**UNITED
        STATES SECURITIES AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
  ________________
  **Form
        10-K**
 
 **(Mark
        One)**
 
 **x**
              **ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
 
 
 **For
        the fiscal year ended December 31, 2005**
 
 **or**
 
 **o**
              **TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
 
 **For
        the transition period from  _________ to
        _________.**
 
 **Commission
        File Number 000-30715**
 
 **CoSine
        Communications, Inc.**
 *(Exact
        name of registrant as specified in its charter)*
 
 **Delaware**
              **94-3280301***(State
                  or other jurisdiction of*
              *(I.R.S.
                  Employer**incorporation
                  or organization)*
              *Identification
                  Number)***560
                  South Winchester Blvd. Suite 500 San Jose, CA**
              **95128***(Address
                  of principal executive offices)*
              *(Zip
                  Code)*
 
 **Registrant’s
        telephone number including area code: (408) 236-7518**
 
 **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 of the Registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act.
 Yes o
        No x
 
 Indicate
        by check mark of the Registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the Act.
 Yes o
        No x
  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 x 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 a large accelerated filer, an
        accelerated filer or a non-accelerated filer. See definition of "accelerated
        filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
 
 Large
                  accelerated filer o
              Accelerated
                  filer o
              Non-accelerated
                  filer x
 
 Indicate
        by check mark whether the Registrant is a shell company (as defined in Rule
        12b-2 of the Act). Yes
        x No o
  The
        aggregate market value of the voting and non voting common equity held by
        non-affiliates of the Registrant was $9,669,668, based on the number of shares
        held by non-affiliates as of March 15, 2006, and based on the reported last
        sale
        price of common stock on June 30, 2005, which is the last business day of
        the
        Registrant’s most recently completed second fiscal quarter. Shares of stock held
        by officers, directors and 5 percent or more stockholders have been excluded
        in
        that such persons may be deemed to be affiliates. This determination of
        affiliate status is not necessarily a conclusive determination for other
        purposes.
 
 As
        of
        March 15, 2006, there were 10,090,365 shares of the Registrant’s Common Stock
        outstanding.
 
 **DOCUMENTS
        INCORPORATED BY REFERENCE**
 
 Not
        applicable
  **COSINE
        COMMUNICATIONS, INC.**
 
 **FORM
        10-K**
 **Year
        Ended December 31, 2005**
 
 **TABLE
        OF CONTENTS**
 
 **Page****Part
                  I**Item
                  1.
              Business
              1Item
                  1A
              Risk
                  Factors
              4Item
                  1B
              Unresolved
                  Staff Comments
              8Item
                  2.
              Properties
              8Item
                  3.
              Legal
                  Proceedings
              8Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              9**Part
                  II**Item
                  5.
              Market
                  for Registrant’s Common Stock, Related Stockholder Matters and Issuer
                  Purchases of Equity Securities
              9Item
                  6.
              Selected
                  Financial Data
              11Item
                  7.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              12Item
                  7A.
              Quantitative
                  and Qualitative Disclosures about Market Risk
              24Item
                  8.
              Financial
                  Statements and Supplementary Data
              25Item
                  9.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              49Item
                  9A.
              Controls
                  and Procedures
              49Item
                  9B.
              Other
                  Information
              49**Part
                  III**Item
                  10.
              Directors
                  and Executive Officers of the Registrant
              50Item
                  11.
              Executive
                  Compensation
              52Item
                  12.
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters
              55Item
                  13.
              Certain
                  Relationships and Related Transactions
              56Item
                  14.
              Principal
                  Accountant Fees and Services
              57**Part
                  IV**Item
                  15.
              Exhibits
                  and Financial Statement Schedules
              58Signatures
              60Exhibit
                  Index
              61
   i
  **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, development of the market for network-based IP services,
        technological changes affecting the value of our intellectual property to
        the
        extent these conditions impact strategic alternatives available to us, failure
        to achieve revenue growth and profitability, changes in general economic
        conditions and in economic conditions in the customer service market that
        we
        currently serve, our ability to identify and acquire new business operations
        while continuing to provide support to our existing customers and continuing
        to
        offer our intellectual property for license or sale, the time and costs required
        to identify and acquire new business operations, management and board interest
        in and distraction due to identifying and acquiring new business operations,
        and
        the reactions, either positive or negative, of investors, competitors,
        customers, employees and others to our strategic direction and to any specific
        business opportunity selected by us, all as are discussed in more detail
        in the
        section entitled "Risk Factors" on pages 4 to 8 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 2006.
 
 **PART
        I**
 
 **Item
        1.** ***Business***
 
 **Overview**
 
 CoSine
        Communications, Inc. ("CoSine" or the "Company," which may be referred to
        as
        "we," "us" or "our") was incorporated in California on April 14, 1997 and
        in
        August 2000 was reincorporated in the State of Delaware. We were a provider
        of
        carrier network equipment products and services until the fourth quarter
        of
        fiscal year 2004 during which time we discontinued our product lines, took
        actions to lay-off most of our employees, terminated contract manufacturing
        arrangements, contractor and consulting arrangements and various facility
        leases, and sold, scraped or wrote-off our inventory, property and equipment.
        Our business currently consists primarily of a customer support capability
        for
        our discontinued products provided by a third party. We intend to continue
        such
        support activities through December 31, 2006, depending on customer demand,
        and
        to offer our intellectual property for license or sale. We are also seeking
        to
        redeploy our existing resources to identify and acquire one or more new business
        operations with existing or prospective taxable earnings that can be offset
        by
        use of our net operating loss carry-forwards (“NOLs”).
 
 **Business**
 
 On
        July
        29, 2004, we announced that we were exploring various strategic alternatives
        and
        that we had hired an investment bank as our financial advisor, which had
        been
        first retained in May 2003.
 
 Beginning
        in September 2004 and continuing through December 2004, we laid-off most
        of our
        employees, took actions to reduce our operating expenses and conserve our
        cash,
        notified our existing customers that our products had been formally discontinued
        and offered existing customers the opportunity to place “lifetime buy” orders to
        support their platform transition plans, negotiated transition support plans
        for
        our customers, terminated contract manufacturing arrangements, contractor
        and
        consulting arrangements, initiated liquidation procedures for certain of
        our
        foreign operations and facility leases and completed the sale, scrap or
        write-off of our inventory, property and equipment.
  On
        January 7, 2005, we entered into an Agreement and Plan of Merger with Tut
        Systems, Inc. The merger was terminated on May 16, 2005.
 
 On
        June
        10, 2005, we reported in our Report on Form 8-K filed with the Securities
        and
        Exchange Commission that our stock would be de-listed from the Nasdaq National
        Market System pursuant to Nasdaq Marketplace Rules 4300 and 4330(a)(3). Our
        stock was de-listed on June 16, 2005 and now trades in the over the counter
        market and is quoted on the Pink Sheets Electronic Quotation Service under
        the
        symbol “COSN.PK.”
   1
  In
        July
        2005, we completed a comprehensive review of strategic alternatives, including
        a
        sale of the Company, a sale or licensing of intellectual property, a
        redeployment of our assets into new business ventures, or a winding-up and
        liquidation of the business and a return of capital. The board of directors
        approved a plan to redeploy our existing resources to identify and acquire
        one
        or more new business operations, while continuing to support our existing
        customers and continuing to offer our intellectual property for license or
        sale.
        Our redeployment strategy involves the acquisition of one or more operating
        businesses with existing or prospective taxable earnings that can be offset
        by
        use of our net operating loss carry-forwards (“NOLs”).
 
 In
        implementing the redeployment strategy, on July 25, 2005 Jack L. Howard was
        elected to fill a vacancy created by the resignation of R. David Spreng,
        the
        managing general partner of Crescendo Ventures Management, LLC. Mr. Spreng
        resigned upon the sale of the shares of our common stock controlled by Crescendo
        Ventures Management, LLC to Steel Partners II, L.P. Mr. Howard holds
        representative positions with Steel Partners II, L.P. Steel Partners II,
        L.P.,
        Mr. Howard and WHX CS Corp., a wholly owned subsidiary of WHX Corporation
        of
        which Steel Partners II, L.P. is a majority stockholder, currently own or
        control, in the aggregate, approximately 45% of our outstanding shares of
        common
        stock.
 
 On
        September 1, 2005, we entered into a stockholders rights plan which provides
        for
        a dividend distribution of one preferred share purchase right for each
        outstanding share of our common stock which, when exercisable, would allow
        its
        holder to purchase from us one one-hundredth of a share of our Series A Junior
        Participating Preferred Stock, par value $0.0001, for a purchase price of
        $3.00.
        Each fractional share of this preferred stock would give the stockholder
        approximately the same dividend, voting and liquidation rights as does one
        share
        of our common stock. The purchase rights become exercisable after the
        acquisition or attempted acquisition of 5% or more of our outstanding common
        stock without the prior approval of our board of directors. The dividend
        was
        paid to our stockholders of record at the close of business on September
        12,
        2005. Our board of directors adopted the stockholders rights plan to protect
        stockholder value by protecting our stockholders from coercive takeover
        practices or takeover bids that are inconsistent with their best interests,
        and
        by protecting our ability to carry forward our NOLs.
 
 Our
        2005
        annual meeting of stockholders was held on November 15, 2005. At that annual
        meeting, Charles J. Abbe was re-elected by our stockholders to serve on our
        board of directors with Donald Green, Jack L. Howard and Terry R. Gibson,
        who
        were not up for election. Our board of directors intends to continue the
        previously adopted strategy of seeking to enhance stockholder value by pursuing
        opportunities to redeploy our assets through an acquisition of one or more
        operating business with existing or prospective taxable earnings that can
        be
        offset by use of our NOLs. No candidate for acquisition has yet been identified,
        and no assurance can be given that we will find suitable candidates, and
        if we
        do, that we will be able to utilize our existing NOLs.
 
 At
        our
        2005 annual meeting, the stockholders also approved two amendments to our
        Second
        Amended and Restated Certificate of Incorporation. The first amendment restricts
        certain acquisitions of our securities in order to help assure the preservation
        of our NOLs. Although the transfer restrictions imposed on our securities
        is
        intended to reduce the likelihood of an impermissible ownership change, no
        assurance can be given that such restrictions would prevent all transfers
        that
        would result in an impermissible ownership change. This amendment generally
        restricts and requires prior approval of our board of directors of direct
        and
        indirect acquisitions of our equity securities if such an acquisition will
        affect the percentage of our capital stock that is treated as owned by a
        5%
        stockholder. The restrictions will generally only affect persons trying to
        acquire a significant interest in our common stock. The second amendment
        to our
        Second Amended and Restated Certificate of Incorporation at our 2005 annual
        meeting de-classified our board of directors providing for an annual election
        of
        all our directors.
 
 As
        a
        result of these activities, as of December 31, 2005, our business consisted
        primarily of a customer support capability for our discontinued products
        provided by a third party. We intend to continue such support activities
        through
        December 31, 2006, depending on customer demand, and to offer our intellectual
        property for license or sale. We are also continuing to seek to redeploy
        our
        existing resources to identify and acquire one or more new business operations
        with existing or prospective taxable earnings that can be offset by use of
        our
        NOLs.
 
 **Prior
        Business**
 
 Prior
        to
        and during the period ended September 30, 2004, we developed, marketed and
        sold
        a communications platform referred to as our IP Service Delivery Platform.
        Our
        product was designed to enable network service providers to rapidly deliver
        a
        portfolio of communication services to business and consumer customers. We
        marketed our IP Service Delivery Platform through our direct sales force
        and
        through resellers to network service providers in Asia, Europe and North
        America.
 
 During
        this period, the market for our IP Service Delivery Platform had been in
        the
        early stages of development, and the volume and timing of orders was difficult
        to predict. A customer’s decision to purchase our platform typically involved a
        significant commitment of its resources and a lengthy evaluation, testing
        and
        product qualification process. The long sales cycle and the timing of our
        customers’ rollout of services made possible by our platform, which affected
        repeat business, caused our revenue and operating results to vary significantly
        and unexpectedly from quarter to quarter and constrained our ability to secure
        new customers. We did not generate sufficient revenue to fund our communications
        platform product operations and were unable to increase our revenue in order
        to
        reduce our cash consumption and remain a viable and competitive supplier
        of
        communications platform products. We formally discontinued our communications
        platform products in fiscal year 2004.
 2
  **Products,
        Services and Technology**
 
 Prior
        to
        our announcement on September 8, 2004 that we were discontinuing sale of
        our
        products, we were a supplier of carrier network equipment which we referred
        to
        as our IP Service Delivery Platform. Our IP Service Delivery Platform consisted
        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 formally discontinued
        our IP
        Service Delivery Platform in fiscal year 2004. We currently provide only
        customer support services, through a third party, for our discontinued
        products.
  **Customers**
 
 During
        the year ended December 31, 2005, we recognized revenue from 15 customers,
        of
        which Sprint and NEC Corporation
        accounted for 43% and 15% of our revenue, respectively. Geographically, our
        revenue was distributed as follows: North America 57%, Asia/Pacific 19% and
        Europe 24% (See Note 1 of the Notes to the Consolidated Financial Statements). A
        small
        number of customers account for a substantial portion of our revenues, and
        the
        loss of any one customer could have a material impact on our results of
        operations.
 
 **Sales
        and Marketing**
 
 We
        ceased
        all sales and marketing activities in September 2004, other than to offer
        existing customers transition support services through December 2006. We
        had no
        employees in sales and marketing at December 31, 2005.
 
 **Customer
        Service and Support**
 
 We
        provide transition support services to our existing customers and plan to
        continue to do so through December 31, 2006, depending on customer demand.
        Our
        service and support operations are conducted by a third party contractor
        and we
        had no employees in customer service and support at December 31, 2005.
 
 **Research
        and Development**
 
 We
        ceased
        all research and development activities in September 2004, other than to
        offer
        our existing customers transition support services, as provided by a third
        party
        contractor. At December 31, 2005, we had no employees in research and
        development.
 
 Our
        research and development expenses, including non-cash charges related to
        equity
        issuances, totaled $0.1 million, $15.1 million
        and $21.8 million for the years ended December 31, 2005, 2004 and 2003,
        respectively.
 
 **Manufacturing**
 
 We
        ceased
        all manufacturing activities in December 2004 and had no employees in
        manufacturing at December 31, 2005.
 
 **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, 2005 and 2004 we had
        no
        backlog.
 
 **Competition**
 
 We
        only
        provide transition support services for our discontinued products to our
        existing customers and intend to continue such support activities only through
        December 31, 2006, depending on customer demand. Due to the limitation of
        our
        transition support services to our own discontinued products and the limited
        period of availability for those transition support services, we do not foresee
        any material competition for our transition support services.
  3
 
 **Intellectual
        Property**
 
 We
        have
        relied on copyright, patent, trade secret and trademark law to protect our
        intellectual property. As of February 22, 2006, we have a total of 24 patent
        applications pending in the United States relating to the design of our
        discontinued products, two PCT patent applications pending and a patent
        application pending in each of Japan and the European Union. As our business
        now
        consists primarily of a customer service capability operated under contract
        by a
        third party, we are now unable to make new product developments and frequent
        product enhancements that are essential to maintain the value, if any, of
        our
        intellectual property. We continue to offer our intellectual property for
        license or sale
 
 We
        continue to license software from network software application companies
        as
        necessary to offer our existing customers transition support services through
        December 2006. 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.
 
 **Employees**
 
 We
        had
        one employee, Terry R. Gibson, our President, Chief Executive Officer and
        Chief
        Financial Officer, at December 31, 2005.
 
 **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 (the "Exchange Act"), and we have an internet website address at
        www.cosinecom.com. We make available free of charge on our internet website
        address our annual report on Form 10-K, quarterly reports on Form 10-Q, current
        reports on Form 8-K, and amendments to those reports filed or furnished pursuant
        to Sections 13(a) or 15(d) of the Exchange Act of 1934, a amended as soon
        as
        reasonably practicable after we electronically file such material with, or
        furnish it to, the SEC. 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 us, that file
        electronically with the SEC. The public can obtain any documents that we
        file
        with the SEC at http://www.sec.gov.
 
 **Item
        1A.** ***Risk
        Factors***
 
 Our
        future results and the market price for our stock are subject to numerous
        risks,
        many of which are driven by factors that we cannot control or predict. The
        following discussion, as well as other sections of this Report on Form 10-K
        including Item 7 - Management's Discussion and Analysis of Financial Condition
        and Results of Operations, describes certain risk factors related to our
        business. You should carefully consider the risk factors described below
        in
        conjunction of the other information is this document.
 
 ***We
        have sold our operating assets and are executing a redeployment strategy.
        There
        can be no assurance that the redeployment strategy will increase shareholder
        value, and we may decide to liquidate.***
  We
        have
        incurred losses since inception and expect that net losses and negative cash
        flow will continue for the foreseeable future. In September 2004, we announced
        the termination of most of our employees to facilitate the strategic
        alternatives then in consideration and ceased all operations other than a
        customer service and support capability. In July 2005, we completed a
        comprehensive review of strategic alternatives and approved a plan to redeploy
        our existing resources to identify and acquire one or more new business
        operations, while continuing to support our existing customers and continuing
        to
        offer our intellectual property for license or sale. If we are not successful
        in
        executing this strategy we will continue to incur operating losses and negative
        cash flow and may at some point decide to liquidate and return the net proceeds
        to our stockholders. In the case of a liquidation or bankruptcy, we would
        need
        to hold back or distribute assets to cover liabilities before paying
        stockholders, which may therefore reduce or delay the proceeds that stockholders
        may receive for their ownership in us. However, we believe we have adequate
        cash
        resources to continue to realize our assets and discharge our liabilities
        as a
        company through 2006.
  4
 
 ***Failure
        to execute our redeployment strategy could cause our stock price to decline.***
  Our
        stock
        price may decline due to any or all of the following potential occurrences:
 
 l
              We
                  may not be able to find suitable acquisition candidates or may
                  not be able
                  to acquire suitable candidates with our limited financial
                  resources;l
              We
                  may not be able to utilize our existing NOLs to offset future
                  earnings;l
              We
                  may have difficulty retaining our key remaining
                  employee;l
              We
                  may have difficulty retaining our board of directors or attracting
                  suitable qualified candidates should a director
                  resign.
 
 ***There
        can be no assurance that we will be able to identify suitable acquisition
        candidates in connection with our redeployment strategy.***
  We
        have
        incurred recurring operating losses, and operations have not generated positive
        cash flows since inception. If we are unable to acquire suitable acquisition
        candidate(s), we will continue to incur operating losses and negative cash
        flows
        and may decide to liquidate. In the case of a liquidation, we would need
        to hold
        back assets to cover liabilities, which may therefore reduce or delay the
        proceeds that stockholders may receive.
  ***We
        may elect to dissolve and distribute assets to stockholders if our board
        of
        directors determines that such action is in the best interest of the
        stockholders.*** ****
 
 If
        our
        redeployment strategy is deemed unsuccessful, our board of directors may
        deem it
        advisable to dissolve the company and distribute assets to stockholders.
        Liquidation and dissolution may not create value to our stockholders or result
        in any remaining capital for distribution to our stockholders. The precise
        nature, amount and timing of any distribution to our stockholders would depend
        on and could be delayed by, among other things, sales of our non-cash assets
        and
        claim settlements with creditors.
 
 ***We
        will incur significant costs in connection with our evaluation of suitable
        acquisition candidates.***
 
 As
        part
        of our plan to redeploy our assets, our management is seeking, analyzing
        and
        evaluating potential acquisition and merger candidates. We will incur
        significant costs, such as due diligence and legal and other professional
        fees
        and expenses, as part of these redeployment efforts. Notwithstanding these
        efforts and expenditures, we cannot give any assurance that we will identify
        an
        appropriate acquisition opportunity in the near term, or at all.
 
 ***We
        will likely have no operating history in our new line of business, which
        is yet
        to be determined, and therefore we will be subject to the risks inherent
        in
        establishing a new business.***
 
 We
        have
        not identified what our new line of business will be and, therefore, we cannot
        fully describe the specific risks presented by such business. It is likely
        that
        we will have had no operating history in the new line of business and it
        is
        possible that the target company may have a limited operating history in
        its
        business. Accordingly, there can be no assurance that our future operations
        will
        generate operating or net income, and as such our success will be subject
        to the
        risks, expenses, problems and delays inherent in establishing a new line
        of
        business for us. The ultimate success of such new business cannot be
        assured.
 
 ***We
        may be unable to realize the benefits of our net operating loss carry-forwards
        ("NOLs").***
 
 NOLs
        may
        be carried forward to offset federal and state taxable income in future years
        and eliminate income taxes otherwise payable on such taxable income, subject
        to
        certain adjustments. Based on current federal corporate income tax rates,
        our
        NOLs and other carry-forwards could provide a benefit to us, if fully utilized,
        of significant future tax savings. However, our ability to use these tax
        benefits in future years will depend upon the amount of our otherwise taxable
        income. If we do not have sufficient taxable income in future years to use
        the
        tax benefits before they expire, we will lose the benefit of these NOLs
        permanently. Consequently, our ability to use the tax benefits associated
        with
        our substantial NOLs will depend significantly on our success in identifying
        suitable acquisition candidates, and once identified, successfully consummate
        an
        acquisition of these candidates.
 5
  Additionally,
        if we underwent an ownership change, the NOLs would be subject an annual
        limit
        on the amount of the taxable income that may be offset by our NOLs generated
        prior to the ownership change. If an ownership change were to occur, we may
        be
        unable to use a significant portion of our NOLs to offset taxable income.
        In
        general, an ownership change occurs when, as of any testing date, the aggregate
        of the increase in percentage points is more than 50 percentage points of
        the
        total amount of a corporation's stock owned by "5-percent stockholders,"
        within
        the meaning of the NOLs limitations, whose percentage ownership of the stock
        has
        increased as of such date over the lowest percentage of the stock owned by
        each
        such "5-percent stockholder" at any time during the three-year period preceding
        such date. In general, persons who own 5% or more of a corporation's stock
        are
        "5-percent stockholders," and all other persons who own less than 5% of a
        corporation's stock are treated, together, as a single, public group "5-percent
        stockholder," regardless of whether they own an aggregate of 5% of a
        corporation's stock.
 
 The
        amount of NOLs that we have claimed has not been audited or otherwise validated
        by the U.S. Internal Revenue Service (“IRS”). The IRS could challenge our
        calculation of the amount of our NOLs or our determinations as to when a
        prior
        change in ownership occurred and other provisions of the Internal Revenue
        Code,
        may limit our ability to carry forward our NOLs to offset taxable income
        in
        future years. If the IRS was successful with respect to any such challenge,
        the
        potential tax benefit of the NOLs to us could be substantially
        reduced.
 
 ***Certain
        transfer restrictions implemented by us to preserve our NOLs may not be
        effective or may have some unintended negative
        effects.***
 
 On
        November 15, 2005, at our 2005 Annual Meeting of Stockholders, our stockholders
        approved an amendment to our Amended and Restated Certificate of Incorporation
        to restrict certain acquisitions of our securities in order to help assure
        the
        preservation of our NOLs. The amendment generally restricts direct and indirect
        acquisitions of our equity securities if such acquisition will affect the
        percentage of our capital stock that is treated as owned by a "5-percent
        stockholder."
 
 Although
        the transfer restrictions imposed on our capital stock is intended to reduce
        the
        likelihood of an impermissible ownership change, there is no guarantee that
        such
        restrictions would prevent all transfers that would result in an impermissible
        ownership change. The transfer restrictions also will require any person
        attempting to acquire a significant interest in us to seek the approval of
        our
        board of directors. This may have an "anti-takeover" effect because our board
        of
        directors may be able to prevent any future takeover. Similarly, any limits
        on
        the amount of capital stock that a stockholder may own could have the effect
        of
        making it more difficult for stockholders to replace current management.
        Additionally, because the transfer restrictions will have the effect of
        restricting a stockholder's ability to dispose of or acquire our common stock,
        the liquidity and market value of our common stock might suffer.
 
 ***We
        could be required to register as an investment company under the Investment
        Company Act of 1940, which could significantly limit our ability to operate
        and
        acquire an established business.***
 
 The
        Investment Company Act of 1940 (the "Investment Company Act") requires
        registration, as an investment company, for companies that are engaged primarily
        in the business of investing, reinvesting, owning, holding or trading
        securities. We have sought to qualify for an exclusion from registration
        including the exclusion available to a company that does not own "investment
        securities" with a value exceeding 40% of the value of its total assets on
        an
        unconsolidated basis, excluding government securities and cash items. This
        exclusion, however, could be disadvantageous to us and/or our stockholders.
        If
        we were unable to rely on an exclusion under the Investment Company Act and
        were
        deemed to be an investment company under the Investment Company Act, we would
        be
 forced
        to
        comply with substantive requirements of Investment Company Act, including:
        (i)
        limitations on our ability to borrow; (ii) limitations on our capital structure;
        (iii) restrictions on acquisitions of interests in associated companies;
        (iv)
        prohibitions on transactions with affiliates; (v) restrictions on specific
        investments; (vi) limitations on our ability to issue stock options; and
        (vii)
        compliance with reporting, record keeping, voting, proxy disclosure and other
        rules and regulations. Registration as an investment company would subject
        us to
        restrictions that would significantly impair our ability to pursue our
        fundamental business strategy of acquiring and operating an established
        business. In the event the SEC or a court took the position that we were
        an
        investment company, our failure to register as an investment company would
        not
        only raise the possibility of an enforcement action by the SEC or an adverse
        judgment by a court, but also could threaten the validity of corporate actions
        and contracts entered into by us during the period we were deemed to be an
        unregistered investment company. Moreover, the SEC could seek an enforcement
        action against us to the extent we were not in compliance with the Investment
        Company Act during any point in time.
 6
  ***We
        may issue a substantial amount of our common stock in the future which could
        cause dilution to new investors and otherwise adversely affect our stock
        price.***
 
 A
        key
        element of our growth strategy is to make acquisitions. As part of our
        acquisition strategy, we may issue additional shares of common stock as
        consideration for such acquisitions. These issuances could be significant.
        To
        the extent that we make acquisitions and issue our shares of common stock
        as
        consideration, your equity interest in us will be diluted. Any such issuance
        will also increase the number of outstanding shares of common stock that
        will be
        eligible for sale in the future. Persons receiving shares of our common stock
        in
        connection with these acquisitions may be more likely to sell off their common
        stock, which may influence the price of our common stock. In addition, the
        potential issuance of additional shares in connection with anticipated
        acquisitions could lessen demand for our common stock and result in a lower
        price than might otherwise be obtained. We may issue common stock in the
        future
        for other purposes as well, including in connection with financings, for
        compensation purposes, in connection with strategic transactions or for other
        purposes.
 
 ***Our
        customers may sue us because we have announced the discontinuance of our
        products and may not meet all our contractual
        commitments.*** ****
  Certain
        of our customer contracts contained provisions relating to the availability
        of
        products, spare parts and services for periods up to ten years. We have worked
        with our customers to aid in a smooth transition, but our customers may choose
        to sue us for breach of contract.
  ***If
        our products contain defects, we may be subject to significant liability
        claims
        from 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, undetected or unresolved
        errors or defects. Despite extensive testing, errors, defects or failures
        may be
        found in our products. If this happens, we may experience product returns,
        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 attempted 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 its products. Although we maintains product liability
        and
        errors and omissions insurance covering certain damages arising from
        implementation and use of their products, our insurance may not cover all
        claims
        sought against it. Liability claims could require it 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 became involved in an intellectual property dispute, we could be subject
        to
        significant liability, the time and attention of our management could be
        diverted from pursuing strategic alternatives.*** ****
  We
        may
        become a party to litigation in the future to protect its intellectual property
        or because others may allege infringement of their intellectual property.
        These
        claims and any resulting lawsuits could subject it 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:
  ·
              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.
  ***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, 2005, we had an accumulated deficit of $517 million. We have
        incurred net losses since our incorporation. If we do not achieve profitability
        and are unable to obtain additional financing, we will run out of cash and
        cease
        operations.
 7
  ***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 officer and directors
        against claims relating to the conduct of our business. This insurance covers,
        among other things, the costs incurred by companies and their management
        to
        defend against and resolve claims relating to management conduct and results
        of
        operations, such as securities class action claims. These claims typically
        are
        expensive to defend against and resolve. We pay significant premiums to acquire
        and maintain this insurance, which is provided by third-party insurers, and
        we
        agree to underwrite a portion of such exposures under the terms of the insurance
        coverage. One consequence of the current economic downturn and decline in
        stock
        prices has been a substantial increase in the number of securities class
        actions
        and similar claims brought against public corporations and their management,
        including the company and certain of its 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 any current securities claims against us have a $500,000
        retention. As a result, the costs we incur in defending such claims will
        not be
        reimbursed until they exceed $500,000 .
        The policies
        that would cover any future claims 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 claims could increase significantly.
        Particularly in the current economic environment, we cannot assure you that
        in
        the future it will be able to obtain sufficient director and officer liability
        insurance coverage at acceptable rates and with acceptable deductibles and
        other
        limitations. Failure to obtain such insurance could materially harm our
        financial condition in the event that we are required to defend against and
        resolve any future or existing securities class actions or other claims made
        against us or our management arising from the conduct of our operations.
        Further, the inability to obtain such insurance in adequate amounts may impair
        our future ability to retain and recruit qualified officers and
        directors.
 
 **Item
        1B.** ***Unresolved
        Staff Comments***
 
 None.
 
 **Item
        2.** ***Properties***
 
 We
        lease approximately 300 square feet of office space in San Jose, California
        under a month-to-month operating lease. We have one remaining sales office
        lease, expiring in March 2006.
 
 **Item
        3.** ***Legal
        Proceedings***
 
 On
        November 15, 2001, we along with certain of our officers and
        directors ** were
        named as defendants in a class action shareholder complaint filed in the
        United
        States District Court for the Southern District of New York, now captioned *In
        re
        CoSine Communications, Inc. Initial Public Offering Securities
        Litigation,* Case No.
        01 CV 10105. The complaint generally alleges that
        various investment bank underwriters engaged in improper and undisclosed
        activities related to the allocation of shares in our initial public offering.
        The complaint brings claims for the violation of several provisions of the
        federal securities laws against those underwriters, and also against us and
        each
        of the directors and officers who signed the registration statement relating
        to
        the initial public offering. The
        plaintiffs seek unspecified monetary damages and other relief. Similar lawsuits
        concerning more than 300 other companies’ initial public offerings were filed
        during 2001, and this lawsuit is being coordinated with those actions in
        the
        Southern District of New York before Judge
        Shira A. Scheindlin .
 
 On
        or
        about July 1, 2002 an omnibus motion to dismiss was filed in the coordinated
        litigation on behalf of the issuer defendants, of which we and our named
        officer
        and directors are a part, on common pleading issues. In October 2002, pursuant
        to stipulation by the parties, the Court entered an order dismissing our
        named
        officers and directors from the action without prejudice. On February 19,
        2003, the
        Court
        dismissed the Section 10(b) and Rule 10b-5 claims against us but did not
        dismiss
        the Section 11 claims against us.
  In
        June
        2004, a stipulation of settlement and release of claims against the issuer
        defendants, including us, was submitted to the court for approval. The terms
        of
        the settlement, if approved, would dismiss and release all claims against
        the
        participating defendants (including us). In exchange for this dismissal,
        D&O
        insurance carriers would agree to guarantee a recovery by the plaintiffs
        from
        the underwriter defendants of at least $1 billion, and the issuer defendants
        would agree to an assignment or surrender to the plaintiffs of certain claims
        the issuer defendants may have against the underwriters. On August 31, 2005,
        the
        Court issued an order granting preliminary approval of the settlement. The
        settlement is subject to a number of conditions, including final court approval,
        which cannot be assured. If the settlement is not consummated, we intend
        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.
 8
  On
        January 18, 2005, we, along with our officers and directors, were named as
        defendants in a securities class action lawsuit filed in San Mateo County
        Superior Court. The suit requested that the acquisition of us by Tut Systems,
        Inc be enjoined due to alleged self-dealing and breach of fiduciary duties
        by
        our officers and directors. The suit was dismissed in May 2005 at the request
        of
        the plaintiffs.
 
 In
        the
        ordinary course of business, we are involved in legal proceedings involving
        contractual obligations, employment relationships and other matters. Except
        as
        described above, we do not believe there are any pending or threatened legal
        proceedings that will have a material impact on our financial position or
        results of operations.
 
 **Item
        4.** ***Submission
        of Matters to a Vote of Security Holders***
 
 On
        November 15, 2005, we held our Annual Meeting of Stockholders at which four
        proposals were considered. We recommended that the stockholders vote for
        each of
        the proposals. The results of each matter considered and voted upon are as
        follow:
 
 **Proposal
                  1:**
              **To
                  elect Charles J. Abbe a Class II director to our board of
                  directors.**An
                  aggregate of 9,688,075 shares voted in connection with the proposal,
                  9,657,947 shares voted for the election of Charles J. Abbe as the
                  Class II
                  director and 30,128 shares were withheld.**Proposal
                  2:**
              **To
                  approve a proposal to amend our Second Amended and Restated Certificate
                  of
                  Incorporation to de-classify the board of directors providing for
                  an
                  annual election of all our directors.**An
                  aggregate of 9,688,075 shares voted in connection with the proposal,
                  9,676,753 shares voted for the proposal, 10,392 shares voted against
                  the
                  proposal, and 930 shares abstained.**Proposal
                  3:**
              **To
                  approve a proposal to amend our Second Amended and Restated Certificate
                  of
                  Incorporation to restrict certain acquisitions of its securities
                  to help
                  assure the preservation of its net operating loss
                  carry-forwards.**An
                  aggregate of 5,929,229 shares voted in connection with the proposal,
                  5,861,064 shares voted for the proposal, 66,855 shares voted against
                  the
                  proposal, 1,310 shares abstained and there were 3,758,846 broker
                  non-votes.**Proposal
                  4:**
              **To
                  ratify the appointment of Burr, Pilger & Mayer LLP as our independent
                  registered public accounting firm for the 2005 fiscal
                  year.**An
                  aggregate of 9,688,075 shares voted in connection with the proposal,
                  9,675,470 shares voted for the proposal, 11,285 shares voted against
                  the
                  proposal, and 1,320 shares
                  abstained.
  Our
        remaining directors, Donald Green, Jack L. Howard and Terry R. Gibson, were
        not
        up for election at the 2005 Annual Meeting.
 
 **PART
        II**
 
 **Item
        5.** ***Market
        for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases
        of Equity Securities***
 
 **Market
        Information**
 
 Our
        common stock currently trades in the over the counter market and is quoted
        on
        the Pink Sheets Electronic Quotation Service under the symbol “COSN.PK.” Our
        common stock had been traded on the Nasdaq National Market under the symbol
        COSN
        from our initial public offering in September 2000 through June 15, 2005,
        when
        we were de-listed from the Nasdaq National Market System. There was no public
        market for our common stock prior to our September 2000 initial public offering.
 
  9
  The
        following table sets forth the high and low sales price of our common stock
        in
        the year ended December 31, 2004 and for the first quarter of fiscal year
        2005.
        Our common stock was de-listed from Nasdaq National Market System on June
        15,
        2005. For the remainder of fiscal year 2005, the following table sets forth
        the
        range of high and low bid information of our common stock. The high and low
        bid
        quotations reflect inter-dealer prices, without retail mark-up, mark-down
        or
        commission, and may not represent actual transactions.
 
 **High**
              
              **Low****2005**First
                  quarter
              
              $
              2.54
              
              $
              1.94Second
                  quarter
              
              $
              2.76
              
              $
              1.94Third
                  quarter
              
              $
              3.15
              
              $
              1.85Fourth
                  quarter
              
              $
              2.85
              
              $
              2.30**2004**First
                  quarter
              
              $
              10.33
              
              $
              6.05Second
                  quarter
              
              $
              6.48
              
              $
              3.98Third
                  quarter
              
              $
              4.51
              
              $
              2.83Fourth
                  quarter
              
              $
              3.30
              
              $
              2.60
 
 
 **Stockholders**
 
 According
        to the records of our transfer agent, at March 15, 2006 we had approximately
        230
        shareholders of record. The majority of our shares are held in approximately
        4,000 customer accounts held by brokers and other institutions on behalf
        of
        stockholders.
 
 **Dividends**
 
 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
        we
        do not anticipate paying any cash dividends in the foreseeable
        future.
 
 **Securities
        Authorized for Issuance under Equity Compensation Plans**
 
 The
        following table summarizes equity compensation plans approved by stockholders
        and equity compensation plans that were not approved by the stockholders
        as of
        December 31, 2005:
 
 **EQUITY
        COMPENSATION PLAN INFORMATION**
 **Plan
                    category**
                
                **Number
                    of Securities****to
                    be Issued Upon****Exercise
                    of Outstanding****Options,
                    Warrants and****Rights**
                
                **Weighted-Average****Exercise
                    Price of****Outstanding
                    Options,****Warrants
                    and Rights**
                
                **Number
                    of Securities****Remaining
                    Available for****Future
                    Issuance Under****Equity
                    Compensation****Plans
                    (1)**Equity
                    compensation plans approved by stockholders
                
                
                147,175
                    (2
                )
                $
                8.37
                    (2
                )
                
                2,372,717
                    (3
                )Equity
                    compensation plans not approved by stockholders (4)
                
                
                ---
                
                
                ---
                
                
                1,000,000Total
                
                
                147,175
                
                $
                8.37
                
                
                3,372,717
 (1)
              These
                  numbers exclude share listed under the column heading "Number of
                  Securities to be Issued Upon Exercise of Outstanding Options, Warrants
                  and
                  Rights."(2)
              Includes
                  6,300 shares subject to outstanding options under the 1997 Stock
                  Plan,
                  114,875 shares subject to outstanding options under the 2000 Stock
                  Plan,
                  and 26,000 shares subject to outstanding options under the Director
                  Plan.(3)
              Includes
                  1,918,455 shares available for future issuance under the 2000 Stock
                  Plan,
                  22,000 shares available for future issuance under the Director
                  Plan, and
                  432,262 shares available for future issuance under the Employee
                  Stock
                  Purchase Plan.(4)
              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 to make available for issuance certain shares of
                  our
                  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 us 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 us 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.
 
 **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 $220 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 potential acquisitions
        pursuant to our redeployment strategy. Pending further use of the net proceeds,
        we have invested them in short-term, interest-bearing, investment-grade
        securities.
 10
  **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, 2005, 2004 and 2003 and the selected consolidated balance sheet data
        as of
        December 31, 2005 and 2004, are derived from, and are qualified by reference
        to,
        the audited consolidated financial statements included elsewhere in this
        Annual
        Report on Form 10-K. The selected consolidated statements of operations data
        for
        the fiscal years ended prior to December 31, 2003, and the selected consolidated
        balance sheet data prior to December 31, 2004, are derived from our audited
        consolidated financial statements that are not included in this Annual Report
        on
        Form 10-K. The historical results presented below are not necessarily indicative
        of future results.
 **Year
                        Ended December 31****2005**
                    
                    **2004**
                    
                    **2003**
                    
                    **2002**
                    
                    **2001****(In
                        thousands, except per share data)****Consolidated
                        Statements of Operations Data:**Revenue
                    
                    $
                    3,315
                    
                    $
                    9,675
                    
                    $
                    14,621
                    
                    $
                    23,632
                    
                    $
                    34,293Cost
                        of revenue
                    
                    
                    2,049
                    
                    
                    7,086
                    
                    
                    6,765
                    
                    
                    13,807
                    
                    
                    30,214Gross
                        profit
                    
                    
                    1,266
                    
                    
                    2,589
                    
                    
                    7,856
                    
                    
                    9,825
                    
                    
                    4,079Operating
                        expenses:Research
                        and development
                    
                    
                    103
                    
                    
                    15,078
                    
                    
                    21,756
                    
                    
                    32,396
                    
                    
                    66,091Sales
                        and marketing
                    
                    
                    105
                    
                    
                    10,052
                    
                    
                    13,808
                    
                    
                    28,271
                    
                    
                    60,000General
                        and administrative
                    
                    
                    3,227
                    
                    
                    6,064
                    
                    
                    7,226
                    
                    
                    10,959
                    
                    
                    23,525Restructuring
                        and impairment charges
                    
                    
                    (91
                    )
                    
                    8,909
                    
                    
                    336
                    
                    
                    34,538
                    
                    
                    8,991Total
                        operating expenses
                    
                    
                    3,344
                    
                    
                    40,103
                    
                    
                    43,126
                    
                    
                    106,164
                    
                    
                    158,607Loss
                        from operations
                    
                    
                    (2,078
                    )
                    
                    (37,514
                    )
                    
                    (35,270
                    )
                    
                    (96,339
                    )
                    
                    (154,528
                    )Other
                        income (expense):Interest
                        income
                    
                    
                    678
                    
                    
                    489
                    
                    
                    1,296
                    
                    
                    3,535
                    
                    
                    11,086Interest
                        expense
                    
                    
                    —
                    
                    
                    (3
                    )
                    
                    (224
                    )
                    
                    (966
                    )
                    
                    (1,675
                    )Other
                    
                    
                    (46
                    )
                    
                    (276
                    )
                    
                    (447
                    )
                    
                    313
                    
                    
                    (299
                    )Total
                        other income
                    
                    
                    632
                    
                    
                    210
                    
                    
                    625
                    
                    
                    2,882
                    
                    
                    9,112Loss
                        before income tax provision (credit)
                    
                    
                    (1,446
                    )
                    
                    (37,304
                    )
                    
                    (34,645
                    )
                    
                    (93,457
                    )
                    
                    (145,416
                    )Income
                        tax provision (credit)
                    
                    
                    (
                        228
                    )
                    
                    33
                    
                    
                    287
                    
                    
                    509
                    
                    
                    837Net
                        loss
                    
                    $
                    (1,218
                    )
                    $
                    (37,337
                    )
                    $
                    (34,932
                    )
                    $
                    (93,966
                    )
                    $
                    (146,253
                    )Basic
                        and diluted net loss per common share
                    
                    $
                    (0.12
                    )
                    $
                    (3.70
                    )
                    $
                    (3.57
                    )
                    $
                    (9.72
                    )
                    $
                    (15.09
                    )Shares
                        used in computing basic and diluted net loss per common
                        share
                    
                    
                    10,094
                    
                    
                    10,082
                    
                    
                    9,791
                    
                    
                    9,670
                    
                    
                    9,695
 
 **Consolidated
                  Balance Sheets Data:**Cash,
                  cash equivalents and short-term investments
              
              $
              23,166
              
              $
              24,913
              
              $
              57,752
              
              $
              101,467
              
              $
              164,878Working
                  capital
              
              
              22,353
              
              
              23,214
              
              
              59,705
              
              
              91,868
              
              
              163,424Total
                  assets
              
              
              23,840
              
              
              27,823
              
              
              73,426
              
              
              119,561
              
              
              221,203Working
                  capital loans
              
              
              —
              
              
              —
              
              
              —
              
              
              131
              
              
              1,992Accrued
                  rent
              
              
              —
              
              
              —
              
              
              2,078
              
              
              2,069
              
              
              2,556Long-term
                  capital lease obligations
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,905Other
                  long-term liabilities
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              11Total
                  stockholders’ equity
              
              
              22,603
              
              
              23,364
              
              
              61,174
              
              
              93,481
              
              
              187,065
 
  11
  **Quarterly
        financial information (unaudited):**
 **2004**
                
                **2005****1st**
                  **Quarter**
                
                **2nd**
                  **Quarter**
                
                **3rd**
                  **Quarter(1)**
                
                **4th**
                  **Quarter
                    (1)**
                
                **1st**
                  **Quarter**
                
                **2nd**
                  **Quarter**
                
                **3rd**
                  **Quarter**
                
                **4th**
                  **Quarter****(In
                    thousands, except per share data)**Revenue
                
                $
                4,455
                
                $
                2,568
                
                $
                1,088
                
                $
                1,564
                
                $
                897
                
                $
                699
                
                $
                785
                
                $
                934Gross
                    profit (loss)
                
                
                2,958
                
                
                1,133
                
                
                (3,353
                )
                
                1,851
                
                
                443
                
                
                310
                
                
                83
                
                
                430Net
                    income (loss)
                
                
                (7,385
                )
                
                (9,706
                )
                
                (14,619
                )
                
                (5,627
                )
                
                (878
                )
                
                (633
                )
                
                (
                    31
                )
                
                324Basic
                    net income (loss) per share
                
                $
                (0.74
                )
                $
                (0.96
                )
                $
                (1.47
                )
                $
                (0.53
                )
                $
                (0.09
                )
                $
                (0.06
                )
                $
                (0.00
                )
                $
                0.03
 __________
 
 (1)
              Includes
                  restructuring and impairment charges of $6.8 million in the third
                  quarter
                  of 2004 and $3.7 million in the fourth quarter of
                  2004.
 
 **Item
        7.** ***Management’s
        Discussion and Analysis of Financial Condition and Results of
        Operations***
 
 **OVERVIEW**
 
 Our
        current business consists primarily of a customer support capability for
        our
        discontinued products provided by a third party. We intend to continue such
        support activities through December 31, 2006, depending on customer demand,
        and
        to offer our intellectual property for license or sale. We have also adopted
        a
        strategy of seeking to enhance stockholder value by pursuing opportunities
        to
        redeploy our assets through an acquisition of one or more operating business
        with existing or prospective taxable earnings that can be offset by use of
        our
        net operating loss carry-forwards (“NOLs”).
 
 We
        were a
        provider of carrier network equipment products and services until the fourth
        quarter of fiscal year 2004 during which time we discontinued our product
        lines,
        took actions to lay-off most of our employees, terminated contract manufacturing
        arrangements, contractor and consulting arrangements and various facility
        leases, and sold, scraped or wrote-off our inventory, property and equipment.
        In
        July 2005, we completed a comprehensive review of strategic alternatives,
        including a sale of the Company, a sale or licensing of intellectual property,
        a
        redeployment of our assets into new business ventures, or a winding-up and
        liquidation of the business and a return of capital. At that time, the board
        of
        directors approved the strategy of redeploying our existing resources to
        identify and acquire one or more new business operations, while continuing
        to
        support our existing customers and continuing to offer our intellectual property
        for license or sale.
 
 DUE
        TO
        THE ADOPTION OF OUR REDEPLOYMENT STRATEGY, THE INFORMATION APPEARING BELOW,
        WHICH RELATES TO PRIOR PERIODS, MAY NOT BE INDICATIVE OF THE RESULTS THAT
        MAY BE
        EXPECTED FOR ANY SUBSEQUENT PERIODS. THE YEAR ENDED DECEMBER 31, 2005 PRIMARILY
        REFLECTS, AND FUTURE PERIODS PRIOR TO A REDEPLOYMENT OF OUR ASSETS ARE EXPECTED
        TO PRIMARILY REFLECT, GENERAL AND ADMINISTRATIVE EXPENSES AND TRANSACTION
        EXPENSES ASSOCIATED WITH THE CONTINUING ADMINISTRATION OF THE COMPANY AND
        ITS
        EFFORTS TO REDEPLOY ITS ASSETS.
 
 **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 U.S. generally accepted accounting principles. 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 disclosures 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.
 
  12
  The
        following accounting policies are significantly affected by the judgments
        and
        estimates we use in the preparation of our consolidated financial
        statements.
 
 **Revenue
        Recognition**
 
 Historically,
        prior to discontinuing our products, most of our sales were generated from
        complex arrangements. Recognizing revenue in these arrangements required
        our
        making significant judgments, particularly in the areas of customer acceptance
        and collectibility.
 
 Certain
        of our historic product sales arrangements required formal acceptance by
        our
        customers. In such cases, we did not recognize revenue until we received
        formal
        notification of acceptance. Although we worked closely with our customers
        to
        help them achieve satisfaction with our products prior to and after acceptance,
        the timing of customer acceptance could greatly affect the timing of the
        recognition of our revenue.
 
 While
        the
        end user of our product was normally a large network service provider, we
        also
        sold 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 were required to assess that collection from the customer
        was probable. If we could not satisfy ourselves that collection is probable,
        we
        deferred revenue recognition until we collected payment.
 
 Our
        current business consists primarily of customer service revenue. We record
        revenue as earned for customer service revenue, once we satisfy ourselves
        that
        collection from the customer is probable. If we cannot satisfy ourselves
        that
        collection is probable, we defer revenue recognition until we 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**
 
 Our
        inventory was either sold, scrapped or fully written-off at December 31,
        2004
        and 2005, respectively.
 
 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.
        Prior
        to September 30, 2004, we generally used a 12-month forecast to assess future
        demand. Inventory write-downs are charged to cost of revenue. At September
        30,
        2004, in connection with our decision to discontinue our products, we recorded
        a
        charge of $3.5 million to cost of revenue to write our inventory down to
        its
        estimated net realizable value. During 2005, we sold $26,000 of previously
        written-down inventory. During 2004 we sold $0.7 million of previously
        written-down inventory. During 2003, we charged $0.2 million of inventory
        write-downs and $0.1 million of excess purchase commitments to cost of revenue
        primarily as the result of reduced forecasted demand for certain of our
        components and we sold $0.9 million of previously written-down inventory.
 
 **Long-lived
        assets**
 
 At
        December 31, 2005 and 2004, respectively, all of our long-lived assets had
        been
        either sold, scrapped or fully written-off.
 
 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 of the assets 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 2005 or 2003. During 2004, we charged $2.3 million to operating
        expenses as a result of impairments. During 2004, we had a gain of $ 0.9
        million
        with the sale of previously written-down long-lived assets.
 13
  **Warranties**
 
 Prior
        to
        discontinuing our products, we
        provided a basic limited warranty, including repair or replacement of parts,
        and
        technical support for our products. The specific terms and conditions of
        those
        warranties varied depending on the customer or region in which we did business.
        We estimated the costs that could be incurred under our basic limited warranty
        and recorded a liability in the amount of such costs at the time product
        revenue
        was 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 revenue may
        result.
 
 We
        no
        longer offer any warranty on product or service sales.
 
 **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
        cost
        of revenue, operating expenses and interest expense were affected significantly
        by charges related to warrants and options issued for services. Furthermore,
        some of our employee stock option transactions have resulted in deferred
        compensation, which is presented as a reduction of stockholders’ equity on our
        consolidated balance sheet and was 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 are 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 compensation 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 previouslybeen
                  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. During the year ended December 31, 2005, no stock options
                  re-priced in November 2002 were still
                  outstanding.
 
 Some
        of
        the stock options granted to our employees had 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 consolidated 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.
 
  14
  In
        the
        first quarter of 2004, we began a program whereby we granted employees bonuses
        in shares of our common stock based on the achievement of certain Company
        objectives. At the end of each quarter, we determined whether objectives
        have
        been achieved and set the total value of the common stock grant. The number
        of
        shares to be issued is calculated the following quarter based on the fixed
        value
        of the common stock issued, as determined at quarter-end, divided by our
        stock
        price on the issuance date. Compensation expense is accrued in full in the
        quarter in which it is earned. No employee bonuses were earned in the second,
        third or fourth quarters of 2004 or in any quarter of 2005 as the quarterly
        objectives were not met.
 
 In
        the
        second quarter of 2004, we issued to a reseller a warrant to acquire 254,489
        shares of our common stock at an exercise price of $4.65 per share. The warrant
        has a two-year term beginning May 28, 2004 and vests ratably over the term.
        If
        during the two-year term (1) any person or entity acquires a greater than
        50%
        interest in us or the ownership or control of more than 50% of our voting
        stock
        or (2) we sell substantially all of our intellectual property assets, the
        warrant becomes exercisable. Even if the reseller does not immediately exercise
        the warrant upon the occurrence of such an event that makes the warrant
        exercisable (a “trigger event”), the reseller shall be entitled to securities,
        cash and property to which it would have been entitled to upon the consummation
        of the trigger event, less the aggregate price applicable to the warrant.
        We
        calculated the fair value of the warrant to be approximately $487,000 using
        the
        Black-Scholes option pricing model, using a volatility factor of .97, a
        risk-free interest rate of 2.5%, and an expected life of two years. The fair
        value of the warrant was being amortized over the two-year expected life
        of the
        warrant. During the year ended December 31, 2005, we amortized $339,000 to
        cost
        of revenue. During the year ended December 31, 2004, we amortized $6,000
        to cost
        of revenue and $42,000 to general and administrative expenses.
 
 **RESULTS
        OF OPERATIONS**
 
 **Revenue**
 
 In
        2003
        and 2004, the majority of our revenue was recognized from the sale of our
        IP
        Service Delivery Platform and subsequent service support arrangements. In
        2005, our revenues were earned primarily from our customer service contracts. We
        recognize product revenue at the time of shipment or delivery (depending
        on
        shipping terms), 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” (VSOE) of fair value. 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.
  Revenue
        from customers by geographic region for the years ended December 31, 2005,
        2004
        and 2003 was as follows, in thousands:
  2005
                
                %
                
                2004
                
                %
                
                2003
                
                %North
                    America
                
                $
                1,901
                
                
                57%
                
                $
                3,364
                
                
                35%
                
                $
                6,808
                
                
                47%Asia/Pacific
                
                
                617
                
                
                19
                
                
                3,258
                
                
                34
                
                
                5,137
                
                
                35Europe
                
                
                797
                
                
                24
                
                
                3,053
                
                
                31
                
                
                2,676
                
                
                18Total
                    revenue
                
                $
                3,315
                
                
                100%
                
                $
                9,675
                
                
                100%
                
                $
                14,621
                
                
                100%





15





Hardware,
      software and service revenue for the years ended December 31, 2005, 2004 and
      2003 was as follows, in thousands:


2005
              
              %
              
              2004
              
              %
              
              2003
              
              %Hardware
              
              $
              26
              
              
              1%
              
              $
              6,316
              
              
              65%
              
              $
              11,352
              
              
              78%Software
              
              
              190
              
              
              6
              
              
              608
              
              
              6
              
              
              451
              
              
              3Services
              
              
              3,099
              
              
              93
              
              
              2,751
              
              
              29
              
              
              2,818
              
              
              19Total
                  revenue
              
              $
              3,315
              
              
              100%
              
              $
              9,675
              
              
              100%
              
              $
              14,621
              
              
              100%




In
      2005, our revenues were earned primarily from our customer service contracts.
      Hardware revenue consisted of a $26,000 sale of previously written-down
      equipment and software revenue consisted of $190,000 for sales of nonexclusive
      software licenses. Our customers have purchased service contracts for their
      installed systems while they plan and execute their transition from our
      networking systems to other suppliers. This transition is expected to continue
      into 2006, depending on individual customer plans, at which time we will likely
      cease customer support operations.





At
      December 31, 2005, our business consists of a customer support operation,
      provided by a third party contractor. These services are being offered to our
      existing customers through December 31, 2006, depending on customer demand.
      As
      such, we expect our revenues to decline significantly during 2006 as our
      customers make other arrangements to service and support their equipment or
      decide to remove or replace their CoSine equipment. See
      "Outlook" section on page 23 and "Risk Factors" section on pages 4 to
      8.





In
      2004, product shipments declined compared to 2003. The decline was noted in
      all
      regions and was due to completion of expansion projects for certain customers
      in
      Japan and North America and no significant new customer wins or expansions
      by
      existing customers, partially offset by over $700,000 in “last time buy” sales
      in connection with our announced plans to discontinue our products. Service
      revenue remained relatively constant as existing customers continued to purchase
      service and support for their installed units. Software revenue increased over
      2003 due to certain customers purchasing new software licenses for their
      existing installed base.




As
      of
      December 31, 2005, 2004 and 2003, we deferred
      $0.1 million, $0.5 million and $3.5 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) $0.3 million, ($0.8) million and $1.3 million of
      non-cash charges (credits) related to equity issuances to cost of revenue,
      operating expenses and interest expense, for the years ended December 31, 2005,
      2004 and 2003, respectively.







16







Below
      is
      a reconciliation of non-cash charges related to equity issuances for the years
      ended December 31, 2005, 2004 and 2003, affecting our cost of revenue, operating
      expenses and interest expense, in thousands:




**Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**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
              
              $
              —
              
              $
              92
              
              $
              1,377Credits
                  related to the reversal of deferred stock compensation amortization
                  in
                  excess of vesting for terminated employees
              
              
              —
              
              
              (1,203
              )
              
              (956
              )Amortization
                  of deferred compensation associated with re-pricing
              
              
              —
              
              
              55
              
              
              797Charges
                  related to options with accelerated vesting
              
              
              —
              
              
              —
              
              
              1Issuance
                  of common stock for employee stock bonus
              
              
              —
              
              
              228
              
              
              ---Amortization
                  of charges related to warrants or stock options issued to non-employees
                  in
                  conjunction with lease, debt and reseller agreements
              
              
              339
              
              
              48
              
              
              92Net
                  non-cash charges related to equity issuances
              
              $
              339
              
              $
              (780
              )
              $
              1,311
 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 Revenue**





Cost
      of
      revenue 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 revenue. We have also incurred non-cash charges
      and
      credits related to equity issuances including amortization of a warrant issued
      to a reseller in 2004. We have outsourced the majority of our manufacturing
      and
      repair operations and customer support capabilities. A significant portion
      of
      our cost of revenue consists of payments to our contract manufacturers and
      third
      party customer support service provider. Historically, we conducted
      manufacturing engineering, final assembly, configuration testing and
      documentation control at our facilities in Redwood City,
      California.





Cost
      of
      revenue for the year ended December 31, 2005 was $2.0 million, or 61.8% of
      revenue. Cost of revenue included $1.7 million or 93% for the cost of our third
      party customer support service provider, and $0.3 million or 7% for amortization
      of a warrant issued to a reseller in 2004.





For
      the
      year ended December 31, 2004, cost of revenue was $7.1 million, of which $4.1
      million or 58% represented the write-down of inventory, $(0.7) million or (10%)
      represented sales of previously written-down inventory, $0.4 million or 6%
      represented costs to terminate contract manufacturing agreements, $2.8 million
      or 39% represented the material, labor and overhead, warranty and the cost
      of
      providing customer support services and $0.5 million, or 7% represented software
      royalties.







17







**Gross
      Profit**





For
      the
      years ended December 31, 2005, 2004 and 2003, gross profit was $1.3 million,
      or
      38% of revenue, $2.6 million or 27% of revenue, and $7.9 million, or 54% of
      revenue, respectively.





The
      11
      percentage point increase in gross margin for the year ended December 31, 2005
      compared to December 31, 2004 is due to the charges taken in 2004, including
      the
      $2.8 million net inventory write-down and the $0.4 million in costs to terminate
      contract manufacturing agreements. There were no such charges in 2005.





The
      27
      percentage point decrease gross margin percentage from 2003 to 2004 is primarily
      the result of the net $2.8 million inventory write-down and the $0.4 million
      in
      costs to terminate contract manufacturing agreements, partially offset by lower
      warranty and manufacturing overhead costs.





**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. Historically, several components of our research and
      development effort required significant expenditures, the timing of which caused
      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 was large, and this building and testing process occurred over a short
      period of time.





Research
      and development expenses were $0.1 million, $15.1 and $21.8 million for the
      years ended December 31, 2005, 2004, and 2003, respectively.





Research
      and development expense decreased $15.0 million in the year ended December
      31,
      2005 and by $6.7 million or 31% in the year ended December 31, 2004 due to
      the
      September 2004 decision to discontinue development and sale of our products
      and
      the termination of our research staff in 2004. The majority of our research
      and
      development employees were laid-off in September 2004 while a small team of
      engineers were retained to support customer transition activities, documentation
      of our intellectual property, due diligence and technical support for our
      ongoing review of strategic alternatives and the training of a subcontractor
      for
      ongoing customer support programs.





Non-cash
      credits related to equity issuances were nil and $0.2 million for the years
      ended December 31, 2005 and 2004, respectively. Non-cash charges related to
      equity issuances were $0.6 million for the year ended December 31,
      2003.





**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. Historically, 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 was installed and integrated
      often required extensive evaluation periods and trials. These trials were
      conducted by our customers at customer-designated locations or within our sales
      laboratories and required support from our highly trained systems engineers
      and
      service and support personnel. These evaluations and trials generally took
      approximately three to 12 months.





Sales
      and
      marketing expenses were $0.1 million, $10.1 million, and $13.8 million for
      the
      years ended December 31, 2005, 2004, and 2003, respectively.





Sales
      and
      marketing expense decreased by $10.0 million in the year ended December 31,
      2005
      and by $3.8 million or 27% in the year ended December 31, 2004. The decreases
      are due primarily to our decision in September 2004 to discontinue our products
      and lay-off all of our employees to conserve cash. The majority of our sales
      and
      marketing employees were laid-off in September 2004 while a select team of
      employees were retained to support customer transition activities, including
      negotiating transition support plans, last time buys and related matters.








18







Non-cash
      credits related to equity issuances were nil and $0.2 million in the years
      ended
      December 31, 2005 and 2004, respectively. Non-cash charges related to equity
      issuances were $0.1 million for the year ended December 31, 2003.





**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 $3.2 million, $6.1 million, and $7.2 million
      for the years ended December 31, 2005, 2004 and 2003, respectively.





General
      and administrative expense decreased $2.8 million, or 47% and $1.2 million
      or
      16% for the years ended December 31, 2005 and 2004, respectively. The decreases
      are due primarily to our decision in September 2004 to discontinue our products
      and lay-off all of our employees to conserve cash. The majority of our general
      and administrative employees were laid off in October and November of 2004,
      and
      substantially all employees were laid-off by December 31, 2004. Our
      administrative functions are now performed by our chief executive officer and
      a
      consultant.





General
      and administrative non-cash credits related to equity issuances were nil and
      $0.3 million for the years ended December 31, 2005 and 2004, respectively.
      General and administrative non-cash charges related to equity issuances were
      $0.5 million for the year ended December 31, 2003.











**Restructuring
      and Impairment Charges**





*December
      2004 Restructuring*





In
      the
      quarter ended December 31, 2004, we continued our previously announced
      restructuring activities initiated in September 2004. Such activities included
      the termination of the remaining workforce, with a charge of $619,000,
      termination of a facility lease in Redwood City for a net charge of $2,522,000
      and the termination of an office in Japan for a net charge of $396,000. The
      Redwood City lease termination included a cash payment of $3,763,000, forfeiture
      of a $420,000 lease deposit, the write-off of $388,000 unamortized value of
      warrants issued in connection with the original execution of the lease, net
      of
      accrued rent of $2,049,000. In addition, we accrued $1,037,000 for the
      termination of non-cancelable software license agreements, as the licenses
      were
      not expected to be used in the ongoing operations.





Activity
      related to the December 2004 restructuring is as follows (in
      thousands):





**Worldwide**
              **Workforce**
              **Reduction**
            
            **Lease**
              **Terminations**
            
            **Software**
              **License**
              **Terminations**
            
            **Total**December
                2004 restructuring charges
            
            $
            619
            
            $
            2,918
            
            $
            1,037
            
            $
            4,574Cash
                payments
            
            
            (66
            )
            
            (3,900
            )
            
            —
            
            
            (3,966
            )Write-offs
            
            
            —
            
            
            982
            
            
            —
            
            
            982**Provision
                balance at December 31, 2004**
            
            
            553
            
            
            —
            
            
            1,037
            
            
            1,590Cash
                payments
            
            
            (550
            )
            
            —
            
            
            (564
            )
            
            (1,114
            )Accrual
                adjustments
            
            
            —
            
            
            —
            
            
            (23
            )
            
            (23
            )**Provision
                balance at December 31, 2005**
            
            $
            3
            
            $
            —
            
            $
            450
            
            $
            453





*September
      2004 Restructuring*





In
      September 2004, we announced actions to terminate most of our workforce,
      retaining a limited team of employees to provide customer support and handle
      matters related to the ongoing exploration of strategic alternatives. The
      specific actions include workforce reductions, with a charge of $2,872,000,
      announced discontinuance of our products, with a related charge to cost of
      sales
      of $3,466,000 to write inventory down to net realizable value and a $75,000
      charge for unrecoverable royalties, and termination of third party manufacturing
      agreements, with a charge of $375,000.







19







Effective
      September 23, 2004, we approved severance agreements to Stephen Goggiano, our
      president and chief executive officer, and Terry Gibson, our chief financial
      officer, covering the period of August 1, 2004 through the earlier of (i)
      December 31, 2004 or (ii) the termination of their respective employments due
      to
      the elimination of their respective jobs if caused by a merger, sale,
      acquisition, liquidation, dissolution, consolidation or similar corporate
      transaction, in exchange for their continued service to us as we explored
      strategic alternatives, including a sale of the Company, a sale or licensing
      of
      products, intellectual property, or individual assets or a winding-up and
      liquidation of the business. In exchange for their continued service during
      this
      time period, Mr. Goggiano and Mr. Gibson each received a retention bonus equal
      to 100% of their base 2004 annual salary payable on or before December 31,
      2004.
      In addition, upon completion of these services, we agreed to pay for the cost
      of
      Mr. Goggiano's and Mr. Gibson's family health care coverage for a period of
      up
      to 12 months after termination of their respective employment. These amounts
      were accrued in the December 31, 2004 restructuring. The termination payments
      were paid in January 2005 and the health care payments were made in
      2005.





Activity
      related to the September 2004 restructuring is as follows (in
      thousands):





**Worldwide**
              **Workforce**
              **Reduction**
            
            **Write-down
                of**
              **Inventory
                and**
              **Prepaid
                Royalty**
            
            **Manufacturing**
              **Agreement**
              **Termination**
            
            **Total**September
                2004 restructuring charges
            
            $
            2,872
            
            $
            3,541
            
            $
            375
            
            $
            6,788Cash
                payments
            
            
            (2,448
            )
            
            —
            
            
            (278
            )
            
            (2,726
            )Write
                offs
            
            
            —
            
            
            (3,541
            )
            
            (97
            )
            
            (3,638
            )**Provision
                balance at December 31, 2004**
            
            
            424
            
            
            —
            
            
            —
            
            
            424Cash
                payments
            
            
            (424
            )
            
            —
            
            
            —
            
            
            (424
            )**Provision
                balance at December 31, 2005**
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





*May
      and March 2003 Restructuring*





In
      May
      and March 2003, our senior management communicated 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. The restructuring programs were an extension of
      the
      October 2002 restructuring, which was implemented to reduce operating expenses
      and conserve cash.





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





**Worldwide
                Workforce**
              **Reduction**
            
            **Lease**
              **Termination**
              **and
                Other**
            
            **Total**Charges
            
            $
            277
            
            $
            17
            
            $
            294Cash
                payments
            
            
            (284
            )
            
            (12
            )
            
            (296
            )Non-cash
                items
            
            
            (20
            )
            
            (4
            )
            
            (24
            )Accrual
                adjustment
            
            
            75
            
            
            (1
            )
            
            74**Provision
                balance at December 31, 2003**
            
            
            48
            
            
            —
            
            
            48Cash
                payments
            
            
            (38
            )
            
            —
            
            
            (38
            )Accrual
                adjustment
            
            
            (10
            )
            
            —
            
            
            (10
            )**Provision
                balance at December 3, 2004**
            
            $
            —
            
            $
            —
            
            $
            —











20







**Impairment
      of Long-lived Assets**





*2004
      Impairment*





As
      a
      result of our assessment of our business, we concluded that indicators of
      impairment of our long-lived assets were present at June 30, 2004 and at
      September 30, 2004. Such indicators included ongoing operating losses, inability
      to achieve sustainable revenue growth, including our failure to attract new
      customers, and our decision to evaluate strategic alternatives. Accordingly,
      we
      performed an impairment test of the carrying value of our long-lived assets,
      consisting primarily of property and equipment in accordance with Statement
      of
      Financial Accounting Standards (“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 $2.3 million
      to write down the carrying value of our long-lived assets held for use to their
      fair values in the second quarter of 2004. At September 30, 2004, we obtained
      competitive bids from qualified prospective purchasers to determine the fair
      values of long-lived assets. The fair values, as indicated by competitive bids,
      exceeded the net book value of the long-lived assets at September 30, 2004,
      accordingly no adjustment was made in the third quarter of 2004. During 2005
      and
      2004, we had gains of $0.1 million and $0.9 million, respectively, from sales
      of
      previously written-down long-lived assets. At December 31, 2005 and 2004, we
      had
      sold, scrapped or written-off all of our long-lived assets.





**Interest
      Income and Other Expense**





For
      the
      year ended December 31, 2005, interest income was $0.7 million as compared
      to
      $0.5 million in the year ended December 31, 2004. The increase is due to higher
      interest rates in 2005, partially offset by lower average cash balances. For
      the
      year ended December 31, 2004, interest income and other income (expense) was
      $0.2 million, a decrease of $0.4 million when compared with the year ended
      December 31, 2003. The decrease from 2003 to 2004 is due to decreased interest
      income due to lower levels of cash and short-term investments and lower interest
      rates on invested amounts.





**Interest
      Expense**





For
      the
      years ended December 31, 2005 and 2004, respectively, interest expense was
      nil,
      as compared to $0.2 million for the year ended December 31, 2003. The decrease
      from 2003 is due to repayment on the equipment loans and capital leases in
      2003.





**Income
      Tax Provision (Benefit)**





Provisions
      (benefits) for income taxes of ($0.2 million), $33,000, and $0.3 million for
      the
      years ended December 31, 2005, 2004 and 2003, respectively, were comprised
      entirely of foreign corporate income taxes, which are a function of our
      operations in subsidiaries in various countries. The provision (benefit) for
      income taxes is based on income taxes on minimum profits the foreign operations
      generated for services they provided to us. The $0.2 million credit in 2005
      relates to the liquidation of several of the foreign subsidiaries, and
      completion of the related tax settlements.





We
      have
      not recognized any benefit from the future use of net operating loss
      carry-forwards for these periods, or for any other periods, since our
      incorporation. We are not recognizing the potential tax benefits of our net
      operating loss carry-forwards 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 carry-forwards 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
      carry-forwards 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 and do not expect
      to sustain our revenue.





Our
      current business consists primarily of a customer support capability for our
      discontinued products provided by a third party. We intend to continue such
      support activities through December 31, 2006, depending on customer demand,
      and
      to offer our intellectual property for license or sale. In March 2006, we signed
      an agreement to sell the rights to our patent portfolio for cash consideration
      of $180,000 (see Note 9 to the Consolidated Financial Statements). We have
      also
      adopted a strategy of seeking to enhance stockholder value by pursuing
      opportunities to redeploy our assets through an acquisition of one or more
      operating business with existing or prospective taxable earnings that can be
      offset by use of our net operating loss carry-forwards. Based on restructuring
      activities initiated in September 2004 and completed in the quarter ended
      December 31, 2004, on the significant reduction in cash usage resulting from
      those restructuring activities, and on the costs to extend customer support
      activities through December 2006, 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, our restructuring
      activities and our new redeployment of assets strategy raise substantial doubt
      as to our ability to continue as a going concern. See “Financial Results and
      Liquidity” in Note 1 of the Notes to the Consolidated Financial Statements. See
“Outlook” on page 23 and “Risk Factors” on pages 4 to 8, which describes
      are redeployment of assets strategy.




21




We
      will
      continue to prepare our financial statements on the assumption that we will
      continue as a going concern, which contemplates the realization of assets and
      liquidation of liabilities in the normal course of business. As such, the
      financial statements do not include any adjustments to reflect possible future
      effects of the recoverability and classification of assets or the amounts and
      classification of liabilities that may result from any decisions made with
      respect to an assessment of our strategic alternatives. If at some point we
      were
      to decide to pursue alternative plans, we may be required to present the
      financial statements on a different basis. As an example, if we were to decide
      to pursue a liquidation and return of capital, it would be appropriate to
      prepare and present financial statements on the liquidation basis of accounting,
      whereby assets are valued at their estimated net realizable values and
      liabilities are stated at their estimated settlement amounts.





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





At
      December 31, 2005, cash, cash equivalents and short-term investments were $23.2
      million. This compares with $24.9 million at December 31, 2004.





**Operating
      Activities**





We
      used
      $1.8 million in cash for operations for the year ended December 31 2005, a
      decrease of $31.2 million from the cash used for operations in 2004. The
      improvement is due to the $36.1 million reduction in our net loss from 2004
      to
      2005, and reductions in accounts receivable, partially offset by decreases
      in
      accrued liabilities as we completed our restructuring activities.





We
      used
      $33.0 million in cash for operations for the year ended December 31, 2004,
      a
      decrease of $5.4 million from the amount used in 2003. The net loss in the
      year
      ended December 31, 2004 included significant non-cash charges, such as a $2.7
      million inventory write-down, a $1.4 million property and equipment net
      impairment charge, and $2.1 million of other non-cash restructuring charges.
      Working capital changes also contributed to the reduced cash usage,
      specifically, reductions in accounts receivable, partially offset by reductions
      in accounts payable and accrued liabilities.





**Investing
      Activities**





For
      the
      year ended December 31, 2005, investing activities provided $5.0 million in
      cash, a decrease of $17.3 million from the prior year. The decrease in cash
      provided was due to reduced investment activity during the year and the
      significant improvement in our cash usage from operations as compared to the
      prior year.





For
      the
      year ended December 31, 2004, investing activities provided $22.4 million in
      cash, a decrease of $28.9 million from the prior year. The decrease in cash
      provided was due to reduced balances in our short-term investment portfolio
      in
      2004 as compared to 2003, combined with a $1.9 million reduction in capital
      expenditures from 2003 to 2004, partially offset by proceeds from sales of
      fixed
      assets.





**Financing
      Activities**





We
      had no
      financing activities during the year ended December 31, 2005.





For
      the
      year ended December 31, 2004, we generated $97,000 from financing activities
      as
      compared to a usage of $2.4 million in 2003. The improvement is due to the
      $3.6
      million reduction in equipment and working capital loan and lease payments
      in
      2004 as compared to 2003, partially offset by a $1.2 million reduction in
      proceeds from sales of common stock.





**Off-Balance
      Sheet Arrangements**





We
      have
      no off-balance sheet arrangements that have or are reasonable likely to have
      a
      current or future material affect.




22





**Contractual
      Obligations**





Our
      contractual obligations as of December 31, 2005 are as follows (in
      thousands):





**Total**
            
            **Due
                in**
              **2006**
            
            **Due
                in 2007**
              **and
                2008**
            
            **Due
                in 2009**
              **and
                2010**
            
            **Due**
              **Thereafter**Operating
                lease obligations
            
            $
            6
            
            $
            6
            
            $
            —
            
            $
            ---
            
            $
            ---Accrued
                severance-related restructuring charges
            
            
            3
            
            
            3
            
            
            —
            
            
            —
            
            
            —Software
                license obligations
            
            
            450
            
            
            450
            
            
            —
            
            
            —
            
            
            —Total
            
            $
            459
            
            $
            459
            
            $
            —
            
            
            
            
            $$





**OUTLOOK**





Our
      board
      of directors, on completion of a comprehensive review of strategic alternatives,
      approved a plan to redeploy our existing resources to identify and acquire
      one
      or more new business operations, while continuing to support our existing
      customers and continuing to offer our intellectual property for license or
      sale.
      Our redeployment strategy will involve the acquisition of one or more operating
      businesses with existing or prospective taxable earnings that can be offset
      by
      use of our net operating loss carry-forwards (“NOLs”). As of this date, no
      candidate has been identified, and no assurance can be given that we will find
      suitable candidates, and if we do, that we will be able to utilize our existing
      NOLs. We will continue to support our existing customers through our transition
      support programs as we execute our new strategy.





At
      December 31, 2005, we had $23.2 million in cash and short-term investments.
      Cash
      consumption by operations during the year ended December 31, 2005 was $1.8
      million. We believe we possess sufficient liquidity and capital resources to
      fund our operations and working capital requirements for at least the next
      12
      months.





**Recent
      Accounting Pronouncements**





In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 153, “Exchanges of Non-monetary
      Assets - An Amendment of APB Opinion No. 29” (“SFAS 153”). SFAS 153 eliminates
      the exception from fair value measurement for non-monetary exchanges of similar
      productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for
      Non-monetary Transactions,” and replaces it with the exception for exchanges
      that do not have commercial substance. SFAS 153 specifies that a non-monetary
      exchange has commercial substance if the future cash flows of the entity are
      expected to change significantly as a result of the exchange. SFAS 153 is
      effective for fiscal periods beginning after June 15, 2005 and is required
      to be
      adopted by the Company in the first quarter of fiscal 2006, beginning on January
      1, 2006. The Company does not expect it to have a material financial statement
      impact.





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which
      requires the measurement of all share-based payments to employees, including
      grants of stock options, using a fair-value-based method and the recording
      of
      such expense in the consolidated statements of operations. The accounting
      provisions of SFAS 123(R) were originally effective for all reporting
      periods beginning after June 15, 2005. The pro forma disclosures previously
      permitted under SFAS 123 no longer will be an alternative to financial
      statement recognition. See “Stock-Based Compensation” in Note 1 to the financial
      statements for the pro forma net income (loss) and net income (loss) per share
      amounts, as if the Company had used a fair-value-based method similar to the
      methods required under SFAS 123(R) to measure compensation expense for
      employee stock incentive awards.





In
      March
      2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting
      Bulletin (“SAB”) No. 107, providing supplemental implementation guidance
      for SFAS 123R. In April 2005, the SEC approved a rule that delayed the effective
      date of SFAS 123(R) to the first annual reporting period beginning after June
      15, 2005. Although the Company has not yet determined whether the adoption
      of
      SFAS 123(R) will result in amounts that are similar to the current pro
      forma disclosures under SFAS 123, it is evaluating the requirements under
      SFAS  123(R) and SAB No. 107 and expects the adoption to have a
      significant adverse impact on the Company’s consolidated statements of
      operations and net loss per share. SFAS123(R) will be effective for the Company
      beginning with the first quarter of 2006.




23




In
      May
      2005, the FASB issued Statement of Financial Accounting Standards 154,
“Accounting Changes and Error Corrections—a replacement of APB Opinion
      No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 changes the
      requirements for the accounting for and reporting of a change in accounting
      principle, and applies to all voluntary changes in accounting principle. It
      also
      applies to changes required by an accounting pronouncement in the unusual
      instance that the pronouncement does not include specific transition provisions.
      This statement requires retrospective application to prior periods’ financial
      statements of changes in accounting principle, unless it is impracticable to
      determine either the period-specific effects or the cumulative effect of the
      change. SFAS 154 is effective for accounting changes made in fiscal years
      beginning after December 15, 2005. The Company does not expect the adoption
      of this statement will have a material impact on our results of operations
      or
      financial condition.





In
      November 2005, the FASB issued FASB Staff Position FAS 115-1 and
      FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its
      Application to Certain Investments” (“FSP FAS 115-1”), which provides
      guidance on determining when investments in certain debt and equity securities
      are considered impaired, whether that impairment is other-than-temporary, and
      on
      measuring such impairment loss. FSP FAS 115-1 also includes accounting
      considerations subsequent to the recognition of an other-than temporary
      impairment and requires certain disclosures about unrealized losses that have
      not been recognized as other-than-temporary impairments. FSP FAS 115-1 is
      required to be applied to reporting periods beginning after December 15,
      2005. The Company is required to adopt FSP FAS 115-1 in the first quarter of
      fiscal 2006. The Company does not expect the adoption of this statement will
      have a material impact on our results of operations or financial
      condition.





**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, 2005 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 $30,000 decrease in the fair value of our
      investments in debt securities as of December 31, 2005.





**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.




24





**Item
      8.** ***Financial
      Statements and Supplementary Data***





**REPORT
      OF BURR, PILGER & MAYER LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING
      FIRM**







To
      the
      Board of Directors and Stockholders of


CoSine
      Communications, Inc.




We
      have
      audited the accompanying consolidated balance sheets of CoSine Communications,
      Inc. and Subsidiaries (the “Company”) as of December 31, 2005 and 2004 and the
      related consolidated statements of operations, stockholders’ equity, and cash
      flows for each of the two years in the period ended December 31, 2005. Our
      audits also included the financial statement schedule listed in Item
      15(a)(2) as of and for the years ended December 31, 2005 and 2004. The
      consolidated financial statements and financial statement schedule are the
      responsibility of the Company’s management. Our responsibility is to express an
      opinion on these consolidated financial statements and financial statement
      schedule based on our audits.




We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (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 financial position of CoSine Communications,
      Inc.
      and Subsidiaries as of December 31, 2005 and 2004 and the results of their
      operations and their cash flows for each of the two years in the period ended
      December 31, 2005, in conformity with accounting principles generally accepted
      in the United States of America. Also, in our opinion, the related financial
      statement schedule as of and for the years ended December 31, 2005 and 2004,
      when considered in relation to the consolidated financial statements taken
      as a
      whole, presents fairly, in all material respects, the information set forth
      therein.





As
      discussed in Note 1 to the consolidated financial statements, the Company’s
      actions in September 2004 in connection with its ongoing evaluation of strategic
      alternatives, to terminate most of its employees and discontinue production
      activities in an effort to conserve cash raise substantial doubt about its
      ability to continue as a going concern. Management’s plans as to these matters
      are also described in Note 1. The consolidated financial statements do not
      include any adjustments to reflect the possible future effects on the
      recoverability and classification of assets or the amount and classification
      of
      liabilities that may result from the outcome of this uncertainty.








/s/
      Burr,
      Pilger & Mayer LLP








Palo
      Alto, California


March
      14,
      2006




25





**REPORT
      OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




The
      Board
      of Directors and Stockholders


CoSine
      Communications, Inc.




We
      have
      audited the accompanying consolidated statements of operations, stockholders’
equity, and cash flows of CoSine Communications, Inc. for the year ended
      December 31, 2003. Our audit also included the financial statement schedule
      for
      the year ended December 31, 2003 listed in the Index at Item 15(a) (2). These
      financial statements and schedule are the responsibility of the Company’s
      management. Our responsibility is to express an opinion on these financial
      statements and schedule based on our audit.




We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (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 audit provides a
      reasonable basis for our opinion.




In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the consolidated results of operations and cash flows of
      CoSine Communications, Inc. for the year ended December 31, 2003, in conformity
      with U.S. generally accepted accounting principles. 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. The financial statement schedule does not
      include any adjustments to reflect the possible future effects on the
      recoverability and classification of assets that may result from the outcome
      of
      the uncertainty regarding the Company’s ability to continue as a going concern.





As
      discussed in Note 1 to the consolidated financial statements, the Company’s
      actions in September 2004, in connection with its ongoing evaluation of
      strategic alternatives, to terminate most of its employees and discontinue
      production activities in an effort to conserve cash raise substantial doubt
      about its ability to continue as a going concern. Management’s plans as to these
      matters are also described in Note 1. The consolidated financial statements
      do not include any adjustments to reflect the possible future effects on the
      recoverability and classification of assets or the amounts and classification
      of
      liabilities that may result from the outcome of this uncertainty.










/s/  ERNST
      & YOUNG LLP




San
      Jose,
      California


February
      6, 2004, except for the second sentence of the first paragraph of Note 1 and
      the
      penultimate sentence of the second paragraph of Note 1, as to which the date
      is
      February 14, 2005




26




**COSINE
      COMMUNICATIONS, INC.**





**CONSOLIDATED
      BALANCE SHEETS**


**(In
      thousands, except for share and per share data)**





**December
                31,**
              **2005**
            
            **December
                31,**
              **2004****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            12,417
            
            $
            9,203Short-term
                investments
            
            
            10,749
            
            
            15,710Accounts
                receivable:Trade (net of allowance for doubtful accounts of  nil and $90 at
                December 31, 2005 and  2004, respectively)
            
            
            96
            
            
            1,328Other
            
            
            209
            
            
            483Prepaid
                expenses and other current assets
            
            
            119
            
            
            949Total
                current assets
            
            
            23,590
            
            
            27,673Long
                term deposit and other
            
            
            250
            
            
            150$
            23,840
            
            $
            27,823**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            237
            
            $
            252Accrued
                warranty liability
            
            
            —
            
            
            157Other
                accrued liabilities
            
            
            874
            
            
            3,129Accrued
                compensation
            
            
            —
            
            
            412Deferred
                revenue
            
            
            126
            
            
            509Total
                current liabilities
            
            
            1,237
            
            
            4,459Commitments
                and contingencies (Notes 1, 2 and 3)Stockholders'
                equity:Preferred stock, no par value, 3,000,000 shares authorized, no
                shares  issued and outstanding
            
            
            —
            
            
            —Common stock, $0.0001 par value, 300,000,000 shares authorized; 10,090,365
                and 10,159,790 shares issued and outstanding at December 31, 2005
                and
                2004, respectively
            
            
            1
            
            
            1Additional
                paid-in capital
            
            
            538,947
            
            
            540,028Notes
                receivable from stockholders
            
            
            —
            
            
            (1,520
            )Accumulated
                other comprehensive income
            
            
            632
            
            
            614Accumulated
                deficit
            
            
            (516,977
            )
            
            (515,759
            )Total
                stockholders' equity
            
            
            22,603
            
            
            23,364$
            23,840
            
            $
            27,823







See
      accompanying notes to consolidated financial statements.






27




**COSINE
      COMMUNICATIONS, INC.**





**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**(In
      thousands, except for per share data)**





**Year
                Ended December 31,****2005**
            
            **2004**
            
            **2003**Revenue:Product
            
            $
            216
            
            $
            6,924
            
            $
            11,803Service
            
            
            3,099
            
            
            2,751
            
            
            2,818Total
                revenue
            
            
            3,315
            
            
            9,675
            
            
            14,621Cost
                of revenue (1)
            
            
            2,049
            
            
            7,086
            
            
            6,765Gross
                profit
            
            
            1,266
            
            
            2,589
            
            
            7,856Operating
                expenses:Research
                and development (2)
            
            
            103
            
            
            15,078
            
            
            21,756Sales
                and marketing (3)
            
            
            105
            
            
            10,052
            
            
            13,808General
                and administrative (4)
            
            
            3,227
            
            
            6,064
            
            
            7,226Restructuring
                and impairment charges
            
            
            (91
            )
            
            8,909
            
            
            336Total
                operating expenses
            
            
            3,344
            
            
            40,103
            
            
            43,126Loss
                from operations
            
            
            (2,078
            )
            
            (37,514
            )
            
            (35,270
            )Other
                income (expense):Interest
                income
            
            
            678
            
            
            489
            
            
            1,296Interest
                expense (5)
            
            
            ---
            
            
            (3
            )
            
            (224
            )Other
                (6)
            
            
            (46
            )
            
            (276
            )
            
            (447
            )Total
                other income (expense)
            
            
            632
            
            
            210
            
            
            625Loss
                before income tax provision (benefit)
            
            
            (1,446
            )
            
            (37,304
            )
            
            (34,645
            )Income
                tax provision (benefit)
            
            
            (228
            )
            
            33
            
            
            287Net
                loss
            
            $
            (1,218
            )
            $
            (37,337
            )
            $
            (34,932
            )Basic
                and diluted net loss per share
            
            $
            (
                0.12
            )
            $
            (3.70
            )
            $
            (3.57
            )Shares
                used in computing basic and diluted net loss per share
            
            
            10,094
            
            
            10,082
            
            
            9,791


__________





(1)
            Cost
                of revenue includes $339 and $65 of non-cash charges and credits
                related
                to equity issuances in 2005 and 2004, respectively, and $130 of non-cash
                charges related to equity issuances in
                2003.


(2)
            Research
                and development expenses include no non-cash credits or charges related
                to
                equity issuances in 2005, $213 of non-cash credits related to equity
                issuances in 2004, and $568 of non-cash charges related to equity
                issuances in 2003.


(3)
            Sales
                and marketing expenses include no non-cash credits or charges related
                to
                equity issuances in 2005, $195 of non-cash credits related to equity
                issuances in 2004, and $124 of non-cash charges related to equity
                issuances in 2003.


(4)
            General
                and administrative expenses include no non-cash credits or charges
                related
                to equity issuances in 2005, $305 of non-cash credits related to
                equity
                issuances in 2004 and $459 of non-cash charges related to equity
                issuances
                in 2003.


(5)
            Interest
                expense includes nil, nil and $30 of non-cash credits related to
                equity
                issuances in 2005, 2004 and 2003, respectively.


(6)
            Other
                includes foreign exchange losses of nil, $236, and $432 in 2005,
                2004 and
                2003, respectively.




See
      accompanying notes to consolidated financial statements.




28




**COSINE
      COMMUNICATIONS, INC.**





**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY**


**(In
      thousands, except share data)**




**Common
                  Stock****Shares**
              
              **Amount**
              
              **Additional**
                **Paid-in
                  Capital**
              
              **Notes**
                **Receivable**
                **From
                  Stockholders**
              
              **Accumulated**
                **Other**
                **Comprehensive
                  Income**
              
              **Deferred
                  Compensation**
              
              **Accumulated
                  Deficit**
              
              **Total**
                **Stockholders’**
                **Equity****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 connectionWith
                  stock options
              
              
              245,629
              
              
              —
              
              
              1,207
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,207Issuance
                  of common stock in connectionWith
                  the Employee Stock Purchase Plan
              
              
              57,480
              
              
              —
              
              
              231
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              231Repayment
                  of notes receivable from stockholders
              
              
              —
              
              
              —
              
              
              —
              
              
              32
              
              
              —
              
              
              —
              
              
              —
              
              
              32Repurchase
                  of unvested shares
              
              
              (85,356
              )
              
              —
              
              
              (3,905
              )
              
              3,840
              
              
              —
              
              
              —
              
              
              —
              
              
              (65
              )Remeasurement
                  of deferred stock-based compensation
              
              
              —
              
              
              —
              
              
              619
              
              
              —
              
              
              —
              
              
              (619
              )
              
              —
              
              
              —Cancellation
                  of options with deferredStock
                  compensation charges
              
              
              —
              
              
              —
              
              
              (264
              )
              
              —
              
              
              —
              
              
              264
              
              
              —
              
              
              —Amortization
                  of deferred stock-based compensation
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              2,174
              
              
              —
              
              
              2,174Reversal
                  of amortization in excess of vesting
              
              
              —
              
              
              —
              
              
              (956
              )
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (956
              )Options
                  with vesting accelerated or exercise deadline extended
              
              
              —
              
              
              —
              
              
              1
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1Components
                  of comprehensive loss:Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (34,932
              )
              
              (34,932
              )Unrealized
                  loss on investments, net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (315
              )
              
              —
              
              
              —
              
              
              (315
              )Translation
                  adjustment, net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              316
              
              
              —
              
              
              —
              
              
              316Total
                  comprehensive income (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**Issuance
                  of common stock in connectionWith
                  stock options
              
              
              28,804
              
              
              —
              
              
              144
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              144Issuance
                  of common stock in connection with Employee Stock Purchase
                  Plan
              
              
              23,491
              
              
              —
              
              
              82
              
              
              
              
              
              —
              
              
              —
              
              
              —
              
              
              82Issuance
                  of common stock for employee stock bonus
              
              
              43,300
              
              
              —
              
              
              228
              
              
              ---
              
              
              —
              
              
              —
              
              
              —
              
              
              228Issuance
                  of warrant
              
              
              —
              
              
              —
              
              
              48
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              48Repurchase
                  of unvested shares
              
              
              (112,650
              )
              
              —
              
              
              (5,139
              )
              
              5,139
              
              
              —
              
              
              —
              
              
              —
              
              
              ---Remeasurement
                  of deferred stock-based compensation
              
              
              —
              
              
              —
              
              
              (250
              )
              
              —
              
              
              —
              
              
              250
              
              
              —
              
              
              —Cancellation
                  of options with deferredStock
                  compensation charges
              
              
              —
              
              
              —
              
              
              (58
              )
              
              —
              
              
              —
              
              
              58
              
              
              —
              
              
              —Amortization
                  of deferred stock-based compensation
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              147
              
              
              —
              
              
              147Reversal
                  of amortization in excess of vesting
              
              
              —
              
              
              —
              
              
              (1,203
              )
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (1,203
              )Components
                  of comprehensive loss:Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (37,337
              )
              
              (37,337
              )Unrealized
                  loss on investments, net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (42
              )
              
              —
              
              
              —
              
              
              (42
              )Translation
                  adjustment, net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              123
              
              
              —
              
              
              —
              
              
              123Total
                  comprehensive income (loss)
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              81
              
              
              —
              
              
              (37,337
              )
              
              (37,256
              )**Balance
                  at December 31, 2004**
              
              
              **10,159,790**
              
              
              **1**
              
              
              **540,028**
              
              
              (1,520
              )
              
              **614**
              
              
              **---**
              
              
              (515,759
              )
              
              **23,364**Repurchase
                  of unvested shares
              
              
              (69,155
              )
              
              —
              
              
              (1,520
              )
              
              1,520
              
              
              —
              
              
              —
              
              
              —
              
              
              —Valuation
                  of warrant
              
              
              —
              
              
              —
              
              
              439
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              439Components
                  of comprehensive loss:Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (1,218
              )
              
              (1,218
              )Unrealized
                  gain on investments, net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              20
              
              
              —
              
              
              —
              
              
              20Translation
                  adjustment, net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (2
              )
              
              —
              
              
              —
              
              
              (
                  2
              )Total
                  comprehensive income ( loss)
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              18
              
              
              —
              
              
              (1,218
              )
              
              (1,200
              )**Balance
                  at December 31, 2005**
              
              
              **10,090,635**
              
              **$**
              **1**
              
              **$**
              **538,947**
              
              **$**
              **—**
              
              **$**
              **632**
              
              **$**
              **—**
              
              **$**
              (516,977
              )
              **$**
              **22,603**
  See
      accompanying notes to consolidated financial statements.




29




**COSINE
      COMMUNICATIONS, INC.**





**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(In
      thousands)**





**Year
                  Ended December 31,****2005**
              
              **2004**
              
              **2003****Operating
                  activities:**Net
                  loss
              
              $
              (1,218
              )
              $
              (37,337
              )
              $
              (34,932
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Depreciation
              
              
              —
              
              
              1,398
              
              
              2,715Allowance
                  for doubtful accounts
              
              
              (90
              )
              
              (60
              )
              
              (113
              )Non-cash
                  charges related to inventory write-down
              
              
              —
              
              
              2,684
              
              
              193Write-down
                  of property and equipment
              
              
              —
              
              
              1,427
              
              
              —Non-cash
                  restructuring charges
              
              
              —
              
              
              2,089
              
              
              66Gain
                  on sale of fixed assets
              
              
              (67
              )
              
              —
              
              
              —Amortization
                  of deferred stock compensation and charges related to vesting
                  acceleration
              
              
              —
              
              
              147
              
              
              2,175Reversal
                  of amortization in excess of vesting
              
              
              —
              
              
              (1,203
              )
              
              (956
              )Amortization
                  of warrants issued for services
              
              
              339
              
              
              48
              
              
              92Issuance
                  of common stock for employee stock bonus
              
              
              —
              
              
              228
              
              
              —Other
              
              
              18
              
              
              124
              
              
              (11
              )Change
                  in operating assets and liabilities:Accounts
                  receivable (trade)
              
              
              1,322
              
              
              3,694
              
              
              1,524Other
                  receivables
              
              
              274
              
              
              11
              
              
              185Inventory
              
              
              —
              
              
              1,319
              
              
              (841
              )Prepaid
                  expenses and other current assets
              
              
              830
              
              
              1,644
              
              
              1,294Long-term
                  deposits and other assets
              
              
              —
              
              
              497
              
              
              333Accounts
                  payable
              
              
              (15
              )
              
              (1,405
              )
              
              (836
              )Provision
                  for warranty liability
              
              
              (157
              )
              
              (307
              )
              
              (639
              )Accrued
                  compensation
              
              
              (412
              )
              
              (1,409
              )
              
              113Accrued
                  other liabilities
              
              
              (2,255
              )
              
              (1,445
              )
              
              (10,847
              )Deferred
                  revenue
              
              
              (383
              )
              
              (3,034
              )
              
              2,099Accrued
                  rent
              
              
              —
              
              
              (2,078
              )
              
              9Net
                  cash used in operating activities
              
              
              (1,814
              )
              
              (32,968
              )
              
              (38,377
              )**Investing
                  activities:**Capital
                  expenditures
              
              
              —
              
              
              (1,096
              )
              
              (2,983
              )Proceeds
                  from sale of property and equipment
              
              
              67
              
              
              1,171
              
              
              —Purchase
                  of short-term investments
              
              
              (14,089
              )
              
              (34,466
              )
              
              (76,849
              )Proceeds
                  from sales and maturities of short-term investments
              
              
              19,050
              
              
              56,746
              
              
              131,065Net
                  cash provided by investing activities
              
              
              5,028
              
              
              22,355
              
              
              51,233**Financing
                  activities:**Principal
                  payments of equipment and working capital loans and capital
                  leases
              
              
              —
              
              
              (129
              )
              
              (3,772
              )Proceeds
                  from issuance of common stock, net
              
              
              —
              
              
              226
              
              
              1,438Proceeds
                  from notes receivable from stockholders
              
              
              —
              
              
              —
              
              
              32Repurchase
                  of common stock
              
              
              —
              
              
              —
              
              
              (65
              )Net
                  cash provided by (used in) financing activities
              
              
              —
              
              
              97
              
              
              (2,367
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              3,214
              
              
              (10,516
              )
              
              10,489Cash
                  and cash equivalents at the beginning of the period
              
              
              9,203
              
              
              19,719
              
              
              9,230Cash
                  and cash equivalents at the end of the period
              
              $
              12,417
              
              $
              9,203
              
              $
              19,719**Supplemental
                  information:**Cash
                  paid for interest
              
              $
              —
              
              $
              3
              
              $
              195Income
                  taxes paid
              
              $
              7
              
              $
              41
              
              $
              110Cancellation
                  of notes receivable due to repurchase of unvested stock
              
              $
              1,520
              
              $
              5,139
              
              $
              3,840Net
                  transfer from inventory to property and equipment
              
              $
              —
              
              $
              —
              
              $
              180Net
                  transfer to property and equipment from inventory
              
              $
              —
              
              $
              31
              
              $
              —


See
      accompanying notes to consolidated financial statements.




30




**COSINE
      COMMUNICATIONS, INC.**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**1.
      Summary of Significant Accounting Policies**





***Description
      of Business***





CoSine
      Communications, Inc. ("CoSine" or the "Company," which may be referred to as
      "we," "us" or "our") was incorporated in California on April 14, 1997 and in
      August 2000 was reincorporated in the State of Delaware. We were a provider
      of
      carrier network equipment products and services until the fourth quarter of
      fiscal year 2004 during which time we discontinued our product lines, took
      actions to lay-off most of our employees, terminated contract manufacturing
      arrangements, contractor and consulting arrangements and various facility
      leases, and sold, scraped or wrote-off our inventory, property and equipment.
      As
      a result of these activities, as of December 31, 2005, our business consisted
      primarily of a customer support capability for our discontinued products
      provided by a third party. We intend to continue such support activities through
      December 31, 2006, depending on customer demand, and to offer our intellectual
      property for license or sale. We are also continuing to seek to redeploy our
      existing resources to identify and acquire one or more new business operations
      with existing or prospective taxable earnings that can be offset by use of
      our
      net operating loss carry-forwards ("NOLs").





***Liquidity
      and Redeployment Strategy***





The
      accompanying financial statements have been prepared in conformity with U.S.
      generally accepted accounting principles, which contemplate continuation of
      the
      Company as a going concern. However, at December 31, 2005, we have an
      accumulated deficit of $517 million and we sustained a net loss during the
      year
      ended December 31, 2005 of $1.2 million. As of December 31, 2005, our business
      consisted primarily of a customer service capability operated under contract
      by
      a third party. In July 2004, we announced that we were exploring various
      strategic alternatives and as a result, we initiated, in September 2004, actions
      to terminate most of our employees and discontinue production activities in
      an
      effort to conserve cash. These actions raised substantial doubt about our
      ability to continue as a going concern. The financial statements do not include
      any adjustments to reflect the possible future effects relating to the
      recoverability and classification of the recorded asset amounts or amounts
      and
      classification of liabilities that might result from the outcome of this
      uncertainty.





In
      July
      2005, we completed a comprehensive review of strategic alternatives, including
      a
      sale of CoSine, a sale or licensing of intellectual property, a redeployment
      of
      our assets into new business ventures, or a winding-up and liquidation of the
      business and a return of capital. The board of directors approved a plan to
      redeploy our existing resources to identify and acquire one or more new business
      operations, while continuing to support our existing customers and continuing
      to
      offer our intellectual property for license or sale. Our redeployment strategy
      involves the acquisition of one or more operating businesses with existing
      or
      prospective taxable earnings that can be offset by use of our NOLs.





***Basis
      of Consolidation***





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





***Use
      of Estimates***





The
      preparation of consolidated financial statements in conformity with U.S.
      generally accepted accounting principles 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***





We
      evaluate the carrying value of long-lived assets, consisting primarily of
      property 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
      of the assets to the undiscounted future cash flows the assets are expected
      to
      generate. If the total of the undiscounted future cash flows is less than the
      carrying amount of the assets, the assets will be written down to their
      estimated fair value. Fair value is generally determined by calculating the
      discounted future cash flows using a discount rate based upon our weighted
      average cost of capital or specific appraisal, as appropriate. Significant
      judgments and assumptions are required in the forecast of future operating
      results used in the preparation of the estimated future **** cash
      flows, including long-term forecasts of overall market conditions and our
      participation in the market.




31




As
      a
      result of our assessment of our business, we concluded that indicators of
      impairment of our long-lived assets were present at September 30, 2004 and
      at
      June 30, 2004. Such indicators included ongoing operating losses, inability
      to
      achieve sustainable revenue growth, including our failure to attract new
      customers, and our decision to evaluate strategic alternatives. Accordingly,
      we
      performed an impairment test of the carrying value of our long-lived assets,
      consisting primarily of property and equipment in accordance with Statement
      of
      Financial Accounting Standard (“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 $2.3 million
      to write down the carrying value of our long-lived assets held for use to their
      fair values in the second quarter of 2004. At September 30, 2004, we obtained
      competitive bids from qualified prospective purchasers to determine the fair
      values of long-lived assets. The fair values, as indicated by competitive bids,
      exceeded the net book value of the long-lived assets at September 30, 2004,
      accordingly no adjustment was made in the third quarter of 2004. During 2005
      and
      2004, we had gains of $0.1 million and $ 0.9 million, respectively, with the
      sale of previously written-down long-lived assets.





At
      December 31, 2005 and 2004, respectively, all of our long-lived assets had
      been
      either sold, scrapped or fully written-off.





***Significant
      Concentrations***





Financial
      instruments that potentially subject us to concentrations of credit risk
      primarily consist of cash, cash equivalents and short-term investments. We
      mitigate investment risk by investing only in government and high quality
      corporate securities and by limiting the amount of exposure to any one
      issuer. **** Deposits
      held with financial institutions may exceed the amount of insurance provided
      on
      such deposits **.** We
      are
      exposed to credit risks in the event of default by these institutions to the
      extent of the amount recorded on the balance sheet. We have not experienced
      any
      material losses on its deposits of cash and cash equivalents.





We
      rely
      on one company to provide all our customer support services. If this supplier
      were unable to satisfy the customer support requirements, we may be unable
      to
      meet customer demand.





For
      the year ended December 31, 2005, we recognized revenue from two customers
      who
      accounted for 43% and 15% of total revenue, respectively. At December 31, 2005,
      we had three customers who accounted for 52%, 28% and 14% of total accounts
      receivable, respectively. For the year ended December 31, 2004, we had three
      customers who accounted for 24%, 15% and 14% of revenues, respectively. At
      December 31, 2004, we had two customers who accounted for 58% and 15%,
      respectively, of total accounts receivable. We do not
      require collateral and maintain adequate reserves for potential credit
      losses.





***Guarantees***





We may
      enter into certain types of contracts that require that we indemnify parties
      against certain third party claims that may arise. These contracts primarily
      relate to: (i) certain agreements with our officers, directors and
      employees, under which we may be required to indemnify such persons for
      liabilities arising out of their employment relationship, (ii) contracts under which we may be required to indemnify customers against loss
      or
      damage to property or persons as a result of willful or negligent conduct by
      our
      employees or sub-contractors, (iii) contracts under which we may be required
      to
      indemnify customers against third party claims that our product infringes a
      patent, copyright or other intellectual property right and (iv) procurement
      or
      license agreements under which we may be required to indemnify licensors or
      vendors for certain claims that may be brought against them arising from our
      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,
      we have not been obligated to make payments for these obligations, and no
      liabilities have therefore been recorded for these obligations on our
      consolidated balance sheets as of December 31, 2005 and 2004.




32




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





We
      consider 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. We determine the appropriate
      classification of cash equivalents and investment securities at the time of
      purchase. We have classified our 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.





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





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





**December
                31,****2005**
            
            **2004**Money
                market funds
            
            $
            16,660
            
            $
            13,593Corporate
                obligations
            
            
            1,575
            
            
            5,127Government
                securities
            
            
            4,248
            
            
            4,51422,483
            
            
            23,234Amounts
                classified as cash equivalents
            
            
            (11,734
            )
            
            (7,524
            )$
            10,749
            
            $
            15,710




As
      of
      December 31, 2005 and 2004, there were net unrealized losses of $13,000 and
      $33,000, respectively. All available-for-sale securities have contractual
      maturities of one year or less.





As
      of
      December 31, 2005 and 2004, $150,000 of restricted cash was included in
      long-term deposits. The amount represents a security deposit for corporate
      bank
      credit cards.





***Allowance
      for Doubtful Accounts***





We
      maintain allowances for doubtful accounts for estimated losses resulting from
      the inability of our customers to pay their 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 customer payment patterns.





***Inventories***





In
      the
      quarter ended September 30, 2004, we announced that we had discontinued our
      products and accordingly wrote our inventory down to net realizable value.
      At
      December 31, 2005 and 2004, respectively, all inventory had been sold, scrapped
      or written-off and there was no inventory awaiting customer acceptance.





In
      assessing the value of inventory prior to the September 2004 decision to
      discontinue its products, we were 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. We generally used a 12-month forecast to assess future demand. Inventory
      write-downs were charged to cost of revenue. During 2005, we sold $26,000 of
      previously written-down inventory and no inventory was written-down. During
      2004, we sold $700,000 of previously written-down inventory and $4.1 million
      of
      inventory was written down. During 2003, we sold $891,000 of previously
      written-down inventory and $193,000 of inventory was written down.




33




We
      periodically reviewed the rates used to determine overhead capitalization
      applied to inventory.  As a result of restructuring activity and
      refinements in its business model, we 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 revenue by $527,000
      for the year ended December 31, 2003.





***Property
      and Equipment***





At
      December 31, 2005 and 2004, respectively, we had sold, scrapped or written-off
      all of our property and equipment .
      Property and equipment were depreciated using the straight-line method over
      the
      estimated useful lives of the assets (ranging from one to five
      years).





***Warranties***





Prior
      to
      discontinuing our products in September 2004, we provided
      a basic limited warranty, including repair or replacement of parts, and
      technical support. The specific terms and conditions of those warranties varied
      depending on the customer or region in which we do business. We estimated the
      costs that could be incurred under its basic limited warranty and recorded
      a
      liability in the amount of such costs at the time product revenue is recognized.
      Our warranty obligation is affected by the number of installed units, product
      failure rates, materials usage and service delivery costs incurred in correcting
      product failures. We periodically assess the adequacy of our recorded warranty
      liabilities and adjust the amounts as necessary.





Changes
      in our warranty liability were as follows (in thousands):





******2005**
            
            ******2004**
            
            ******2003**Beginning
                balance
            
            $
            157
            
            $
            464
            
            $
            1,103Warranty
                charged to cost of revenue
            
            
            —
            
            
            6
            
            
            352Utilization
                of warranties
            
            
            —
            
            
            (313
            )
            
            (894
            )Changes
                in estimated liability based on experience
            
            
            (157
            )
            
            —
            
            
            (97
            )Ending
                balance
            
            $
            —
            
            $
            157
            
            $
            464





***Stock-Based
      Compensation***





We
      account 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 Financial Accounting Standards Board (“FASB”)
      Interpretation No. 44, “Accounting for Certain Transactions involving Stock
      Compensation,” (“FIN 44”). The fair value disclosures required by Statement of
      Financial Accounting Standards No. 123, “Accounting for Stock-Based
      Compensation,” (“SFAS 123”) are included below and in Note 5. SFAS 123 requires
      the disclosure of pro forma information regarding net loss and net loss per
      share as if we had accounted for its stock options under the fair value
      method.





In
      connection with our initial public offering, the fair value of our 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. We are 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, we repriced 1,091,453 outstanding employee stock options to
      purchase shares of our common stock with original exercise prices ranging from
      $5.45 per share to $159.38 per share. These options were repriced to $5.00
      per
      share, which was above the fair market value of the underlying shares on the
      repricing date. We recorded deferred stock compensation and compensation charges
      in connection with these repriced options, as the price of our stock was higher
      than the repriced amount at December 31, 2002 and during certain quarters of
      2003. In July 2001, we repriced 722,071 unexercised employee stock options
      to
      $15.50 per share, the fair market value of the underlying shares on the
      repricing date. These options had previously been granted at prices ranging
      from
      $40.00 to $400.00 per share (See Note 5). Compensation associated with re-priced
      options was remeasured until the options were exercised, canceled or expired.




34




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” (“EITF No. 96-18”), 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 option pricing model.





***Pro
      Forma Information***





We
      have
      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.





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





**2005**
            
            **2004**
            
            **2003**Net
                loss, as reported
            
            $
            (1,218
            )
            $
            (37,337
            )
            $
            (34,932
            )Add:
                Stock-based employee compensation expense included in reported net
                loss
            
            
            ----
            
            
            147
            
            
            2,175Deduct:
                Reversal of amortization in excess of vesting
            
            
            ----
            
            
            (1,203
            )
            
            (956
            )Deduct:
                Stock-based employee compensation expense determined under fair value
                method for all stock option grants (SFAS 123 expense)
            
            
            (43
            )
            
            (173
            )
            
            (2,556
            )Pro
                forma net loss
            
            $
            (1,261
            )
            $
            (38,566
            )
            $
            (36,269
            )Basic
                and diluted net loss per share, as reported
            
            $
            (0.12
            )
            $
            (3.70
            )
            $
            (3.57
            )Pro
                forma basic and diluted net loss per share
            
            $
            (0.12
            )
            $
            (3.83
            )
            $
            (3.70
            )





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





**Fiscal
                Year Ended December 31,**
            
            **Fiscal
                Year Ended December 31,**
            
            **Fiscal
                Year Ended December 31,****2005**
            
            **2004**
            
            **2003**Weighted
                average fair value of shares granted
            
            $
            1.07
            
            $
            4.41
            
            $
            3.23Dividend
                yield
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %Volatility
            
            
            0.47
            
            
            0.95
            
            
            0.82Risk
                free interest rate
            
            
            4.2
            %
            
            2.6
            %
            
            2.2
            %Expected
                life
            
            
            4
                years
            
            
            4
                years
            
            
            4
                years





The
      estimated weighted average fair value of shares granted under the Employee
      Stock
      Purchase Plan in 2004 was $4.09, using a volatility of 0.64, risk-free interest
      rate of 2% and an expected life of one year. The estimated weighted average
      fair
      value of shares granted under the Employee Stock 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 Employee Stock Purchase Plan was inactive in
      2005.





***Revenue
      Recognition***





In
      2003
      and 2004, the majority of our revenue was recognized from the sale of our IP
      Service Delivery Platform and subsequent service support arrangements. In
      2005, our revenues were earned primarily from our customer service contracts. 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
      requires 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 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 (“VSOE”) of fair value. 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.




35




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 us under separate support services agreement.
      In
      cases where the support service is sold as part of an arrangement including
      multiple elements, we allocate revenue to the support service based on the
      VSOE
      of the services 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.





***Cost
      of Revenue***





Cost
      of
      revenue is comprised primarily of material, labor, overhead, shipping costs,
      subcontractor costs, warranty costs and inventory write-downs. In addition,
      cost
      of revenue 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 our product development process,
      technological feasibility is established upon the completion of a working model.
      Through December 31, 2005, capitalizable costs incurred after achieving
      technological feasibility have not been significant for any development project.
      Accordingly, we have charged all such costs to research and development expense
      in the periods they were incurred.





***Advertising
      Expense***





Advertising
      costs are expensed as incurred. For the years ended December 31, 2005, 2004
      and
      2003, we incurred no expense for advertising.





***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 our 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.




36




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





**Year
                ended December 31****2005**
            
            **2004**
            
            **2003**Net
                loss
            
            $
            (1,218
            )
            $
            (37,337
            )
            $
            (34,932
            )Basic
                and diluted:Weighted
                average shares of common stock outstanding
            
            
            10,094
            
            
            10,199
            
            
            9,999Less:
                weighted average shares subject to repurchase
            
            
            ---
            
            
            117
            
            
            208Weighted
                average shares used in basic and diluted netLoss
                per share
            
            
            10,094
            
            
            10,082
            
            
            9,791Basic
                and diluted net loss per share
            
            $
            (0.12
            )
            $
            (3.70
            )
            $
            (3.57
            )





During
      all periods presented, we 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 436,000, 879,000 and 1,280,000 for
      the
      years ended December 31, 2005, 2004 and 2003, respectively.





***Segment
      Reporting***





We
      operate in only one segment: IP Service Delivery Platforms. Substantially all
      of
      our assets are located in the United States.





Revenues
      from customers by geographic region for the years ended December 31, 2005,
      2004
      and 2003 were as follows (in thousands):





******Region**
            
            ******Revenue****2005**
              Europe
            
            $
            797Japan
            
            
            527South
                Korea
            
            
            90United
                States
            
            
            1,901$
            3,315**2004**
              Europe
            
            $
            3,053Japan
            
            
            1,620South
                Korea
            
            
            1,602Rest
                of Asia/Pacific
            
            
            36United
                States
            
            
            3,364$
            9,675**2003**
              Europe
            
            $
            2,676Japan
            
            
            2,957South
                Korea
            
            
            1,717Rest
                of Asia/Pacific
            
            
            463United
                States
            
            
            6,808$
            14,621





***Recent
      Accounting Pronouncements***





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No.
      153, “Exchanges of Non-monetary Assets - An Amendment of APB Opinion No. 29”
(“SFAS 153”). SFAS 153 eliminates the exception from fair value measurement for
      non-monetary exchanges of similar productive assets in paragraph 21(b) of APB
      Opinion No. 29, “Accounting for Non-monetary Transactions,” and replaces it with
      the exception for exchanges that do not have commercial substance. SFAS 153
      specifies that a non-monetary exchange has commercial substance if the future
      cash flows of the entity are expected to change significantly as a result of
      the
      exchange. SFAS 153 is effective for fiscal periods beginning after June 15,
      2005
      and is required to be adopted by the Company in the first quarter of fiscal
      2006, beginning on January 1, 2006. The Company does not expect it to have
      a
      material financial statement impact.




37




In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which
      requires the measurement of all share-based payments to employees, including
      grants of stock options, using a fair-value-based method and the recording
      of
      such expense in the consolidated statements of operations. The accounting
      provisions of SFAS 123(R) were originally effective for all reporting
      periods beginning after June 15, 2005. The pro forma disclosures previously
      permitted under SFAS 123 no longer will be an alternative to financial
      statement recognition. See “Stock-Based Compensation” above for the pro forma
      net income (loss) and net income (loss) per share amounts, as if the Company
      had
      used a fair-value-based method similar to the methods required under
      SFAS 123(R) to measure compensation expense for employee stock incentive
      awards.





In
      March
      2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting
      Bulletin (“SAB”) No. 107, providing supplemental implementation guidance
      for SFAS 123R.  In
      April
      2005, the SEC approved a rule that delayed the effective date of SFAS 123(R)
      to
      the first annual reporting period beginning after June 15, 2005. Although the
      Company has not yet determined whether the adoption of SFAS 123(R) will
      result in amounts that are similar to the current pro forma disclosures under
      SFAS 123, it is evaluating the requirements under SFAS  123(R)
      and SAB No. 107 and expects the adoption to have a significant adverse impact
      on
      the Company’s consolidated statements of operations and net loss per share.
      SFAS123(R) will be effective for the Company beginning with the first quarter
      of
      2006.





In
      May
      2005, the FASB issued Statement
      of Financial Accounting Standards 154,
      “Accounting Changes and Error Corrections—a replacement of APB Opinion
      No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 changes the
      requirements for the accounting for and reporting of a change in accounting
      principle, and applies to all voluntary changes in accounting principle. It
      also
      applies to changes required by an accounting pronouncement in the unusual
      instance that the pronouncement does not include specific transition provisions.
      This statement requires retrospective application to prior periods’ financial
      statements of changes in accounting principle, unless it is impracticable to
      determine either the period-specific effects or the cumulative effect of the
      change. SFAS 154 is effective for accounting changes made in fiscal years
      beginning after December 15, 2005. The Company does not expect that the
      adoption of this statement will have a material impact on our results of
      operations or financial condition.





In
      November 2005, the FASB issued FASB Staff Position FAS 115-1, “The
      Meaning of Other-Than-Temporary Impairment and Its Application to Certain
      Investments” (“FSP FAS 115-1”), which provides guidance on determining when
      investments in certain debt and equity securities are considered impaired,
      whether that impairment is other-than-temporary, and on measuring such
      impairment loss. FSP FAS 115-1 also includes accounting considerations
      subsequent to the recognition of an other-than temporary impairment and requires
      certain disclosures about unrealized losses that have not been recognized as
      other-than-temporary impairments. FSP FAS 115-1 is required to be applied
      to reporting periods beginning after December 15, 2005. The Company is
      required to adopt FSP FAS 115-1 in the first quarter of fiscal 2006. The Company
      does not expect that the adoption of this statement will have a material impact
      on our results of operations or financial condition.





***Reclassifications***




Certain
      prior year amounts have been reclassified to conform to the current year
      presentation. The reclassification had no effect on total assets or net loss.




**2.
      Leases**





We
      lease
      our facilities under operating leases, with terms ranging to May 2006. Future
      minimum payments for all operating leases were $6,000 at December 31, 2005.




Rent
      expense was $83,000, $2,748,000 and $3,126,000 for the years ended December
      31,
      2005, 2004 and 2003, respectively, and is calculated on a straight-line
      basis.





**3.
      Commitments and Contingencies**





On
      November 15, 2001, we along with certain of our officers and
      directors ** were
      named as defendants in a class action shareholder complaint filed in the United
      States District Court for the Southern District of New York, now captioned *In
      re
      CoSine Communications, Inc. Initial Public Offering Securities
      Litigation,* Case No.
      01 CV 10105. The complaint generally alleges that
      various investment bank underwriters engaged in improper and undisclosed
      activities related to the allocation of shares in our initial public offering.
      The complaint brings claims for the violation of several provisions of the
      federal securities laws against those underwriters, and also against us and
      each
      of the directors and officers who signed the registration statement relating
      to
      the initial public offering. The
      plaintiffs seek unspecified monetary damages and other relief. Similar lawsuits
      concerning more than 300 other companies’ initial public offerings were filed
      during 2001, and this lawsuit is being coordinated with those actions in the
      Southern District of New York before Judge
      Shira A. Scheindlin .




38




On
      or
      about July 1, 2002 an omnibus motion to dismiss was filed in the coordinated
      litigation on behalf of the issuer defendants, of which we and our named officer
      and directors are a part, on common pleading issues. In October 2002, pursuant
      to stipulation by the parties, the Court entered an order dismissing our named
      officers and directors from the action without prejudice. On February 19, 2003, the
      Court
      dismissed the Section 10(b) and Rule 10b-5 claims against us but did not dismiss
      the Section 11 claims against us.




In
      June
      2004, a stipulation of settlement and release of claims against the issuer
      defendants, including us, was submitted to the court for approval. The terms
      of
      the settlement, if approved, would dismiss and release all claims against the
      participating defendants (including us). In exchange for this dismissal, D&O
      insurance carriers would agree to guarantee a recovery by the plaintiffs from
      the underwriter defendants of at least $1 billion, and the issuer defendants
      would agree to an assignment or surrender to the plaintiffs of certain claims
      the issuer defendants may have against the underwriters. On August 31, 2005,
      the
      court issued an order granting preliminary approval of the settlement. The
      settlement is subject to a number of conditions, including final court approval,
      which cannot be assured. If the settlement is not consummated, we intend 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.





On
      January 18, 2005, we, along with our officers and directors, were named as
      defendants in a securities class action lawsuit filed in San Mateo County
      Superior Court. The suit requested that the acquisition of us by Tut Systems,
      Inc be enjoined due to alleged self-dealing and breach of fiduciary duties
      by
      our officers and directors. The suit was dismissed in May 2005 at the request
      of
      the plaintiffs.





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





**4.
      401(** k **)
      Plan**





We
      have 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. We may contribute a discretionary matching contribution. Since inception
      we have made no matching contributions to the plan.





**5.
      Stockholders’ Equity**





***Common
      Stock***





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





**2005**
            
            **2004**Stock
                options:Options
                outstanding
            
            
            147
            
            
            590Available
                for future grants
            
            
            2,940
            
            
            2,487Warrants
                outstanding
            
            
            289
            
            
            2893,229
            
            
            3,366




39





***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 were 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 owned stock representing more
      than
      10% of all the voting power of all classes of our stock, in which case the
      purchase price was 110% of the fair market value of the common stock on the
      date
      of grant. Nonstatutory stock options granted under the 1997 Plan were 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 owned stock representing more than 10% of all
      the
      voting power of all classes of stock of CoSine, in which case the purchase
      price
      was be 110% of the fair market value of the common stock on the date of grant.
      Options granted under the 1997 Plan generally vested over four years at a rate
      of 25% one year from the grant date and ratably monthly thereafter and were
      to
      expire 10 years after the grant, or earlier upon termination. Options could
      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 was subject to right of repurchase by
      CoSine. The rights of repurchase generally lapsed at the rate noted above.
      At
      December 31, 2004, all repurchase rights had lapsed. During 2005 and 2004,
      employees defaulted on notes receivable in the amounts of $1,520,000 and
      $5,139,000, respectively, secured by 69,155 shares and 112,650
      shares of common stock, respectively. The shares were returned to
      us.





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 our 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.





We
      have
      authorized 2,215,779 shares of common stock for issuance under the 2000 Plan.
      At
      December 31, 2005 and 2004, a total of
      1,918,455 and 1,588,741 shares
      were available for future options grants under the 2000 Plan,
      respectively.





***2002
      Stock Option Plan***





In
      January 2002, the board of directors adopted the 2002 Stock Plan (“2002 Plan”).
      The purpose of the 2002 Plan is to make available for issuance certain shares
      of
      common stock that have been (i) previously issued pursuant to the exercise
      of
      stock options granted under the 1997 Plan and (ii) subsequently reacquired
      by us
      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 us have been or will be reserved for
      issuance under the 2002 Plan.





We
      have
      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, 2005, there were an
      aggregate of 1,037,107 Reacquired Shares under the 2002 Plan. At December 31,
      2005 and 2004, a total of
      1,000,000 and 873,986 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.




40





***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, 2005, and 2004, a total of 48,000 shares of common stock have
      been
      authorized for issuance under the Director’s Plan. At December 31, 2005 and
      2004, a total of
      22,000 and 24,000 shares,
      respectively, were available for future options grants under the Director’s
      Plan.





The
      Director’s Plan will automatically grant an option to purchase 8,000 shares of
      common stock to each non-employee director when he or she is first elected
      to
      our 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.





***Summary
      Stock Option Plan Activity***





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




**Options
                  Outstanding****Shares
                  Available for Grant**
              
              **Shares**
              
              **Weighted-Average
                  Price Per Share****Balance
                  as of December 31, 2002**
              
              
              1,856
              
              
              1,298
              
              $
              9.18Repurchased
              
              
              85
              
              
              —
              
              
              —Granted
              
              
              (695
              )
              
              695
              
              
              5.42Exercised
              
              
              —
              
              
              (246
              )
              
              4.93Canceled
              
              
              501
              
              
              (501
              )
              
              11.45**Balance
                  as of December 31, 2003**
              
              
              1,747
              
              
              1,246
              
              
              7.01Repurchased
              
              
              113
              
              
              —
              
              
              —Granted
              
              
              (86
              )
              
              86
              
              
              6.67Exercised
              
              
              —
              
              
              (29
              )
              
              5.00Canceled
              
              
              713
              
              
              (713
              )
              
              5.50**Balance
                  as of December 31, 2004**
              
              
              2,487
              
              
              590
              
              
              8.88Repurchased
              
              
              10
              
              
              —Granted
              
              
              (112
              )
              
              112
              
              
              2.56Canceled
              
              
              555
              
              
              (555
              )
              
              7.72**Balance
                  as of December 31, 2005**
              
              
              2,940
              
              
              147
              
              $
              8.37
  The
      following table summarizes information concerning options outstanding and
      exercisable at December 31, 2005 (in thousands, except per share
      data):


**Options
                  Outstanding**
              
              **Options
                  Exercisable****Range
                  of Exercise Prices**
              
              **Number
                  Of Shares**
              
              **Weighted-Average
                  Remaining Contractual Life (Years)**
              
              **Weighted-Average
                  Exercise Price**
              
              **Number
                  Of Shares**
              
              **Weighted-Average
                  Exercise Price**$2.15-2.60
              
              
              112
              
              
              9.8
              
              $
              2.56
              
              
              50
              
              $
              2.605.20
              
              
              4
              
              
              7.4
              
              
              5.20
              
              
              -
              
              
              -6.96
              
              
              15
              
              
              7.8
              
              
              6.96
              
              
              9
              
              
              6.968.80
              
              
              4
              
              
              6.4
              
              
              8.80
              
              
              -
              
              
              -22.30
              
              
              6
              
              
              5.5
              
              
              22.30
              
              
              6
              
              
              22.3040.00-120.00
              
              
              6
              
              
              4.6
              
              
              103.50
              
              
              6
              
              
              103.49$4.00-120.00
              
              
              147
              
              
              9.0
              
              $
              8.37
              
              
              71
              
              $
              13.69


41





Exercisable
      options at December 31, 2004 and 2003 were 590,000 shares and 494,000 shares,
      respectively, at weighted average exercise prices of $9.87 and $9.05,
      respectively.





***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
      were
      authorized for issuance under the Purchase Plan. Under the terms of the Purchase
      Plan, employees could 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. There was no activity in the Purchase Plan
      for
      2005 and the Purchase Plan was cancelled in 2005.





***Stock-Based
      Compensation***





During
      the year ended December 31, 2000, we issued stock options to employees with
      exercise prices that we believed represented the fair value of the stock. In
      March 2000, after we began the initial public offering process, we reevaluated
      the fair value of our common stock. In connection with the reevaluation, we
      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 was recorded as a
      reduction of stockholders’ equity and was being amortized over the vesting
      period of the individual options, generally four years, using the graded vesting
      method. We recorded amortization of deferred stock compensation
      of nil, $92,000, and $1,377,000 for the years ended December 31, 2005, 2004
      and
      2003, 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, 2005, 2004 and 2003,
      credits of nil, $143,000, and $956,000, respectively, were recorded to reverse
      deferred stock compensation amortization in excess of vesting. In 2004 and
      2003,
      we additionally recorded a reversal of deferred stock compensation of $13,000
      and $196,000, respectively, due to employee terminations.





During
      the year ended December 31, 2000, we granted common stock options to
      non-employees at exercise prices that range from $40.00 to $95.00 per share
      for
      services provided to us. 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. We recognized no expense in 2005, 2004 or 2003 for these
      transactions. The fair value of these options was periodically re-measured
      as
      they vested over the performance period and was estimated using the
      Black-Scholes option pricing 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, 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 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
      2005, 2004 and 2003, we recorded no amortization or changes to deferred stock
      compensation for employee stock options exercised with non-recourse promissory
      notes.





On
      November 1, 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, $1.00 more than the
      fair
      market value of the underlying shares on the re-pricing date. Compensation
      associated with these options were re-measured during the years ended December
      31, 2003 and 2004 and the re-priced employee stock options were cancelled during
      the year ended December 31, 2005 as a result of the termination of all
      employees. During 2004, we recorded amortization of $55,000, a reversal of
      deferred compensation of $250,000 due to price decreases and a reversal of
      deferred compensation of $45,000 due to terminated employees. Also in 2004,
      we
      recorded $1,019,000 in reversals of deferred compensation amortization and
      $41,000 reversal due to amortization in excess of vesting for terminated
      employees. During 2003, we recorded deferred stock compensation in relation
      to
      re-priced stock options amounting to $619,000 and amortization of $797,000,
      as
      the price of our stock at December 31, 2003 was higher than the re-priced
      amount. In 2003, we additionally recorded a reversal of deferred stock
      compensation of $68,000 due to employee terminations.




42




On
      July
      10, 2001, we re-priced 722,071 outstanding employee stock options to purchase
      shares of our 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 was re-measured until they were
      exercised, canceled, or expired. During the years ended December 31, 2005,
      2004
      and 2003, we did not record any deferred stock compensation in connection with
      these re-priced options, as the price of our 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, we 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 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 warrants were fully amortized as of December
      31, 2005 and will no longer affect our financial statements.





In
      August
      1998, in connection with a facilities lease arrangement, we 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 were 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 option pricing model, 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 was 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. The facilities lease was terminated in December 2004, accordingly, the
      $388,000 unamortized balance of the warrants was charged to restructuring costs
      in 2004.





In
      the
      second quarter of 2004, we issued to a reseller a warrant to acquire 254,489
      shares of our stock at an exercise price of $4.65 per share. The warrant has
      a
      two-year term beginning May 28, 2004 and vests ratably over the term. If during
      the two-year term (1) any person or entity acquires a greater than 50% interest
      in CoSine or the ownership or control of more than 50% of the voting stock
      of
      CoSine or (2) we sell substantially all of our intellectual property assets,
      the
      warrant becomes fully exercisable. Even if the reseller does not immediately
      exercise the warrant upon the occurrence of such an event that makes the warrant
      fully exercisable (a “trigger event”), the reseller shall be entitled to
      securities, cash and property to which it would have been entitled to upon
      the
      consummation of the trigger event, less the aggregate price applicable to the
      warrant. We calculated the fair value of the warrant to be approximately
      $487,000 using the Black-Scholes valuation method, using a volatility factor
      of
      0.97, a risk-free interest rate of 2.5%, and an expected life of two years.
      The
      fair value of the warrant is being amortized over the two-year life of the
      warrant. During the year ended December 31, 2005, we amortized $339,000 to
      cost
      of sales. During the year ended December 31, 2004, we amortized $6,000 to cost
      of revenue and $42,000 to general and administrative costs.





At
      December 31, 2005 and 2004, warrants to purchase 288,727 shares of common stock
      at prices ranging from $4.65 to $80.00 per share were outstanding.





**6.
      Related Parties**




During
      2005, we, working with Steel Partners II, L.P. (“Steel Partners”), an entity
      that owns 24% of our common stock, conducted a review or our historical net
      operating losses and a review of our ownership changes since our inception.
      The
      study was initiated to determine the effect, if any, of such ownership changes
      on the availability of our net operating loss carry-forwards. Steel Partners
      incurred direct expenses, primarily outside legal fees, in the amount of $40,728
      in connection with the study and we have reimbursed them for these costs. At
      December 31, 2005, there were no amounts due to Steel Partners.





As
      of
      December 31, 2004 and 2003, we had non-recourse promissory notes receivable
      secured by a pledge of our common stock totaling $920,000 and $6,059,000,
      respectively, from certain of our non-officer employees for the payment of
      stock
      option exercises. Yearly interest in 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 2005,
      2004 and 2003, non-officer employees defaulted on notes receivable in the
      amounts of $920,000, $5,139,000 and $3,665,000, respectively, secured by 9,155,
      112,650 and 80,981 shares of common stock.





As
      of
      December 31, 2004 and 2003, we had non-recourse promissory notes receivable
      of
      $600,000 from an officer of ours for the payment of stock option exercises.
      The
      note was secured by a pledge of our common stock and had an annual interest
      rate
      of 6.77%. The note and accrued but unpaid interest were due and payable during
      2008. During 2005, a former officer, whose employment with us was terminated,
      defaulted on the payment of a non-recourse loan amounting to $600,000, secured
      by 60,000 shares of common stock. The shares were rescinded. During 2003, one
      officer, whose employment with us terminated, defaulted on the payment of a
      non-recourse loan amounting to $175,000, secured by 4,375 shares of common
      stock.




43





**7.
      Income Taxes**





The
      provisions (benefits) for income taxes of $(228,000), $33,000, and $287,000
      for
      the years ended December 31, 2005, 2004 and 2003, 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):





**2005**
            
            **2004**
            
            **2003**U.S.
                federal tax benefit at federal statutory rate
            
            $
            (353
            )
            $
            (12,683
            )
            $
            (11,780
            )Loss
                for which no tax benefit is currently recognizable
            
            
            125
            
            
            12,825
            
            
            11,910Non-cash
                charges related to equity issuances
            
            
            —
            
            
            (109
            )
            
            157Total
                provision (benefit)
            
            $
            (228
            )
            $
            33
            
            $
            287





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 our deferred
      tax assets (liabilities) are as follows (in thousands):





**December
                31,****2005**
            
            **2004**Deferred
                tax assets (liabilities):Net
                operating loss carryforwards
            
            $
            126,918
            
            $
            125,976Equity
                related charges
            
            
            (193
            )
            
            (193
            )Tax
                credit carryforwards
            
            
            8,435
            
            
            8,435Deferred
                revenue
            
            
            80
            
            
            3Inventory
                reserve
            
            
            157
            
            
            157Capitalized
                research and development
            
            
            6,978
            
            
            8,170Capital
                loss carryforward
            
            
            29,350
            
            
            27,789Accruals
                and reserves not currently deductible
            
            
            648
            
            
            1,358Total
                deferred tax assets (liabilities)
            
            
            172,373
            
            
            171,695Valuation
                allowance
            
            
            (172,373
            )
            
            (171,695
            )Net
                deferred tax assets (liabilities)
            
            $
            —
            
            $
            —





Statement
      of Financial Accounting Standards No. 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 $678,000 in 2005 and by $10,483,000 in 2004.




As
      of
      December 31, 2005, we had federal net operating loss carryforwards of
      approximately $340,000,000, which will begin to expire in 2018 if not utilized
      and state net operating loss carryforwards of approximately $190,000,000, which
      will begin to expire in 2007 if not utilized. Due to the “change in ownership”
provisions of the Internal Revenue Code, the availability of our net operating
      loss and credit carryforwards may be subject to an annual limitation in future
      periods. Based on our review of historical “changes of control,” the maximum
      amount of federal net operating loss carryforwards subject to “change of
      control” limitations at December 31, 2005 was less than $3.0 million.





As
      of
      December 31, 2005 and 2004, we also had federal and state research and
      development tax credit carryforwards of approximately $7,113,000 and $7,967,000,
      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, we liquidated a certain subsidiary, resulting in a capital loss
      carryforward of approximately $73,375,000. These losses may only be offset
      against future capital gains and will expire in fiscal 2008 if not
      utilized.




44





**8.
      Restructuring and Impairment Charges**





***Restructuring
      Charges***





*December
      2004 Restructuring*





**** In
      the
      quarter ended December 31, 2004, we continued our previously announced actions
      to terminate the remainder of our workforce, with a charge of $619,000,
      terminate the lease of our facilities in Redwood City, California, for a net
      charge of $2,522,000, representing a cash payment of $3,763,000, forfeiture
      of a
      $420,000 lease deposit, plus the write-off of $388,000 unamortized value of
      warrants issued in connection with the original execution of the lease, net
      of
      accrued rent of $2,049,000, and terminated our office lease in Japan for a
      net
      charge of $396,000. In addition, we accrued $1,037,000 for the termination
      of
      non-cancelable software license agreements, as the licenses were not expected
      to
      be used in the ongoing operations.





Activity
      related to the December 2004 restructuring is as follows (in
      thousands):





**Worldwide
                Workforce**
              **Reduction**
            
            **Lease****Terminations**
            
            **Software
                License**
              **Terminations**
            
            **Total**December
                2004 restructuring charges
            
            $
            619
            
            $
            2,918
            
            $
            1,037
            
            $
            4,574Cash
                payments
            
            
            (66
            )
            
            (3,900
            )
            
            —
            
            
            (3,966
            )Write
                offs
            
            
            —
            
            
            982
            
            
            —
            
            
            982**Provision
                balance at December 31, 2004**
            
            
            553
            
            
            —
            
            
            1,037
            
            
            1,590Cash
                payments
            
            
            (550
            )
            
            —
            
            
            (564
            )
            
            (1,114
            )Accrual
                adjustments
            
            
            —
            
            
            —
            
            
            (23
            )
            
            (
                23
            )**Provision
                balance at December 31, 2005**
            
            $
            3
            
            
            —
            
            $
            450
            
            $
            453





*September
      2004 Restructuring*





In
      September 2004, we announced actions to terminate most of our workforce,
      retaining a limited team of employees to provide customer support and handle
      matters related to the ongoing exploration of strategic alternatives. The
      specific actions include workforce reductions, with a charge of $2,872,000,
      announced discontinuance of the CoSine products, with a related charge to cost
      of sales of $3,466,000 to write inventory down to net realizable value and
      a
      $75,000 charge for unrecoverable royalties, and termination of third party
      manufacturing agreements, with a charge of $375,000.




Effective
      September 23, 2004, we approved severance agreements to Stephen Goggiano, our
      president and chief executive officer, and Terry Gibson, our chief financial
      officer, covering the period of August 1, 2004 through the earlier of (i)
      December 31, 2004 or (ii) the termination of their respective employments due
      to
      the elimination of their respective jobs if caused by a merger, sale,
      acquisition, liquidation, dissolution, consolidation or similar corporate
      transaction, in exchange for their continued service to us as we explored
      strategic alternatives, including a sale of the Company, a sale or licensing
      of
      products, intellectual property, or individual assets or a winding-up and
      liquidation of the business. In exchange for their continued service during
      this
      time period, Mr. Goggiano and Mr. Gibson each received a retention bonus equal
      to 100% of their base 2004 annual salary payable on or before December 31,
      2004.
      In addition, upon completion of these services, we agreed to pay for the cost
      of
      Mr. Goggiano's and Mr. Gibson's family health care coverage for a period of
      up
      to 12 months after termination of their respective employment. These amounts
      were accrued in the December 31, 2004 restructuring. The termination payments
      were paid in January 2005 and the health care payments were made in
      2005.




45




Activity
      related to the September 2004 restructuring is as follows (in
      thousands):





**Worldwide
                Workforce****Reduction**
            
            **Write-down
                of Inventory and****Prepaid
                royalty**
            
            **Manufacturing
                Agreement****Termination**
            
            **Total**September
                2004 restructuring charges
            
            $
            2,872
            
            $
            3,541
            
            $
            375
            
            $
            6,788Cash
                payments
            
            
            (2,448
            )
            
            —
            
            
            (278
            )
            
            (2,726
            )Write
                offs
            
            
            —
            
            
            (3,541
            )
            
            (97
            )
            
            (3,638
            )**Provision
                balance at December 31, 2004**
            
            
            424
            
            
            —
            
            
            —
            
            
            424Cash
                payments
            
            
            (424
            )
            
            —
            
            
            —
            
            
            (424
            )**Provision
                balance at December 31, 2005**
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





*May
      and March 2003 Restructuring*





In
      May
      and March 2003, we 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.





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





**Worldwide
                Workforce****Reduction**
            
            **Lease
                Termination****and
                Other**
            
            **Total**Charges
            
            $
            277
            
            $
            17
            
            $
            294Cash
                payments
            
            
            (284
            )
            
            (12
            )
            
            (296
            )Non-cash
                items
            
            
            (20
            )
            
            (4
            )
            
            (24
            )Accrual
                adjustment
            
            
            75
            
            
            (1
            )
            
            74**Provision
                balance at December 31, 2003**
            
            
            48
            
            
            —
            
            
            48Cash
                payments
            
            
            (38
            )
            
            —
            
            
            (38
            )Accrual
                adjustment
            
            
            (10
            )
            
            —
            
            
            (10
            )**Provision
                balance at December 31, 2004**
            
            $
            —
            
            $
            —
            
            $
            —





*October
      2002 Restructuring*





In
      October 2002, we initiated restructuring plan 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 concluded negotiations to settle obligations associated
      with
      Redwood City, California leased facilities we exited during 2002 and made a
      payment of $8,104,000.




46




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





**Worldwide
                Workforce****Reduction**
            
            **Lease
                Termination****and
                Other**
            
            **Total**Charges
            
            $
            1,945
            
            $
            7,854
            
            $
            9,799Cash
                payments
            
            
            (1,628
            )
            
            —
            
            
            (1,628
            )Deposit
                forfeiture and deferred rent
            
            
            —
            
            
            305
            
            
            305**Provision
                balance at December 31, 2002**
            
            
            317
            
            
            8,159
            
            
            8,476Cash
                payments
            
            
            (310
            )
            
            (8,112
            )
            
            (8,422
            )Accrual
                adjustment
            
            
            (7
            )
            
            (47
            )
            
            (54
            )**Provision
                balance at December 31, 2003**
            
            $
            —
            
            $
            —
            
            $
            —





*May
      2002 Restructuring*





In
      May
      2002, we initiated a restructuring program 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.





Activity
      related to the May 2002 restructuring for the years ended December 31, 2004,
      2003 and 2002 was as follows, (in thousands):





**Worldwide
                Workforce****Reduction**
            
            **Write-down
                of Property and E****quipment**
            
            **Lease
                commitments****and
                other**
            
            **Total**Charges
            
            $
            3,660
            
            $
            3,248
            
            $
            2,318
            
            $
            9,226Cash
                payments
            
            
            (3,660
            )
            
            —
            
            
            (1,503
            )
            
            (5,163
            )Non-cash
                charges
            
            
            —
            
            
            (3,248
            )
            
            -
            
            
            (3,248
            )**Provision
                balance at December 31, 2002**
            
            
            —
            
            
            —
            
            
            815
            
            
            815Cash
                payments
            
            
            
            
            
            
            
            
            (677
            )
            
            (677
            )Non-cash
                charges
            
            
            —
            
            
            —
            
            
            (42
            )
            
            (42
            )Accrual
                adjustment
            
            
            —
            
            
            
            
            
            22
            
            
            22**Provision
                balance at December 31, 2003**
            
            
            —
            
            
            —
            
            
            118
            
            
            118Cash
                payments
            
            
            
            
            
            
            
            
            (153
            )
            
            (153
            )Non-cash
                charges
            
            
            —
            
            
            —
            
            
            —
            
            
            —Accrual
                adjustment
            
            
            —
            
            
            —
            
            
            35
            
            
            35**Provision
                balance at December 31, 2004**
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





***Impairment
      of Long-lived Assets***





At
      December 31, 2005 and 2004, we had sold or scrapped all of our long-lived
      assets. During 2005 and 2004, we had gains of $0.1 million and $ 0.9 million,
      respectively, from the sale of previously written-down long-lived assets.




47




*2004
      Impairment Charges*





At
      June
      30, 2004, we made an assessment of our business and concluded that indicators
      of
      impairment were present at June 30, 2004. Such indicators included ongoing
      operating losses and inability to achieve sustainable revenue growth, including
      our failure to attract new customers, and our decision to evaluate strategic
      alternatives. Accordingly, we performed an impairment test of the carrying
      value
      of its long-lived assets, consisting primarily of property and equipment in
      accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of
      Long-Lived Assets." Based on an undiscounted cash flow analysis, the cash flows
      expected to be generated by 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 $2.3 million to write down the
      carrying value of the long-lived assets held for use to their fair values in
      the
      second quarter of 2004.





At
      September 30, 2004, we concluded that indicators of impairment were again
      present. Such indicators included ongoing operating losses, inability to achieve
      sustainable revenue growth, and our decision to evaluate strategic alternatives.
      Accordingly, we performed an impairment test of the carrying value of its
      long-lived assets, consisting primarily of property and equipment in accordance
      with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
      Assets." Based on an undiscounted cash flow analysis, the cash flows expected
      to
      be generated by 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 competitive bids from qualified prospective purchasers
      to determine fair values. The fair values of the long-lived assets, as indicated
      by competitive bids, exceeded the net book value of the long-lived assets at
      September 30, 2004, accordingly, no further impairment adjustment was made
      in
      the third quarter of 2004.




**9** . **Subsequent
        Event**
 
 **** In March
        2006, we signed an agreement to sell the rights to our patent portfolio for
        cash
        consideration of $180,000. The agreement includes a royalty-free license
        allowing us to use the patents in support of our existing customers through
        January 2008.




48





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





On
      September 14, 2004, we were advised by Ernst & Young LLP (“E&Y”) that it
      would resign as our independent registered public accounting firm effective
      upon
      the filing of our quarterly report on Form 10-Q for the quarter ending September
      30, 2004. E&Y resigned on November 15, 2004.





On
      October 11, 2004, the audit committee of our board of directors engaged Burr,
      Pilger & Mayer LLP as our new independent registered public accounting firm
      to provide financial audit services.





**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. Our chief executive officer and chief financial officer has
      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** .
      In
      connection with its audit of our consolidated financial statements for the
      year
      ended December 31, 2005, Burr, Pilger & Mayer LLP identified significant
      deficiencies, which represent material weaknesses. The material weaknesses
      were
      related to a lack of adequate segregation of duties. In addition, significant
      audit adjustments and financial statement disclosure changes were needed that
      were the result of an insufficient quantity of experienced resources involved
      with the financial reporting and year end closing process resulting from staff
      reductions associated with our downsizing.




Prior
      to
      the issuance of our consolidated financial statements, we completed the needed
      analyses and our management review such that we can certify that the information
      contained in our consolidated financial statements for the year ended December
      31, 2005, fairly presents, in all material respects, our financial condition
      and
      results of operations.




**Limitations
      on Effectiveness of Controls and Procedures.** Our
      management, including our chief executive officer and chief financial officer,
      does not expect that our disclosure controls and procedures or our internal
      controls will prevent all errors and all fraud. A control system, no matter
      how
      well conceived and operated, can provide only reasonable, not absolute,
      assurance that the objectives of the control system are met. Further, the design
      of a control system must reflect the fact that there are resource constraints
      and the benefits of controls must be considered relative to their costs. Because
      of the inherent limitations in all control systems, no evaluation of controls
      can provide absolute assurance that all control issues and instances of fraud,
      if any, within the Company have been detected. These inherent limitations
      include, but are not limited to, the realities that judgments in decision-making
      can be faulty and that breakdowns can occur because of simple error or mistake.
      Additionally, controls can be circumvented by the individual acts of some
      persons, by collusion of two or more people, or by management override of the
      control. The design of any system of controls also 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. Over time, controls may become inadequate because of changes
      in conditions, or the degree of compliance with the policies or procedures
      may
      deteriorate. Because of the inherent limitations in a cost-effective control
      system, misstatements due to error or fraud may occur and not be detected.





**Item
      9B.** ***Other
      Information***





None.




49




**PART
      III**





**Item
      10.** ***Directors
      and Executive Officers of the Registrant***





**Executive
      Officer of the Registrant**





The
      name
      of our executive officer and his age, title and biography as of March 15, 2006
      appears below.





**Name**
            **Age**
            **Position**Terry
                R. Gibson
            52
            President,
                Chief Executive Officer, Chief Financial Officer and
                Secretary




Terry
      R.
      Gibson has served as our Chief Executive Officer since January 16, 2005 and
      as
      our Executive Vice President and Chief Financial Officer since joining us in
      January 2002. Prior to joining us, 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.





**Directors**





The
      names
      of our directors and their ages, titles and biographies as of March 15, 2006
      appear below.





**Name**
            **Age**
            **Position**Donald
                Green
            74
            Chairman
                of the Board of DirectorsCharles
                J. Abbe
            64
            DirectorJack
                L. Howard
            44
            DirectorTerry
                R. Gibson
            52
            Director,
                President, Chief Executive Officer and Chief Financial
                Officer





Donald
      Green, 74, has served as Chairman of our Board of Directors 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 a director of Turin Networks,
      Inc. Mr. Green holds a higher national certificate in electrical engineering
      from Willesdon Technical College.





Charles
      J. Abbe, 64, 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. Mr. Abbe currently serves as a director of Cymer, Inc., a
      semi-conductor equipment company; a director of Xponent, Inc., a manufacturer
      of
      fiber optics components; and a director of Nova-Sol, Inc., a defense industry
      development company. Mr. Abbe holds a B.S. and an M.S. in chemical engineering
      from Cornell University and an M.B.A. from Stanford University.





Jack
      L.
      Howard, 44, has served as a director of CoSine since July 25, 2005, when he
      was
      elected to the board of directors to fill the vacancy created by the resignation
      of R. David Spreng. In 1993, Mr. Howard co-founded Steel Partners II, L.P.
      where
      he currently holds representative positions. Since 2004, Mr. Howard has served
      as a director of BNS Holdings, Corp., a real estate management company. Mr.
      Howard has served as a director of WebFinancial Corp. (formerly Rose’s Holders
      Inc.), which owns WebBank Corp., an FDIC insured Industrial Loan Bank, since
      1996 and as its Vice President since 1997. In 2005, Mr. Howard began serving
      as
      a director of WHX Corporation. Mr. Howard is a Principal of Mutual Securities,
      Inc., a registered broker-dealer. Mr. Howard holds a B.A. in Finance from the
      University of Oregon.




50




Terry
      R.
      Gibson has served as a director and Chief Executive Officer of CoSine since
      January 16, 2005 and as Executive Vice President and Chief Financial Officer
      since joining CoSine in January 2002. Prior to joining us, 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.





**Audit
      Committee**





Our
      board
      of directors currently has an Audit Committee, which is composed of Messrs.
      Green, Abbe and Howard and is chaired by Mr. Green. Our board of directors
      has
      determined that Messrs. Green 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.
      Due
      to Mr. Howard's relationship with Steel Partners II, L.P., our largest
      stockholder, he is not “independent” as defined in the Nasdaq listing standards.
      As we are no longer listed on the Nasdaq National Market System, the members
      of
      our Audit Committee are not required to be "independent directors."





The
      Audit
      Committee oversees our accounting and financial reporting processes and the
      audit of our financial statements, reviews our 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 our 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.





**Stockholder
      Nominations of Directors**





There
      have been no changes in the procedures by which our stockholders may recommend
      nominees to our board of directors since we described those procedures in our
      Proxy Statement relating to our 2005 Annual Meeting of Stockholders.





**Section
      16(a) Beneficial Ownership Reporting Compliance**





Section
      16(a) of the Securities Exchange Act of 1934 requires our directors and
      executive officers, and persons who own more than 10 percent of a registered
      class of our equity securities, to file with the Securities and Exchange
      Commission initial reports of ownership and reports of changes in ownership
      of
      our common stock and other equity securities. Officers, directors and greater
      than 10 percent stockholders are required by the regulations of the Securities
      and Exchange Commission to furnish us with copies of all Section 16(a) forms
      they file. To our knowledge, based solely on review of the copies of such
      reports furnished to us and written representations that no other reports were
      required, during the fiscal years ended December 31, 2005 and 2004 all Section
      16(a) filing requirements applicable to its officers, directors and greater
      than
      10 percent beneficial owners were complied with, except that on November 4,
      2005, Jack L. Howard filed a Form 3 reporting his appointment to our board
      of
      directors on July 25, 2005; on November 17, 2005, Jack L. Howard filed a Form
      4
      reporting the automatic grant on July 25, 2005 upon becoming a member of our
      board of directors of a stock option for the purchase of 8,000 shares of our
      common stock under our 2000 Director Option Plan; and on November 17, 2005,
      Terry L. Gibson filed a Form 4 reporting the grant on October 6, 2005 upon
      commencing employment with us of a stock option for the purchase of 100,000
      shares of our common stock under our 2000 Stock Option Plan.





**Code
      Of Ethics**





We
      have
      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. We will provide to any
      person, without charge, a copy of code of ethics upon written requests. Written
      requests should be submitted to Terry Gibson, Corporate Secretary, 560 S.
      Winchester Blvd., Suite 500, San Jose, California 95128.




51





**Item
      11.** ***Executive
      Compensation***




**Executive
      Compensation**





The
      following table summarizes the total compensation awarded to, earned by, or
      paid
      for services rendered to us in all capacities during each of the fiscal years
      ended December 31, 2005, 2004 and 2003, respectively, by each person who served
      as an one of our executive officers at any time during fiscal year 2005 (the
      "Named Executive Officers").





**Summary
      Compensation Table**





**Long
                Term****Compensation****Awards****Annual**
            
            **Securities****Compensation**
            
            **Underlying**
            
            **All
                Other****Fiscal**
            
            **Salary**
            
            **Bonus**
            
            **Options**
            
            **Compensation****Name
                and Principal Position**
            
            **Year**
            
            **($)**
            
            **($)**
            
            **(#)**
            
            **($)**Stephen
                Goggiano (1)
            
            
            2005
            
            $
            34,531
            
            
            —
            
            
            —
            
            $
            324,454
                (3
            )Director,
                President and Chief Executive Officer
            
            
            2004
            
            
            300,908
            
            
            —
            
            
            **—**
            
            
            —2003
            
            
            300,908
            
            
            —
            
            
            90,000
            
            
            —Terry
                Gibson (2)
            
            
            2005
            
            $
            49,299
            
            
            —
            
            
            100,000
            
            $
            478,774
                (4
            )Director,
                President, Chief Executive Officer Executive, Chief Financial Officer
                and
                Secretary
            
            
            2004
            
            
            265,358
            
            
            —
            
            
            —
            
            
            —2003
            
            
            265,358
            
            
            —
            
            
            46,000
            
            
            —






(1)
            Mr.
                Goggiano served as President and Chief Operating Officer beginning
                in
                fiscal year 2001 and was appointed to the board of directors and
                named
                Chief Executive Officer on March 3, 2002. Mr. Goggiano passed away
                on
                January 14, 2005.(2)
            Mr.
                Gibson has served as our Chief Financial Officer since January 2002
                and as
                Chief Executive Officer since January 16, 2005 when he assumed the
                additional duties of President and Chief Executive Officer upon the
                death
                of Mr. Goggiano. Mr. Gibson terminated employment on January 3, 2005,
                while continuing to serve as an officer and a consultant. On October
                6,
                2005, Mr. Gibson was rehired as an employee, at which time he was
                granted
                options to purchase 100,000 shares of our common stock, of which
                50,000
                shares were immediately exercisable with the balance vesting over
                the next
                three years.(3)
            Mr.
                Goggiano earned a retention bonus in the amount of $300,000 effective
                on
                termination of his employment on January 3, 2005, as well as reimbursement
                of his family health care insurance for 2005, in the amount of $11,954
                and
                payment of consulting fees in the amount of $12,500 for services
                rendered
                from January 4, 2005 through his death on January 14, 2005.(4)
            Mr.
                Gibson earned a retention bonus if the amount of $265,000 effective
                on
                termination of his employment on January 3, 2005, as well as reimbursement
                of his family health care insurance for 2005, in the amount of $10,947
                and
                payment of consulting fees in the amount of $202,827 for services
                rendered
                from January 4, 2005 through October 6, 2005 when he was rehired
                as an
                employee. Upon rehiring, Mr. Gibson's annual salary was set at $225,000
                per year.





**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,
      2005.





**Stock
      Option Grants in 2005**


**Individual
                  Grants**
              
              **Potential
                  Realizable Values at Assumed Annual Rates of Stock Price Appreciation
                  for
                  Options Term(1)****Number
                  of Securities Underlying Options Granted (#)**
              
              **Percent
                  of Total Options Granted to Employees in Fiscal
                  2005**
              
              **Exercise
                  Price Per Share ($)**
              
              **Expiration
                  Date**
              
              **5%
                  ($)**
              
              **10%
                  ($)**Terry
                  Gibson
              
              
              100,000(2
              )
              
              100
              %
              $
              2.60
              
              
              10/06/2015
              
              $
              185,000
              
              $
              482,000










(1)
            Potential
                realizable value is based on the assumption that our common stock
                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 our 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 our common stock. All assumed values are
                before
                taxes and do not include dividends.(2)
            This
                option was vested and immediately exercisable on the date of grant
                as to
                1/2 of the option shares. The remaining option shares vest over three
                years with 1/3 of such remaining option shares vesting on each one-year
                anniversary of the date of grant.




52


**Stock
      Option Exercises in 2005 and 2005 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, 2005 and stock options held as of December 31, 2005 by the Named Executive
      Officers.





**Aggregate
      Stock Option Exercises in Last Fiscal Year**


**and
      Fiscal Year End Option Values**





**Number
                of Securities Underlying Unexercised Options at December
                31,2005**
            
            **Value
                of Unexercised In-the-Money Options at December 31,
                2005(2)****Shares
                Acquired or Exercised**
            
            **Value
                Realized(1)**
            
            **Exercisable**
            
            **Unexercisable**
            
            **Exercisable**
            
            **Unexercisable****(#)**
            
            **($)**
            
            **(#)**
            
            **(#)**
            
            **($)**
            
            **($)**Terry
                Gibson
            
            
            —
            
            
            —
            
            
            50,000
            
            
            50,000
            
            
            -
            
            
            -







(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 $ 2.40 of the underlying securities as of December
      31, 2005 as reported on the Pink Sheets Electronic Quotation Service minus
      the
      exercise price. Values are stated on a pre-tax basis.





**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 our 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 our 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. Non-employee
      directors received option grants during 2005 as listed in the table below.
      The
      options granted to Messrs. Green and Abbe each vest on the fourth anniversary
      of
      the date of grant. The options granted to Mr. Howard vest in four equal annual
      installments.





**Director
                Name**
            
            **Date
                of Grant**
            
            **Exercise**
              **Price**
            
            **Number
                of**
              **Shares**Charles
                J. Abbe
            
            
            November
                15, 2005
            
            
            2.40
            
            
            2,000Donald
                Green
            
            
            November
                15, 2005
            
            
            2.40
            
            
            2,000Jack
                L. Howard
            
            
            July
                25, 2005
            
            
            2.15
            
            
            8,000





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




53





**Compensation
      Committee Interlocks And Insider Participation**





The
      members of the Compensation Committee of the board of directors during fiscal
      year 2005, were Donald Green, Charles J. Abbe and R. David Spreng through his
      resignation in July 2005. On September 29, 2005, the board of directors
      appointed Jack L. Howard to the Compensation Committee. Mr. Abbe serves as
      Chairman of the Compensation Committee. During fiscal year 2005, the
      Compensation Committee was composed solely of non-employee directors. None
      of
      these persons is, nor 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 ours 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.




54





**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 March 15, 2006, 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 executive officers named
      in the Summary Compensation Table set forth in the “Executive Compensation”
section of this proxy statement (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 March 15, 2006 as a
      group.


**Shares
                  of Common Stock****Beneficially
                  Owned(2)****Percent
                  of****Name
                  and Address of Beneficial Owner(1)**
              
              **Number**
              
              **Class(3)***5%
                  Stockholders*Steel
                  Partners II, L.P. (4)
              
              
              2,441,384
              
              
              24.2
              %590
                  Madison Avenue, 32ndFloorNew
                  York, NY 10022WHX
                  CS Corp. (5)
              
              
              1,898,337
              
              
              18.8
              %555
                  Theodore Fremd AvenueRye,
                  New York 10580Empyrean
                  Capital Partners, LP (6)
              
              
              760,000
              
              
              7.5
              %10250
                  Constellation Boulevard, Suite 2950Los
                  Angeles, CA 90667Dimensional
                  Fund Advisors Inc.(7)
              
              
              689,253
              
              
              6.8
              %1299
                  Ocean Avenue11thFloorSanta
                  Monica, CA 90401*Directors
                  and Named Executive Officers*Terry
                  Gibson, Director, Chief Executive Officer, Chief Financial Officer
                  andSecretary
                  (8)
              
              
              50,000
              
              
              *Charles
                  J. Abbe, Director(9)
              
              
              15,750
              
              
              *Donald
                  Green, Chairman(10)
              
              
              38,294
              
              
              *Jack
                  L. Howard, Director (11)
              
              
              170,800
              
              
              1.7
              %Stephen
                  Goggiano(12)
              
              
              -
              
              
              -All
                  directors and current executive officers as a group (4
                  persons)(13)
              
              
              274,844
              
              
              2.7
              %




*
            Less
                than 1%.




(1)
            Unless
                otherwise indicated, the address for each listed stockholder is
                c/o CoSine Communications, Inc., 560 South Winchester Blvd.
                Suite 500, San Jose, CA 95128. 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 March 15, 2006 (or as of May 15, 2006) 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 March 15, 2006 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.




55




(3)
            Percentage
                of beneficial ownership is based on 10,090,635 shares of common stock
                outstanding as of March 15, 2006, adjusted as required by rules
                promulgated by the Securities and Exchange Commission.(4)
            Steel
                Partners II, L.P. holds sole voting and investment power over all
                2,441,384 shares. Steel Partners, L.C.C. is the general partner of
                Steel
                Partners II, L.P. Warren G. Lichtenstein is the sole executive officer
                and
                managing member of Steel Partners, L.C.C. and, in such capacity,
                holds
                sole voting and investment power over all 2,441,384 shares. Jack
                L.
                Howard, a director of the Company, co-founded Steel Partners II,
                L.P. where he currently holds representative positions. Mr.
                Howard is also the director and President of JL Howard, Inc. and
                J Howard,
                Inc. and, in such capacities, holds sole voting and investment power
                over
                500 shares of the Company stock held by JL Howard, Inc. and 170,300
                shares
                of the Company stock held by J Howard, Inc. The information in this
                footnote is based upon the Schedule 13D/A filed on March 15, 2006 on
                behalf of Steel Partners II, L.P., Steel Partners, L.C.C., Mr.
                Lichtenstein, Mr. Howard, JL Howard, Inc., and J Howard,
                Inc.(5)
            WHX
                CS Corp. and WHX Corporation each has sole power to vote and to dispose
                of
                the 1,898,337 shares. WHX CS Corp. is a wholly owned subsidiary of
                WHX
                Corporation. Steel Partners II, L.P. is a majority stockholder of
                WHX
                Corporation. Steel Partners, L.L.C. is the general partner of Steel
                Partners II, L.P. Warren G. Lichtenstein is the sole executive officer
                and
                managing member of Steel Partners, L.L.C. By virtue of the relationship
                of
                WHX Corporation to Steel Partners II, L.P., Steel Partners, L.L.C
                and Mr.
                Lichtenstein (collectively, the Steel Entities), as more fully described
                above, WHX CS Corp., WHX Corporation, Steel Partners II, L.P., Steel
                Partners, L.L.C and Mr. Lichtenstein constitute a "group" for purposes
                of
                Section 13(d)(3) of the Securities Exchange Act of 1934, as amended.
                WHX
                CS Corp. and WHX Corporation disclaim beneficial ownership of the
                shares
                held by Steel Partners II, L.P., Steel Partners, L.L.C and Mr.
                Lichtenstein, as described in footnote 4 above. Steel Partners II,
                L.P.,
                Steel Partners, L.L.C and Mr. Lichtenstein each disclaim beneficial
                ownership of shares held by WHX CS Corp. and WHX Corporation, as
                described
                in this footnote 5. The information in this footnote is based upon
                the
                Schedule 13D filed on November 1, 2005 and a Form 3 filed on November
                2, 2005 on behalf of WHX CS Corp. and WHX Corporation.(6)
            Of
                the 760,000 shares, 265,208 shares are held directly by Empyrean
                Capital
                Fund, LP ("ECF") which has shared voting and investment power over
                such
                shares, LP, 444,617 shares are held by Empyrean Capital Overseas
                Fund,
                Ltd. ("ECOF") which has shared voting and investment power over such
                shares and 50,175 shares are held by Empyrean Capital Overseas Benefit
                Plan Fund, Ltd. ("ECOBPF") which has shared voting and investment
                power
                over such shares. Empyrean Capital Partners, LP ("ECP”) is the investment
                manager for ECF, ECOF and ECOBPF and in such capacity holds shared
                voting
                and investment power over all 760,000 shares. Empyrean Capital, LLC
                is the
                general partner of ECP and in such capacity holds shared voting and
                investment power over all 760,000 shares. Empyrean Associates, LLC
                ("EA")
                is the general partner of ECF and in such capacity holds shares voting
                and
                investment power over 265,208 shares. Amos Meron, Michael Price and
                Scott
                Imbach are the managing members of EC and EA and in such capacities
                share
                voting and investment power over all 760,000 shares. The information
                in
                this footnote is based upon the Schedule 13G filed August 15, 2005 on
                behalf of Messrs. Meron, Price, Imbach, EC, EA, ECP, ECF, ECOF and
                ECOBPF.(7)
            Dimensional
                Fund Advisors Inc. holds sole voting and investment power over all of
                the 689,253 shares pursuant to separate arrangements whereby it acts
                as
                investment adviser to certain entities. The information in this footnote
                is based upon the Schedule 13G/A filed February 6, 2006 on behalf of
                Dimensional Fund Advisors Inc.


(8)
              All
                  50,000 shares are subject to exercisable options.(9)
              Of
                  the 15,750 shares, 12,750 are subject to exercisable
                  options.(10)
              Of
                  the 38,234 shares, 7,750 are subject to exercisable options, 173
                  shares are owned directly by Green Venture Capital I, L.P. and
                  14,265
                  shares are owned directly by Green Venture Capital II, L.P. Mr.
                  Green is
                  the general partner of Green Venture Capital I, L.P. and Green
                  Venture
                  Capital II, L.P. Mr. Green disclaims beneficial ownership of the
                  shares
                  owned directly by Green Venture Capital I, L.P. and Green Venture
                  Capital
                  II, L.P., except to the extent of his pecuniary interest in the
                  shares.(11)
              Mr.
                  Howard is also the director and President of JL Howard, Inc. and
                  J Howard,
                  Inc. and, in such capacities, holds sole voting and investment
                  power over
                  500 shares held by JL Howard, Inc. and 170,300 shares held by J
                  Howard,
                  Inc. Mr. Howard co-founded Steel Partners II, L.P. where he currently
                  holds representative positions. Steel Partners II, L.P. has sole
                  voting and investment power over 2,441,384 shares as explained
                  in footnote
                  4 above.(12)
              Mr.
                  Goggiano was a director and the Chief Executive Officer of the
                  Company
                  until his death on January 14, 2005.(13)
              Of
                  the 274,844 shares, 14,438 shares are owned by Green Venture
                  Capital I, L.P. and Green Venture Capital II, L.P as explained
                  in
                  footnote 10 above, 500 shares are held by JL Howard, Inc. and 170,300
                  shares are held by J Howard, Inc. as explained in footnote 11 above,
                  and
                  an additional 70,500 shares are subject to options that are
                  exercisable within 60 days of March 15, 2006 all of which will be
                  vested as of May 15, 2006.




**Item
      13.** ***Certain
      Relationships and Related Transactions***





**Indebtedness
      of Management**





Prior
      to
      our 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. We have
      held
      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.




56





On
      January 14, 2005, our former chief executive officer died. His non-recourse
      promissory note, in the amount of $600,000, and bearing an interest rate of
      6.77%, was cancelled in exchange for 60,000 shares of our common
      stock.





At
      December 31, 2005, there were no outstanding promissory notes executed by our
      executive officers.





**Certain
      Transactions**





Effective
      September 23, 2004, we extended severance agreements to Stephen Goggiano, our
      then President and Chief Executive Officer, and Terry Gibson, our Chief
      Financial Officer, covering the period of August 1, 2004 through the earlier
      of
      (i) December 31, 2004 or (ii) the termination of their respective employments
      due to the elimination of their respective jobs if caused by a merger, sale,
      acquisition, liquidation, dissolution, consolidation or similar corporate
      transaction, in exchange for their continued service to us as we explored
      strategic alternatives, including a possible merger, sale and/or dissolution.
      In
      exchange for their continued service during this time period, Mr. Goggiano
      and
      Mr. Gibson received a retention bonus equal to 100% of their base 2004 annual.
      These amounts were paid in January 2005. In addition, we paid for the cost
      of
      Mr. Goggiano's and Mr. Gibson's family health care coverage through December
      31,
      2005.





Mr.
      Gibson continues to serve as our Chief Financial Officer and since January
      16,
      2005 has served as our Chief Executive Officer as a consultant, on a
      month-to-month basis, and was compensated at a monthly rate of $22,083 through
      October 6, 2005, at which time he rejoined us as an employee, holding the
      positions of President, Chief Executive Officer, Chief Financial Officer and
      Secretary.





**Item
      14.** ***Principal
      Accountant Fees and Services***




Aggregate
      fees for professional services rendered by Ernst & Young LLP and Burr,
      Pilger & Mayer LLP during 2005 and 2004 were as follows:





**2005**
              
              **2004**Audit
                  Fees - Ernst & Young LLP (1)
              
              $
              20,000
              
              $
              179,300Audit
                  Fees - Burr, Pilger & Mayer LLP (1)
              
              
              172,679
              
              
              226,657Total
                  audit fees
              
              
              192,679
              
              
              405,957Audit
                  related fees - Burr, Pilger & Mayer LLP (2)
              
              
              21,660
              
              
              ---Audit
                  related fees - Ernst & Young LLP (2)
              
              
              105,000
              
              
              ---Tax
                  fees (3)
              
              
              ---
              
              
              ---All
                  other fees (4)
              
              
              ---
              
              
              5,600Total
              
              $
              319,339
              
              $
              411,557




(1)
              Audit
                  fees include fees associated with the annual audit and 10-K, the
                  reviews
                  of the Company’s quarterly reports on Form 10-Q.(2)
              Audit
                  related fees related to Form S-4 and related filings(3)
              Tax
                  fees included tax compliance and tax advice.(4)
              All
                  other fees principally included stock options advise, internal
                  control
                  consultation and subsidiary liquidation
                  services.





Effective
      May 2003, all professional services rendered by Burr, Pilger & Mayer LLP and
      Ernst & Young LLP are required to be pre-approved by the audit committee. In
      fiscal years 2003 (effective May 2003), 2004 and 2005, all services were
      pre-approved by the audit committee. See Item 9, “Changes in and Disagreements
      with Accountants on Accounting and Financial Disclosures,” in Form 10-K.




57





**Item
      15.** ***Exhibits
      and Financial Statement Schedules***





(a)
              The
                  following documents are filed as part of this Annual Report on
                  Form
                  10-K:(1)
              *Financial
                  Statements:*


**Page**Report
                of Independent Registered Public Accounting Firm - Burr, Pilger &
                Mayer LLP
            25Report
                of Independent Registered Public Accounting Firm - Ernst & Young
                LLP
            26Consolidated
                Balance Sheets — December 31, 2005 and 2004
            27Consolidated
                Statements of Operations — Years ended December 31, 2005, 2004 and
                2003
            28Consolidated
                Statements of Stockholders’ Equity and Comprehensive Loss — Years ended
                December 31, 2005, 2004 and 2003
            29Consolidated
                Statements of Cash Flows — Years ended December 31, 2005, 2004 and
                2003
            30Notes
                to Consolidated Financial Statements
            31




(2)
                *Financial
                    Statement Schedules:*




Schedule
                II — Valuation and Qualifying Accounts
            59





All
      other
      schedules are omitted as they are not applicable or the required information
      is
      shown in the consolidated financial statements or the notes
      thereto.


(3)
              *Exhibits:*


See
      Exhibit Index on page 61. The Exhibits listed in the accompanying Exhibit Index
      are filed as part of this Annual Report on Form 10-K.




58




**COSINE
      COMMUNICATIONS, INC.**





**SCHEDULE
      II — VALUATION AND QUALIFYING ACCOUNTS**





**Classification**
            
            **Balance
                at**
              **Beginning
                of Year**
            
            **Charged
                to**
              **Expenses****(Credits)**
            
            **Additions**
              **(Deductions)(1)**
            
            **Balance
                at End**
              **of
                Year****(In
                thousands)**Year
                ended December 31, 2005Reserves
                for accounts receivable
            
            $
            90
            
            $
            (90
            )
            
            —
            
            $
            —Year
                ended December 31, 2004:Reserves
                for accounts receivable
            
            $
            150
            
            $
            38
            
            $
            (98
            )
            $
            90Year
                ended December 31, 2003:Reserves
                for accounts receivable
            
            $
            233
            
            $
            (113
            )
            $
            30
            
            $
            150





__________





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





59




**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 24, 2006.




COSINE
                COMMUNICATIONS, INCBy:
              /s/
                Terry
                R. GibsonTerry R. Gibson*Chief
                Executive Officer*


**POWER
      OF ATTORNEY**





KNOW
      ALL
      PERSONS BY THESE PRESENTS, that each person whose signature appears below
      constitutes and appoints Terry Gibson 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 24, 2006 by the following persons in the capacities
      indicated.





**Signature**
            
            **Title**/s/TERRY
                R. GIBSON
            
            Chief
                Executive Officer, Chief Financial Officer andTerry
                R. Gibson
            
            Director
                (Principal Executive Officer and Principal Accounting
                Officer)/s/Donald
                Green
            
            Chairman
                of the Board and DirectorDonald
                Green/s/Charles
                J. Abbe
            
            DirectorCharles
                J. Abbe/s/Jack
                L. Howard
            
            DirectorJack
                L. Howard






60








**EXHIBIT
      INDEX**





**Description**





2.1*
            Agreement
                and Plan of Merger by and among Registrant, Tut Systems, Inc. and
                Cadillac
                Merger Sub, Inc., dated January 7, 2005 (incorporated by reference
                to
                Exhibit 2.1 to Form 8-K filed January 10, 2005) (the schedules and
                exhibits have been omitted pursuant to Item 602(b)(2) of Regulation
                S-K).2.2*
            Amendment
                No. 1 to Agreement and Plan of Merger by and among Registrant, Tut
                Systems, Inc. and Cadillac Merger Sub, Inc., dated as of February
                14,
                2005.3.1
            Third
                Amended and Restated Certificate of Incorporation filed with the
                Delaware
                Secretary of State on December 6, 2005.3.2*
            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 (incorporated by reference
                to
                Exhibit 3.5 to Form 10-K filed March 25, 2004).3.6*
            Certificate
                of Designation of Series A Junior Participating Preferred Stock,
                as filed
                with the Secretary of State of Delaware on September 8, 2005 (incorporated
                by reference to Exhibit 3.1 to Form 8-K filed September 8,
                2005).4.1*
            Form
                of Rights Certificate (incorporated by reference to Exhibit 4.1 to
                Form
                8-K filed September 8, 2005).4.2*
            Rights
                Agreement, dated as of September 1, 2005, by and between CoSine
                Communications, Inc. and Mellon Investor Services LLC (incorporated
                by
                reference to Exhibit 4.2 to Form 8-K filed September 8,
                2005).4.3*
            Form
                of warrant to purchase common stock issued by the Registrant to Fujitsu
                Network Communications, Inc. dated as of May 28, 2004 (incorporated
                by reference to Exhibit 4.1 to Form 10-Q filed August 9,
                2004).10.1*
            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).10.2*
            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*
            2002
                Stock Plan and forms of agreements thereunder (incorporated by reference
                to Exhibit 10.17 to Form 10-K filed March 25, 2002).10.6*
            Form
                of Severance Agreement extended to Stephen Goggiano, President and
                Chief
                Executive Officer of Registrant, and Terry R. Gibson, Chief Financial
                Officer of Registrant, as of September 23, 2004 (incorporated by
                reference
                to Exhibit 10.1 to Form 10-Q filed November 15, 2004).10.7*
            Statement
                of Work between Registrant and Wipro Limited, dated October 14, 2004
                (incorporated by reference to Exhibit 10.2 to Form 10-Q filed November
                15,
                2004).21.1
            Subsidiaries
                of the Registrant23.1
            Consent
                of Independent Registered Public Accounting Firm - Burr, Pilger &
                Mayer LLP.23.2
            Consent
                of Independent Registered Public Accounting Firm - Ernst & Young
                LLP.31.1
            Certification
                of Terry R. Gibson, Chief Executive Officer 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
                2002.32.1
            Certification
                of Terry R. Gibson, Chief Executive Officer 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.






61