**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, 2006**


**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, California**
            **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 if 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 if 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 $10,535,817 based on the number of shares
      held by non-affiliates as of March 1, 2007, and based on the reported last
      sale
      price of common stock on June 30, 2006, 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 1, 2007, there were 10,090,635 shares of the Registrant’s Common Stock
      outstanding.





**DOCUMENTS
      INCORPORATED BY REFERENCE**





Portions
      of the Proxy Statement for our 2007 Annual Meeting of Shareholders are
      incorporated into Part III of this


Form
      10-K.





**COSINE
      COMMUNICATIONS, INC.**





**FORM
      10-K**


**Year
      Ended December 31, 2006**





**TABLE
      OF CONTENTS**





**Page****Part
                I**Item
                1.
            Business
            3Item
                1A.
            Risk
                Factors
            6Item
                1B.
            Unresolved
                Staff Comments
            10Item
                2.
            Properties
            10Item
                3.
            Legal
                Proceedings
            10Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            10**Part
                II**Item
                5.
            Market
                for Registrant’s Common Stock, Related Stockholder Matters and Issuer
                Purchases of Equity Securities
            11Item
                6.
            Selected
                Financial Data
            14Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            15Item
                7A.
            Quantitative
                and Qualitative Disclosures about Market Risk
            26Item
                8.
            Financial
                Statements and Supplementary Data
            28Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            50Item
                9A.
            Controls
                and Procedures
            50Item
                9B.
            Other
                Information
            50**Part
                III**Item
                10.
            Directors,
                Executive Officers and Corporate Governance
            50Item
                11.
            Executive
                Compensation
            51Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            51Item
                13.
            Certain
                Relationships and Related Transactions and Director
                Independence
            51Item
                14.
            Principal
                Accountant Fees and Services
            51**Part
                IV**Item
                15.
            Exhibits
                and Financial Statement Schedules
            51Signatures
            53Exhibit
                Index
            55




2




**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, failure to achieve revenue growth and profitability,
      our
      ability to identify and acquire new business operations, 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 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 6 to 9 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 2007.





**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, scrapped or wrote-off our inventory, property and equipment.
      From the fourth quarter of fiscal year 2004 through December 31, 2006, our
      business consisted primarily of a customer support capability for our
      discontinued products provided by a third party. In March 2006, we sold the
      rights to our patent portfolio, and in November 2006, we sold the remaining
      intellectual property rights to our carrier network equipment products and
      services. We terminated all customer service operations effective December
      31,
      2006 and do not intend to offer customer support services for our discontinued
      products in the future. We continue to execute our redeployment strategy,
      whereby we plan 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 Current 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.”




3




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 enhance stockholder value by redeploying our existing assets
      and 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”). 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.





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.





At
      our
      2005 Annual Meeting of Stockholders, the stockholders 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.





In
      March
      2006, we sold the rights to our patent portfolio and, in November 2006, the
      rights to the intellectual property related to our carrier networking products
      and services. At December 31, 2006, we ceased all customer service
      operations.





We
      are
      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 carrier 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 and ceased all our related customer
      support services as of December 31, 2006.




4





**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, sold the rights to our patent
      portfolio in March 2006, sold the remaining rights to our carrier network
      intellectual property in November 2006 and ceased all our related customer
      support services as of December 31, 2006.




**Customers**





During
      the year ended December 31, 2006, we recognized revenue from seven customers.
      Sprint, AT&T and Rogers Telecom a ccounted
      for 58%, 19% and 11% of our revenue, respectively. Geographically, our revenue
      was distributed as follows: North America 89% and Europe 11% (See Note 1 of
      the
      Notes to Consolidated Financial Statements). A
      small
      number of customers accounted for a substantial portion of our revenues, and
      the
      loss of any one customer would have a material impact on our results of
      operations. At December 31, 2006, we had no customers.





**Sales
      and Marketing**





We
      ceased
      all sales and marketing activities in September 2004. We had no sales and
      marketing employees at December 31, 2006.





**Customer
      Service and Support**





We
      provided transition support services to our existing customers through December
      31, 2006, at which time we ceased providing customer support services. Our
      service and support operations were conducted by a third party contractor,
      and
      we had no employees in customer service and support at December 31, 2006.





**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 through December 31, 2006. At December 31, 2006, we had no employees
      in research and development.





Our
      research and development expenses, including non-cash charges related to equity
      issuances, totaled nil, $0.1 million and $15.1 million
      for the years ended December 31, 2006, 2005 and 2004, respectively.





**Manufacturing**





We
      ceased
      all manufacturing activities in December 2004 and had no employees in
      manufacturing at December 31, 2006.





**Backlog**





Historically,
      our backlog has included purchase orders from customers with approved credit
      status, representing products and services we planned to deliver within 12
      months, plus our then current balance of deferred revenue. At December 31,
      2006,
      2005 and 2004, we had no backlog.





**Competition**





We
      provided transition support services for our discontinued products to our
      existing customers through December 31, 2006 at which time we terminated all
      such services. Due to the fact that our transition support services were limited
      to our own discontinued products and the limited period of availability for
      those transition support services, we did not foresee any material competition
      for our transition support services.




5




**Intellectual
      Property**





We
      have
      relied on copyright, patent, trade secret and trademark law to protect our
      intellectual property. In March 2006, we sold the rights to our patent portfolio
      for cash consideration of $180,000, retaining a royalty-free license allowing
      us
      to continue to use our former patent portfolio in support of our existing
      customers. In November 2006, we sold the remaining intellectual property rights
      related to our carrier networking products and services for consideration of
      $80,000, retaining rights to support our existing customers through December
      31,
      2006.





**Employees**





We
      had
      one employee, Terry R. Gibson, our President, Chief Executive Officer and Chief
      Financial Officer, at December 31, 2006.





**Executive
      Officers of the Registrant**





The
      name
      of our executive officer and his age, title and biography as of March 15, 2007
      appears below.





**Name**
            
            **Age**
            
            **Position**Terry
                R. Gibson
            
            53
            
            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.





**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").. 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 Annual 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, our patent portfolio and our intellectual
      property 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. Between September 2004 and
      December 2004, we announced the termination of most of our employees and that
      our products had been formally discontinued 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. In March 2006, we sold
      the
      rights to our patent portfolio, and in November 2006, we sold the remaining
      intellectual property rights related to our carrier network equipment products
      and services. In December 2006, we discontinued our customer service business.
      If we are not successful in executing our redeployment 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
      2007.




6




***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:





·
            we
                may not be able to find suitable acquisition candidates or may not
                be able
                to acquire suitable candidates with our limited financial
                resources;





·
            we
                may not be able to utilize our existing NOLs to offset future
                earnings;





·
            we
                may have difficulty retaining our key remaining
                employee;





·
            we
                may have difficulty retaining our board of directors or attracting
                suitable qualified candidates should a director
                resign.





***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 consummating
      an acquisition of these candidates.





Additionally,
      if we underwent an ownership change, the NOLs would be subject to 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.




7





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 net operating loss
      carryforwards 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.





***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 discontinued 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.




8




***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, 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
      maintain 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 us. Liability claims could require us to
      spend significant time and money in litigation or to pay significant damages.
      As
      a result, any such claims, whether or not successful, could seriously damage
      our
      business prospects.




***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 because others may allege
      infringement of their intellectual property. These claims and any resulting
      lawsuits could subject us to significant liability for damages. 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, 2006, 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.





***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 we will be able to obtain sufficient director and officer liability
      insurance coverage at acceptable rates and with acceptable deductibles and
      other
      limitations. Failure to obtain such insurance could materially harm our
      financial condition in the event that we are required to defend against and
      resolve any future or existing securities class actions or other claims made
      against us or our management arising from the conduct of our operations.
      Further, the inability to obtain such insurance in adequate amounts may impair
      our future ability to retain and recruit qualified officers and
      directors.




9





**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.





**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. On April
      24, 2006, the court held a fairness hearing in connection with the motion for
      final approval of the settlement but has yet to rule on this
      motion.




On
      December 5, 2006, the Court of Appeals for the Second Circuit reversed the
      court's October 2004 order certifying a class in six test cases that were
      selected by the underwriter defendants and plaintiffs in the coordinated
      proceedings. It is unclear what impact this will have on the case. 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.




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***





None.




10





**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.





The
      following table sets forth the high and low sales price of our common stock
      in
      the years ended December 2005 and 2006. Our common stock was de-listed from
      Nasdaq National Market System on June 15, 2005. For the remainder of fiscal
      year
      2005 and for all of fiscal year 2006, our common stock is traded in the
      over-the-counter market. 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****2006**First
                quarter
            
            $
            2.55
            
            $
            2.31Second
                quarter
            
            $
            2.70
            
            $
            2.35Third
                quarter
            
            $
            2.85
            
            $
            2.42Fourth
                quarter
            
            $
            3.40
            
            $
            2.58**2005**First
                quarter
            
            $
            2.54
            
            $
            1.94Second
                quarter
            
            $
            2.76
            
            $
            1.94Third
                quarter
            
            $
            3.15
            
            $
            1.85Fourth
                quarter
            
            $
            2.85
            
            $
            2.30




**Stockholders**





According
      to the records of our transfer agent, at March 12, 2007 we had approximately
      276
      shareholders of record. The majority of our shares are held in approximately
      4,100 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 approved and not approved by the
      stockholders as of December 31, 2006:





11




**EQUITY
      COMPENSATION PLAN INFORMATION**




**Number
                      of Securitiesto be Issued UponExercise of OutstandingOptions,
                      Warrants
                      and**
            
            **Weighted-
                      AverageExercise Price of
                      Outstanding Options, Warrants  and**
            
            **Number
                      of Securities Remaining Available forFuture Issuance UnderEquity
                      Compensation****Plan
                category**
            
            **Rights**
            
            **Rights**
            
            **Plans
                (1)**Equity
                compensation plans approved by stockholders
            
            
            147,000
                (2
            )
            $
            7.69
                (2
            )
            
            1,940,455
              (3
            )Equity
                compensation plans not approved by stockholders (4)
            
            
            —
            
            
            —
            
            
            1,000,000Total
            
            
            147,000
            
            $
            7.69
            
            
            2,940,455





(1)
            These
                numbers exclude shares listed under the column heading "Number of
                Securities to be Issued Upon Exercise of Outstanding Options, Warrants
                and
                Rights."(2)
            Includes
                5,000 shares subject to outstanding options under the 1997 Stock
                Plan,
                112,000 shares subject to outstanding options under the 2000 Stock
                Plan,
                and 30,000 shares subject to outstanding options under the Director
                Plan.(3)
            Includes
                1,924,455 shares available for future issuance under the 2000 Stock
                Plan,
                16,000 shares available for future issuance under the Director 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.




**Performance
      Graph**





*Notwithstanding
      anything to the contrary set forth in any of our previous or future filings
      under the Securities Act of 1933, as amended, or the Securities Exchange Act
      of
      1934, as amended, the following Performance Graph, in whole or in part, shall
      not be incorporated by reference into any such filings and shall not otherwise
      be deemed to be "soliciting material" or " filed" under such acts.*





The
      following graph demonstrates a comparison of cumulative total returns for our
      Common Stock, the Nasdaq Composite Index, the Russell 2000 Index and the
      Nasdaq Telecommunications Index for each of the last five fiscal years ended
      December 31, 2006. The graph assumes an investment of $100 on December 31,
      2001 in each of our Common Stock, and the stocks comprising the Nasdaq Composite
      Index, the Russell 2000 Index and the Nasdaq Telecommunications Index. The
      Indices assume that all dividends were reinvested. On June 16, 2005, our Common
      Stock was de-listed from the Nasdaq National Market System and now trades in
      the
      over the counter market and is quoted on the Pink Sheets Electronic Quotation
      Service under the symbol “COSN.PK.” 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. We terminated all customer
      service operations effective December 31, 2006 and do not intend to offer
      customer support services for our discontinued products in the future. We are
      currently 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 NOLs. We have not identified any suitable
      acquisition candidates or what our new line of business will be and, therefore,
      cannot currently identify a group of comparable peer companies in an industry
      or
      line of business similar to our current business that we believe would provide
      our stockholders with a meaningful comparison.





12









**12/31/01**
            
            **12/31/02**
            
            **12/31/03**
            
            **12/31/04**
            
            **12/31/05**
            
            **12/31/06**COSINE
                COMMUNICATIONS, INC.
            
            
            100.00
            
            
            38.97
            
            
            47.61
            
            
            18.06
            
            
            15.48
            
            
            21.42NASDAQ
                COMPOSITE INDEX
            
            
            100.00
            
            
            69.66
            
            
            99.71
            
            
            113.79
            
            
            114.47
            
            
            124.20RUSSELL
                2000 INDEX
            
            
            100.00
            
            
            79.52
            
            
            117.09
            
            
            138.55
            
            
            144.86
            
            
            171.47NASDAQ
                TELECOMMUNICATIONS INDEX
            
            
            100.00
            
            
            61.62
            
            
            110.79
            
            
            106.16
            
            
            100.63
            
            
            127.11





*The
      Stock Performance shown on the Graph above is not necessarily indicative of
      future performance. We will not make nor endorse any predictions as to future
      stock performance.*





**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.




13





**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, 2006, 2005 and 2004 and the selected consolidated balance sheet data as
      of
      December 31, 2006 and 2005, 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, 2004, and the selected consolidated
      balance sheet data prior to December 31, 2005, 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****2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002****(In
                thousands, except per share data)****Consolidated
                Statements of Operations Data:**Revenue
            
            $
            1,361
            
            $
            3,315
            
            $
            9,675
            
            $
            14,621
            
            $
            23,632Cost
                of revenue
            
            
            1,663
            
            
            2,049
            
            
            7,086
            
            
            6,765
            
            
            13,807Gross
                profit (loss)
            
            
            (302
            )
            
            1,266
            
            
            2,589
            
            
            7,856
            
            
            9,825Operating
                expenses:Research
                and development
            
            
            —
            
            
            103
            
            
            15,078
            
            
            21,756
            
            
            32,396Sales
                and marketing
            
            
            —
            
            
            105
            
            
            10,052
            
            
            13,808
            
            
            28,271General
                and administrative
            
            
            1,316
            
            
            3,227
            
            
            6,064
            
            
            7,226
            
            
            10,959Restructuring
                and impairment charges
            
            
            —
            
            
            (91
            )
            
            8,909
            
            
            336
            
            
            34,538Total
                operating expenses
            
            
            1,316
            
            
            3,344
            
            
            40,103
            
            
            43,126
            
            
            106,164Loss
                from operations
            
            
            (1,618
            )
            
            (2,078
            )
            
            (37,514
            )
            
            (35,270
            )
            
            (96,339
            )Other
                income (expense):Interest
                income
            
            
            1,101
            
            
            678
            
            
            489
            
            
            1,296
            
            
            3,535Interest
                expense
            
            
            (4
            )
            
            —
            
            
            (3
            )
            
            (224
            )
            
            (966
            )Other
            
            
            918
            
            
            (46
            )
            
            (276
            )
            
            (447
            )
            
            313Total
                other income
            
            
            2,015
            
            
            632
            
            
            210
            
            
            625
            
            
            2,882Income
                (loss) before income tax provision (credit)
            
            
            397
            
            
            (1,446
            )
            
            (37,304
            )
            
            (34,645
            )
            
            (93,457
            )Income
                tax provision (credit)
            
            
            (
                52
            )
            
            (
                228
            )
            
            33
            
            
            287
            
            
            509Net
                income (loss)
            
            $
            449
            
            $
            (1,218
            )
            $
            (37,337
            )
            $
            (34,932
            )
            $
            (93,966
            )Basic
                net income (loss) per common share
            
            $
            0.04
            
            $
            (0.12
            )
            $
            (3.70
            )
            $
            (3.57
            )
            $
            (9.72
            )Diluted
                net income (loss) per common share
            
            $
            0.04
            
            $
            (0.12
            )
            $
            (3.70
            )
            $
            (3.57
            )
            $
            (9.72
            )Shares
                used in computing basic net income (loss) per common share
            
            
            10,091
            
            
            10,094
            
            
            10,082
            
            
            9,791
            
            
            9,670Shares
                used in computing diluted net income (loss) per common share
            
            
            10,096
            
            
            10,094
            
            
            10,082
            
            
            9,791
            
            
            9,670


**Consolidated
                Balance Sheets Data:**Cash,
                cash equivalents and short-term investments
            
            $
            22,857
            
            $
            23,166
            
            $
            24,913
            
            $
            57,752
            
            $
            101,467Working
                capital
            
            
            22,477
            
            
            22,353
            
            
            23,214
            
            
            59,705
            
            
            91,868Total
                assets
            
            
            23,036
            
            
            23,840
            
            
            27,823
            
            
            73,426
            
            
            119,561Working
                capital loans
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            131Accrued
                rent
            
            
            —
            
            
            —
            
            
            —
            
            
            2,078
            
            
            2,069Total
                stockholders’ equity
            
            
            22,477
            
            
            22,603
            
            
            23,364
            
            
            61,174
            
            
            93,481




14


**Quarterly
      financial information (unaudited):**





**2005**
            
            **2006****1st**
              **Quarter**
            
            
            **2nd**
              **Quarter**
            
            
            **3rd**
              **Quarter**
            
            
            **4th**
              **Quarter**
            
            
            **1st**
              **Quarter**
            
            
            **2nd**
              **Quarter**
            
            
            **3rd**
              **Quarter**
            
            
            **4th**
              **Quarter****(In
                thousands, except per share data)**Revenue
            
            $
            897
            
            $
            699
            
            $
            785
            
            $
            934
            
            $
            579
            
            $
            520
            
            $
            134
            
            $
            128Gross
                profit (loss)
            
            
            443
            
            
            310
            
            
            83
            
            
            430
            
            
            9
            
            
            (13
            )
            
            (232
            )
            
            (66
            )Net
                income (loss)
            
            
            (878
            )
            
            (633
            )
            
            (
                31
            )
            
            324
            
            
            (126
            )
            
            205
            
            
            (225
            )
            
            595Basic
                and diluted net income (loss) per share
            
            $
            (0.09
            )
            $
            (0.06
            )
            $
            (0.00
            )
            $
            0.03
            
            $
            (0.01
            )
            $
            0.02
            
            $
            (0.02
            )
            $
            0.05




**Item
              7.**
            ***Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations***





**OVERVIEW**





Our
      strategy is 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”). In 2006, we completed the wrap-up of our
      carrier services business, providing customer support services for our
      discontinued products through December 31, 2006, at which time we terminated
      all
      customer support offerings. We also sold the remaining assets of our carrier
      network products business with the sale of our patent portfolio in March 2006
      and the sale of the rights to the related intellectual property in November
      2006.





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, scrapped 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, 2006 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.





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




15




**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 products 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 was probable,
      we
      deferred revenue recognition until we collected payment.





Through
      December 31, 2006, our business consisted 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
      collect 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,
      2005 and 2006, 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. 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.





**Long-lived
      assets**





At
      December 31, 2006, 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 2006 or 2005. 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.




16





**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 a warranty on product or service sales and all warranty obligations
      have expired prior to December 31, 2006.





**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, 2006, no stock options
                re-priced in November 2002 were still outstanding.





Some
      of
      the stock options granted to our employees prior to our IPO in September 2000
      had resulted in deferred compensation as a result of stock options having an
      exercise price below their estimated fair value. Deferred compensation was
      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.





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 or 2006 as the
      quarterly objectives were not met.




17





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
      had a two-year term beginning May 28, 2004 and vested ratably over the term.
      If
      during the two-year term (1) any person or entity had acquired a greater than
      50% interest in us or the ownership or control of more than 50% of our voting
      stock or (2) we had sold substantially all of our intellectual property assets,
      the warrant would have become exercisable. Even if the reseller did not
      immediately exercise the warrant upon the occurrence of such an event that
      made
      the warrant exercisable (a “trigger event”), the reseller would have been
      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 years ended December 31,
      2006
      and 2005, we amortized $100,000 and $339,000, respectively, 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
      2004,
      the majority of our revenue was recognized from the sale of our IP Service
      Delivery Platform and subsequent service support arrangements. In
      2005 and 2006, 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, 2006,
      2005
      and 2004 was as follows, in thousands:





**2006**
            
            **%**
            ****
            **2005**
            ****
            **%**
            ****
            **2004**
            ****
            **%**North
                America
            
            $
            1,211
            
            
            89
            %
            $
            1,901
            
            
            57
            %
            $
            3,364
            
            
            35
            %Asia/Pacific
            
            
            —
            
            
            —
            
            
            617
            
            
            19
            
            
            3,258
            
            
            34Europe
            
            
            150
            
            
            11
            %
            
            797
            
            
            24
            
            
            3,053
            
            
            31Total
                revenue
            
            $
            1,361
            
            
            100
            %
            $
            3,315
            
            
            100
            %
            $
            9,675
            
            
            100
            %





18




Hardware,
      software and service revenue for the years ended December 31, 2006, 2005 and
      2004 was as follows, in thousands:




**2006**
            ****
            **%**
            ****
            **2005**
            ****
            **%**
            ****
            **2004**
            ****
            **%**Hardware
            
            $
            —
            
            
            —
            
            $
            26
            
            
            1
            %
            $
            6,316
            
            
            65
            %Software
            
            
            —
            
            
            —
            
            
            190
            
            
            6
            
            
            608
            
            
            6Services
            
            
            1,361
            
            
            100
            %
            
            3,099
            
            
            93
            
            
            2,751
            
            
            29Total
                revenue
            
            $
            1,361
            
            
            100
            %
            $
            3,315
            
            
            100
            %
            $
            9,675
            
            
            100
            %





In
      2006, all of our revenue was earned from our customer service contracts. The
      decline in revenue as compared to the prior year is due to the fact that our
      customers continued their transition from the discontinued CoSine products
      to
      other suppliers and, as a result, the demand for our services decreased during
      the year. At December 31, 2006, we discontinued our service offerings. See
      "Outlook" section on pages 25 to 26 and "Risk Factors" section on pages 6
      to 9.





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 purchased service contracts for their installed
      systems while they planned and executed their transition from our networking
      systems to other suppliers.





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, 2006, 2005 and 2004, we deferred
      nil, $0.1 million and $0.5 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) $140,000, $339,000 and ($780,000) of non-cash charges
      (credits) related to equity issuances to cost of revenue, operating expenses
      and
      interest expense, for the years ended December 31, 2006, 2005 and 2004,
      respectively.





Below
      is
      a reconciliation of non-cash charges related to equity issuances for the years
      ended December 31, 2006, 2005 and 2004, affecting our cost of revenue, operating
      expenses and interest expense, in thousands:





**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004**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
            
            $
            —
            
            $
            —
            
            $
            92Credits
                related to the reversal of deferred stock compensation amortization
                in
                excess of vesting for terminated employees
            
            
            —
            
            
            —
            
            
            (1,203
            )Amortization
                of deferred compensation associated with re-pricing
            
            
            —
            
            
            —
            
            
            55Issuance
                of common stock for employee stock bonus
            
            
            —
            
            
            —
            
            
            228Amortization
                of charges related to warrants or stock options issued to non-employees
                in
                conjunction with lease, debt and reseller agreements
            
            
            100
            
            
            339
            
            
            48Employee
                stock-based compensation
            
            
            40
            
            
            —
            
            
            —Net
                non-cash charges related to equity issuances
            
            $
            140
            
            $
            339
            
            $
            (780
            )




19


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 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, 2006 was $1.7 million. Cost of revenue
      included $1.6 million for the cost of our third party customer support service
      provider, and $0.1 million for amortization of a warrant issued to a reseller
      in
      2004.





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 83% for the cost of our third
      party customer support service provider, and $0.3 million or 17% 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.





**Gross
      Profit**





For
      the
      years ended December 31, 2006, 2005 and 2004, gross profit (loss) was ($0.3)
      million, $1.3 million and $2.6 million, respectively.





The
      decrease in gross profit for the year ended December 31, 2006 compared to
      December 31, 2005 is due to the decline in revenue and to the fact that the
      resources needed to provide the support services could not be reduced to fully
      offset the revenue decline.





The
      increase in gross margin as a percent of revenue 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.





**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.




20





Research
      and development expenses were nil, $0.1 million and $15.1 for the years ended
      December 31, 2006, 2005, and 2004, respectively.





Research
      and development expense decreased $0.1 million in the year ended December 31,
      2006 and $15.0 million in the year ended December 31, 2005 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, nil and $0.2 million for the
      years
      ended December 31, 2006, 2005 and 2004, respectively.





**Sales
      and Marketing Expenses**





Sales
      and
      marketing expenses consist primarily of salaries and related expenses for
      personnel engaged in sales, marketing and customer evaluations, as well as
      the
      costs associated with customer evaluations and trials and other promotional
      and
      marketing expenses. Historically, we devoted 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 nil, $0.1 million and $10.1 million for the years ended
      December 31, 2006, 2005, and 2004, respectively.





Sales
      and
      marketing expense decreased by $0.1 million in the year ended December 31,
      2006
      and $10.0 million in the year ended December 31, 2005. 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.





Non-cash
      credits related to equity issuances were nil, nil and $0.2 million in the years
      ended December 31, 2006, 2005 and 2004, respectively.





**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 $1.3 million, $3.2 million and $6.1 million
      for
      the years ended December 31, 2006, 2005 and 2004, respectively.





General
      and administrative expense decreased by $1.9 million, $2.8 million and $1.2
      million for the years ended December 31, 2006, 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 charges (credits) related to equity issuances were
      $40,000, nil and ($0.3) million for the years ended December 31, 2006, 2005
      and
      2004, respectively.




21





**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****Cash
                payments
            
            
            (3
            )
            
            —
            
            
            (450
            )
            
            (453
            )**Provision
                balance at December 31, 2006**
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





*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.




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 paid in January 2005. 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 charged
      to
      restructuring in December 2004 and were paid in 2005.





22




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**
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





**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, 2006, 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, 2006, interest income was $1.1 million, as compared
      to
      $0.7 million at December 31, 2005, and $0.5 million in the year ended December
      31, 2004. The increase is due to higher interest rates in 2006 and 2005,
      partially offset by lower average cash balances.





**Other
      Income**





For
      the
      year ended December 31, 2006, other income includes $640,000 gain on liquidation
      of foreign subsidiaries. The gain is due to the cumulative effect of gains
      and
      losses of converting foreign subsidiaries financial statements into United
      States dollars. The gain, which had been deferred prior to the year ended
      December 31, 2006, was recognized in 2006 with the liquidation of the
      subsidiaries. The liquidations were completed in connection with the cessation
      of our service operations. Other income in 2006 also included $180,000 and
      $80,000 in connection with the sale of our patent portfolio and intellectual
      property, respectively.





**Interest
      Expense**





For
      the
      years ended December 31, 2006, 2005 and 2004, respectively, interest expense
      was
      $4,000, nil and $3,000.





23




**Income
      Tax Provision**





Provisions
      (credits) for income taxes of ($52,000), ($228,000) and $33,000 for the years
      ended December 31, 2006, 2005 and 2004, respectively, were comprised entirely
      of
      foreign corporate income taxes, which are a function of our operations in
      subsidiaries in various countries. The provision (credit) for income taxes
      is
      based on income taxes on minimum profits the foreign operations generated for
      services they provided to us. The credits in 2006 and 2005 relate to the
      liquidation of 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.





Through
      December 31, 2006, our business consisted primarily of a customer support
      capability for our discontinued products provided by a third party. We
      terminated our customer service offerings at December 31, 2006. In March 2006,
      we signed an agreement to sell the rights to our patent portfolio for cash
      consideration of $180,000 and in November 2006 we sold the rights to our
      intellectual property for $80,000 (see Note 9 of the Notes to Consolidated
      Financial Statements). We have 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 our $22.9 million in cash and short term investments
      at
      December 31, 2006 and on our cost reduction activities over the past two years,
      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
      Consolidated Financial Statements. See “Outlook” on pages 25 to 26 and
“Risk Factors” on pages 6 to 9, which describes our redeployment of assets
      strategy.





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, 2006, cash, cash equivalents and short-term investments were $22.9
      million. This compares with $23.2 million at December 31, 2005.





**Operating
      Activities**





We
      used
      $334,000 in cash for operations for the year ended December 31, 2006, a decrease
      of $1.5 million from the cash used for operations in 2005. The improvement
      is
      due primarily to the $449,000 in net income in 2006 as compared to a $1.2
      million net loss in 2005, partially offset by decreases in accrued liabilities
      as we completed our restructuring activities.




24




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, 2006, we utilized $6.9 million in cash to fund an
      increase in our short term investments. For the year ended December 31, 2005,
      we
      generated $5.0 million in cash from investing activities.





**** 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.





**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.





**Financing
      Activities**





**** We
      had no
      financing activities during the years ended December 31, 2006 or
      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.





**Contractual
      Obligations**





Our
      contractual obligations as of December 31, 2006 consist of a month-to-month
      office lease with a total annual rent of $48,000.





**OUTLOOK**





Our
      board
      of directors, on completion of a comprehensive review of strategic alternatives,
      has approved a plan to redeploy our existing resources to identify and acquire
      one or more new business operations. 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.





At
      December 31, 2006, we had $22.9 million in cash and short-term investments.
      Cash
      consumption by operations during the year ended December 31, 2006 was $308,000.
      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
      June
      2006, the Financial Accounting Standards Board (“FASB”) issued FASB
      Interpretation No. 48, “Accounting for Uncertainty in Income Taxes —
an interpretation of FASB Statement No. 109” (FIN 48). FIN 48
      prescribes a recognition threshold and measurement attribute for financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return, and also provides guidance on derecognition,
      classification, interest and penalties, accounting in interim periods,
      disclosure, and transition. FIN 48 is effective for fiscal years beginning
      after December 15, 2006. We are currently evaluating the impact of adopting
      FIN 48 on our financial statements.




In
      September 2006, the FASB issued FASB Statement No. 157, Fair Value
      Measurements, or SFAS 157. The standard provides guidance for using fair
      value to measure assets and liabilities. The standard also responds to
      investors’ requests for expanded information about the extent to which companies
      measure assets and liabilities at fair value, the information used to measure
      fair value, and the effect of fair value measurements on earnings. The standard
      applies whenever other standards require or permit assets or liabilities to
      be
      measured at fair value. The standard does not expand the use of fair value
      in
      any new circumstances. SFAS 157 must be adopted prospectively as of the
      beginning of the year it is initially applied. SFAS 157 is effective for
      financial statements issued for fiscal years beginning after November 15,
      2007, and interim periods within those fiscal years. We are still evaluating
      the
      impact of this standard will have on our financial position or results of
      operations.




25





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No,
      158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement
      Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (SFAS
      158). This statement requires balance sheet recognition of the overfunded or
      underfunded status of pension and postretirement benefit plans. Under SFAS
      158,
      actuarial gains and losses, prior service costs or credits, and any remaining
      transition assets or obligations that have not been recognized under previous
      accounting standards must be recognized in Accumulated Other Non-Shareowners’
Changes in Equity, net of tax effects, until they are amortized as a component
      of net periodic benefit cost. The adoption of SFAS 158 is not expected to have
      a
      material impact on the consolidated financial position or results of operations
      of the Company.





In
      September 2006, the Securities and Exchange Commission issued Staff Accounting
      Bulletin No. 108, “Considering the Effects of Prior Year Misstatements
      when Quantifying Misstatements in the Current Year Financial Statements”
(SAB 108). SAB 108 addresses how the effects of prior-year uncorrected
      misstatements should be considered when quantifying misstatements in
      current-year financial statements. SAB 108 requires an entity to quantify
      misstatements using a balance sheet and income-statement approach and to
      evaluate whether either approach results in quantifying an error that is
      material in light of relevant quantitative and qualitative factors. The guidance
      is applicable for fiscal years ending after November 15, 2006. SAB 108
      did not have a material impact on our December 31, 2006 consolidated financial
      statements.





In
      February 2007, the FASB issued FASB Statement No. 159, “The Fair Value Option
      for Financial Assets and Financial Liabilities—Including an amendment of FASB
      Statement No. 115” (“SFAS 159”). SFAS 159 creates a “fair value option” under
      which an entity may elect to record certain financial assets or liabilities
      at
      fair value upon their initial recognition. Subsequent changes in fair value
      would be recognized in earnings as those changes occur. The election of the
      fair
      value option would be made on a contract-by contract basis and would need to
      be
      supported by concurrent documentation or a preexisting documented policy. SFAS
      159 requires an entity to separately disclose the fair value of these items
      on
      the balance sheet or in the footnotes to the financial statements and to provide
      information that would allow the financial statement user to understand the
      impact on earnings from changes in the fair value. SFAS 159 is effective for
      us
      beginning with fiscal year 2008. We are currently evaluating the impact that
      the
      adoption of SFAS 159 will have on our consolidated financial
      statements.




**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, 2006 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 $48,000 decrease in the fair value of our
      investments in debt securities as of December 31, 2006.




26





**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.




27


**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 Subsidiary (the “Company”) as of December 31, 2006, and 2005 and the
      related consolidated statements of operations, stockholders’ equity, and cash
      flows for each of the three years in the period ended December 31, 2006. Our
      audits also included the financial statement schedule listed in Item
      15(a)(2) as of and for the years ended December 31, 2006, 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. The Company is not required to
      have, nor have we been engaged
      to perform, an audit of the Company's internal control over financial reporting.
      Our audits included consideration of internal control over financial reporting
      as a basis for designing audit procedures that are appropriate in the
      circumstances, but not for the purpose of expressing an opinion on the
      effectiveness of the Company's internal control over financial reporting.
      Accordingly, we express no such opinion. An
      audit
      also includes examining, on a test basis, evidence supporting the amounts and
      disclosures in the financial statements, 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 Subsidiary as of December 31, 2006 and 2005 and the results of their
      operations and their cash flows for each of the three years in the period ended
      December 31, 2006, 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, 2006, 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
      20,
      2007





28






**COSINE
      COMMUNICATIONS, INC.**





**CONSOLIDATED
      BALANCE SHEETS**


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





**December
                31,**
              **2006**
            
            **December
                31,**
              **2005****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            5,207
            
            $
            12,417Short-term
                investments
            
            
            17,650
            
            
            10,749Accounts
                receivable:Trade
                (net of allowance for doubtful accounts of nil at December 31, 2006
                and
                2005, respectively)
            
            
            55
            
            
            96Other
            
            
            68
            
            
            209Prepaid
                expenses and other current assets
            
            
            56
            
            
            119Total
                current assets
            
            
            23,036
            
            
            23,590Long
                term deposit and other
            
            
            —
            
            
            250$
            23,036
            
            $
            23,840**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            320
            
            $
            237Other
                accrued liabilities
            
            
            239
            
            
            874Deferred
                revenue
            
            
            —
            
            
            126Total
                current liabilities
            
            
            559
            
            
            1,237Commitments
                and contingencies (Notes 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, 22,000,000 shares authorized; 10,090,635
                shares
                issued and outstanding at December 31, 2006 and 2005
            
            
            1
            
            
            1Additional
                paid-in capital
            
            
            538,987
            
            
            538,947Accumulated
                other comprehensive income
            
            
            17
            
            
            632Accumulated
                deficit
            
            
            (516,528
            )
            
            (516,977
            )Total
                stockholders' equity
            
            
            22,477
            
            
            22,603$
            23,036
            
            $
            23,840




See
      accompanying notes to consolidated financial statements.





29


**COSINE
      COMMUNICATIONS, INC.**





**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


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





**Year
                Ended December 31,****2006**
            
            **2005**
            
            **2004**Revenue:Product
            
            $
            —
            
            $
            216
            
            $
            6,924Service
            
            
            1,361
            
            
            3,099
            
            
            2,751Total
                revenue
            
            
            1,361
            
            
            3,315
            
            
            9,675Cost
                of revenue (1)
            
            
            1,663
            
            
            2,049
            
            
            7,086Gross
                profit (loss)
            
            
            (302
            )
            
            1,266
            
            
            2,589Operating
                expenses:Research
                and development (2)
            
            
            —
            
            
            103
            
            
            15,078Sales
                and marketing (3)
            
            
            —
            
            
            105
            
            
            10,052General
                and administrative (4)
            
            
            1,316
            
            
            3,227
            
            
            6,064Restructuring
                and impairment charges
            
            
            —
            
            
            (91
            )
            
            8,909Total
                operating expenses
            
            
            1,316
            
            
            3,344
            
            
            40,103Loss
                from operations
            
            
            (1,618
            )
            
            (2,078
            )
            
            (37,514
            )Other
                income (expense):Interest
                income
            
            
            1,101
            
            
            678
            
            
            489Interest
                expense
            
            
            (4
            )
            
            —
            
            
            (3
            )Other
                (5), (6)
            
            
            918
            
            
            (46
            )
            
            (276
            )Total
                other income
            
            
            2,015
            
            
            632
            
            
            210Income
                (loss) before income tax provision
            
            
            397
            
            
            (1,446
            )
            
            (37,304
            )Income
                tax provision (benefit)
            
            
            (
                52
            )
            
            (228
            )
            
            33Net
                income (loss)
            
            $
            449
            
            $
            (1,218
            )
            $
            (37,337
            )Basic
                net income (loss) per share
            
            $
            0.04
            
            $
            (
                0.12
            )
            $
            (3.70
            )Diluted
                net income (loss) per share
            
            $
            0.04
            
            $
            (
                0.12
            )
            $
            (3.70
            )Shares
                used to calculate net income (loss) per share:Basic
            
            
            10,091
            
            
            10,094
            
            
            10,082Diluted
            
            
            10,096
            
            
            10,094
            
            
            10,082





(1)
            Cost
                of revenue includes $100, $339 and $65 of non-cash charges related
                to
                equity issuances in 2006, 2005 and 2004,
                respectively.


(2)
            Research
                and development expenses include no non-cash credits or charges related
                to
                equity issuances in 2006 and 2005, and $213 of non-cash credits related
                to
                equity issuances in 2004.


(3)
            Sales
                and marketing expenses include no non-cash credits or charges related
                to
                equity issuances in 2006 and 2005, and $195 of non-cash credits related
                to
                equity issuances in 2004.


(4)
            General
                and administrative expenses include $40 in non-cash charges related
                to
                equity issuances in 2006, no credits or charges related to equity
                issues
                in 2005, and $305 of non-cash credits related to equity issuances
                in
                2004.


(5)
            Other
                includes foreign exchange gains (losses) of nil, nil, and ($236)
                in 2006,
                2005 and 2004, respectively.


(6)
            Other
                includes gain on disposal of subsidiaries of $640, nil and nil in
                2006,
                2005 and 2004, respectively.




See
      accompanying notes to consolidated financial statements.





30


**COSINE
      COMMUNICATIONS, INC.**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY**


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


**Notes**
              
              **Accumulated****Additional**
              
              **Receivable**
              
              **Other**
              
              
              
              
              
              **Total****Common
                  Stock**
              
              **Paid-in**
              
              **From**
              
              **Comprehensive**
              
              **Deferred**
              
              **Accumulated**
              
              **Stockholders’****Shares**
              
              **Amount**
              
              **Capital**
              
              **Stockholders**
              
              **Income**
              
              **Compensation**
              
              **Deficit**
              
              **Equity****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**Stock
                  based compensation
              
              
              —
              
              
              —
              
              
              40
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              40Components
                  of comprehensive income (loss):Net
                  income
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              449
              
              
              449Unrealized
                  gain on investments, net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              25
              
              
              —
              
              
              **—**
              
              
              25Translation
                  adjustment, net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (640
              )
              
              —
              
              
              —
              
              
              (640
              )Total
                  comprehensive income ( loss)
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (615
              )
              
              —
              
              
              449
              
              
              (166
              )**Balance
                  at December 31, 2006**
              
              
              **10,090,635**
              
              **$**
              **1**
              
              **$**
              **538,987**
              
              **$**
              **—**
              
              **$**
              **17**
              
              **$**
              **—**
              
              **$**
              **(516,528**
              **)**
              **$**
              **22,477**




See
      accompanying notes to consolidated financial statements.




31


**COSINE
      COMMUNICATIONS, INC.**





**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(In
      thousands)**




**Year
                  Ended December 31,****2006**
              
              **2005**
              
              **2004****Operating
                  activities:**Net
                  income (loss)
              
              $
              449
              
              $
              (1,218
              )
              $
              (37,337
              )Adjustments
                  to reconcile net income (loss) to net cash used in operating
                  activities:Depreciation
              
              
              —
              
              
              —
              
              
              1,398Allowance
                  for doubtful accounts
              
              
              —
              
              
              (90
              )
              
              (60
              )Non-cash
                  charges related to inventory write-down
              
              
              —
              
              
              —
              
              
              2,684Write-down
                  of property and equipment
              
              
              —
              
              
              —
              
              
              1,427Non-cash
                  restructuring charges
              
              
              —
              
              
              —
              
              
              2,089Gain
                  on sale of fixed assets
              
              
              —
              
              
              (67
              )
              
              —Stock
                  compensation expense
              
              
              40
              
              
              —
              
              
              —Amortization
                  of deferred stock compensation and charges related to vesting
                  acceleration
              
              
              —
              
              
              —
              
              
              147Reversal
                  of amortization in excess of vesting
              
              
              —
              
              
              —
              
              
              (1,203
              )Amortization
                  of warrants issued for services
              
              
              100
              
              
              339
              
              
              48Issuance
                  of common stock for employee stock bonus
              
              
              —
              
              
              —
              
              
              228Gain
                  on liquidation of foreign subsidiaries
              
              
              (640
              )
              
              —
              
              
              —Other
              
              
              —
              
              
              18
              
              
              124Change
                  in operating assets and liabilities:Accounts
                  receivable (trade)
              
              
              41
              
              
              1,322
              
              
              3,694Other
                  receivables
              
              
              141
              
              
              274
              
              
              11Inventory
              
              
              —
              
              
              —
              
              
              1,319Prepaid
                  expenses and other current assets
              
              
              63
              
              
              830
              
              
              1,644Long-term
                  deposits and other assets
              
              
              150
              
              
              —
              
              
              497Accounts
                  payable
              
              
              83
              
              
              (15
              )
              
              (1,405
              )Provision
                  for warranty liability
              
              
              —
              
              
              (157
              )
              
              (307
              )Accrued
                  compensation
              
              
              —
              
              
              (412
              )
              
              (1,409
              )Accrued
                  other liabilities
              
              
              (635
              )
              
              (2,255
              )
              
              (1,445
              )Deferred
                  revenue
              
              
              (126
              )
              
              (383
              )
              
              (3,034
              )Accrued
                  rent
              
              
              —
              
              
              —
              
              
              (2,078
              )Net
                  cash used in operating activities
              
              
              (334
              )
              
              (1,814
              )
              
              (32,968
              )**Investing
                  activities:**Capital
                  expenditures
              
              
              —
              
              
              —
              
              
              (1,096
              )Proceeds
                  from sale of property and equipment
              
              
              —
              
              
              67
              
              
              1,171Purchase
                  of short-term investments
              
              
              (20,013
              )
              
              (14,089
              )
              
              (34,466
              )Proceeds
                  from sales and maturities of short-term investments
              
              
              13,137
              
              
              19,050
              
              
              56,746Net
                  cash provided by (used in) investing activities
              
              
              (6,876
              )
              
              5,028
              
              
              22,355**Financing
                  activities:**Principal
                  payments of equipment and working capital loans and capital
                  leases
              
              
              —
              
              
              —
              
              
              (129
              )Proceeds
                  from issuance of common stock, net
              
              
              —
              
              
              —
              
              
              226Net
                  cash provided by financing activities
              
              
              —
              
              
              —
              
              
              97Net
                  (decrease) increase in cash and cash equivalents
              
              
              (7,210
              )
              
              3,214
              
              
              (10,516
              )Cash
                  and cash equivalents at the beginning of the period
              
              
              12,417
              
              
              9,203
              
              
              19,719Cash
                  and cash equivalents at the end of the period
              
              $
              5,207
              
              $
              12,417
              
              $
              9,203**Supplemental
                  information:**Cash
                  paid for interest
              
              $
              4
              
              $
              —
              
              $
              3Income
                  taxes paid
              
              $
              —
              
              $
              7
              
              $
              41Cancellation
                  of notes receivable due to repurchase of unvested stock
              
              $
              —
              
              $
              1,520
              
              $
              5,139Net
                  transfer to property and equipment from inventory
              
              $
              —
              
              $
              —
              
              $
              31




See
      accompanying notes to consolidated financial statements.




32


**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, scrapped or wrote-off our inventory, property and equipment.
      As a result of these activities, our business consisted primarily of a customer
      support capability for our discontinued products provided by a third party.
      We
      continued such support activities through December 31, 2006, at which time
      we
      ceased all customer support services. In 2006 we sold our patent portfolio
      and
      the intellectual property related to our carrier products and service business.
      We continue 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, 2006, we have an
      accumulated deficit of $517 million. As of December 31, 2006, we have ceased
      our
      customer service capability. Our actions in the fourth quarter of fiscal year
      2004 to terminate most of our employees and discontinue production activities
      in
      an effort to conserve cash raise 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. We continued to provide
      customer support services through December 31, 2006, at which time we terminated
      customer support operations. During 2006, we sold the rights to our patent
      portfolio and the intellectual property related to our carrier products and
      service business. We continue to pursue our redeployment strategy, which
      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 subsidiary. 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.





33




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, 2006, 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.





For
      the year ended December 31, 2006, we recognized revenue from three customers
      who
      accounted for 58%, 19% and 11% of total revenue, respectively. At December
      31,
      2006 we had two customers who accounted for 67% and 27% of total trade accounts
      receivable, respectively. 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. 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, 2006, 2005 and 2004.





34





***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,****2006**
            
            **2005**Money
                market funds
            
            $
            5,079
            
            $
            16,660Corporate
                obligations
            
            
            16,150
            
            
            1,575Government
                securities
            
            
            1,500
            
            
            4,24822,729
            
            
            22,483Amounts
                classified as cash equivalents
            
            
            (
                5,079
            )
            
            (11,734
            )$
            17,650
            
            $
            10,749





As
      of
      December 31, 2006 and 2005, there were net unrealized gains (losses) of $17,000
      and ($13,000), respectively. All available-for-sale securities have contractual
      maturities of one year or less.





As
      of
      December 31, 2005, $150,000 of restricted cash was included in long-term
      deposits. The amount represents a security deposit for corporate bank credit
      cards. The restriction was removed in 2006.





***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, 2006 and 2005, 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.





35




***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):





******2006**
            
            ******2005**Beginning
                balance
            
            $
            —
            
            $
            157Warranty
                charged to cost of revenue
            
            
            —
            
            
            —Utilization
                of warranties
            
            
            —
            
            
            —Changes
                in estimated liability based on experience
            
            
            —
            
            
            (157
            )Ending
                balance
            
            $
            —
            
            $
            —





All
      warranty obligations have expired on or before December 31, 2006.





***Stock-Based
      Compensation***





On
      January 1, 2006, the Company adopted Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which
      requires the measurement and recognition of compensation expense for all
      share-based payment awards made to employees and directors, including employee
      stock options based on estimated fair values. SFAS 123(R) supersedes the
      Company’s previous accounting under Accounting Principles Board Opinion
      No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods
      beginning in 2006. In March 2005, the Securities and Exchange Commission issued
      Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The
      Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).




The
      Company adopted SFAS 123(R) using the modified prospective transition method.
      The Company’s consolidated financial statements as of December 31, 2006 reflect
      the impact of SFAS 123(R). In accordance with the modified prospective
      transition method, the Company’s consolidated financial statements for prior
      periods have not been restated to reflect, and do not include, the impact of
      SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R)
      for
      the year ended December 31, 2006 was $40,000, which consisted of stock-based
      compensation expense related to employee stock options. No stock-based
      compensation expense related to employee stock options was recognized for the
      year ended December 31, 2005.





SFAS
      123(R) requires companies to estimate the fair value of share-based payment
      awards on the date of grant using an option-pricing model. The value of the
      portion of the award that is ultimately expected to vest is recognized as
      expense over the requisite service periods in the Company’s consolidated
      statements of operations. Prior to the adoption of SFAS 123(R), the Company
      accounted for stock-based awards to employees and directors using the intrinsic
      value method in accordance with APB 25 as allowed under Statement of Financial
      Accounting Standards No. 123, “Accounting for Stock-Based Compensation”
(“SFAS 123”). Under the intrinsic value method, no stock-based compensation
      expense had been recognized in the Company’s consolidated statements of
      operations because the exercise price of the Company’s stock options granted to
      employees and directors equaled the fair market value of the underlying stock
      at
      the date of grant.





Stock-based
      compensation expense recognized during the current period is based on the value
      of the portion of share-based payment awards that is ultimately expected to
      vest
      during the period. Stock-based compensation expense recognized in the Company’s
      consolidated statements of operations for the year ended December 31, 2006
      included compensation expense for share-based payment awards granted prior
      to,
      but not yet vested as of December 31, 2005 based on the grant date fair value
      estimated in accordance with the pro forma provisions of SFAS 123, and
      compensation expense for the share-based payment awards granted subsequent
      to
      December 31, 2005 based on the grant date fair value estimated in accordance
      with the provisions of SFAS 123(R). As stock-based compensation expense
      recognized in the consolidated statement of operations for the year ended
      December 31, 2006 is based on awards ultimately expected to vest, it has been
      reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be
      estimated at the time of grant and revised, if necessary, in subsequent periods
      if actual forfeitures differ from those estimates. In the Company’s pro forma
      information required under SFAS 123 for the periods ended prior to January
      1,
      2006, the Company accounted for forfeitures as they occurred.





36


Upon
      adoption of SFAS 123(R), the Company selected the Black-Scholes option-pricing
      model (“Black-Scholes model”) to determine the fair value of share-based awards
      granted beginning in fiscal 2006, the same model which was previously used
      for
      the Company’s pro forma information required under SFAS 123. The Company’s
      determination of fair value of share-based payment awards on the date of grant
      using an option-pricing model is affected by the Company’s stock price as well
      as assumptions regarding a number of complex and subjective variables. These
      variables include, but are not limited to, the Company’s expected stock price
      volatility over the term of the awards, and actual and projected employee stock
      option exercise behaviors. Expected volatilities are based on the historical
      volatility of the Company’s common stock. The Company uses historical data to
      estimate option exercise and employee terminations. The expected term of the
      options granted represents the period of time that options are expected to
      be
      outstanding, based on historical information. The risk-free interest rate is
      based on the U.S Treasury zero-coupon issues with remaining terms similar to
      the
      expected term of the Company’s equity awards. The Company does not anticipate
      paying any cash dividends in the foreseeable future and therefore used an
      expected dividend yield of zero. All of our stock compensation is accounted
      for
      as an equity instrument.





*Prior
      to the Adoption of SFAS 123(R)*





In
      2005
      and 2004, the Company accounted for stock-based employee compensation
      arrangements in accordance with provisions of APB Opinion No. 25, “Accounting
      for Stock Issued to Employees,” as interpreted by FASB Interpretation No. 44
      (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an
      Interpretation of APB 25,” Emerging Issues Task Force No. 00-23 (“EITF 00-23”),
“Issues related to the Accounting for Stock Compensation under APB 25 and FIN
      44,” and Financial Accounting Standards Board Interpretation (“FIN”) No. 28,
“Accounting for Stock Appreciation Rights and Other Variable Stock Option or
      Award Plans,” and complied with the disclosure provisions of SFAS No. 148,
“Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment
      of SFAS 123.” Under APB Opinion No. 25, compensation expense was based on the
      difference, if any, on the date of the grant, between the fair value of the
      Company’s stock and the exercise price. SFAS No. 123 as amended by SFAS No. 148
      requires a “fair value” based method of accounting for an employee stock option
      or similar equity instrument. Had compensation cost for the Company’s
      stock-based compensation plan been determined based on the fair value at the
      grant date for awards for 2005 and 2004 consistent with the provisions of SFAS
      No. 123, the Company’s net loss would have been increased to the pro forma
      amounts indicated below (in thousands, except per share data):


Year
                  Ended December 31, 2005
              
              Year
                  Ended December 31, 2004Net
                  loss, as reported
              
              $
              (1,218
              )
              $
              (37,337
              )Add:
                  Stock-based employee compensation expense, net of tax, included
                  in
                  reported net loss
              
              
              —
              
              
              147Deduct:
                  Reversal of amortization in excess of vesting, net of
                  tax
              
              
              —
              
              
              (1,203
              )Deduct:
                  Stock-based employee compensation expense determined under fair
                  value
                  method for all   stock option grants (SFAS 123 expense), net of
                  tax
              
              
              43
              
              
              (173
              )Pro
                  forma net loss
              
              $
              (1,261
              )
              $
              (38,566
              )Basic
                  and diluted net loss per share, as reported
              
              $
              (0.12
              )
              $
              (3.70
              )Pro
                  forma basic and diluted net loss per share
              
              $
              (0.12
              )
              $
              (3.83
              )





37




***Revenue
      Recognition***





In
      2004,
      the majority of our revenue was recognized from the sale of our IP Service
      Delivery Platform and subsequent service support arrangements. In
      2005 and 2006, 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.





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, 2006, 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, 2006, 2005
      and
      2004, we incurred no expense for advertising.





***Net
      Income ( loss) Per Share***





Basic
      net
      income (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 gives 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.





38


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****2006**
            
            **2005**
            
            **2004**Numerator:Net
                income (loss)
            
            $
            449
            
            $
            (1,218
            )
            $
            (37,337
            )Denominator:Weighted
                average shares outstanding for basic income (loss) per
                share
            
            
            10,091
            
            
            10,094
            
            
            10,199Less:
                weighted average shares subject to repurchase
            
            
            —
            
            
            —
            
            
            (117
            )Add:
                effect of dilutive securities - stock options
            
            
            5
            
            
            —
            
            
            —Weighted
                average shares used in basic and diluted netincome
                (loss) per share
            
            
            10,096
            
            
            10,094
            
            
            10,082Basic
                net income (loss) per share
            
            $
            0.04
            
            $
            (0.12
            )
            $
            (3.70
            )Diluted
                net income (loss) per share
            
            $
            0.04
            
            $
            (0.12
            )
            $
            (3.70
            )





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 26,000, 436,000 and 879,000 for
      the
      years ended December 31, 2006, 2005 and 2004, 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, 2006,
      2005
      and 2004 were as follows (in thousands):




**Region**
            
            **Revenue****2006**Europe
            
            $
            150Japan
            
            
            —South
                Korea
            
            
            —North
                America
            
            
            1,211$
            1,361**2005**Europe
            
            $
            797Japan
            
            
            527South
                Korea
            
            
            90Rest
                of Asia/Pacific
            
            
            1,901North
                America
            
            $
            3,315**2004**Europe
            
            $
            3,053Japan
            
            
            1,620South
                Korea
            
            
            1,602Rest
                of Asia/Pacific
            
            
            36North
                America
            
            
            3,364$
            9,675


***Recent
        Accounting Pronouncements***
 
 In
        June
        2006, the Financial Accounting Standards Board (“FASB”) issued FASB
        Interpretation No. 48, “Accounting for Uncertainty in Income Taxes —
an interpretation of FASB Statement No. 109” (FIN 48). FIN 48
        prescribes a recognition threshold and measurement attribute for financial
        statement recognition and measurement of a tax position taken or expected
        to be
        taken in a tax return, and also provides guidance on derecognition,
        classification, interest and penalties, accounting in interim periods,
        disclosure, and transition. FIN 48 is effective for fiscal years beginning
        after December 15, 2006. We are currently evaluating the impact of adopting
        FIN 48 on our financial statements.


39




In
      September 2006, the FASB issued FASB Statement No. 157, “Fair Value
      Measurements,” or SFAS 157. The standard provides guidance for using fair
      value to measure assets and liabilities. The standard also responds to
      investors’ requests for expanded information about the extent to which companies
      measure assets and liabilities at fair value, the information used to measure
      fair value, and the effect of fair value measurements on earnings. The standard
      applies whenever other standards require or permit assets or liabilities to
      be
      measured at fair value. The standard does not expand the use of fair value
      in
      any new circumstances. SFAS 157 must be adopted prospectively as of the
      beginning of the year it is initially applied. SFAS 157 is effective for
      financial statements issued for fiscal years beginning after November 15,
      2007, and interim periods within those fiscal years. We are still evaluating
      the
      impact of this standard will have on our financial position or results of
      operations





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No,
      158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement
      Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (SFAS
      158). This statement requires balance sheet recognition of the overfunded or
      underfunded status of pension and postretirement benefit plans. Under SFAS
      158,
      actuarial gains and losses, prior service costs or credits, and any remaining
      transition assets or obligations that have not been recognized under previous
      accounting standards must be recognized in Accumulated Other Non-Shareowners’
Changes in Equity, net of tax effects, until they are amortized as a component
      of net periodic benefit cost. The adoption of SFAS 158 is not expected to have
      a
      material impact on the consolidated financial position or results of operations
      of the Company.





In
      September 2006, the Securities and Exchange Commission issued Staff Accounting
      Bulletin No. 108, “Considering the Effects of Prior Year Misstatements
      when Quantifying Misstatements in the Current Year Financial Statements”
(SAB 108). SAB 108 addresses how the effects of prior-year uncorrected
      misstatements should be considered when quantifying misstatements in
      current-year financial statements. SAB 108 requires an entity to quantify
      misstatements using a balance sheet and income-statement approach and to
      evaluate whether either approach results in quantifying an error that is
      material in light of relevant quantitative and qualitative factors. The guidance
      is applicable for fiscal years ending after November 15, 2006. SAB 108
      did not have a material impact on our December 31, 2006 consolidated financial
      statements.





In
      February 2007, the FASB issued FASB Statement No. 159, “The Fair Value Option
      for Financial Assets and Financial Liabilities—Including an amendment of FASB
      Statement No. 115” (“SFAS 159”). SFAS 159 creates a “fair value option” under
      which an entity may elect to record certain financial assets or liabilities
      at
      fair value upon their initial recognition. Subsequent changes in fair value
      would be recognized in earnings as those changes occur. The election of the
      fair
      value option would be made on a contract-by contract basis and would need to
      be
      supported by concurrent documentation or a preexisting documented policy. SFAS
      159 requires an entity to separately disclose the fair value of these items
      on
      the balance sheet or in the footnotes to the financial statements and to provide
      information that would allow the financial statement user to understand the
      impact on earnings from changes in the fair value. SFAS 159 is effective for
      us
      beginning with fiscal year 2008. We are currently evaluating the impact that
      the
      adoption of SFAS 159 will have on our consolidated financial
      statements.





***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 a month-to-month operating lease.




Rent
      expense was $55,000, $83,000, and $2,748,000 for the years ended December 31,
      2006, 2005 and 2004, 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.


40






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. On April
      24, 2006, the court held a fairness hearing in connection with the motion for
      final approval of the settlement but has yet to rule on this
      motion.




On
      December 5, 2006, the Court of Appeals for the Second Circuit reversed the
      court's October 2004 order certifying a class in six test cases that were
      selected by the underwriter defendants and plaintiffs in the coordinated
      proceedings. It is unclear what impact this will have on the case. 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.




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.





**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):





**2006**
            
            **2005**Stock
                options:Options
                outstanding
            
            
            147
            
            
            147Available
                for future grants
            
            
            2,940
            
            
            2,940Warrants
                outstanding
            
            
            4
            
            
            2893,091
            
            
            3,229





41




***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, 2006 and 2005, a total of
      1,924,455 and 1,918,455 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, 2006 there were an
      aggregate of 1,037,107 reacquired Shares under the 2002 Plan. At December 31,
      2006 and 2005, a total of
      1,000,000 sh ares
      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.





42




***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, 2006, and 2005, a total of 48,000 shares of common stock have
      been
      authorized for issuance under the Director’s Plan. At December 31, 2006 and
      2005, a total of
      16,000 and 22,000 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.





***Impact
      of the Adoption of SFAS No. 123 (R)***





We
      elected to adopt the modified prospective application method as provided by
      SFAS
      No. 123 (R). The effect of recording stock-based compensation for the year
      ended
      2006 was as follows (in thousands except per share data):


**Year
                  Ended December 31, 2006**Stock-based
                  compensation expense
              
              $
              40Tax
                  effect on stock-based compensation
              
              
              -Net
                  effect on net loss
              
              $
              40Effect
                  on basic and diluted net loss per share
              
              $
              (0.00
              )





Under
      the 1997, 2000 and 2002 stock option plans, the Board of Directors has the
      authority to determine the type of option and the number of shares subject
      to
      each option. The exercise price is generally equal to fair value of the
      underlying stock at the date of grant. Options generally become exercisable
      over
      a four-year period and, if not exercised, expire ten years from the date of
      grant. The 1997 Plan was terminated in connection with our initial public
      offering in 2000, and the shares reserved and unissued under the 1997 Plan
      were
      reserved for issuance under the 2000 Plan.





Under
      the
      Directors’ Option Plan, option grants are made to new non-employee directors and
      to continuing non-employee directors pursuant to the terms contained in the
      Director Stock Option Plan Agreement. The exercise price is equal to fair value
      of the underlying stock at the date of grant. Initial options vest in four
      equal
      annual increments immediately following the date of grant and the subsequent
      options vest on the fourth anniversary of the date of grant. The options, if
      not
      exercised, expire tem years from date of grant.





At
      December 31, 2006, the Company had the following stock plans:


**Shares**
                  **Available for**
                  **Grant**
                
                **Options**
                  **Outstanding**2000
                    Stock Option Plan
                
                
                1,924,000
                
                
                117,0002002
                    Stock Option Plan
                
                
                1,000,000
                
                
                —Directors’
                    Option Plan
                
                
                16,000
                
                
                30,000Totals
                
                
                2,940,000
                
                
                147,000




43





As
      of
      January 1, 2006, we had an unrecorded deferred stock compensation balance
      related to stock options of approximately $139,000 before estimated forfeitures.
      In our pro forma disclosures prior to the adoption of SFAS No. 123 (R), we
      accounted for forfeitures upon occurrence. SFAS No. 123 (R) requires forfeitures
      to be estimated at the time of grant and revised if necessary in subsequent
      periods if actual forfeitures differ from those estimates. Based on our analysis
      of historical experience and review of current option holders, we have assumed
      an annual forfeiture rate of 2.5% for our options. Accordingly, as of January
      1,
      2006, we estimated that the stock-based compensation for the awards not expected
      to vest was approximately $13,000, and therefore, the unrecorded deferred
      stock-based compensation balance related to stock options was adjusted to
      approximately $126,000 after estimated forfeitures.




During
      the fiscal year ended December, 31 2006, there were stock option grants for
      a
      total of 6,000 shares, with an exercise price of $2.45 per share, the market
      price on the date of grant, and 6,000 options were cancelled.





As
      of
      December 31, 2006, the unrecorded stock-based compensation balance related
      to
      stock options was $89,000 and will be recognized over an estimated weighted
      average amortization period of 3 years.





***Valuation
      Assumptions***





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,****2006**
            
            **2005**
            
            **2004**Weighted
                average fair value of shares granted
            
            $
            1.17
            
            $
            1.07
            
            $
            4.41Dividend
                yield
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %Volatility
            
            
            0.40
            
            
            0.47
            
            
            0.95Risk
                free interest rate
            
            
            5.0
            %
            
            4.2
            %
            
            2.6
            %Expected
                life
            
            
            6.25
                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 Employee Stock Purchase Plan
      was terminated in **** 2004.





***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, 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
            
            
            2.56Exercised
            
            
            555
            
            
            (555
            )
            
            7.72Canceled**Balance
                as of December 31, 2005**
            
            
            2,940
            
            
            147
            
            
            8.37Granted
            
            
            (6
            )
            
            6
            
            
            2.45Canceled
            
            
            6
            
            
            (6
            )
            
            18.88**Balance
                as of December 31, 2006**
            
            
            2,940
            
            
            147
            
            $
            7.69





44







The
      aggregate intrinsic value of stock options outstanding at December 31, 2006
      is
      $90,000. The aggregate intrinsic value of options vested and expected to vest
      is
      $88,000 at December 31, 2006 and the weighted average contractual life is 9
      years. The intrinsic value of options exercisable at December 31, 2006 is
      $38,000 and the weighted average contractual life is 9 years.





The
      following table summarizes information concerning options outstanding and
      exercisable at December 31, 2006 (in thousands, except per share
      data):





**Options
                Outstanding****Weighted-**
            
            
            
            **Options
                Exercisable****Average**
            
            **Weighted-**
            
            
            
            **Weighted-****Number**
            
            **Remaining**
            
            **Average**
            
            **Number**
            
            **Average****Range
                of**
            
            **Of**
            
            **Contractual**
            
            **Exercise**
            
            **Of**
            
            **Exercise****Exercise
                Prices**
            
            **Shares**
            
            **Life
                (Years)**
            
            **Price**
            
            **Shares**
            
            **Price**$2.15-2.60
            
            
            118
            
            
            9.0
            
            $
            2.56
            
            
            52
            
            $
            2.585.20
            
            
            4
            
            
            6.6
            
            
            5.20
            
            
            -
            
            
            -6.96
            
            
            12
            
            
            7.1
            
            
            6.96
            
            
            9
            
            
            6.968.80
            
            
            4
            
            
            5.6
            
            
            8.80
            
            
            4
            
            
            8.8022.30
            
            
            4
            
            
            4.7
            
            
            22.30
            
            
            4
            
            
            22.30120.00
            
            
            5
            
            
            3.9
            
            
            120.00
            
            
            5
            
            
            120.00$2.15-120.00
            
            
            147
            
            
            8.4
            
            $
            7.69
            
            
            74
            
            $
            12.47





Exercisable
      options at December 31, 2006 and 2005 were 74,000 and 71,000 shares,
      respectively, at weighted average exercise prices of $12.47 and $13.69 per
      share, 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, nil and $92,000 the years ended December 31, 2006, 2005 and 2004,
      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, 2006, 2005 and 2004,
      credits of nil, nil and $143,000, respectively, were recorded to reverse
      deferred stock compensation amortization in excess of vesting. In 2004, we
      additionally recorded a reversal of deferred stock compensation of $13,000
      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 2006, 2005 or 2004 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.




45





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.





***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 had
      a
      two-year term beginning May 28, 2004 and vested ratably over the term. If during
      the two-year term (1) any person or entity had acquired 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 had sold substantially all of our intellectual
      property assets, the warrant would have become fully exercisable. Even if the
      reseller did not immediately exercise the warrant upon the occurrence of such
      an
      event that made the warrant fully exercisable (a “trigger event”), the reseller
      would have been 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, 2006 and 2005,
      we amortized $100,000 and $339,000 to cost of sales, respectively. During the
      year ended December 31, 2004, we amortized $6,000 to cost of revenue and $42,000
      to general and administrative costs. The fair value of this warrant was fully
      amortized in 2006.





At
      December 31, 2006, warrants to purchase 3,750 shares of common stock at $80.00
      per share were outstanding.





**6.
      Related Parties**




During
      2006 and 2005, we, working with Steel Partners II, L.P. (“Steel Partners”), an
      entity that owns or controls 45% 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 $42,000 and $40,728 in the years ended December 31, 2006 and 2005,
      respectively, in connection with the study and we have reimbursed them for
      these
      costs. At December 31, 2006, there were no amounts due to Steel
      Partners.




46





As
      of
      December 31, 2004, 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.





**7.
      Income Taxes**





The
      provisions (credits) for income taxes of $ (52,000), (228,000) and $33,000
      for
      the years ended December 31, 2006, 2005 and 2004, 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):





**2006**
            
            **2005**
            
            **2004**U.S.
                federal tax benefit at federal statutory rate
            
            $
            170
            
            $
            (353
            )
            $
            (12,683
            )Loss
                for which no tax benefit is currently recognizable
            
            
            .—
            
            
            125
            
            
            12,825Loss
                for which a tax benefit is currently recognizable
            
            
            (170
            )
            
            .
                —
            
            
            .
                —Non-cash
                charges related to equity issuances
            
            
            —
            
            
            —
            
            
            (109
            )Reduction
                of foreign tax accrual
            
            
            (52
            )
            
            —
            
            
            —Total
                provision
            
            $
            (52
            )
            $
            (228
            )
            $
            33





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,****2006**
            
            **2005**Deferred
                tax assets (liabilities):Net
                operating loss carryforwards
            
            $
            128,632
            
            
            126,918Equity
                related charges
            
            
            (193
            )
            
            (193
            )Tax
                credit carryforwards
            
            
            8,435
            
            
            8,435Deferred
                revenue
            
            
            —
            
            
            80Inventory
                reserve
            
            
            157
            
            
            157Capitalized
                research and development
            
            
            5,815
            
            
            6,978Capital
                loss carryforward
            
            
            61,011
            
            
            29,350Accruals
                and reserves not currently deductible
            
            
            26
            
            
            648Total
                deferred tax assets (liabilities)
            
            
            203,883
            
            
            172,373Valuation
                allowance
            
            
            (203,883
            )
            
            (172,373
            )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 $31,510,000 in 2006 and by $678,000 in 2005.




As
      of
      December 31, 2006, we had federal net operating loss carryforwards of
      approximately $342,000,000, which will begin to expire in 2018 if not utilized
      and state net operating loss carryforwards of approximately $207,000,000, 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, 2006 was less than $3.0 million.




47





As
      of
      December 31, 2006 and 2005, 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 2006, we liquidated various foreign subsidiaries resulting in a capital
      loss carryforward of approximately $79,152,000. These losses may only be offset
      against future capital gains and will expire in fiscal 2011 if not utilized.
      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.





**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****Cash
                payments
            
            
            (3
            )
            
            —
            
            
            (450
            )
            
            (453
            )**Provision
                balance at December 31, 2006**
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





*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 paid in January 2005. 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. These amounts were charged to restructuring
      in December 2004 and were paid in 2005.




48





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**
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





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





At
      December 31, 2006 and 2005, 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.





*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.
      Sale of Intellectual Property**





In
      March
      2006, we signed agreements to sell the rights to our patent portfolio for
      $180,000 and in November 2006 we sold the rights to our intellectual property
      for $80,000. These amounts were recorded as other income for the year ended
      December 31, 2006.





49




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





None.





**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, 2006, 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
      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, 2006, 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.





**PART
      III**





**Item
      10.** ***Directors,
      Executive Officers and Corporate Governance***





Except
      as
      set forth above in Part I under “Executive Officers of the Registrant” and in
      the paragraph below, the information required by Item 10 has been omitted from
      this Annual Report on Form 10-K, and is incorporated by reference to the
      sections “Election of Directors” and “Section 16(a) Beneficial Ownership
      Reporting Compliance” in our definitive Proxy Statement for the 2007 Annual
      Meeting of Stockholders, which we will file with the Commission pursuant to
      Regulation 14A within 120 days after the end of our 2006 fiscal
      year.





We
      have
      adopted a code of ethics that applies to our officers, including our principal
      executive officer, principal financial officer, principal accounting officer
      and
      all other officers, directors and employees in compliance with applicable rules
      of the Securities and Exchange Commission. Stockholders may obtain copies of
      our
      code of ethics discussed above by contacting the Secretary of CoSine
      Communications at the address or phone number listed on the cover page of this
      Annual Report.




50




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





Information
      required by Item 11 has been omitted from this Annual Report on Form 10-K and
      is
      incorporated by reference to the section “Executive Compensation” in our
      definitive Proxy Statement for the 2007 Annual Meeting of Stockholders.





**Item
      12.** ***Security
      Ownership of Certain Beneficial Owners and Management and Related Stockholder
      Matters***





Information
      required by Item 12 has been omitted from this Annual Report on Form 10-K and
      is
      incorporated by reference to the sections “Security Ownership of Management and
      Certain Beneficial Owners” and “Equity Compensation Plan Information” in our
      definitive Proxy Statement for the 2007 Annual Meeting of Stockholders.





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





Information
      required by Item 13 has been omitted from this Annual Report on Form 10-K and
      is
      incorporated by reference to the section “Election of Directors” in our
      definitive Proxy Statement for the 2007 Annual Meeting of
      Stockholders.





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





Information
      required by Item 14 has been omitted from this Annual Report on Form 10-K and
      is
      incorporated by reference to the section “Audit Committee Disclosure” in our
      definitive Proxy Statement for the 2007 Annual Meeting of
      Stockholders.





**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
            
            28Consolidated
                Balance Sheets — December 31, 2006 and 2005
            
            29Consolidated
                Statements of Operations — Years ended December 31, 2006, 2005 and
                2004
            
            30Consolidated
                Statements of Stockholders’ Equity and Comprehensive Loss — Years ended
                December 31, 2006, 2005 and 2004
            
            31Consolidated
                Statements of Cash Flows — Years ended December 31, 2006, 2005 and
                2004
            
            32Notes
                to Consolidated Financial Statements
            
            33





(2)  *Financial
      Statement Schedules:*





Schedule
                II — Valuation and Qualifying Accounts
            52





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





51


**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, 2006Reserves
                for accounts receivable
            
            $
            —
            
            
            —
            
            
            —
            
            $
            —Year
                ended December 31, 2005:Reserves
                for accounts receivable
            
            $
            90
            
            $
            (90
            )
            
            —
            
            $
            —Year
                ended December 31, 2004:Reserves
                for accounts receivable
            
            $
            150
            
            $
            38
            
            $
            (98
            )
            $
            90


52





**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 23, 2007.


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




53




**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 23, 2007 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




54





**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 (incorporated by reference
                to
                Exhibit 3.1 to Form 10-K filed March 24, 2006).3.2*
            
            Fourth
                Amended and Restated Certificate of Incorporation filed with the
                Delaware
                Secretary of State on May 30, 2006 (incorporated by reference to
                Exhibit
                3.1 to Form 10-Q filed August 2, 2006).3.3*
            
            Bylaws
                (incorporated by reference to Exhibit 3.3 to Form 8A (file no. 000-30715)
                filed May 26, 2000).3.4*
            
            First
                Amendment to Bylaws dated April 30, 2001 (incorporated by reference
                to
                Exhibit 3.3 to Form 10-Q filed August 13, 2001).3.5*
            
            Second
                Amendment to Bylaws dated January 28, 2003 (incorporated by reference
                to
                Exhibit 3.4 to Form 10-K filed March 27, 2003).3.6*
            
            Third
                Amendment to Bylaws dated February 2, 2004 (incorporated by reference
                to
                Exhibit 3.5 to Form 10-K filed March 25, 2004).3.7*
            
            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
            
            Subsidiary
                of the Registrant23.1
            
            Consent
                of Independent Registered Public Accounting Firm - Burr, Pilger &
                Mayer 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.





55