| | ----------------------
| | 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, 2003 and 2002, 3,333 and 45,952 shares of
common stock were subject to repurchase at an aggregate
repurchase price of $233,737 and $1,930,000 respectively. During
2003 and 2002, employees defaulted on notes receivable in the
amounts of $3,840,000 and $14,701,000, respectively, secured by
84,703 shares and 325,916 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.



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

In May 2000, the board of directors adopted the
2000 Stock Plan (2000 Plan). The 2000 Plan was approved by
CoSines shareholders 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.

CoSine has authorized 2,215,779 shares of common
stock for issuance under the 2000 Plan. At December 31,
2003 and 2002, a total of 1,066,640 and 1,273,467 shares were
available for future options grants under the 2000 Plan,
respectively.

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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |                       
| | ----------------------
| | 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. Only shares that were previously
issued under the 1997 Plan and subsequently reacquired by CoSine
have been or will be reserved for issuance under the 2002 Plan.

CoSine has authorized up to a maximum of
1,000,000 shares of common stock for issuance of Reacquired
Shares under the 2002 Plan. At December 31, 2003, there
were an aggregate of 729,598 Reacquired Shares under the 2002
Plan. At December 31, 2003 and 2002, a total of 656,538 and
558,745 shares were available for future options grants under
the 2002 Plan, respectively.

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, 2003, and 2002, a total of 48,000 and 40,000
shares of common stock have been authorized for issuance under
the Directors Plan. At December 31, 2003 and 2002, a
total of 24,000 and 32,000 shares were available for future
options grants under the Directors Plan, respectively.

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.

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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, 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  | 
|Repurchased                     |  |               | 85     |                     |  |           |       |   |  |   |      | 
|Granted                         |  |               | (695   | )                   |  |           | 695    |   |  |   | 5.42  | 
|Exercised                       |  |               |       |                     |  |           | (246   | ) |  |   | 4.93  | 
|Canceled                        |  |               | 501    |                     |  |           | (501   | ) |  |   | 11.45 | 
|                                |  |               |        |                     |  |           |        |   |  |   |       | 
|Balance as of December 31, 2003 |  |               | 1,747  |                     |  |           | 1,246  |   |  |   | 7.01  | 
|                                |  |               |        |                     |  |           |        |   |  |   |       | 

The following table summarizes information
concerning options outstanding and exercisable at
December 31, 2003 (in thousands, except per share data):

|                         |  |                     |       |                     |  |           |     |        |  |           |       |  |  |  |     |  |  |   |       | 
|------------------------ |  | ------------------- | ----- | ------------------- |  | --------- | --- | ------ |  | --------- | ----- |  |  |  | --- |  |  | - | ----- | 
|                         |  |                     |       |                     |  |          
|                         |  | Options Outstanding |       |                    
|                         |  |                     |       | Options Exercisable
|                         |  |                     |       | Weighted-           |  |           |     |       
|                         |  |                     |       | Average             |  | Weighted- |     |        |  | Weighted-
|                         |  | Number              |       | Remaining           |  | Average   |     | Number |  | Average  
|                         |  | of                  |       | Contractual         |  | Exercise  |     | of     |  | Exercise 
|Range of Exercise Prices |  | Shares              |       | Life (Years)        |  | Price     |     | Shares |  | Price    
|                         |  |                     |       |                     |  |           |     |        |  |          
|$1.50-4.94               |  |                     | 22    |                     |  |           | 9.0 |        |  | $         | 4.69  |  |  |  | 1   |  |  | $ | 3.77  | 
|5.00                     |  |                     | 628   |                     |  |           | 7.5 |        |  |           | 5.00  |  |  |  | 448 |  |  |   | 5.00  | 
|5.06-6.00                |  |                     | 468   |                     |  |           | 9.4 |        |  |           | 5.36  |  |  |  |    |  |  |   |      | 
|6.12-7.30                |  |                     | 60    |                     |  |           | 9.7 |        |  |           | 6.58  |  |  |  |    |  |  |   |      | 
|8.80-17.70               |  |                     | 35    |                     |  |           | 7.8 |        |  |           | 13.76 |  |  |  | 20  |  |  |   | 15.09 | 
|22.30-120.00             |  |                     | 33    |                     |  |           | 6.7 |        |  |           | 64.08 |  |  |  | 25  |  |  |   | 78.16 | 
|                         |  |                     |       |                     |  |           |     |        |  |           |       |  |  |  |     |  |  |   |       | 
|$1.50-120.00             |  |                     | 1,246 |                     |  |           | 8.3 |        |  | $         | 7.01  |  |  |  | 494 |  |  | $ | 9.05  | 
|                         |  |                     |       |                     |  |           |     |        |  |           |       |  |  |  |     |  |  |   |       | 



| |                                      
| | -------------------------------------
| | 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 provisions of section 423 of
the 1986 Internal Revenue Code of the United States. A total of
654,185 shares are authorized for issuance under the Purchase
Plan. Under the terms of the Purchase Plan, employees may

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##### Table of Contents



COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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 $1,377,000, $7,273,000 and
$29,691,000 for the years ended December 31, 2003, 2002 and
2001, 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 years ended
December 31, 2003 and 2002, credits of $956,000 and
$8,466,000, respectively, were recorded to reverse deferred
stock compensation amortization in excess of vesting. In 2003,
CoSine additionally recorded a reversal of deferred stock
compensation of $196,000 due to employee terminations.

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 in 2001 for these
transactions, and no expense in 2003 or 2002. The fair value of
these options was periodically re-measured 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 re-measure the compensation associated with these
shares until the earlier of the note being repaid or defaulted.
The result of each re-measurement is deferred compensation
expense, which is amortized over the remaining vesting period of
the underlying options. In 2003, CoSine recorded no amortization
or changes to deferred stock compensation for employee stock
options exercised with non-recourse promissory notes. 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 re-measurement of
compensation associated with these unvested shares and
amortization of $173,000. In 2001, CoSine recorded a reduction
deferred stock compensation due to the re-measurement of
compensation associated with these unvested shares amounting to
$31,586,000 and a reversal of amortization of $526,000.

On November 1, 2002, CoSine re-priced
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 re-priced to $5.00 per share, $1.00 more than the fair
market value of the underlying shares on the re-pricing date.
Compensation associated with these options will be re-measured
until they are exercised, canceled, or expire. During 2003,
CoSine recorded deferred stock compensation in relation to
re-priced stock options amounting to $619,000 and amortization
of $797,000, as the price of CoSines stock at
December 31, 2003 was higher than the re-priced amount. In
2003, CoSine additionally recorded a reversal of deferred stock
compensation of $68,000 due to employee terminations. During
2002, CoSine recorded deferred stock compensation in relation to
re-priced stock options amounting to $1,111,000 and amortization

56



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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

of $514,000, as the price of CoSines stock
at the end of the quarter after the November 2002 re-pricing was
higher than the re-priced amount.

On July 10, 2001, CoSine re-priced 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
re-priced to $15.50 per share, the fair market value of the
underlying shares on the re-pricing date. Compensation
associated with these options will be re-measured until they are
exercised, canceled, or expire. During the years ended
December 31, 2003, 2002 and 2001, CoSine did not record any
deferred stock compensation in connection with these re-priced
options, as the price of CoSines stock was not higher than
the re-priced amount at any quarter-end during those periods.



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

During the period from August 1998 to April 2000,
CoSine issued warrants to purchase common stock to various
consultants, lessors, lenders, service providers and customers.
The warrants had a variable measurement date and, accordingly,
were periodically revalued based on the guidance of Emerging
Issues Taks Force Consensus No. 96-18 (EITF
No. 96-18). The fair value of these warrants has been
amortized over the expected life of the warrants. Except for the
warrants discussed below, all of these warrants were fully
amortized as of December 31, 2003 and no longer affect the
Companys financial statements.

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. At December 31, 2003 and 2002, CoSine had $435,000
and $497,000, respectively, of unamortized warrant charges
related to the facilities lease.

At December 31, 2003 and 2002, 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, 2003 and 2002, CoSine had
non-recourse promissory notes receivable of $600,000 and
$775,000, respectively, from officers of CoSine for the payment
of stock option exercises. The remaining note is secured by a
pledge of CoSines common stock and has an annual interest
rate of 6.77%. The note and interest accrued but unpaid are due
and payable during 2008. During 2003, one officer, whose
employment with CoSine terminated, defaulted on the payment of a
non-recourse loan amounting to $175,000, secured by
4,375 shares of common stock. 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.

As of December 31, 2003 and 2002, CoSine had
non-recourse promissory notes receivable secured by a pledge of
CoSines common stock totaling $6,059,000 and $9,756,000,
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 2003 and 2002, non-officer employees defaulted

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

on notes receivable in the amounts of $3,665,000
and $12,216,000, respectively, secured by 80,981 shares and
264,907 shares of common stock, respectively.



|   |             
|-- | ------------
|8. | Income Taxes

The provisions for income taxes of $287,000,
$509,000 and $837,000 for the years ended December 31,
2003, 2002 and 2001, 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):

|                                                            |                 |      |         |      |  |      |         |     |  |   |         |     | 
|----------------------------------------------------------- | --------------- | ---- | ------- | ---- |  | ---- | ------- | --- |  | - | ------- | --- | 
|                                                            |                 | 2003 |         | 2002 |  | 2001
|                                                            |                 |      |         |      |  |     
|U.S. federal tax benefit at federal
    statutory rate      |                 | $    | (11,780 | )    |  | $    | (32,888 | )   |  | $ | (50,896 | )  
|Loss for which no tax benefit is currently
    recognizable |                 |      | 11,910  |      |  |      | 30,828  |     |  |   | 46,030  |    
|Non-cash charges related to equity issuances                |                 |      | 157     |      |  |      | 2,569   |     |  |   | 5,703   |    
|                                                            |                 |      |         |      |  |      |         |     |  |   |         |    
|                                                            | Total provision |      | $       | 287  |  |      | $       | 509 |  |   | $       | 837 | 
|                                                            |                 |      |         |      |  |      |         |     |  |   |         |    

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):

|                          |                                                |              |          |         |  |  |          |        | 
|------------------------- | ---------------------------------------------- | ------------ | -------- | ------- |  |  | -------- | ------ | 
|                          |                                                |             
|                          |                                                | December 31,
|                          |                                                | 2003         |          | 2002   
|                          |                                                |              |          |        
|Deferred tax assets:      |                                                |              |          |         |  |  |          |       
|                          | Net operating loss carryforwards               |              | $        | 101,653 |  |  | $        | 85,000 | 
|                          | Equity related charges                         |              |          | 150     |  |  |          | 13,719 | 
|                          | Tax credit carryforwards                       |              |          | 8,359   |  |  |          | 5,496  | 
|                          | Deferred revenue                               |              |          | 579     |  |  |          | 592    | 
|                          | Inventory reserve                              |              |          | 5,471   |  |  |          | 2,905  | 
|                          | Capitalized research and development           |              |          | 9,332   |  |  |          | 6,685  | 
|                          | Capital loss carryforward                      |              |          | 27,789  |  |  |          |       | 
|                          | Accruals and reserves not currently deductible |              |          | 7,879   |  |  |          | 6,760  | 
|                          |                                                |              |          |         |  |  |          |       
|Total deferred tax assets |                                                |              | 161,212  |         |  |  | 121,157  |       
|Valuation allowance       |                                                |              | (161,212 | )       |  |  | (121,157 | )     
|                          |                                                |              |          |         |  |  |          |       
|                          | 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 $40,055,000 in 2003 and by
$20,448,000 in 2002. The valuation allowance at
December 31, 2003 includes approximately $150,000 relating
to equity issuances, compared to approximately $13,719,000 at
December 31, 2002. The decrease during fiscal 2003 relates
primarily to a reduction in the expected future tax benefits
from previously issued stock options.

As of December 31, 2003, CoSine had federal
net operating loss carryforwards of approximately $276,000,000,
which will begin to expire in 2018 if not utilized and state net
operating loss carryforwards of approximately $129,000,000,
which will begin to expire in 2007 if not utilized. As of
December 31, 2002, CoSine had federal net operating loss
carryforwards of approximately $232,000,000, which will begin to
expire

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

in 2013 if not utilized and state net operating
loss carryforwards of approximately $101,000,000, which will
begin to expire in 2007 if not utilized.

As of December 31, 2003, CoSine also had
federal and state research and development tax credit
carryforwards of approximately $7,113,000 and $7,967,000,
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. The federal tax credit carryforwards will expire
at various dates beginning in 2013, if not utilized. The State
credits do not expire.

During fiscal 2003, the Company liquidated
certain subsidiary, resulting in a capital loss carryforward of
approximately $69,470,000. These losses may only be offset
against future capital gains and will expire in fiscal 2008 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



| |                                 
| | --------------------------------
| | May and March 2003 Restructuring

In May and March 2003, CoSines senior
management communicated additional reductions in its workforce
related to employees in its European region and the closure of a
sales office in the Asia/ Pacific Rim region. The employees were
notified in May and March 2003 that their job functions would be
eliminated and that termination benefits would be paid to them.
As a result of the workforce reduction, five employees were
designated for termination. Amounts related to the workforce
reduction and the other items are expected to be paid through
June of 2004.

Activity related to the May and March 2003
restructurings for the year ended December 31, 2003 was as
follows, (in thousands):

|                                           |  |           |      |             |  |       |     |   |  |   |      |  
|------------------------------------------ |  | --------- | ---- | ----------- |  | ----- | --- | - |  | - | ---- | -
|                                           |  | Worldwide |      | Lease       |  |      
|                                           |  | Workforce |      | Termination |  |      
|                                           |  | Reduction |      | and Other   |  | Total
|                                           |  |           |      |             |  |      
|Charges                                    |  | $         | 277  |             |  | $     | 17  |   |  | $ | 294  |  
|Cash payments                              |  |           | (284 | )           |  |       | (12 | ) |  |   | (296 | )
|Non-cash items                             |  |           | (20  | )           |  |       | (4  | ) |  |   | (24  | )
|Accrual adjustment                         |  |           | 75   |             |  |       | (1  | ) |  |   | 74   |  
|                                           |  |           |      |             |  |       |     |   |  |   |      |  
|Provision balance at December 31,
    2003 |  | $         | 48   |             |  | $     |    |   |  | $ | 48   |  
|                                           |  |           |      |             |  |       |     |   |  |   |      |  



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

In October 2002, CoSines senior management
approved a restructuring plan to reduce its worldwide workforce.
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 were paid out through September of 2003. In
addition, during the first quarter of 2003, CoSine concluded
negotiations to settle obligations associated with Redwood City,
California leased facilities it exited during 2002 and made a
payment of $8,104,000.

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Activity related to the October 2002
restructuring for the years ended December 31, 2003 and
2002 was 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  |  
|                                           |  |           |        |             |  |       |        |   |  |   |        |  
|Cash payments                              |  |           | (310   | )           |  |       | (8,112 | ) |  |   | (8,422 | )
|Accrual adjustment                         |  |           | (7     | )           |  |       | (47    | ) |  |   | (54    | )
|                                           |  |           |        |             |  |       |        |   |  |   |        |  
|Provision balance at December 31,
    2003 |  | $         |       |             |  | $     |       |   |  | $ |       |  
|                                           |  |           |        |             |  |       |        |   |  |   |        |  



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

In May 2002, CoSines senior management
approved a restructuring program 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 taking place 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 through March 2004. 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.

Activity related to the May 2002 restructuring
for the years ended December 31, 2003 and 2002 was as
follows, (in thousands):

|                                           |  |           |        |               |  |             |        |       |  |   |        |   |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ------------- |  | ----------- | ------ | ----- |  | - | ------ | - |  | - | ------ | -
|                                           |  | Worldwide |        | Write-down of |  | Lease       |        |      
|                                           |  | Workforce |        | Property 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    |  
|                                           |  |           |        |               |  |             |        |       |  |   |        |   |  |   |        |  
|Cash payments                              |  |           |        |               |  |             |        |       |  |   | (677   | ) |  |   | (677   | )
|Non-cash charges                           |  |           |       |               |  |             |       |       |  |   | (42    | ) |  |   | (42    | )
|Accrual adjustment                         |  |           |        |               |  |             |        |       |  |   | 22     |   |  |   | 22     |  
|                                           |  |           |        |               |  |             |        |       |  |   |        |   |  |   |        |  
|Provision balance at December 31,
    2003 |  | $         |       |               |  | $           |       |       |  |   | 118    |   |  |   | 118    |  
|                                           |  |           |        |               |  |             |        |       |  |   |        |   |  |   |        |  



| |                                
| | -------------------------------
| | 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

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COSINE COMMUNICATIONS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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 were 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 programs 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 in September 2001 that
certain job functions would be eliminated and that particular
termination benefits would be paid to affected employees.

Activity related to the April and September 2001
restructurings for the years ended December 31, 2002 and
2001 was as follows (in thousands):

|                                           |  |           |        |               |  |             |        |       |  |   |      |   |  |   |        |  
|------------------------------------------ |  | --------- | ------ | ------------- |  | ----------- | ------ | ----- |  | - | ---- | - |  | - | ------ | -
|                                           |  | Worldwide |        | Write-down of |  | Lease       |        |      
|                                           |  | Workforce |        | Property 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.

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

Not applicable.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

Evaluation of Disclosure Controls and
Procedures.The Securities and
Exchange Commission defines the term disclosure controls
and procedures to mean a companys controls and other
procedures that are designed to ensure that information required
to be disclosed in the reports that it files or submits under
the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported, within the time periods specified in
the Commissions rules and forms. While our disclosure
controls and procedures are designed to provide reasonable
assurance of achieving their objectives, the design of any
system of controls is based in part upon certain assumptions
about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated
goals under all potential future conditions regardless of how
remote. Our chief executive officer and chief financial officer
have concluded, based on the evaluation of the effectiveness of
the disclosure controls and procedures by our management, with
the participation of our chief executive officer and chief
financial officer, as of the end of the period covered by this
report, that our disclosure controls and procedures were
effective for this purpose, except as noted below under
Changes in Internal Controls.

Changes in Internal
Controls.During the fourth
quarter of fiscal year 2003, there were no changes in our
internal control over financial reporting that materially
affected, or are reasonably likely to materially affect, our
internal control over financial reporting. However, we intend to
continue to refine our internal controls on an ongoing basis.
Our management and our independent auditors have reported to our
Audit Committee certain matters involving internal controls that
our independent auditors consider to be reportable conditions,
but not material weaknesses, under standards established by the
American Institute of Certified Public Accountants. The first
reportable condition relates to the control processes related to
revenue recognition. The annual audit process identified
instances of a lack of timely communication between the sales
and finance departments for certain contractual terms and
instances of incorrect interpretation of the accounting
literature for a certain type of transaction. The revenue
recognition items related to this reportable condition were
adjusted in connection with the preparation of the audited
financial statements for the year ended December 31, 2003.
The second reportable condition relates to the December 31,
2003 financial close process. Certain adjustments were
identified in the annual audit process, related to stock-based
compensation amortization, a balance sheet adjustment for a
specific fixed asset capitalization, foreign income tax accruals
and inventory reserves. In addition, there were instances where
accounting analyses did not include evidence of a timely review.
The adjustments related to these matters were made by the
Company in connection with the preparation of the audited
financial statements for the year ended December 31, 2003.

Given these reportable conditions, management
devoted additional resources to resolving questions that arose
during our year-end audit. As a result, we are confident that
our consolidated financial statements for the year ended
December 31, 2003 fairly present, in all material respects,
our financial condition and results of operations.

The reportable conditions have been discussed in
detail among management, our Audit Committee and our independent
auditors, and we are committed to addressing and resolving these
matters fully and promptly, by putting in place the personnel,
processes, technology and other resources appropriate to support
our revenue recognition and financial close processes. We have
completed a full review of our revenue recognition policy and
practices and have implemented a number of process improvements.
We intend to complete a review of our financial close process
and define and implement needed improvements in the quarter
ending March 31, 2004.

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PART III






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

DIRECTORS

The names of our directors and their ages, titles
and biographies as of March 25, 2004 appear below. Our
board of directors has determined that each of our outside
directors (Messrs. Green, Spreng and Abbe) are
independent directors as defined in the applicable
Nasdaq listing standards and meet all additional independence
requirements set forth in SEC rules for membership on the Audit
Committee.

|                 |  |     |    |          |  |                                                
|---------------- |  | --- | -- | -------- |  | -----------------------------------------------
|Name             |  | Age |    | Position
|                 |  |     |    |         
|Donald Green     |  |     | 72 |          |  | Chairman of the Board of Directors             
|R. David Spreng  |  |     | 42 |          |  | Director                                       
|Stephen Goggiano |  |     | 51 |          |  | Director, President and Chief Executive Officer
|Charles J. Abbe  |  |     | 63 |          |  | Director                                       

Donald Green has served as Chairman of CoSine
since March 2002 and as a Director since June 1999.
Mr. Green was a co-founder of Advanced Fibre
Communications, Inc., a provider of multi-service access
solutions for the telecommunications industry, and served as its
Chairman of the Board from May 1999 until his retirement in
September 2001, and also served as Chief Executive Officer from
May 1992 to May 1999. Mr. Green is also a Director of TCSI
Corporation, a software company. Mr. Green holds a higher
national certificate in electrical engineering from Willesdon
Technical College.

R. David Spreng has served as a director of
CoSine since December 1998. Mr. Spreng has served as the
Managing General Partner of Crescendo Venture Management, LLC
since September 1998. Mr. Spreng served as President of IAI
Ventures, Inc. from March 1996 to September 1998 and served in
various capacities at Investment Advisers, Inc. since 1989.
Mr. Spreng is also a Director of Allied Riser
Communications Corporation, a broadband communications services
provider; Oplink Communications, Inc., a designer, developer and
manufacturer of fiber optic components; and Tut Systems, Inc., a
developer of multi-service broadband access systems.
Mr. Spreng holds a B.S. in finance and accounting from the
University of Minnesota.

Stephen Goggiano has served as a Director and
Chief Executive Officer of CoSine since March 2002. He served as
Chief Operating Officer from December 1999 to March 2002 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.

Charles J. Abbe has served as a Director of
CoSine since August 2000. Until his retirement in June 2001,
Mr. Abbe has served as President and Chief Operating
Officer of JDS Uniphase Corporation, a designer, developer and
manufacturer of fiber optic products, since April 2000,
following the merger of Optical Coating Laboratory, Inc. with
JDS Uniphase in February of the same year. Mr. Abbe served
as Optical Coating Laboratorys President and Chief
Executive Officer from April 1998 to March 2000, as its
President from November 1997 to April 1998 and as its Vice
President and General Manager for North America and Asia from
April 1996 to November 1997. From 1991 to 1996, Mr. Abbe
held several senior executive positions with Raychem
Corporation, a materials science company, including Senior Vice
President, Electronics Sector. Mr. Abbe currently serves as
a Director of Cymer, Inc., a semi-conductor equipment company;
the chairman of Nova Crystals, Inc., a manufacturer of fiber
optics components; and a director of Xponent, Inc., a
manufacturer of fiber optics components. Mr. Abbe holds a
B.S. and an M.S. in chemical engineering from Cornell University
and an M.B.A. from Stanford University.

The board of directors currently has an Audit
Committee, which is composed of Messrs. Abbe, Green and
Spreng and is chaired by Mr. Green. The Audit Committee
oversees the accounting and financial

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reporting processes of the Company and the audit
of its financial statements, reviews the Companys internal
accounting procedures, appoints, compensates, retains and
oversees the independent accountants, reviews and approves all
audit and non-audit services performed by the independent
accountants, reviews with the independent accountants the scope
and results of their annual examination of the Companys
consolidated financial statements, and performs the other
functions specified in the Audit Committee Charter. The board of
directors has determined that Mr. Abbe is an audit
committee financial expert as defined in SEC rules.


EXECUTIVE OFFICERS

The information required by this item with
respect to our executive officers is set forth in Item 1 of
this report on page 10.

SECTION 16(a) BENEFICIAL OWNERSHIP
REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act
of 1934 requires the Companys directors and executive
officers, and persons who own more than 10 percent of a
registered class of the Companys equity securities, to
file with the Securities and Exchange Commission initial reports
of ownership and reports of changes in ownership of Common Stock
and other equity securities of the Company. Officers, directors
and greater than 10 percent stockholders are required by
the regulations of the Securities and Exchange Commission to
furnish the Company with copies of all Section 16(a) forms
they file. To the Companys knowledge, based solely on
review of the copies of such reports furnished to the Company
and written representations that no other reports were required,
during the fiscal year ended December 31, 2003 all
Section 16(a) filing requirements applicable to its
officers, directors and greater than 10 percent beneficial
owners were complied with, except that on October 21, 2003,
Vinton Cerf, Donald Green, Charles J. Abbe and R. David
Spreng each filed a Form 4 reporting the automatic grant on
May 6, 2003 of a stock option for the purchase of 2,000
shares of the Companys common stock under the
Companys 2000 Director Option Plan, on November 26,
2003, Stephen Goggiano, Terry Gibson and Robert Iannucci each
filed a Form 4 reporting stock option grants on May 6,
2003 under the Companys 2000 Stock Plan for the purchase
of 90,000 shares, 46,000 shares and 46,000 shares,
respectively, and on December 10, 2003, Jill Bresnahan
filed a Form 4 reporting stock option grants on May 6,
2003 under the Companys 2000 Stock Plan for the purchase
of 37,000 shares.

CODE OF ETHICS

The Company has adopted a code of ethics that
applies to our principal executive officer, principal financial
officer and controller. Our code of ethics satisfies the
requirements set forth in Item 406 of Regulation S-K
and is posted on our Internet website (www.cosinecom.com). The
Company intends to disclose any amendments to its code of ethics
on its Internet website.






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

EXECUTIVE COMPENSATION

The following table summarizes the total
compensation awarded to, earned by, or paid for services
rendered to the Company in all capacities during each of the
fiscal years ended December 31, 2003, 2002 and

64



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##### Table of Contents



2001, respectively, by each person who served as
an executive officer of the Company at any time during 2003 (the
Named Executive Officers).


Summary Compensation Table

|                            |                                |        |      |                     |  |            |         |              |  |              |        |        |  |  |        |         |     |   |         |      | 
|--------------------------- | ------------------------------ | ------ | ---- | ------------------- |  | ---------- | ------- | ------------ |  | ------------ | ------ | ------ |  |  | ------ | ------- | --- | - | ------- | ---- | 
|                            |                                |        |      |                     |  |            |         | Long Term    |  |             
|                            |                                |        |      |                     |  |            |         | Compensation |  |             
|                            |                                |        |      |                     |  |            |         | Awards       |  |             
|                            |                                |        |      |                     |  |            |         |             
|                            |                                |        |      | Annual Compensation |  | Securities |         |             
|                            |                                |        |      |                     |  | Underlying |         | All Other   
|                            |                                | Fiscal |      | Salary              |  | Bonus      |         | Options      |  | Compensation
|Name and Principal Position |                                | Year   |      | ($)                 |  | ($)        |         | (#)          |  | ($)         
|                            |                                |        |      |                     |  |            |         |              |  |             
|Stephen Goggiano(1)         |                                |        | 2003 |                     |  | $          | 300,908 |              |  | $            |       |        |  |  | 90,000 |         |     | $ |        |     
|                            | Director, President and        |        |      | 2002                |  |            |         | 300,908      |  |              |        |       |  |  |        | 220,000 | (6) |   |         |     | 
|                            | Chief Executive Officer        |        |      | 2001                |  |            |         | 299,393      |  |              |        | 28,271 |  |  |        |        |     |   |         |     | 
|Jill Bresnahan(2)           |                                |        | 2003 |                     |  |            | 162,365 |              |  |              |       |        |  |  | 37,000 |         |     |   | 93,946  | (10)
|                            | Senior Vice President, General |        |      | 2002                |  |            |         | 206,307      |  |              |        |       |  |  |        | 76,000  | (7) |   |         |     | 
|                            | Counsel and Secretary          |        |      | 2001                |  |            |         | 196,713      |  |              |        | 30,000 |  |  |        | 18,375  |     |   |         |     | 
|Terry Gibson(3)             |                                |        | 2003 |                     |  |            | 265,358 |              |  |              |       |        |  |  | 46,000 |         |     |   |        |     
|                            | Executive Vice President       |        |      | 2002                |  |            |         | 260,128      |  |              |        |       |  |  |        | 60,000  | (8) |   |         |     | 
|                            | and Chief Financial Officer    |        |      | 2001                |  |            |         |             |  |              |        |       |  |  |        |        |     |   |         |     | 
|Robert Iannucci(4)          |                                |        | 2003 |                     |  |            | 238,703 |              |  |              | 25,000 |        |  |  | 46,000 |         |     |   | 116,307 | (11)
|                            | Senior Vice President,         |        |      | 2002                |  |            |         | 272,935      |  |              |        | 50,000 |  |  |        | 60,000  | (9) |   |         |     | 
|                            | Engineering                    |        |      | 2001                |  |            |         |             |  |              |        |       |  |  |        |        |     |   |         |     | 
|Jerry Jalaba(5)             |                                |        | 2003 |                     |  |            | 92,975  |              |  |              | 10,000 |        |  |  | 50,000 |         |     |   |        |     
|                            | Senior Vice President,         |        |      | 2002                |  |            |         |             |  |              |        |       |  |  |        |        |     |   |         |     | 
|                            | Worldwide Sales                |        |      | 2001                |  |            |         |             |  |              |        |       |  |  |        |        |     |   |         |     | 



---



| |     |                                                                                                                                                                                                                                                                
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Mr. Goggiano served as President and Chief
    Operating Officer in fiscal year 2001 and was appointed to the
    board of directors and named Chief Executive Officer on
    March 3, 2002.                                                                   
|
| | (2) | Ms. Bresnahan resigned as Senior Vice
    President, General Counsel and Secretary effective
    September 5, 2003.                                                                                                                                            
|
| | (3) | Mr. Gibson began employment with the Company
    on January 7, 2002.                                                                                                                                                                                           
|
| | (4) | Mr. Iannucci resigned as Senior Vice
    President, Engineering effective November 14, 2003.                                                                                                                                                                   
|
| | (5) | Mr. Jalaba began employment with the Company
    on August 4, 2003.                                                                                                                                                                                            
|
| | (6) | Includes the grant of options in 2002 for the
    purchase of 90,000 shares, the subsequent re-pricing of those
    options in November of 2002, and the re-pricing of options
    granted prior to 2002 for the purchase of an aggregate of 40,000
    shares.
|
| | (7) | Includes the grant of options in 2002 for the
    purchase of 20,000 shares, the subsequent re-pricing of those
    options in November of 2002, and the re-pricing of options
    granted prior to 2002 for the purchase of an aggregate of
    36,000 shares.
|
| | (8) | Includes the grant of options in 2002 for the
    purchase of 30,000 shares and the subsequent re-pricing of
    those options in November of 2002.                                                                                                            
|
| | (9) | Includes the grant of options in 2002 for the
    purchase of 30,000 shares and the subsequent re-pricing of
    those options in November of 2002.                                                                                                            



|     |                                                                                                                                      
|---- | -------------------------------------------------------------------------------------------------------------------------------------
|(10) | Represents relocation expenses paid to
    Ms. Bresnahan.                                                                            
|    
|(11) | Represents severance payments paid to
    Mr. Iannucci in connection with the termination of his
    employment on November 14, 2003.

65



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##### Table of Contents



Stock Option Grants

The following table provides information relating
to stock options awarded to each of the Named Executive Officers
during the year ended December 31, 2003.

Stock Option Grants in 2003

|                 |  |                   |        |                      |  |           |      |                        |  |                 |      |         |  |  |            |  |  |   |         |  |  |   |         | 
|---------------- |  | ----------------- | ------ | -------------------- |  | --------- | ---- | ---------------------- |  | --------------- | ---- | ------- |  |  | ---------- |  |  | - | ------- |  |  | - | ------- | 
|                 |  |                   |        |                     
|                 |  | Individual Grants |        | Potential Realizable
|                 |  |                   |        | Values at Assumed   
|                 |  | Number of         |        | Percent of           |  |           |      | Annual Rates of Stock 
|                 |  | Securities        |        | Total Options        |  |           |      | Price Appreciation for
|                 |  | Underlying        |        | Granted to           |  | Exercise  |      |                        |  | Options Term(1)
|                 |  | Options           |        | Employees in         |  | Price Per |      | Expiration             |  |                
|                 |  | Granted (#)       |        | Fiscal 2003          |  | Share ($) |      | Date                   |  | 5% ($)          |      | 10% ($)
|                 |  |                   |        |                      |  |           |      |                        |  |                 |      |        
|Stephen Goggiano |  |                   | 90,000 | (2)                  |  |           | 13.0 | %                      |  | $               | 5.20 |         |  |  | 05/06/2013 |  |  | $ | 294,323 |  |  | $ | 745,871 | 
|Jill Bresnahan   |  |                   | 37,000 | (2)                  |  |           | 5.3  | %                      |  |                 | 5.20 |         |  |  | 05/06/2013 |  |  |   | 120,999 |  |  |   | 306,636 | 
|Jerry Jalaba     |  |                   | 50,000 | (2)                  |  |           | 7.2  | %                      |  |                 | 5.92 |         |  |  | 09/08/2013 |  |  |   | 186,153 |  |  |   | 471,748 | 
|Terry Gibson     |  |                   | 46,000 | (2)                  |  |           | 6.6  | %                      |  |                 | 5.20 |         |  |  | 05/06/2013 |  |  |   | 150,432 |  |  |   | 381,223 | 
|Robert Iannucci  |  |                   | 46,000 | (2)                  |  |           | 6.6  | %                      |  |                 | 5.20 |         |  |  | 05/06/2013 |  |  |   | 150,432 |  |  |   | 381,223 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Potential realizable value is based on the
    assumption that the Common Stock of the Company appreciates at
    the annual rate shown (compounded annually) from the date of
    grant until the expiration of the ten-year option term. These
    numbers are calculated based on the requirements of the
    Securities and Exchange Commission and do not reflect the
    Companys estimate of future stock price growth. The actual
    realizable value depends on the market value of the Common Stock
    on the exercise date. No gain to the optionee is possible
    without an increase in the price of the Common Stock. All
    assumed values are before taxes and do not include dividends.
|   
|(2) | This option vests and becomes exercisable with
    respect to 25% of the shares subject to the option on one year
    from the grant date and with respect to an additional 1/48th of
    the shares subject to the option each month thereafter until
    fully vested.                                                                                                                                                                                                                                                                                                                                                                                                                                     

Stock Option Exercises in 2003 and 2003 Year
End Values

The following table sets forth certain
information regarding the exercise of stock options by the Named
Executive Officers during the fiscal year ended
December 31, 2003 and stock options held as of
December 31, 2003 by the Named Executive Officers.

Aggregate Stock Option Exercises in Last
Fiscal Year

and Fiscal Year End Option Values


|                 |  |             |        |             |  |                         |        |                          |  |             |        |               |  |  |         |  |  |   |         |  |  |   |         | 
|---------------- |  | ----------- | ------ | ----------- |  | ----------------------- | ------ | ------------------------ |  | ----------- | ------ | ------------- |  |  | ------- |  |  | - | ------- |  |  | - | ------- | 
|                 |  |             |        |             |  |                         |        |                          |  |            
|                 |  |             |        |             |  | Number of Securities    |        |                         
|                 |  |             |        |             |  | Underlying Unexercised  |        | Value of Unexercised In-
|                 |  |             |        |             |  | Options at December 31, |        | the-Money Options at    
|                 |  | Shares      |        |             |  | 2003                    |        | December 31, 2003(2)    
|                 |  | Acquired or |        | Value       |  |                         |        |                         
|                 |  | Exercised   |        | Realized(1) |  | Exercisable             |        | Unexercisable            |  | Exercisable |        | Unexercisable
|                 |  |             |        |             |  |                         |        |                          |  |             |        |              
|                 |  | (#)         |        | ($)         |  | (#)                     |        | (#)                      |  | ($)         |        | ($)          
|Stephen Goggiano |  |             |       |             |  | $                       |       |                          |  |             | 78,749 |               |  |  | 141,251 |  |  | $ | 187,423 |  |  | $ | 318,177 | 
|Jill Bresnahan   |  |             | 37,830 |             |  |                         | 80,955 |                          |  |             |       |               |  |  |        |  |  |   |        |  |  |   |        | 
|Terry Gibson     |  |             |       |             |  |                         |       |                          |  |             | 14,375 |               |  |  | 61,625  |  |  |   | 34,213  |  |  |   | 137,468 | 
|Robert Iannucci  |  |             |       |             |  |                         |       |                          |  |             | 13,750 |               |  |  | 62,250  |  |  |   | 32,725  |  |  |   | 138,955 | 
|Jerry Jalaba     |  |             |       |             |  |                         |       |                          |  |             |       |               |  |  | 50,000  |  |  |   |        |  |  |   | 73,000  | 



---



|    |                                                                                                                                                                                                                     
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Based on the fair value of the underlying
    securities on the date of exercise minus the exercise price.
    Values are stated on a pre-tax basis.                                                                
|   
|(2) | Based on the closing sales price of $7.38 of the
    underlying securities as of December 31, 2003 as reported
    on the Nasdaq National Market minus the exercise price. Values
    are stated on a pre-tax basis.

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DIRECTOR COMPENSATION

Each non-employee director receives a quarterly
retainer in the amount of $2,000. In addition, each non-employee
director receives $1,000 for attending a board meeting in
person, $500 for attending a committee meeting in person, and
$250 for attending a board or committee meeting by telephone. We
do not compensate directors for committee meetings held together
with a board meeting. We reimburse directors for travel and
other expenses incurred in attending board and committee
meetings.

Each non-employee director who is first appointed
or elected after September 26, 2000 (the date of our
initial public offering) will automatically receive under our
2000 Director Option Plan an option to acquire 8,000 shares of
Common Stock. These initial options will vest in four equal
annual installments. Under the 2000 Director Option Plan, each
non-employee director in office for at least six months before
each annual meeting of stockholders will receive an additional
option to acquire 2,000 shares of Common Stock. These subsequent
options will vest on the fourth anniversary of the date of
grant. We may also grant directors options or restricted
stock under our 2000 Stock Plan. On October 20, 2003, upon
the recommendation of management, the Compensation Committee
approved a resolution increasing the annual option grant to each
non-employee director from 2,000 shares to 8,000 shares,
with the additional 6,000 shares to be granted under our 2000
Stock Plan. Non-employee directors received option grants during
2003 as listed in the table below. Each of these grants vests on
the fourth anniversary of the date of grant.

|                  |  |               |                  |          |  |           |      |  |  |  |       | 
|----------------- |  | ------------- | ---------------- | -------- |  | --------- | ---- |  |  |  | ----- | 
|                  |  |               |                  | Exercise |  | Number   
|Director Name     |  | Date of Grant |                  | Price    |  | of Shares
|                  |  |               |                  |          |  |          
|Charles J. Abbe   |  |               | May 6, 2003      |          |  | $         | 5.20 |  |  |  | 2,000 | 
|                  |  |               | October 20, 2003 |          |  |           | 6.96 |  |  |  | 6,000 | 
|Vinton G. Cerf(1) |  |               | May 6, 2003      |          |  |           | 5.20 |  |  |  | 2,000 | 
|                  |  |               | October 20, 2003 |          |  |           | 6.96 |  |  |  | 6,000 | 
|Donald Green      |  |               | May 6, 2003      |          |  |           | 5.20 |  |  |  | 2,000 | 
|                  |  |               | October 20, 2003 |          |  |           | 6.96 |  |  |  | 6,000 | 
|R. David Spreng   |  |               | May 6, 2003      |          |  |           | 5.20 |  |  |  | 2,000 | 
|                  |  |               | October 20, 2003 |          |  |           | 6.96 |  |  |  | 6,000 | 



---



|    |                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Mr. Cerf resigned as a director effective
    December 31, 2003, but continues to serve as a technical
    advisor to the board of directors.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER
PARTICIPATION

The members of the Compensation Committee of the
board of directors (the Compensation Committee)
during fiscal year 2003, were Donald Green, Charles J. Abbe and
R. David Spreng. Mr. Abbe serves as Chairman of the
Compensation Committee. During fiscal year 2003, the
Compensation Committee was composed solely of non-employee
directors. None of these persons is, or has been at any time
since our incorporation, one of our officers or employees or an
officer or employee of any of our subsidiaries.

No executive officer of the Company has served as
a member of the board of directors or compensation committee of
any other entity that has or has had one or more executive
officers serving as a member of our board of directors or
Compensation Committee.

CHANGE OF CONTROL ARRANGEMENTS

Some options awarded under our 1997, 2000 and
2002 Stock Plans provide that the options will become fully
vested and fully exercisable if, anytime within 24 months
following a change of control, the option holders
employment is terminated other than for cause or if a
constructive termination of the option holders employment
occurs. Events constituting a constructive termination include a
significant reduction in the option holders duties,
position or responsibilities without the option holders
prior written consent. Options

67



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##### Table of Contents



containing such change of control provisions were
granted to the Named Executive Officers and other employees.







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

SECURITY OWNERSHIP OF MANAGEMENT AND CERTAIN
BENEFICIAL OWNERS

The following table sets forth certain
information regarding the beneficial ownership of the
Companys Common Stock as of February 20, 2004, unless
otherwise noted, by: (i) each person or entity who is known
by the Company to own beneficially 5% or more of the
Companys outstanding Common Stock; (ii) each director
of the Company; (iii) the Named Executive Officers; and
(iv) all directors and executive officers of the Company
who were serving on the board and/or were in office as of
February 20, 2004 as a group.

|                                                                            |                                |                        |           |            |  |  |       |   | 
|--------------------------------------------------------------------------- | ------------------------------ | ---------------------- | --------- | ---------- |  |  | ----- | - | 
|                                                                            |                                |                       
|                                                                            |                                | Shares of Common Stock
|                                                                            |                                | Beneficially Owned(2) 
|                                                                            |                                |                       
|                                                                            |                                |                        |           | Percent of
|Name and Address of Beneficial Owner(1)                                     |                                | Number                 |           | Class(3)  
|                                                                            |                                |                        |           |           
|5% Stockholders                                                             |                                |                        |           |            |  |  |       |  
|George W. Haywood(4)                                                        |                                |                        | 1,614,400 |            |  |  | 15.90 | %
|                                                                            | c/o Cronin and VRIS, LLP       |                        |           |            |  |  |       |   | 
|                                                                            | 380 Madison Avenue             |                        |           |            |  |  |       |   | 
|                                                                            | New York, NY 10017             |                        |           |            |  |  |       |   | 
|Crescendo Ventures(5)                                                       |                                |                        | 892,256   |            |  |  | 8.80  | %
|                                                                            | 800 LaSalle Avenue, Suite 2250 |                        |           |            |  |  |       |   | 
|                                                                            | Minneapolis, MN 55402          |                        |           |            |  |  |       |   | 
|Directors and Named Executive
    Officers                                  |                                |                        |           |            |  |  |       |  
|Stephen Goggiano, Director, President and Chief
    Executive Officer(6)    |                                |                        | 146,248   |            |  |  | 1.40  | %
|Charles J. Abbe, Director(7)                                                |                                |                        | 8,200     |            |  |  | *     |  
|Terry Gibson, Executive Vice President and Chief
    Financial Officer(8)   |                                |                        | 16,875    |            |  |  | *     |  
|Jill Bresnahan, Senior Vice President, General
    Counsel & Secretary(9)   |                                |                        | 94        |            |  |  |      |  
|Donald Green, Chairman(10)                                                  |                                |                        | 30,313    |            |  |  | *     |  
|Robert Iannucci, Senior Vice President,
    Engineering(11)                 |                                |                        | 13,750    |            |  |  | *     |  
|R. David Spreng, Director(5)                                                |                                |                        | 892,256   |            |  |  | 8.80  | %
|All directors and current executive officers as a
    group (6 persons)(12) |                                |                        | 1,083,476 |            |  |  | 10.60 | %



---



| |   |              
| | - | -------------
| | * | Less than 1%.



| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Unless otherwise indicated, the address for each
    listed stockholder is c/o CoSine Communications, Inc., 1200
    Bridge Parkway, Redwood City, CA 94065. Except as otherwise
    indicated, and subject to community property laws where
    applicable, the persons named in the table have sole voting and
    investment power with respect to all shares of Common Stock
    shown as beneficially owned by them.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| | (2) | Beneficial ownership is determined in accordance
    with the rules promulgated by the Securities and Exchange
    Commission. Under such rules, beneficial ownership includes any
    shares as to which the individual or entity has sole or shared
    voting power or investment power and any shares as to which the
    individual or entity has the right to acquire beneficial
    ownership within 60 days after February 20, 2004 (or
    as of April 20, 2004) through the exercise of any stock
    option or other right. Shares of Common Stock subject to options
    that are presently exercisable or exercisable within
    60 days after February 20, 2004 are deemed to be
    beneficially owned by the person holding such options for the
    purpose of computing the percentage of ownership of such person,
    but are not treated as outstanding for the purpose of computing
    the percentage of any other person.
|
| | (3) | Percentage of beneficial ownership is based on
    10,183,479 shares of Common Stock outstanding as of
    February 20, 2004, adjusted as required by rules
    promulgated by the Securities and Exchange Commission.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

68



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| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (4) | Of the 1,614,400 shares, 1,527,000 shares are
    directly owned by Mr. Haywood and 87,400 shares are indirectly
    owned by him. Of these 87,400 shares, 60,000 are indirectly
    owned through Mr. Haywoods spouse and 17,000 are
    indirectly owned through his children. The information in this
    footnote is based upon the Schedule 13G filed
    February 11, 2004 on behalf of Mr. Haywood.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|
| | (5) | Of the 892,256 shares, 225 are directly
    owned by R. David Spreng, a director of CoSine; 173,857 are
    directly owned by Crescendo World Fund, LLC; 13,922 are directly
    owned by Crescendo III, GbR; 20,059 are directly owned by
    Crescendo III Executive Fund, LP; 675,326 are directly
    owned by Crescendo III, LP; 7,307 are directly owned by
    Eagle Ventures WF, LLC; and 1,560 are directly owned by PRISMA
    German American Venture Partners, GbR. The sole general partner
    of Crescendo World Fund, LLC is Crescendo Ventures World Fund,
    LLC. The sole general partner of Crescendo III, LP and
    Crescendo III Executive Fund, LP is Crescendo
    Ventures III, LLC. The general partners of
    Crescendo III, GbR are Crescendo Ventures III, LLC and
    Verbier Ventures, LLC. R. David Spreng is a managing member
    of Crescendo Ventures World Fund, LLC, Crescendo
    Ventures III, LLC, Eagle Ventures WF, LLC, and Verbier
    Ventures, LLC. Crescendo Capital Management, LLC, is an
    investment advisor of, and holds a profit interest in, PRISMA
    German American Venture Partners, GbR. Mr. Spreng is a
    managing member of Crescendo Capital Management, LLC.
    Mr. Spreng disclaims beneficial ownership of the shares
    held by Crescendo World Fund, LLC, Crescendo III, GbR,
    Crescendo III Executive Fund, LP, Crescendo III, LP,
    Eagle Ventures WF, LLC, and PRISMA German American Venture
    Partners, GbR, except to the extent of his pecuniary interest in
    the shares. The information in this footnote is based upon the
    Schedule 13G filed February 15, 2002 on behalf of
    Mr. Spreng and each of the entities named above in this
    footnote.
|
| | (6) | Of the 146,248 shares, 86,248 are subject to
    exercisable options. Of these 86,248 shares,
    8,572 shares will remain unvested as of April 20,
    2004. To the extent these options are exercised prior to
    vesting, the unvested shares acquired would be subject to
    certain restrictions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| | (7) | Of the 8,200 shares, 5,000 are subject to an
    exercisable option. Of these 5,000 shares, 834 will remain
    unvested as of April 20, 2004. To the extent this option is
    exercised prior to vesting, the unvested shares acquired would
    be subject to certain restrictions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| | (8) | All of these shares are subject to an exercisable
    option.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| | (9) | These shares are directly owned by
    Ms. Bresnahans two minor children.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  



|     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Of the 30,313 shares, 14,265 shares are
    owned directly by Green Venture Capital II, L.P. and
    indirectly by Mr. Green as the general partner of Green
    Venture Capital II, L.P. Mr. Green disclaims
    beneficial ownership of the shares owned directly by Green
    Venture Capital II, L.P., except to the extent of his
    pecuniary interest in the shares.                                                                                                                                                                                                                                                                                                                                                                      
|    
|(11) | All of these shares are subject to an exercisable
    option.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|    
|(12) | Of the 1,083,476 shares, 892,256 shares
    are owned by Crescendo Ventures as explained in footnote 5
    above, 14,265 shares are owned by Green Venture Capital as
    explained in footnote 10 above, and an additional 834 are
    restricted shares that were acquired by directors and officers
    pursuant to the exercise of stock options, but remain unvested
    as of April 20, 2004. An additional 121,873 shares are
    subject to options that are exercisable within 60 days of
    February 20, 2004. Of these 121,873 shares, 9,406 will
    remain unvested as of April 20, 2004. To the extent these
    options are exercised prior to vesting, the unvested shares
    acquired would be subject to certain restrictions.

69



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##### Table of Contents



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, 2003:

|                                                              |       |                         |           |                      |  |                         |      |      |  |  |           |           | 
|------------------------------------------------------------- | ----- | ----------------------- | --------- | -------------------- |  | ----------------------- | ---- | ---- |  |  | --------- | --------- | 
|                                                              |       |                         |           |                      |  | (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 and   |           | Outstanding Options, |  | Securities Reflected in
|Plan Category                                                 |       | Rights                  |           | Warrants and Rights  |  | Column (a))            
|                                                              |       |                         |           |                      |  |                        
|Equity compensation plans approved by stockholders            |       |                         | 1,188,062 | (1)                  |  | $                       | 7.11 |      |  |  | 1,546,315 | (2)      
|Equity compensation plans not approved by
    stockholders(3) |       |                         | 92,375    |                      |  |                         | 8.83 |      |  |  | 656,538   |          
|                                                              | Total |                         |           | 1,280,437            |  |                         |      | 7.23 |  |  |           | 2,202,853 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes 179,498 shares subject to outstanding
    options under the 1997 Stock Plan, 984,564 shares subject
    to outstanding options under the 2000 Stock Plan, and
    24,000 shares subject to outstanding options under the
    Director Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   
|(2) | Includes 1,066,640 shares available for
    future issuance under the 2000 Stock Plan, 24,000 shares
    available for future issuance under the Director Plan, and
    455,675 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 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

INDEBTEDNESS OF MANAGEMENT

Prior to the Companys initial public
offering, all employees were allowed to pay the exercise price
for their 1997 Stock Plan options with full recourse promissory
notes secured by a pledge of the shares underlying the exercised
options. The Company holds promissory notes from certain
executive officers that elected to do so. In December 2000, the
Compensation Committee approved the change of all outstanding
promissory notes given by employees in connection with the
exercise of options from full recourse to non-recourse. At

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##### Table of Contents



December 31, 2003, the principal amounts,
maturity dates, and annual rates of interest of the outstanding
notes executed by executive officers were as follows:


|                  |  |           |         |               |  |             |                  |  |  |  |      |  
|----------------- |  | --------- | ------- | ------------- |  | ----------- | ---------------- |  |  |  | ---- | -
|                  |  | Principal |         |               |  |            
|                  |  | Amount of |         |               |  | Annual Rate
|Executive Officer |  | Note(s)   |         | Maturity Date |  | of Interest
|                  |  |           |         |               |  |            
|Stephen Goggiano  |  | $         | 600,000 |               |  |             | February 1, 2010 |  |  |  | 6.77 | %
|Jill Bresnahan    |  | $         | 175,000 |               |  |             | March 28, 2010   |  |  |  | 6.75 | %






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

Aggregate fees for professional services rendered
by Ernst & Young LLP during 2003 and 2002 were as follows:

|                      |       |      |         |         |  |   |         |         | 
|--------------------- | ----- | ---- | ------- | ------- |  | - | ------- | ------- | 
|                      |       | 2003 |         | 2002   
|                      |       |      |         |        
|Audit Fees(1)         |       | $    | 264,208 |         |  | $ | 299,248 |        
|Audit-related Fees(2) |       |      | 6,400   |         |  |   | 65,640  |        
|Tax Fees(3)           |       |      | 35,647  |         |  |   | 193,571 |        
|All Other Fees(4)     |       |      | 14,314  |         |  |   | 55,426  |        
|                      |       |      |         |         |  |   |         |        
|                      | Total |      | $       | 320,569 |  |   | $       | 613,885 | 
|                      |       |      |         |         |  |   |         |        



---



|    |                                                                                                                                                                                                        
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Fees for audit services include fees associated
    with the annual audit and 10-K, the reviews of the
    Companys quarterly reports on Form 10-Q, and
    statutory audits required internationally.
|   
|(2) | Audit-related fees principally included
    consultation on technical accounting matters and benefits plan
    audits.                                                                                 
|   
|(3) | Tax fees included tax compliance and tax advice.                                                                                                                                                       
|   
|(4) | All other fees principally included stock option
    advice, internal control consultation, subsidiary liquidation
    services, real estate advisory services and employee termination
    advice.    

Effective May 2003, all professional services
rendered by Ernst & Young LLP are required to be
pre-approved by the audit committee. In fiscal year 2003, all
services were pre-approved by the audit committee.






|         |                                                                    
|-------- | -------------------------------------------------------------------
|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
|                                                                                                                              |  |     
|Report of Independent Auditors                                                                                                |  |      | 37 | 
|Consolidated Balance Sheets 
    December 31, 2003 and 2002                                                                  |  |      | 38 | 
|Consolidated Statements of Operations 
    Years ended December 31, 2003, 2002 and 2001                                      |  |      | 39 | 
|Consolidated Statements of Stockholders
    Equity and Comprehensive Loss  Years ended
    December 31, 2003, 2002 and 2001 |  |      | 40 | 
|Consolidated Statements of Cash Flows 
    Years ended December 31, 2003, 2002 and 2001                                      |  |      | 41 | 
|Notes to Consolidated Financial Statements                                                                                    |  |      | 42 | 

(2) Financial Statement Schedules:

|                                                    |  |  |    | 
|--------------------------------------------------- |  |  | -- | 
|Schedule II  Valuation and
    Qualifying Accounts |  |  | 72 | 

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

71



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##### Table of Contents



(3) Exhibits:

See Exhibit Index on page 80. The Exhibits
listed in the accompanying Exhibit Index are filed as part
of this Annual Report on Form 10-K.

(b) Reports on Form 8-K.

On October 21, 2003, the Company issued a
press release in which it reported earnings for the quarter
ending September 30, 2003. A copy of such press release was
furnished by the Company with a Form 8-K on
October 21, 2003 as Exhibit 99.1.

COSINE COMMUNICATIONS, INC.

SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

|                              |                                  |                   |   |           |  |                 |   |             |   |  |   |        |   |  |   |     | 
|----------------------------- | -------------------------------- | ----------------- | - | --------- |  | --------------- | - | ----------- | - |  | - | ------ | - |  | - | --- | 
|                              |                                  |                   |   | Charged   |  |                 |   |            
|                              |                                  |                   |   | to        |  |                 |   |            
|                              |                                  | Balance at        |   | Expenses  |  | Additions       |   | Balance at 
|Classification                |                                  | Beginning of Year |   | (Credits) |  | (Deductions)(1) |   | End of Year
|                              |                                  |                   |   |           |  |                 |   |            
|                              |                                  |                  
|                              |                                  | (In thousands)   
|Year ended December 31, 2003: |                                  |                   |   |           |  |                 |   |             |   |  |   |        |   |  |   |    
|                              | Reserves for accounts receivable |                   | $ | 233       |  |                 | $ | (113        | ) |  | $ | 30     |   |  | $ | 150 | 
|                              |                                  |                   |   |           |  |                 |   |             |   |  |   |        |   |  |   |    
|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 | 
|                              |                                  |                   |   |           |  |                 |   |             |   |  |   |        |   |  |   |    



---



|    |                                                                                                                 
|--- | ----------------------------------------------------------------------------------------------------------------
|(1) | Represents write offs of accounts receivable. In
    2003, CoSine collected a receivable previously written off.

72



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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, 2004.



| |                            
| | ---------------------------
| | 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, Marc Bocci 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, 2004 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/ R. DAVID SPRENGR. David Spreng   |  | Director                                                                                             

73



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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).                                                                                                                                         
|        | 3  | .3*         |  | First Amendment to Bylaws dated April 30,
    2001 (incorporated by reference to Exhibit 3.3 to
    Form 10-Q filed August 13, 2001).                                                                                                                 
|        | 3  | .4*         |  | Second Amendment to Bylaws dated January 28,
    2003 (incorporated by reference to Exhibit 3.4 to
    Form 10-K filed March 27, 2003).                                                                                                               
|        | 3  | .5          |  | Third Amendment to Bylaws dated February 2,
    2004.                                                                                                                                                                                                 
|        | 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 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 | .8*         |  | 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 | .9*         |  | 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).                             
|        | 10 | .10*        |  | 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 | .11         |  | Amendment to Lease Agreement between Registrant
    and Westport Joint Venture executed as of February 17, 2003.                                                                                                                                      
|        | 10 | .12*        |  | 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.                                                                                                                                                                                                                      
|        | 31 | .1          |  | Certification of Stephen Goggiano, President and
    Chief Executive Officer of CoSine Communications, Inc., pursuant
    to 15 U.S.C. Section 7241, as adopted pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002.                        
|        | 31 | .2          |  | Certification of Terry Gibson, Executive Vice
    President and Chief Financial Officer of CoSine Communications,
    Inc., pursuant to 15 U.S.C. Section 7241, as adopted
    pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.             

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|        |    |             |  |                                                                                                                                                                                                                                          
|------- | -- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 32 | .1          |  | Certification of Stephen Goggiano, President and
    Chief Executive Officer of CoSine Communications, Inc., pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.           
|        | 32 | .2          |  | Certification of Terry Gibson, Executive Vice
    President and Chief Financial Officer of CoSine Communications,
    Inc., pursuant to 18 U.S.C. Section 1350, as adopted
    pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



---



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

75