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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For the fiscal year ended December 31, 2004



OR



| ̈ | 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 0-25996



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TRANSWITCH CORPORATION

(Exact name of Registrant as Specified in its Charter)



|                         |  |                                        
|------------------------ |  | ---------------------------------------
|Delaware                 |  | 06-1236189                             
|(State of Incorporation) |  | (I.R.S. Employer Identification Number)



Three Enterprise
Drive

Shelton, Connecticut 06484

(Address of principal executive offices, including zip code)



Telephone (203) 929-8810



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Securities registered pursuant to Section 12(b) of the Act:



None



Securities registered pursuant to Section 12(g) of the Act:



|                                        |  |                                          
|--------------------------------------- |  | -----------------------------------------
|Title of Each Class                     |  | Name of Each Exchange on Which Registered
|Common Stock, par value $.001 per share |  | Nasdaq National Market                   



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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 ̈



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. ̈



Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act
Rule 12b-2).    Yes  x    No ̈



The aggregate market value of the outstanding common stock, other than
shares held by persons who may be deemed affiliates of the Registrant, as of the last business day of the Registrants most recently completed second fiscal quarter was approximately $159.7 million. At February 28, 2005, as reported on the
Nasdaq National Market, there were 103,470,549 shares of common stock, par value $.001 per share, of the Registrant outstanding.



DOCUMENTS INCORPORATED BY REFERENCE



Parts of the following document are incorporated by reference in Part III of this Form 10-K Report:



(1) Proxy Statement for the Registrants 2005 Annual Meeting of
ShareholdersItems 10, 11, 12, 13 and 14.



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Item 1.Business.



The following description of our business should be read in conjunction with the information included elsewhere in this
document. The description contains certain forward-looking statements that involve risks and uncertainties. When used in this document, the words intend, anticipate, believe, estimate,
plan, and expect and similar expressions as they relate to us are included to identify forward-looking statements. Our actual results could differ materially from the results discussed in the forward-looking statements as a
result of risk factors set forth elsewhere in this document. See also, Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations and Factors That May Affect Future Results.



General



TranSwitch is a Delaware corporation incorporated on April 26, 1988. We
design, develop and market highly integrated semiconductor devices, also referred to as very large scale integration (VLSI) devices, that provide core functionality in voice, data and video communications network equipment deployed in the global
communications network infrastructure. In addition to their high degree of functionality, our products incorporate digital and mixed-signal (analog and digital) processing capabilities, providing comprehensive system-on-a-chip (SOC) solutions to our
customers.



Our products are compliant with relevant
communications network standards including Asynchronous/Plesiochronous Digital Hierarchy (Asynchronous/PDH), Synchronous Optical Network/Synchronous Digital Hierarchy (SONET/SDH), Ethernet and Asynchronous Transfer Mode/Internet Protocol
(ATM/IP).We offer several products that combine multi-protocol capabilities on a single chip, enabling our customers to develop network equipment for multi-service (voice, data and video) applications. A key attribute of our products is
their inherent flexibility. Many of our products incorporate embedded programmable micro-processors, enabling us to rapidly accommodate new customer requirements or evolving network standards by modifying a function of the device via software
instruction.



We bring value to our customers through our
communications systems expertise, VLSI design skills and commitment to excellence in customer support. Our emphasis on technical innovation and complete reference solutions enables us to define and develop products that permit our customers to
achieve faster time-to-market, and to develop communications systems that offer a host of benefits such as greater functionality, improved performance, lower power dissipation, reduced system size and cost, and greater reliability for their
customers.



Our principal customers are the telecommunications
and data communications original equipment manufacturers (OEMs) that serve three market segments:



| |  |  | the worldwide public network infrastructure that supports voice and data communications;
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | the Internet infrastructure that supports the world wide web and other data services; and
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | corporate wide area networks (WANs) that support voice and data information exchange within medium-sized and large enterprises.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



We have sold our VLSI devices to more than 400 customers worldwide since
shipping our first product in 1990. Our products are sold through a worldwide direct sales force and a worldwide network of independent distributors and sales representatives.



Industry Background



State of the Market



After the severe downturn in the global telecommunication market in 2001 and 2002, the market showed signs of stability and mild recovery in the latter
part of 2003. In 2004, the market for our products continued its



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recovery, but showed additional fluctuations in demand. However, communication service providers, Internet service providers, regional Bell operating
companies and interexchange carriers continue to closely monitor their capital expenditures. Spending on voice-only equipment is still slow while spending on equipment providing the efficient transport of data services on existing infrastructure
appears to be slowly recovering. Demand for new, high bandwidth applications such as video conferencing, broadband audio and telephone is placing an increased burden on existing public network infrastructure.



We are heavily focused on two means of efficiently transporting data across
the existing WAN infrastructure: Digital Subscriber Line (DSL) and Ethernet over SONET/SDH (EoS). With the advent of new technologies such as Asymmetrical Digital Subscriber Line 2+ (ADSL2+) and Very high data rate Digital Subscriber Line (VDSL)
that allow greater bandwidth, network equipment deployed in the field will need to be upgraded to provide these services.



Since network growth and investment is increasingly being driven by data applications rather than voice traffic, Ethernet, the ubiquitous standard for
data networking, is gaining traction in the public network infrastructure. Likewise, Internet Protocol (IP) is moving towards replacing Asynchronous Transfer Mode (ATM), frame relay and other legacy protocols.



A key technology in this evolution is EoS, which enables Ethernet services to
be efficiently transported over existing SONET/SDH networks eliminating the need for forklift upgrades of equipment by the service providers. Because of its ability to mesh with the existing investment, EoS is economically attractive to
communication service providers and equipment manufacturers alike.



Data applications are driving new investment not just in wire-line networks, but also in wireless network infrastructures. Higher bandwidth third generation infrastructures, such as UMTS and CDMA2000, will also be based on IP and Ethernet.
The convergence of the wire-line and wireless network infrastructures is underway.



The Role of Communications Standards



In an effort to provide interoperability among communication networks and equipment, the communications industry has established numerous standards and protocols that address connectivity issues between networks and
network equipment. Communication standards protocols for transmission of information such as voice, high speed data or video over electrical, optical or wireless media have been implemented to ensure that equipment from different manufacturers and
the various public and private networks can communicate with each other reliably and efficiently. The VLSI devices supplied by us conform to these standards.



SONET and SDH standards were defined for efficient and reliable transport of information over optical fiber. SONET is primarily a North American standard,
while SDH is its international counterpart. Introduced in the late 1980s, SONET and SDH were initially employed primarily for the transport of voice traffic in telephone networks. Prior to the introduction of the SONET/SDH standards,
Asynchronous/PDH standards were in use for transmission over metallic cables, radio and optical fiber. ATM is a higher level standard that enables public networks, Internet, WAN and local area network (LAN) systems designers to provide a mix of
services to network users. ATM allows communication service providers to reduce the impact of network congestion, assure quality of service and to provide mixed high-speed and high-volume data communications, voice, video and imaging services. This
ability allows the communication service providers to generate more revenue by offering more services to their customers.



IP is another standard that allows packets or frames of data to be forwarded, transmitted, and routed between networks. In the Access networks, IP packets
are generally carried over ATM, where ATM serves as a transport layer for IP packets (i.e. DSL).



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Recently, industry standards have emerged for carrying Ethernet over SONET/SDH. Ethernet is a protocol
that is used throughout LANs. Increased requirements for connectivity between corporate LANs and WANs are driving the need for bridging Ethernet protocol over the public network. Communication service providers are beginning to deploy EoS services
because they represent additional revenue opportunities and are a relatively efficient way to handle increasing amounts of data moving from the LAN to the WAN and then from the WAN to another LAN.



Communications Semiconductors



In order to deploy new infrastructures and transmission protocols,
communication service providers are demanding improved time to market of cost-effective, differentiated products from OEMs. The complexity of the equipment, increasing cost pressures and the need for high reliability and standards compliance mandate
the use of VLSI devices incorporating a high degree of functionality. OEMs recognize that, similar to the trend experienced in the computer industry, the functionality incorporated into VLSI devices is contributing an increasing share of the
intellectual property and the value of network equipment. The design of VLSI devices contained in SONET/SDH, Asynchronous/PDH and ATM/IP equipment requires specialized expertise in mixed-signal semiconductor design and implementation, in-depth
knowledge of telecommunications and data communications standards and systems engineering expertise. Expertise in mixed-signal device design is relatively uncommon, and, as a result, OEMs needing these capabilities often seek independent
semiconductor vendors. However, many semiconductor vendors lack the communications industry knowledge and experience, as well as familiarity with the standards, to be able to contribute significant value to the OEMs systems designs.
Consequently, OEMs require a semiconductor vendor that understands their markets and the applicable standards and is able to provide a broad range of cost-effective semiconductor devices. One of our core competencies is our understanding of these
standards and protocols and our experience in designing these specialized VLSI products.



Our Products and their Applications



We supply high-speed, broadband VLSI semiconductor devices to network systems OEMs that serve three market segments: the worldwide public network infrastructure that supports both voice and data communications, the
Internet infrastructure that supports the World Wide Web and other data services, and corporate WANs that support voice and data information exchange within medium-sized and large enterprises. As a system-on-a-chip innovation leader, our core
competencies include:



| |  |  | an in-depth understanding of SONET/SDH, Ethernet, Asynchronous/PDH and ATM/IP standards;
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | the ability to design complex mixed-signal high-speed VLSI devices; and
| | - |  | -----------------------------------------------------------------------



| |  |  | the capability to verify the design against our customers requirements and industry standards through analysis, simulation, emulation, verification and certification.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our products comply with all relevant industry
standards and provide functionality in three key areas:



| |  |  | SONET/SDH (including EoS) used in high speed (optical) networks;
| | - |  | ----------------------------------------------------------------



| |  |  | Asynchronous/PDH for lower speed (metallic wire) networks; and
| | - |  | --------------------------------------------------------------



| |  |  | ATM and IP data networking protocols.
| | - |  | -------------------------------------



We believe that our chip-set approach and broad product coverage in all three product lines position us as a one-stop source for broadband
communications VLSI products. Network equipment OEMs can mix and match our VLSI devices to optimally configure their specific systems. Our product lines can be combined to provide a cost-effective communication systems solution with increased
functional integration and features while providing seamless integration of SONET/SDH, Asynchronous/PDH and ATM/IP for broadband network applications. In 2004, the prices for our products ranged from approximately $10 to $200 per device, depending
on technology, volume, complexity and functionality.



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Our product portfolio continued to expand in 2004, driven by our customer needs and objectives. Our focus
is on delivering products that enable our OEM customers to support the telecommunication carriers that provide not only data services, but also voice services worldwide. During 2004, we successfully demonstrated several of our new products,
including EtherMap 12/48, Envoy CE-2/CE-4 and PacketTrunk-4. These data-oriented products have continued their design-win momentum during 2004 with many customers worldwide.



SONET/SDH Products



In the SONET/SDH area, we offer framer devices that provide a direct interface for fiber optic transmission in North America, Europe and Asia. Our
mappers bridge the interconnections between SONET/SDH equipment and Asynchronous/PDH equipment, allowing DS-series and E-series transmission lines to be connected with SONET/SDH lines. These mappers transparently transport Asynchronous/PDH signals
across the SONET/SDH network.



Our EtherMap family of products
constitutes a major extension of our SONET/SDH product line. These products comply with recently introduced industry standards for efficient and flexible transport of Ethernet over SONET/SDH networks. Ethernet is universally deployed in enterprise
LANs, while SONET/SDH is equally ubiquitous in optical WANs. Our EtherMap products enable our customers to rapidly enhance their existing systems or to develop new systems that provide Ethernet transport capabilities. This in turn provides value to
their customers, the service providers, by enabling service providers to leverage their existing investment in SONET/SDH networks to provide new revenue generating services.



Our SONET/SDH products have traditionally been used to build Access equipment, add/drop multiplexers, digital cross-
connects and other telecommunication and data communications equipment. This equipment is configured for use in both domestic and international fiber-based public networks. Our SONET/SDH products also have applications in customer premise equipment,
such as routers and hubs, and in central offices, adding integrated fiber optic transmission capability to telephone switches.



With the introduction of the VTXP family of products during 2004, we further strengthened our SONET/SDH switching product offerings. TranSwitch now
provides complete product solutions for our OEM customers to develop scalable, compact and cost-effective Multi-Service Provisioning Platforms (MSPP) for the Access/Metro networks. These products provide a uniform architecture and ease of
integration for OC-3 through OC-48 applications.



Asynchronous/PDH Products



Our
Asynchronous/PDH products are used to configure transmission equipment to increase the capacity of the radio and copper-based public network. Our Asynchronous/PDH VLSI products also enable customer premise equipment to access the public network for
voice and data communications.



Our Asynchronous/PDH products
provide high levels of integration, as well as cost, power and performance benefits relative to discrete and competing integrated circuit solutions. Our Asynchronous/PDH VLSI products include devices that provide solutions for DS-0 through DS-3 and
E-1 through E-3 transmission lines. This product line includes line interfaces, multiplexers, which combine multiple low-speed lines to form a higher speed line, as well as demultiplexers, which perform the reverse function. In addition, we offer
framers, which are devices that identify the starting points of defined bit streams and enable systems to recognize the remaining bits.



ATM/IP Products



Our ATM/IP products provide the key functions of ATM/IP-based multi-service access multiplexer systems. CellBus®is a patented system architecture invented by us for implementing ATM/IP access multiplexers and



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ATM/IP switching systems. The products incorporating ourCellBustechnology include the CUBIT®and ASPEN®families of VLSI devices. Our CellBustechnology provides single-chip ATM/IP switching capability in access equipment. These products have been designed into many network system OEMs
solutions since late 1995, establishingCellBus as a significant technology in the global broadband network access market. Our ATM/IP products also include VLSI semiconductor devices for line interfacing and service adaptation functions,
including the mapping of these data protocols into SONET/SDH.



Our Envoy family of products provides valuable bridging functions for LAN/WAN interconnection. In conjunction with off-the-shelf network processor devices, these devices provide Ethernet services to LAN/WAN routers and switches. Our Envoy
family of products was expanded with additional bandwidth capacity and flexibility with the introduction of Envoy-CE2 and Envoy-CE4 in 2004. These new products incorporate more intelligence and flexibility, allowing OEM customers to address a wide
range of applications in SONET/SDH, MSPP or IP routing applications for the edge or access markets. Standard interfaces such as POS-PHY Level 2/SPI-3 allow OEM customers to develop cost-effective platforms to meet the emerging need of carrier-class
IP/MPLS routers or SONET/SDH data transport applications. Our products have successfully completed interoperability testing with Intel ® IXP2400 network processors.



With the PacketTrunk-4 device, we extended our reach from the Access portion of the communications network to the Edge portion of the communications
network allowing customers to efficiently transport legacy time division multiplexing (TDM) services over IP/MPLS/Ethernet equipment. While communication service providers continue to deploy new data services, predominantly based on Ethernet (EoS)
technology, the need to carry TDM legacy services continues. PacketTrunk allows legacy services to be provided over IP based networks.



The following tables summarize our net product revenue mix by product line for the fiscal years ended December 31, 2004, 2003 and 2002 (dollar amounts in
thousands), respectively:



|                 |  |                              |        |                             |                              |   |                  |                              |                             |  |     |                  |  |                             |        |  |     |  
|---------------- |  | ---------------------------- | ------ | --------------------------- | ---------------------------- | - | ---------------- | ---------------------------- | --------------------------- |  | --- | ---------------- |  | --------------------------- | ------ |  | --- | -
|                 |  | Year ended December 31, 2004 |        |                             | Year ended December 31, 2003 |   |                  | Year ended December 31, 2002 |                            
|                 |  | Product Revenues             |        | Percent of Product Revenues |                              |   | Product Revenues |                              | Percent of Product Revenues |  |     | Product Revenues |  | Percent of Product Revenues |       
|SONET/SDH        |  | $                            | 15,385 |                             | 46                           | % |                  | $                            | 11,155                      |  | 49  | %                |  | $                           | 6,600  |  | 42  | %
|ATM/IP           |  |                              | 9,861  |                             | 29                           | % |                  |                              | 8,066                       |  | 35  | %                |  |                             | 5,193  |  | 33  | %
|Asynchronous/PDH |  |                              | 8,235  |                             | 25                           | % |                  |                              | 3,749                       |  | 16  | %                |  |                             | 4,037  |  | 25  | %
|                 |  |                              |        |                             |                              |   |                  |                              |                             |  |     |                  |  |                             |        |  |     |  
|Total            |  | $                            | 33,481 |                             | 100                          | % |                  | $                            | 22,970                      |  | 100 | %                |  | $                           | 15,830 |  | 100 | %
|                 |  |                              |        |                             |                              |   |                  |                              |                             |  |     |                  |  |                             |        |  |     |  



Applications of
our Products in the Network



The following briefly
describes our view of the Metro and Access areas of the network infrastructure and some typical equipment that may include our VLSI products.



The Access Network



This section of the network infrastructure interconnects end user locations (residences or businesses) to the nearest service provider location (usually
the telephone company central office). The primary functions performed by equipment in the access network are aggregation and distribution of traffic and interconnection to the switching or transmission equipment that connects to the WAN. The Access
network may consist of electrical, optical or wireless transmission equipment. Our VLSI products are used in a variety of equipment in the access network. For example, members of our ASPEN and CUBIT product families are used in Digital Subscriber
Line Access Multiplexers (DSLAMs) that are used to provide DSL services. These products are also used in Base Station equipment for cellular phone service. Our SONET/SDH and Asynchronous/PDH products



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are used in add-drop multiplexers that serve as a primary vehicle for aggregation and distribution of traffic in the Access network.



The Metro Network



The Metro network infrastructure is principally an optical fiber-based
network that provides high-speed communications and data transfer covering an area larger than a campus area network and smaller than a WAN, interconnects two or more LANs, and usually covers an entire metropolitan area, such as a large city and its
suburbs. In addition to interconnecting locations within the metropolitan area, the Metro network connects to the Access portion of the network and the long-haul or core network which interconnects different metropolitan networks across a region, a
country or internationally. Equipment in the Metro network perform functions such as switching or routing of traffic, processing of data in various protocols, and further aggregation and distribution of traffic. Our SONET/SDH framer and mapper
products are used in digital cross-connect systems, add-drop multiplexers and voice equipment that switches high-speed analog signals to digital signals, and also in equipment that splits or combines various transmission signals.



Technology



We believe that one of our core competencies is our knowledge of the telecommunications and data communications landscape.
Specifically, our systems engineering personnel possess substantial telecommunications and data communications design experience, as well as extensive knowledge of the relevant standards. This includes not only a thorough understanding of the actual
written standards, but also an awareness of and appreciation for the nuances associated with the standards necessary for assuring that device designs are fully compliant.



Complementing our communications industry expertise is our VLSI design competence. Our VLSI design personnel have extensive
experience in designing high-speed digital and mixed-signal devices for communications applications. These designs require a sophisticated understanding of complex technology, as well as the specifics of deep sub-micron manufacturing processes and
their resulting impact on device performance. We have developed a large number of VLSI blocks and intellectual property cores that operate under the demanding requirements of the telecommunications and data communications industries. These blocks
and intellectual property cores have been designed using standard VLSI-oriented programming languages such as Visic Hardware Descriptive Language (VHDL) and Verilog, and have been authenticated with standard verification tools.



We have developed proprietary tool sets, called Test Benches,
that facilitate rapid development of VLSI products and help assure that our products are standards compliant and meet customer requirements. These Test Benches consist of behavioral models of all applicable functions in a high-level design
environment and also include test signal generators and analyzers such as models of SONET/SDH signals. Systems engineers use Test Benches to test new architectural concepts, while VLSI designers use Test Benches to ensure that the device conforms to
product specifications.



In addition to the extensive hardware
functionality, many of our products utilize embedded processors that are software programmable. This approach enables us to develop products with higher levels of functionality and flexibility than are possible with purely hardware based solutions.



The new Envoy-CE2, VTXP-6/12 and EtherPHAST-48 Plus are
multi-million gate devices, which will be implemented in 0.18 and 0.13 micron complementary metal oxide semiconductor (CMOS) silicon technologies. They incorporate high speed mixed signal circuitry, and some of these devices are equipped with
embedded processors that provide added functionality through software.



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Other products that incorporate programmability are the ASPEN family of ATM processors, and the PHAST
series of products that target simultaneous mapping and transport of ATM/point-to-point protocol (PPP) and TDM services over fiber optic networks. In addition, we have introduced a family of devices, which provide a high degree of granularity for
access networks. The T3BwP and TEPro VLSI devices support both data and management planes with an on-chip Reduced Instruction Set Computing (RISC) processor supporting full standards-based management and performance monitoring.



We have continued to improve upon our internal chip layout capabilities and
our design for test capability, both of which have resulted in significant improvements in silicon efficiency, silicon testability and time-to-market. Our system-on-a-chip definition, architecture, verification expertise and design methodology
ensure that hardware and software architectural trade-offs yield desired performance testing from our VLSI solutions. The system-on-a-chip performance simulation, emulation, verification and stress testing, using Test Benches and test equipment,
ensure that our products meet carrier class quality, performance and reliability requirements.



The expertise of our personnel, our rigorous design methodology and our investment in state-of-the-art electronic design automation tools enable us to develop the complex and innovative products our customers demand.



Strategy



Our goal is to be the leading supplier of innovative, complete VLSI solutions to telecommunications and data communications
OEMs worldwide. The key elements of our business strategy include the following:



Provide Complete Solutions Within Target Markets



We offer network equipment OEMs chip sets that represent complete solutions for SONET/SDH, Asynchronous/PDH and ATM/IP applications. In addition to
providing our families of VLSI devices, we offer OEM customers the following:



| |  |  | software programs for control of our configurable devices;
| | - |  | ----------------------------------------------------------



| |  |  | product reference design models for both hardware and software applications;
| | - |  | ----------------------------------------------------------------------------



| |  |  | evaluation boards and reference design;
| | - |  | ---------------------------------------



| |  |  | OEM product design support;
| | - |  | ---------------------------



| |  |  | multi-tier applications support; and
| | - |  | ------------------------------------



| |  |  | product technical and design documentation.
| | - |  | -------------------------------------------



Our chip-set approach allows OEMs to optimally configure their products while maintaining product compatibility over multiple generations.
This approach allows equipment vendors to selectively upgrade their products with next-generation higher functionality VLSI devices. We have extended this approach to provide seamless integration of SONET/SDH, Asynchronous/PDH and ATM/IP
applications.



Continue to Promote the Deployment of
Programmable Devices



We intend to continue to develop
and promote programmable system-level building blocks. By providing core functionality in the form of dense, high-speed, programmable packages, we believe these new devices offer greater power, flexibility and functionality at a lower cost than the
single-function, hard-wired devices they are designed to replace. We believe that our functional building blocks represent a new and more versatile approach to designing communications systems and that these new devices have the potential to play a
significant role as product-building platforms in the development of new generations of equipment by networking OEMs.



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Seek Early Market Penetration Through Customer Sponsorship



We seek to develop close sponsoring relationships with strategic OEMs during
product development in order to secure early adoption of our solutions. We believe that OEMs recognize the value of their early involvement through sponsorship of our products, as they can design their system products in parallel with our product
development, thereby accelerating their time to market. In addition, we believe that our sponsoring relationships with leading OEMs helps us to obtain early design wins and help reduce risks of market acceptance for our new products.



Focus on Mixed-Signal Applications



We seek to identify applications requiring our mixed-signal VLSI device
design capabilities. By leveraging both our industry knowledge and the special design skills required for mixed-signal devices, we believe that we are able to identify and implement optimal combinations of design elements for desired analog and
digital functionality targeted toward the specific needs of network equipment OEMs. We believe that our experience and expertise provides our customers accelerated time to market, better performance and lower costs than combinations of separate
digital and analog solutions.



Partner With Selected
Foundries



We work with select third-party foundries
to obtain our semiconductor devices. This approach allows us to avoid substantial capital spending, obtain competitive pricing and technologies, and retain the ability to migrate our products to new process technologies to reduce costs and optimize
performance. Our design methodology enables the production of our devices at multiple foundries using well-established and proven processes. We engage foundries that are ISO 9001:2000 certified for quality and which use only semiconductor processes
and packages that are qualified under industry-standard requirements.



Marketing and Sales



Our marketing strategy
focuses on key customer relationships to promote early adoption of our VLSI devices in the products of market-leading communications equipment OEMs. Through our customer sponsorship program, OEMs collaborate on product specifications and
applications while participating in product testing in parallel with our own certification process. This approach accelerates our customers time-to-market delivery while enabling us to achieve early design wins for our products and volume
forecasts for specific products from these sponsors.



Our sales
strategy primarily focuses on worldwide suppliers of high-speed communications and communications-oriented equipment. These customers include telecommunications, data communications, wireless and wireline equipment, Internet access, customer
premise, computing, process control and defense equipment vendors. In addition, we target emerging technology leaders in the communications equipment market that are developing next generation solutions for the telecommunications and data
communications markets. We identify and address sales opportunities through our worldwide direct sales force and our worldwide network of independent distributors and sales representatives.



Our worldwide direct sales force, technical support personnel and key
engineers work together in teams to support our customers. We have technical support capabilities located in key geographical locations throughout the world as well as a technical support team at our headquarters as a backup to the field
applications engineers.



We have established foreign
distributors and sales representative relationships in Australia, Belgium, Brazil, Canada, China, Germany, India, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, Scandinavian countries, Spain, Switzerland, Taiwan, Turkey and the United
Kingdom. We also sell our products through domestic distributors and a network of domestic sales representatives. We have regional sales and technical support capabilities in Boston, Massachusetts; San Jose, California; Raleigh/Durham, North
Carolina; Paris,



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France; Rome, Italy; Berkshire, England; Hilversum, Netherlands; Brussels, Belgium; New Delhi, India; and Taipei, Taiwan, as well as at our headquarters
facility in Shelton, Connecticut.



Customers



We have sold our products and services to over 400 customers since shipping
our first product in 1990. Our customers include public network systems OEMs that incorporate our products into telecommunications systems, WAN and LAN equipment OEMs, Internet-oriented OEMs, communications test and performance measurement equipment
OEMs and government, university and private laboratories that use our products in advanced public network, and WAN and LAN developments. A small number of our customers have historically accounted for a substantial portion of our net revenues. The
following table sets forth the percentage of net revenues attributable to our major distributors as well as the significant customers that had total purchases (either direct or through distributors) of greater than 10% of net revenues for the fiscal
years ended December 31, 2004, 2003 and 2002, respectively:



|                             |  |                          |   |  |      |   |  |      |  
|---------------------------- |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                             |  | Years ended December 31, |  
|                             |  | 2004                     |   |  | 2003 |   |  | 2002 |  
|Distributors:                |  |                          |   |  |      |   |  |      |  
|Insight Electronics, Inc.(1) |  | 12                       | % |  | 12   | % |  | 10   | %
|Arrow Electronics, Inc.(2)   |  | 10                       | % |  | 11   | % |  | 19   | %
|Weone Corporation            |  | *                        |   |  | *    |   |  | 13   | %
|Significant Customers:       |  |                          |   |  |      |   |  |      |  
|Siemens AG                   |  | 24                       | % |  | 28   | % |  | 19   | %
|Nortel                       |  | 12                       | % |  | *    |   |  | *    |  
|Tellabs, Inc.(2)             |  | 10                       | % |  | 12   | % |  | 23   | %
|Cisco Systems, Inc.(1)       |  | *                        |   |  | *    |   |  | 11   | %

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|(1) | The end customers of the shipments to Insight Electronics, Inc. during 2004 include: Spirent Communications, Cisco Systems, Inc., and Sonus Networks, Inc.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The primary end customer of the shipments to Arrow Electronics, Inc. is Tellabs, Inc.
|--- | -------------------------------------------------------------------------------------

|* | Revenues were less than 10% of our net revenues in these years.
|- | ---------------------------------------------------------------



Information on reportable operating segments for each of the last three years is located in Note 8 of the Notes to Consolidated Financial Statements in
Item 8 of this report.



Research and Development



We believe that the continued introduction of new products in our target
markets is essential to our growth. As of December 31, 2004, we had 166 full-time employees engaged in research and product development efforts. We employ designers who have the necessary engineering and systems qualifications and who are
experienced in software, mixed-signal, high-speed digital, telecommunications and data communications technologies.



Research and development expenditures for the fiscal years ended December 31, 2004, 2003 and 2002 were $46.0 million, $42.0 million, and $53.5 million,
respectively.In the fiscal years ended December 31, 2003 and 2002, we also expensed $0.5 million and $2.0 million, respectively, of purchased in-process research and development related to the acquisitions of ASIC Design Services, Inc., and
Systems On Silicon, Inc., respectively. There were no charges related to purchased in-process research and development during 2004.



All development efforts are carried out usingISO 9001:2000 certified design processes and our design tools and environment are continuously
updated to improve design, fabrication and verification of products. From time to time, we subcontract design services and acquire products from third parties to enhance our product lines. Our internal research and development organization
thoroughly reviews the external development processes and the design of these products as part of our quality assurance process.



10



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Patents and Licenses



Through the end of 2004, we have been issued or became an assignee of 138 patents worldwide with an additional 109 patents pending worldwide. Of that
number, we have been assigned 53 United States patents, of which two are co-assigned. Among the worldwide patents pending, there were 34 United States patents pending. Many of the United States issued and pending patents were also filed
internationally. For one or more of our United States patents, we have coverage in Canada, China, Taiwan, Israel, Japan, Korea, France, Germany, United Kingdom, Belgium, Italy, Sweden, Spain, Ireland, Denmark, The Netherlands, Portugal, Switzerland
(includes Liechtenstein) and Luxembourg. Internationally, there are 48 patents pending in specific countries with an additional 27 filed in the European Patent Office (EPO) or under the Patent Cooperative Treaty (PCT).



We cannot guarantee that our patents will not be challenged or circumvented
by our competitors, and we cannot be sure that pending patent applications will ultimately be issued as patents. Under current law, patent applications in the United States filed before November 29, 2000 are maintained in secrecy until they are
issued, but applications filed after November 29, 2000 (and foreign applications) are generally published 18 months after their priority date, which is generally the filing date.The right to a patent in the United States is attributable to
the first to invent, while in most jurisdictions the right to a patent is obtained by the first to file the patent application.We cannot be sure that our products or technologies do not infringe patents that may be granted in the future
based upon currently pending non-published patent applications or that our products do not infringe any patents or proprietary rights of third parties. From time to time, we receive communications from third parties alleging patent infringement. If
any relevant claims of third-party patents are upheld as valid and enforceable, we could be prevented from selling our products or could be required to obtain licenses from the owners of such patents or be required to redesign our products to avoid
infringement. We cannot be assured that such licenses would be available or, if available, would be on terms acceptable to us or that we would be successful in any attempts to redesign our products or processes to avoid infringement. Our failure to
obtain these licenses or to redesign our products could have a material adverse effect on our business.



We also have been granted registration of 20 trade or service marks in the United States, of which one has been abandoned, and we have one more U.S.
application for trademarks awaiting approval. We have also obtained five trademark registrations under the European Community Trademark (ECT) procedure with one awaiting approval in the ECT and two awaiting approval in Canada.



Our ability to compete depends to some extent upon our ability to protect our
proprietary information through various means, including ownership of patents, copyrights, mask work registrations and trademarks. While no intellectual property right of ours has been invalidated or declared unenforceable, we cannot assure that
such rights will be upheld in the future. We believe that, in view of the rapid pace of technological change in the communication semiconductor industry, the technical experience and creative skills of our engineers and other personnel are the most
important factors in determining our future technological success.



We have entered into various license agreements for product or technology exchange. The purpose of these licenses has, in general, been to obtain second sources for standard products or to convey or receive rights to certain proprietary or
patented cores, cells or other technology.



We sell our
products for applications in the telecommunications and data communications industries, which require our products to conform to various standards that are agreed upon by recognized industry standards committees. Where applicable, we design our
products to be in conformity with these standards. We have received and expect to continue to receive, in the normal course of business, communications from third parties stating that if certain of our products meet a particular standard, these
products may infringe one or more patents of that third party. We review the circumstances of each communication, and, in our discretion and upon the advice of legal counsel, have taken or may take in the future one of the following courses of
action: we may negotiate payment for a license under the patent or patents that may be infringed, we may use our technology and/or patents to negotiate a cross-license with the third party or we may decline to obtain a license on the basis that we
do not infringe the claimants patent or patents, or that such patents are not valid, or other bases. We



11



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cannot assure that licenses for any such patents will be available to us on reasonable terms or that we would prevail in any litigation seeking damages or
expenses from us or to enjoin us from selling our products on the bases of any of the alleged infringements.



Manufacturing and Quality



Our manufacturing objective is to produce reliable, high-quality devices on a cost effective basis. To this end, we seek to differentiate ourselves by:



| |  |  | maximizing the reliability and quality of our products;
| | - |  | -------------------------------------------------------



| |  |  | achieving on-time delivery of our products to our customers;
| | - |  | ------------------------------------------------------------



| |  |  | minimizing capital and other resource requirements by subcontracting capital-intensive manufacturing; and
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | achieving a gross margin commensurate with the value of our products.
| | - |  | ---------------------------------------------------------------------



Established independent foundries manufacture all of our VLSI devices. This approach permits us to focus on our design strengths, minimize fixed costs and
capital expenditures and access diverse manufacturing technologies. Currently, we utilize four foundries to process our wafers, Texas Instruments Incorporated (TI), LSI Logic Corporation, IBM Microelectronics (a division of IBM) and Taiwan
Semiconductor Manufacturing Company Limited (TSMC). All foundries are required to have qualified and reliable processes. The selection of a foundry for a specific device is based on availability of the required process technology and the
foundrys capability to support the particular set of tools used by us for that device.



Various independent subcontractors and foundry suppliers perform assembly and testing functions.Additionally, certain testing and inspection functions are performed at our facility in Shelton, Connecticut.



TUV Rheinland of North America, Inc. registers us as complying
with the requirements of ISO 9001:2000.



Acquisitions



While some of the next generation products we introduce are based on
technologies that we develop ourselves, we have filled some of our technology and skills needs through acquisitions. The following is a table that summarizes technology and skills we obtained through acquisitions of stand-alone companies during the
fiscal years ended 2003 and 2002, respectively. During the fiscal year ended December 31, 2004, there were no acquisitions.



|                                   |  |               |  |                                                
|---------------------------------- |  | ------------- |  | -----------------------------------------------
|Acquired Company                   |  | Date Acquired |  | Technology / Skill Acquired                    
|                                   |  |              
|Systems On Silicon, Inc. (SOSi)(1) |  | March 2002    |  | VLSI solutions for the metro and access markets
|                                   |  |              
|ASIC Design Services, Inc.         |  | August 2003   |  | SONET/SDH design resources                     

---

|(1) | We closed the design center at SOSi. Refer also to Note 13Restructuring and Asset Impairment Charges of our Consolidated Financial Statements.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------



Investments in Non-Publicly Traded Companies



We will, from time-to-time, make investments (which include convertible debt
investments) in early stage venture-backed, start-up companies that develop technologies that are complementary to our product roadmap. In all cases, when investing in other semiconductor companies, we have also entered into commercial agreements
giving us the rights to resell products developed by these companies. A summary of each of these businesses including their locations follows. When determining the accounting method for these investments, we consider



12



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both direct ownership and indirect ownership. We also consider other factors, such as our influence over the financial, technology and operating policies of
these companies.



Metanoia Technologies, Inc. is
a Delaware corporation with development centers in Austin, Texas and Grass Valley, California. Metanoia is developing advanced VLSI devices for next generation xDSL markets, with specific emphasis on discrete multi-tone technology for maximum
interoperability with existing telecommunications equipment. We account for this investment under the cost method and made our initial investment in April 2004.



Opulan Technologies Corporation is a Cayman Islands corporation with offices in Milpitas, California, and a design center in the
Peoples Republic of China. Opulan Technologies provides high performance, cost-effective, IP convergence Application Specific Standard Product (ASSP)/SoC technologies for use in developing broadband multiservice access platforms such as DSLAM,
wireless base station/Radio Network Controller, and Fiber to the Location for its target markets in China, East Asia and North America. We account for this investment under the cost method and made our initial investment in April 2003.



OptiX Networks Inc.is a Delaware corporation having had a
development center in Kfar Saba, Israel. OptiX Networks was developing VLSI devices in advanced technologies for the broadband optical backbone, interoffice and metro area communications. In 2004 we consolidated the assets and liabilities of OptiX
under the guidelines of FIN 46R. We had accounted for this investment under the equity method and made our initial investment in February 2000. In July 2004, we informed OptiX that we planned to discontinue our ongoing funding of OptiXs
operations. Consequently, the OptiX Board of Directors voted to wind-down its business and operations. OptiX completed the wind-down and permanently closed its operations on December 31, 2004. At the completion of the wind-down, OptiX was
deconsolidated from our financial statements.



TeraOp
(USA), Inc. is a Delaware corporation with a research and development center in Kfar Saba, Israel. TeraOp designs micro electro mechanical systems based optical crossbars and variable optical attenuators for next generation core and metro
storage switches and routers. In September 2004, we entered into an agreement with TeraOp under which we converted our promissory notes issued and payable by TeraOp into shares of TeraOp common stock. We then sold all of our common share holdings in
TeraOp to an independent third party for a nominal amount. As a result of these transactions, we no longer hold any equity or debt interest in TeraOp and we have no influence over the operations of TeraOp. Accordingly, TeraOp was deconsolidated from
our financial statements upon the completion of these transactions.



Accordion Networks, Inc. is a California corporation. Accordion Networks, Inc. (Accordion) had been designing and supplying broadband services platforms designed to allow service providers to remotely activate, personalize and
manage bandwidth-intensive applications. During the first quarter of 2004, we impaired our investments and convertible debt in Accordion. The Board of Directors of Accordion discontinued operations in March 2004.



Investments in Venture Capital Funds



We have also invested in Neurone Ventures II (Neurone), which is a
venture capital fund organized as a partnership in the business of making, supervising and disposing of privately negotiated equity and equity-related investments, principally in early-stage Israeli and Israeli-related high-technology companies. We
have a 3% ownership interest in this partnership and we account for it under the cost method.



Competition



The
communication semiconductor industry is intensely competitive and is characterized by the following:



| |  |  | rapid technological change in electronic design automation tools, wafer-manufacturing technologies, process tools and alternate networking technologies;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



13



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| |  |  | availability of fabrication capacity;
| | - |  | -------------------------------------



| |  |  | unforeseen manufacturing yield problems;
| | - |  | ----------------------------------------



| |  |  | heightened international competition in many markets; and
| | - |  | ---------------------------------------------------------



| |  |  | price erosion.
| | - |  | --------------



The telecommunications and data communications industries, which are our primary target markets, are also intensely competitive due to deregulation and
heightened international competition.



The global
telecommunications market, which experienced a severe downturn in 2001 and continued decline through 2002, began to recover slightly during the latter part of 2003. In the first half of 2004, the market for our products continued its steady
recovery, but in the second half of 2004, the market suffered from excess inventories. We believe that this is a short-term phenomenon. The market conditions have impacted the entire supply chain including communication service providers, Internet
service providers, regional Bell operating companies and interexchange carriers, OEMs such as Alcatel, Cisco, Lucent and Nortel, and communication VLSI product vendors such as TranSwitch.



Through on-going planning and analysis with our customers, TranSwitchs product strategy is updated and focused on
their current needs. We participate in industry standards setting groups that give us further insight into market trends and requirements. Recently, we have introduced new product lines that meet our customers evolving data communications
requirements. Our Ethernet over SONET/SDH (EoS) product line enables telecommunication carriers and Internet service providers the ability to offer new revenue-generating services, such as the high-speed transport of information over IP networks,
based on their current network infrastructure. By utilizing the current network infrastructure, telecommunication carriers can realize revenue growth with only a modest increase in their costs.



We believe that our competitive position in the telecommunications
semiconductor industry has remained relatively unchanged. The overall market for our products has dropped on a relative basis, leaving us in a similar market position as prior to the significant decline experienced in the telecommunications market
during the past four years. Some of our competitors are more diversified than we are and accordingly, their other shipments, such as LAN, wireless, and digital signal processing, have helped them to offset the declines in their telecommunications
revenues. Their overall revenues, therefore, may not have declined on a similar basis to ours because we have focused extensively on telecommunications related products.



Our competition consists of specialized semiconductor companies from the United States as well as other countries and
semiconductor divisions of vertically integrated companies, such as IBM Corporation, Lucent Technologies, Inc., NEC Corporation and Siemens Corporation. New entrants are also likely to attempt to obtain a share of the market for our current and
future products.



Our principal competitors in the
Asynchronous/PDH and SONET/SDH areas are Applied Micro Circuits Corporation, Conexant Systems, Inc., Cirrus Logic, Inc., Infineon Technologies, Exar Corporation, Agere Systems, PMC-Sierra Inc., TriQuint Semiconductor, Inc., Vitesse Semiconductor
Corporation and Broadcom Corporation. In addition, there are a number of Applications Specific Integrated Circuit (ASIC) vendors, including AMI Semiconductor, LSI Logic Corporation and STM Microelectronics Group, which compete with us by supplying
customer-specific products to OEMs. In the ATM market, the principal competitors include all the vendors mentioned above and, in addition, Intel Corporation. Other domestic and international vendors have announced plans to enter into this market.



Backlog



As of December 31, 2004 our backlog was $7.1 million, as compared to $7.1 million as of December 31, 2003. Backlog
represents firm orders anticipated to be shipped within the next 12 months. Our business and, to a



14



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large extent, that of the entire communication semiconductor industry, is characterized by short-term order and shipment schedules. Since orders constituting
our current backlog are subject to changes in delivery schedules or to cancellation at the option of the purchaser without significant penalty, backlog is not necessarily an indication of future revenues.



Employees



At December 31, 2004, we employed 247 full time employees, which included 166 in research and development, 51 in marketing
and sales, 17 in operations and quality assurance, and 13 in administration. We have not entered into any collective bargaining agreements. We have never experienced any work stoppage and we believe our employee relations are good.



In January 2005, we implemented an organizational restructuring that further
eliminated 26 full time positions. In addition refer to Note 19Subsequent Eventin our Consolidated Financial Statements.



In the fourth quarter of 2004, we finalized our plans to disengage from Easics N.V., our Belgian design center. This action resulted in a work force
reduction of 24 employees or approximately 9% of our workforce. Refer to Note 13Restructuring and Asset Impairment Chargesin our Consolidated Financial Statements.



Available Information



Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are made available free
of charge through the Investor Relations section of our Internet website (http://www.transwitch.com) as soon as practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. Our executive
offices are located at Three Enterprise Drive, Shelton, CT 06484.



Item 2.Properties



Our headquarters are
located in a suburban office park in Shelton, Connecticut. We have additional sales offices and design centers located throughout the world.The following is a summary of our offices and locations for which we have lease commitments:



|                               |  |                                                                                                |  |               |  |                       
|------------------------------ |  | ---------------------------------------------------------------------------------------------- |  | ------------- |  | ----------------------
|Location                       |  | Business Use                                                                                   |  | SquareFootage |  | Lease Expiration Dates
|Shelton, Connecticut(1)        |  | Corporation Headquarters, Product Development, Operations, Sales, Marketing and Administration |  | 160,936       |  | May 2004  April 2017 
|Raleigh, North Carolina(3)     |  | Product Development                                                                            |  | 10,572        |  | February 2007         
|Stoneham, Massachusetts(2)     |  | Product Development and Sales Support                                                          |  | 8,924         |  | September 2005        
|Bedford, Massachusetts         |  | Product Development                                                                            |  | 10,053        |  | September 2007        
|San Jose, California           |  | Sales and Sales Support                                                                        |  | 2,535         |  | September 2006        
|South Brunswick, New Jersey(4) |  | Product Development                                                                            |  | 6,786         |  | April 2006            
|Toulouse, France               |  | Product Development                                                                            |  | 4,200         |  | December 2007         
|Eclubens, Switzerland          |  | Product Development                                                                            |  | 2,640         |  | April 2005            
|Taipei, Taiwan                 |  | Sales Support                                                                                  |  | 2,500         |  | January 2006          
|New Delhi, India               |  | Product Development                                                                            |  | 20,000        |  | June 2006  May 2007  
|Antony, France                 |  | Sales and Sales Support                                                                        |  | 355           |  | Less then 1 Year      
|Herzelia, Israel               |  | Sales and Sales Support                                                                        |  | 248           |  | Less then 1 Year      



15



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---

Notes



Refer to Note 14Commitments and Contingencies of our Consolidated Financial Statements
for additional disclosures regarding our commitments under lease obligations.Also, refer to Note 13Restructuring and Asset Impairment Charges in our Consolidated Financial Statements regarding our restructuring charges during fiscal
years 2002 through 2004 as we have recorded charges for future rent payments relating to excess office space.



|(1) | Of the space being leased in Shelton, Connecticut, approximately 108,093 feet is considered excess for which we have taken restructuring charges in 2004, 2003, 2002 and 2001.
Approximately 102,979 square feet of this space is currently being sublet.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | We have taken restructuring charges for the facility in Stoneham, Massachusetts effective December 31, 2001 and have transitioned the staff and business functions to our Bedford,
Massachusetts facility.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | We have taken restructuring charges for the facility in Raleigh, North Carolina effective July 15, 2002 and have transitioned the business functions to other TranSwitch facilities.
The Raleigh, North Carolina space is currently being sublet.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | In January 2003, we recorded restructuring charges for the facility in South Brunswick, New Jersey and for the reduction of staff in Bedford, Massachusetts; Shelton, Connecticut;
Switzerland and Belgium. Refer to Note 13Restructuring and Asset Impairment Charges in our Consolidated Financial Statements.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Item 3.Legal Proceedings



We are not party to any material litigation proceedings. However, we are currently prosecuting civil action number 03-10228NG in U.S. District Court in
Massachusetts instituted on February 4, 2003, entitled TranSwitch Corp. v. Galazar Networks, Inc., (Galazar) and are responsible for litigation costs therefrom. We initially asserted that Galazar infringed three of our United States patents, and
Galazar has alleged that those three patents are not infringed, are invalid and are unenforceable, and counterclaimed alleging unfair competition. The Company and Galazar are presently litigating whether the Company should be allowed to replace the
patent infringement counts with a count for false advertising and unfair competition, and Galazar is seeking to add a counterclaim for antitrust law violation. There can be no assurances that we will be successful in our suit against Galazar or that
Galazar will be unsuccessful in its allegations and counterclaims.



From time to time, we may be subject to other legal proceedings and claims in the ordinary course of business. We are not currently aware of any such proceedings or claims that we believe will have, individually or in the aggregate, a
material adverse effect on the business, financial condition or results of operations of the Company.



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



We did not submit any matters to a vote of our security-holders during the three months ended December 31, 2004.



16



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PART II



Item 5.Market for Registrants Common Equity and Related Stockholder Matters



Our common stock is traded under the symbol TXCC on the Nasdaq
National Market. TranSwitchs common stock was listed on the NASDAQ SmallCap market from October 14, 2002 until July 10, 2003, at which time it resumed trading on the Nasdaq National Market. The following table sets forth, for the periods
indicated, the range of high and low closing prices for our common stock.



|                             |  |      |      |     |   |     
|---------------------------- |  | ---- | ---- | --- | - | ----
|                             |  | High |      | Low
|Year ended December 31, 2004 |  |      |      |     |   |     
|First Quarter                |  | $    | 3.80 |     | $ | 2.31
|Second Quarter               |  | $    | 2.88 |     | $ | 1.48
|Third Quarter                |  | $    | 1.80 |     | $ | 1.20
|Fourth Quarter               |  | $    | 1.54 |     | $ | 1.01
|Year ended December 31, 2003 |  |      |      |     |   |     
|First Quarter                |  | $    | 1.07 |     | $ | 0.49
|Second Quarter               |  | $    | 1.91 |     | $ | 0.48
|Third Quarter                |  | $    | 2.98 |     | $ | 1.39
|Fourth Quarter               |  | $    | 3.64 |     | $ | 2.14



As of January 28, 2005
there were approximately 570 holders of record and approximately 29,393 beneficial shareholders of our common stock.



We have never paid cash dividends on our common stock.We currently do not anticipate paying any cash dividend in the foreseeable future.Any future declaration and payment of dividends will be subject to the discretion of our Board of Directors, will be subject to applicable law and will depend upon our results of operations, earnings, financial condition, contractual
limitations, cash requirements, future prospects and any other factors deemed relevant by our Board of Directors.



We also have securities authorized for issuance under equity compensation plans. The following table provides information as of December 31, 2004 with
respect to shares of our common stock that may be issued under our existing equity compensation plans, including our 1995 Third Amended and Restated Stock Plan (the 1995 Plan), our 2000 Stock Option Plan (the 2000 Plan), the
1995 Non-Employee Director Stock Option Plan (the Non-Employee Director Plan), and the 1995 Employee Stock Purchase Plan (the Purchase Plan) as well as the 1995 Stock Plan of Alacrity Communications, Inc. and the 1999 Stock
Incentive Plan of Onex Communications Corporation.



|                                                           |  |                                                                   |     |  |                                                   |       |     |                                                                                        |          
|---------------------------------------------------------- |  | ----------------------------------------------------------------- | --- |  | ------------------------------------------------- | ----- | --- | -------------------------------------------------------------------------------------- | ---------
|Plan Category                                              |  | Number ofSecurities tobe Issued uponExercise ofOutstandingOptions |     |  | WeightedAverageExercisePrice ofOutstandingOptions |       |     | Number ofSecuritiesRemainingAvailable forFuture IssuanceUnder EquityCompensation Plans
|Equity Compensation Plans Approved by Stockholders (1)     |  | 18,099,388                                                        | (3) |  | $                                                 | 8.53  | (3) |                                                                                        | 3,045,173
|Equity Compensation Plans Not Approved by Stockholders (2) |  | 7,394,062                                                         |     |  | $                                                 | 11.84 |     |                                                                                        | 3,224,008
|                                                           |  |                                                                   |     |  |                                                   |       |     |                                                                                        |          
|Total                                                      |  | 25,493,450                                                        |     |  | $                                                 | 9.49  |     |                                                                                        | 6,269,181
|                                                           |  |                                                                   |     |  |                                                   |       |     |                                                                                        |          

---

|(1) | Consists of the 1995 Plan, the Non-Employee Director Plan and the Purchase Plan.
|--- | --------------------------------------------------------------------------------

|(2) | Consists of the 2000 Plan and shares subject to outstanding options granted under equity compensation plans assumed by us in connection with mergers and acquisitions of the
companies which originally granted those options. No additional options may be granted under the assumed plans.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



17



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|(3) | Excludes purchase rights accruing under the Purchase Plan which had a stockholder-approved reserve of 700,000 shares. Under the Purchase Plan, each eligible employee was able to
purchase up to 600 shares of our common stock at semi-annual intervals each year at a purchase price per share equal to 85% of the lower of the fair market value of our common stock on the first or last trading day of a purchase period. The Purchase
Plan was terminated effective December 31, 2004.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Item 6.Selected Financial Data



The
following selected consolidated financial data should be read in conjunction with the consolidated financial statements and related notes thereto and Managements Discussion and Analysis of Financial Condition and Results of
Operations appearing in Item 7 of this Form 10-K.The selected statements of operations data as well as the selected balance sheet data presented below are derived from our consolidated financial statements. Historical periods have been
restated to reflect the share-for-share exchange accounted for as a pooling of interests with Easics N.V. in May 2000 and to reflect the change in reporting method from the cost to the equity method for our investment in OptiX Networks, Inc., and
reclassified to reflect the gain on debt extinguishment previously classified as extraordinary to continuing operations in accordance with SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections (SFAS 145).



|                                                                                                                                        |  |                                                            |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |        
|--------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | -------- | - |  | ---- | -------- | - |  | - | -------
|                                                                                                                                        |  | Years ended December 31,                                  
|                                                                                                                                        |  | 2004                                                       |         |   | 2003 |   |         | 2002 |  |   | 2001     |   |  | 2000
|                                                                                                                                        |  | (Amounts presented in thousands, except per share amounts)
|Selected Statements of Operations Data:                                                                                                 |  |                                                            |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |        
|Net revenues                                                                                                                            |  | $                                                          | 33,687  |   |      | $ | 23,820  |      |  | $ | 16,636   |   |  | $    | 58,682   |   |  | $ | 155,083
|Gross profit (loss)                                                                                                                     |  |                                                            | 23,347  |   |      |   | 15,903  |      |  |   | 5,857    |   |  |      | (1,799   | ) |  |   | 108,936
|Operating (loss) income(4)                                                                                                              |  |                                                            | (43,049 | ) |      |   | (45,739 | )    |  |   | (134,034 | ) |  |      | (141,015 | ) |  |   | 54,216 
|(Loss) income before extraordinary loss and cumulative effect of adoption of and changes in accounting principle(1)(4)(5)               |  |                                                            | (44,347 | ) |      |   | (37,692 | )    |  |   | (165,224 | ) |  |      | (79,426  | ) |  |   | 37,970 
|Extraordinary loss upon consolidation of TeraOp (USA), Inc.                                                                             |  |                                                            |        |   |      |   | (83     | )    |  |   |         |   |  |      |         |   |  |   |       
|Cumulative effect on prior years adoption of and retroactive application of FIN 46R and new depreciation method                         |  |                                                            | (277    | ) |      |   | (805    | )    |  |   |         |   |  |      |         |   |  |   |       
|                                                                                                                                        |  |                                                            |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |        
|Net (loss) income(1)(5)(6)                                                                                                              |  | $                                                          | (44,624 | ) |      | $ | (38,580 | )    |  | $ | (165,224 | ) |  | $    | (79,426  | ) |  | $ | 37,970 
|                                                                                                                                        |  |                                                            |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |        
|Basic (loss) income per common share before extraordinary loss and cumulative effect of a change in accounting
principle(1)(2)(4)(5)(6) |  | $                                                          | (0.47   | ) |      | $ | (0.42   | )    |  | $ | (1.84    | ) |  | $    | (0.91    | ) |  | $ | 0.46   
|Basic (loss) income per common share(1)(2)(4)(5)(6)                                                                                     |  | $                                                          | (0.47   | ) |      | $ | (0.43   | )    |  | $ | (1.84    | ) |  | $    | (0.91    | ) |  | $ | 0.46   
|Diluted (loss) income per common share(1)(2)(3)(5)(6)                                                                                   |  | $                                                          | (0.47   | ) |      | $ | (0.43   | )    |  | $ | (1.84    | ) |  | $    | (0.91    | ) |  | $ | 0.43   
|Shares used in calculation of basic (loss) income per common share(2)                                                                   |  |                                                            | 94,638  |   |      |   | 90,406  |      |  |   | 90,037   |   |  |      | 86,904   |   |  |   | 81,681 
|Shares used in calculation of diluted (loss) income per common share(2)(3)                                                              |  |                                                            | 94,638  |   |      |   | 90,406  |      |  |   | 90,037   |   |  |      | 86,904   |   |  |   | 87,559 



18



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|                                                                                         |  |              |         |      |   |         |  |      |         |      |   |         |  |   |        
|---------------------------------------------------------------------------------------- |  | ------------ | ------- | ---- | - | ------- |  | ---- | ------- | ---- | - | ------- |  | - | -------
|                                                                                         |  | December 31,
|                                                                                         |  | 2004         |         | 2003 |   | 2002    |  | 2001 |         | 2000
|Selected Balance Sheet Data:                                                             |  |              |         |      |   |         |  |      |         |      |   |         |  |   |        
|Cash, cash equivalents and short-term investments                                        |  | $            | 102,504 |      | $ | 152,051 |  | $    | 183,647 |      | $ | 409,592 |  | $ | 564,124
|Total current assets                                                                     |  |              | 112,475 |      |   | 161,485 |  |      | 194,513 |      |   | 427,303 |  |   | 616,825
|Working capital                                                                          |  |              | 76,361  |      |   | 147,845 |  |      | 176,783 |      |   | 402,007 |  |   | 592,934
|Long-term investments (marketable securities)                                            |  |              | 32,178  |      |   | 27,300  |  |      | 21,819  |      |   | 26,582  |  |   | 54,183 
|Total non-current assets                                                                 |  |              | 42,233  |      |   | 44,821  |  |      | 48,840  |      |   | 189,061 |  |   | 124,420
|Total assets(1)                                                                          |  |              | 154,708 |      |   | 206,306 |  |      | 243,353 |      |   | 616,364 |  |   | 741,245
|4.50% Convertible Notes due 2005                                                         |  |              | 24,442  |      |   |        |  |      |        |      |   |        |  |   |       
|Total current liabilities                                                                |  |              | 36,114  |      |   | 13,640  |  |      | 17,730  |      |   | 25,296  |  |   | 23,891 
|4.50% Convertible Notes due 2005                                                         |  |              |        |      |   | 24,442  |  |      | 114,113 |      |   | 314,050 |  |   | 460,000
|5.45% Convertible Plus Cash Notessmdue 2007, net of debt discount of $13,149 and $21,742 |  |              | 67,370  |      |   | 75,866  |  |      |        |      |   |        |  |   |       
|Derivative liability                                                                     |  |              | 8,461   |      |   | 20,659  |  |      |        |      |   |        |  |   |       
|Total non-current liabilities                                                            |  |              | 97,363  |      |   | 143,656 |  |      | 139,962 |      |   | 340,975 |  |   | 460,000
|Total stockholders equity(1)                                                            |  |              | 21,231  |      |   | 49,010  |  |      | 85,661  |      |   | 250,093 |  |   | 257,354
|Book value per share                                                                     |  | $            | 0.21    |      | $ | 0.54    |  | $    | 0.95    |      | $ | 2.75    |  | $ | 3.08   

---

|(1) | The 2001 and 2000 figures have been adjusted for the effect of the change in the investment in OptiX Networks, Inc. from the cost to the equity method of accounting, as required
under generally accepted accounting principles (U.S. GAAP).
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Revised to reflect a 3-for-2 stock split in the form of a dividend on January 11, 2000 and a 2-for-1 stock split in the form of a dividend on August 10, 2000.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | For purposes of calculating diluted (loss) income per common share for the fiscal years ended December 31, 2004, 2003, 2002 and 2001, respectively, the assumed conversion and
exercise of the dilutive securities is not taken into consideration, as they are anti-dilutive.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | The 2002 and 2001 gain on debt extinguishment, previously classified as extraordinary, has been reclassified to continuing operations in accordance with SFAS 145.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | The Company adopted SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), on January 1, 2002, and accordingly, ceased amortizing goodwill totaling $54.5 million
as of January 1, 2002.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Effective January 1, 2003, the Company changed the method of depreciating property and equipment to the straight-line method. Depreciation of property and equipment in prior years
was computed using the half-year convention method. The effect of the change in depreciation method as of January 1, 2003 was applied retroactively to property and equipment acquisitions of prior years. The cumulative effect of the change with
respect to the retroactive application of the straight-line method was an approximately $0.8 million charge (or $0.01 loss per basic and diluted common share) recorded in 2003.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Managements
Discussion and Analysis of Financial Conditions and Results of Operations (MD&A) is provided as a supplement to the accompanying consolidated financial statements and footnotes in Item 8 to help provide an understanding of our financial
condition, changes in our financial condition and results of operations. The MD&A is organized as follows:



Caution concerning forward-looking statements. This section discusses how certain forward-looking statements made by us
throughout the MD&A are based on managements present expectations about future events and are inherently susceptible to uncertainty and changes in circumstances.



Overview. This section provides a general description of our business.



Critical accounting policies and use of
estimates. This section discusses those accounting policies that are both considered important to our financial condition and operating results and require significant judgment and estimates on the part of management in their application.



19



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Restatements of prior period results. During fiscal 2002, we restated 2001
results due to a change in reporting entity related to an investment in a non-publicly traded company. This restatement is further described in this section.



Results of operations. This section provides an analysis of our results of operations for the fiscal years ended December
31, 2004, 2003 and 2002. In addition, a brief description is provided of transactions and events that impact the comparability of the results being analyzed.



Liquidity and capital resources. This section provides an analysis of our cash position and cash flows, as well as a
discussion of our financing arrangements. In this section, we also summarize related party transactions and recent accounting pronouncements not yet adopted by us.



Factors that may affect future results. In this section, we detail risk factors that affect
our quarterly and annual results, but which are difficult to predict.



CAUTION CONCERNING FORWARD-LOOKING STATEMENTS



Managements Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements that involve risks and uncertainties. When used in this report, the words, intend,
anticipate, believe, estimate, plan, expect and similar expressions as they relate to us are included to identify forward-looking statements. Our actual results could differ materially from
those anticipated in these forward-looking statements as a result of factors, including those set forth under FACTORS THAT MAY AFFECT FUTURE RESULTS and elsewhere in this report. You should read this discussion in conjunction with the
consolidated financial statements and the notes thereto included in this report.



Overview



TranSwitch is a Delaware corporation
incorporated on April 26, 1988. We design, develop and market highly integrated semiconductor devices, also referred to as very large scale integration (VLSI) devices, that provide core functionality in voice and data communications network
equipment deployed in the global communications network infrastructure. In addition to their high degree of functionality, our products incorporate digital and mixed-signal (analog and digital) processing capabilities, providing comprehensive
system-on-a-chip (SOC) solutions to our customers.



Our
products are compliant with relevant communications network standards including Asynchronous/Plesiochronous Digital Hierarchy (Asynchronous/PDH), Synchronous Optical Network/Synchronous Digital Hierarchy (SONET/SDH), Ethernet and Asynchronous
Transfer Mode/Internet Protocol (ATM/IP).We offer several products that combine multi-protocol capabilities on a single chip, enabling our customers to develop network equipment for multi-service (voice, data and video) applications. A key
attribute of our products is their inherent flexibility. Many of our products incorporate embedded programmable micro-processors, enabling us to rapidly accommodate new customer requirements or evolving network standards by modifying a function of
the device via software customers.



We bring value to our
customers through our communications systems expertise, VLSI design skills and commitment to excellence in customer support. Our emphasis on technical innovation and complete reference solutions enables us to define and develop products that permit
our customers to achieve faster time-to-market and to produce communications systems that offer a host of benefits such as greater functionality, improved performance, lower power dissipation, reduced system size and cost and greater reliability for
their customers.



After several years of rapid growth, the
global telecommunications industry experienced a severe downturn beginning in 2001. In response to this downturn, we have taken steps to restructure our operations and reduce operating costs. However, we have continued to invest in the design and
development of future products, which



20



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we believe is vital to maintain a competitive edge. As a result, since 2001, the Company has posted significant operating losses.



Our markets stabilized in 2003, and we believe that we are now in the early
stages of a market recovery. For the year ended December 31, 2004, our revenues are up $9.9 million or 41% over the last year, reflecting this strengthening in demand. As our markets continue to strengthen, we believe that our investment in product
development has positioned us to take advantage of this recovery.



Critical
Accounting Policies and Use Of Estimates



Our consolidated
financial statements and related disclosures, which are prepared to conform with accounting principles generally accepted in the United States of America (U.S. GAAP), require us to make estimates and assumptions that affect the reported amounts of
assets, liabilities, revenues and expenses during the period reported. We are also required to disclose amounts of contingent assets and liabilities at the date of the consolidated financial statements. Our actual results in future periods could
differ from those estimates and assumptions. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary.



We consider the most critical accounting policies and uses of estimates in
our consolidated financial statements to be those surrounding:



(1) revenues, cost of revenues and gross profit;



(2) derivative liability associated with our 5.45% Convertible Plus Cash Notessmdue 2007;



(3) estimated excess and obsolete inventories;



(4) estimated restructuring reserves; and



(5) valuation of investments in non-publicly traded companies.



These accounting policies, the bases for these estimates and their potential impact to our consolidated financial
statements, should any of these estimates change, are further described as follows:



Revenues, Cost of Revenues and Gross Profit. Net revenues are primarily comprised of product shipments, principally to
domestic and international telecommunications and data communications OEMs and to distributors. Net revenues from product sales are recognized at the time of product shipment when the following criteria are met: (1) persuasive evidence of an
arrangement exists; (2) title and risk of loss transfers to the customer; (3) the selling price is fixed or determinable; and (4) collectibility is reasonably assured. Agreements with certain distributors provide price protection and return and
allowance rights. With respect to recognizing revenues from our distributors: (1) the prices are fixed at the date of shipment from our facilities; (2) payment is not contractually or otherwise excused until the product is resold; (3) we do not have
any obligations for future performance relating to the resale of the product; and (4) the amount of future returns, allowances, refunds and costs to be incurred can be reasonably estimated and are accrued at the time of shipment. Service revenues
are recognized when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) we have performed a service in accordance with our contractual obligations; (3) the fee is fixed or determinable; and (4) collectibility is
reasonably assured.



At the time of shipment,
we record an expense (and related liability) against our gross product revenues for future price protection and sales allowances. This liability is established based on historical experience, contractually agreed-to provisions and future shipment
forecasts. We had established liabilities totaling $0.4 million and $0.7 million as of December 31, 2004 and 2003, respectively, for price protection and sales allowances related to shipments that were recorded as revenue during the preceding twelve
months. Should our actual experience differ from our estimated liabilities, there could be adjustments (either favorable or unfavorable) to our net revenues, cost of revenues and gross profits.



21



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We also record, at the time of shipment, an expense (and related liability) against our
gross product revenues and an inventory asset against product cost of revenues in order to establish a provision for the gross margin related to future returns under our distributor stock rotation program. As of December 31, 2004, we had established
a liability of $0.7 million and an inventory asset of $0.1 million for a stock rotation reserve for future estimated returns totaling $0.6 million. This compares to a liability of $1.0 million and an inventory asset of $0.5 million for a stock
rotation reserve for future estimated returns totaling $0.5 million as of December 31, 2003. Should our actual experience differ from our estimated liabilities, there could be adjustments (either favorable or unfavorable) to our net revenues, cost
of revenues and gross profits.



We warranty
our products for up to one year from the date of shipment. A liability is recorded for estimated claims to be incurred under product warranties and is based primarily on historical experience. Estimated warranty expense is recorded as cost of
product revenues when products are shipped. As of December 31, 2004 and 2003, we had a warranty liability established in the amounts of $0.3 million and $0.3 million, respectively, which is included in accrued expenses on the consolidated balance
sheets. We had no material warranty claims during the year ended December 31, 2004. Should future warranty claims differ from our estimated current liability, there could be adjustments (either favorable or unfavorable) to our cost of revenues. Any
adjustments to cost of revenues could also impact future gross profits.



Derivative Liability Associated with our 5.45% Convertible Plus Cash Notessmdue
2007.In accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS 133), the
auto-conversion make-whole provision and the holders conversion right (collectively, the features) contained in the terms governing our 5.45% Convertible Plus Cash Notessmdue 2007 (the Plus Cash Notes) were not clearly and closely related to the characteristics of the Plus Cash Notes upon issuance. Accordingly, these features
qualified as embedded derivative instruments and, because they do not qualify for any scope exception within SFAS 133, they are required by SFAS 133 to be accounted for separately from the debt instrument and recorded as derivative financial
instruments.



During the year ended
December 31, 2004, we recorded other income of $12.1 million, of which, $2.1 million and $10.0 million related to the auto-conversion make-whole provision and holders conversion right, respectively, to reflect the change in fair value of our
derivative liability. During the year ended December 31, 2003, we recorded other income of $2.6 million, of which, $0.8 million and $1.8 million related to the auto-conversion make-whole provision and holders conversion right, respectively, to
reflect the change in fair value of our derivative liability, which is shown below:



|                                                                                                                    |  |                  |        |                  |   |                   |  |   |       
|------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ------ | ---------------- | - | ----------------- |  | - | ------
|(Tabular dollars in thousands, except per share amounts)                                                            |  | December 31,2004 |        | December 31,2003 |   | September 30,2003
|Closing price of our common stock used to value our derivative liability                                            |  | $                | 1.54   |                  | $ | 2.30              |  | $ | 2.48  
|Estimated fair value of Auto-Conversion Make Whole Provision                                                        |  |                  | 74     |                  |   | 2,186             |  |   | 3,011 
|Estimated fair value of Holders Conversion Right                                                                   |  |                  | 8,461  |                  |   | 18,473            |  |   | 20,267
|                                                                                                                    |  |                  |        |                  |   |                   |  |   |       
|Total Liability                                                                                                     |  | $                | 8,535  |                  | $ | 20,659            |  | $ | 23,278
|                                                                                                                    |  |                  |        |                  |   |                   |  |   |       
|Total change in fair value determined during the year ended December 31, 2004 and 2003 and recorded as other income |  | $                | 12,124 |                  | $ | 2,619             |  |   |       



At
each balance sheet date, we adjust the derivative financial instruments to their estimated fair value and analyze the instruments to determine their classification as a liability or equity. As of December 31, 2004, the estimated fair value of our
derivative liability was $8.5 million, of which $0.1 million and $8.4 million related to the auto-conversion make-whole provision and holders conversion right, respectively. As of December 31, 2003, the estimated fair value of our derivative
liability was $20.7 million, of which $2.2



22



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million and $18.5 million related to the auto-conversion make-whole provision and holders conversion right, respectively. The estimated fair value of
the auto-conversion make-whole provision and holders conversion right were determined using the Monte Carlo simulation model and the Black-Scholes option pricing model, respectively. These models use several assumptions including: historical
stock price volatility, risk-free interest rates, remaining maturity, and the closing price of our common stock to determine estimated fair value of our derivative liability. We believe that the assumption that has the greatest impact on the
determination of fair value is the closing price of our common stock during each quarterly period. Accordingly, we have calculated the fair value of the derivative liability as shown in the following different scenarios below. We have included the
change in the fair value of the derivative liability below based on all assumed estimates remaining the same except for our common stock price.



|                                                                                                                                 |  |       |        |       |   |        |  |        |        |     |   |        |     |   |        |     |  |   |        |   |  |   |        |  
|-------------------------------------------------------------------------------------------------------------------------------- |  | ----- | ------ | ----- | - | ------ |  | ------ | ------ | --- | - | ------ | --- | - | ------ | --- |  | - | ------ | - |  | - | ------ | -
|(Tabular dollars in thousands, except per share amounts)                                                                         |  |       |        |       |   |        |  |        |        |     |   |        |     |   |       
|% change from our actual common stockprice of $1.54 as of December 31, 2004                                                      |  | (50)% |        | (25)% |   | (10)%  |  | Actual |        | 10% |   |        | 25% |   |        | 50% | 
|Closing price of our common stock used to value our derivative liability                                                         |  | $     | 0.77   |       | $ | 1.16   |  | $      | 1.39   |     | $ | 1.54   |     | $ | 1.69   |     |  | $ | 1.93   |   |  | $ | 2.31   |  
|                                                                                                                                 |  |       |        |       |   |        |  |        |        |     |   |        |     |   |        |     |  |   |        |   |  |   |        |  
|Estimated fair value of our derivative liability as of December 31, 2004                                                         |  | $     | 3,143  |       | $ | 5,746  |  | $      | 7,413  |     | $ | 8,535  |     | $ | 9,691  |     |  | $ | 11,565 |   |  | $ | 14,624 |  
|                                                                                                                                 |  |       |        |       |   |        |  |        |        |     |   |        |     |   |        |     |  |   |        |   |  |   |        |  
|Change in fair value of our derivative liability determined during the year ended December 31, 2004 and recorded as
other income |  | $     | 17,516 |       | $ | 14,913 |  | $      | 13,246 |     | $ | 12,124 |     | $ | 10,968 |     |  | $ | 9,094  |   |  | $ | 6,035  |  
|                                                                                                                                 |  |       |        |       |   |        |  |        |        |     |   |        |     |   |        |     |  |   |        |   |  |   |        |  
|Incremental other income (expense) that would have been recorded in the year ended December 31, 2004                             |  | $     | 5,392  |       | $ | 2,789  |  | $      | 1,122  |     | $ |       |     | $ | (1,156 | )   |  | $ | (3,030 | ) |  | $ | (6,089 | )
|                                                                                                                                 |  |       |        |       |   |        |  |        |        |     |   |        |     |   |        |     |  |   |        |   |  |   |        |  
|                                                                                                                                 |  |       |        |       |   |        |  |        |        |     |   |        |     |   |        |     |  |   |        |   |  |   |        |  



As of
December 31, 2004 and 2003, these embedded derivative financial instruments were recorded and classified as a derivative liability on our consolidated balance sheet because the daily volume weighted average price of our common stock determined
according to the voluntary conversion provision was below the threshold price of $2.61 as set forth in the terms of the Plus Cash Notes. Thus, if any holders of the Plus Cash Notes voluntarily converted their Plus Cash Notes, we would have to pay
the plus cash amount in cash. Assuming the daily volume weighted average price of our common stock remains below the threshold price, this embedded derivative related to the holders conversion right will continue to be classified as a
derivative liability and adjusted quarterly for changes in fair value during the period of time that any such Plus Cash Notes are outstanding, with the corresponding charge or credit to other expense or income.



In subsequent periods, if the daily volume weighted average
price of our common stock determined according to the voluntary conversion provision equals or exceeds the threshold price of $2.61, the embedded derivative financial instrument related to the holders conversion right will be adjusted to fair
value with the corresponding charge or credit to other expense or income and then reclassified from total liabilities to stockholders equity. Changes in fair value during the period of time that any such Plus Cash Notes are outstanding and
classified within stockholders equity, will be made by a corresponding charge or credit to additional paid-in-capital. The auto-conversion make-whole provision will be adjusted quarterly for changes in fair value during the first two years
that any such Plus Cash Notes are outstanding, with the corresponding charge or credit to other expense or income. The auto-conversion make-whole provision can only be settled with cash and, accordingly, will remain classified as a derivative
liability in the consolidated balance sheets.



Estimated Excess and Obsolete Inventories.We periodically review our inventory levels to determine if inventory is stated at the lower of cost or net realizable value. The telecommunications and data communications industries
have experienced a significant downturn during the past few years and, as a



23



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result, we have had to evaluate our inventory position based on known backlog of orders, projected sales and marketing forecasts, shipment activity and
inventory held at our significant distributors. During the fiscal years ended December 31, 2004, 2003 and 2002, we recorded a charge for excess and obsolete inventories of approximately $0.6 million, $1.5 million and $4.8 million, respectively. Most
of these products have not been disposed of and remain in our inventory.



During fiscal 2004, 2003 and 2002, we recorded net product revenues of approximately $10.9 million, $8.7 million and $4.8 million, respectively, on shipments of excess and obsolete inventory that had previously been
written down to their estimated net realizable value of zero. This resulted in 100% gross margin on these product revenues. Had these products been sold at our historical average cost basis, gross margin would have been 60%, 56% and 51% in 2004,
2003 and 2002 respectively. We currently do not anticipate that a significant amount of the excess and obsolete inventories subject to the write-downs described above will be used in the future based upon our current demand forecast. Should our
actual future demand exceed the estimates that we used in writing down our excess and obsolete inventories, we will recognize a favorable impact to cost of revenues and gross profits. Should demand fall below our current expectations, we may record
additional inventory write-downs which will result in a negative impact to cost of revenues and gross profits.



Estimated Restructuring Reserves. During the fiscal years ended December 31, 2004, 2003 and 2002, we recorded restructuring
charges and asset impairments totaling $1.1 million, $2.5 million and $3.9 million, respectively, related to employee termination benefits and costs to exit certain facilities, net of sub-lease benefits. At December 31, 2004 and 2003, the
restructuring liabilities were $22.6 million and $24.1 million, respectively, on our consolidated balance sheets. Certain assumptions are used by us to derive this estimate, including future maintenance costs, price escalation and sublease income
derived from these facilities. Should we negotiate additional sublease rental income agreements or reach a settlement with our lessors to be released from our existing obligations, we could realize a favorable benefit to our results of future
operations. Should future lease, maintenance or other costs related to these facilities exceed our estimates, we could incur additional expenses in future periods.



Valuation of Investments in Non-Publicly Traded Companies. Since 1999, we have been making
strategic equity investments in non-publicly traded companies that develop technologies that are complementary to our product road map. Depending on our level of ownership and whether or not we have the ability to exercise significant influence, we
account for these investments on either the cost or equity method, and review such investments periodically for impairment. The appropriate reductions in carrying values are recorded when, and if, necessary. The process of assessing whether a
particular investments net realizable value is less than its carrying cost requires a significant amount of judgment. In making this judgment, we carefully consider the investees cash position, projected cash flows (both short and
long-term), financing needs, most recent valuation data, the current investing environment, management / ownership changes, and competition. This evaluation process is based on information that we request from these privately held companies. This
information is not subject to the same disclosure and audit requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary. Based on our evaluations, we recorded impairment charges
related to our investments in non-publicly traded companies of $0.1 million, $1.5 million and $8.7 million during the fiscal years ended December 31, 2004, 2003 and 2002, respectively. The total investment in non-public companies was $2.1 million
and $0.6 million as of December 31, 2004 and 2003, respectively, on our consolidated balance sheets. We used the modified equity method of accounting to determine the impairment loss for certain investments, as it was determined that no better
current evidence of the value of our cost method investments existed and we believe that this gives us the best basis for our estimate given the negative cash flows of these companies. The modified equity method of accounting results in recording an
impairment loss on a cost method investment equal to the investors proportionate share of the investees losses as its contributed capital is consumed to fund operating losses of the investee from the inception of the investors
investment.



24



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RESTATEMENTS OF PRIOR PERIOD RESULTS



Accounting principles generally accepted in the United States of America (U.S. GAAP) requires retroactive restatement where
an equity investment previously accounted for under the cost method of accounting qualifies for use of the equity method. We have restated prior period results to reflect the change from the cost to the equity method of accounting for our investment
in OptiX Networks, Inc. (OptiX) as we obtained the ability to significantly influence the operating and financial policies of OptiX during the third quarter of fiscal 2002 through our investments in convertible preferred stock and convertible debt.
This restatement reduced the investment balance in OptiX (included in investments in non-publicly traded companies on the consolidated balance sheets), as if accounted for on the equity method since inception and we reflected our pro-rata share of
equity in net losses of OptiX. The amounts reflecting equity in net losses of affiliates were recorded on the consolidated statement of operations for the prior periods reported. Refer also to Note 5Investments in Non-Publicly Traded Companies
in our Consolidated Financial Statements.



25



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RESULTS OF OPERATIONS



The results of operations that follow should be read in conjunction with our critical accounting policies and estimates
summarized above as well as our consolidated financial statements and notes thereto contained in Item 8 of this report. The following table sets forth certain consolidated statements of operations data as a percentage of net revenues for the periods
indicated.



|                                               |  |                          |    |  |      |    |  |      |   
|---------------------------------------------- |  | ------------------------ | -- |  | ---- | -- |  | ---- | --
|                                               |  | Years ended December 31, |   
|                                               |  | 2004                     |    |  | 2003 |    |  | 2002 |   
|Net revenues                                   |  |                          |    |  |      |    |  |      |   
|Product revenues                               |  | 99                       | %  |  | 96   | %  |  | 95   | % 
|Service revenues                               |  | 1                        | %  |  | 4    | %  |  | 5    | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Total net revenues                             |  | 100                      | %  |  | 100  | %  |  | 100  | % 
|Cost of revenues:                              |  |                          |    |  |      |    |  |      |   
|Product cost of revenues                       |  | 29                       | %  |  | 26   | %  |  | 30   | % 
|Provision for excess and obsolete inventories  |  | 2                        | %  |  | 6    | %  |  | 29   | % 
|Service cost of revenues                       |  |                         |    |  | 1    | %  |  | 6    | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Total cost of revenues                         |  | 31                       | %  |  | 33   | %  |  | 65   | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Gross profit                                   |  | 69                       | %  |  | 67   | %  |  | 35   | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Operating expenses:                            |  |                          |    |  |      |    |  |      |   
|Research and development                       |  | 137                      | %  |  | 176  | %  |  | 322  | % 
|Marketing and sales                            |  | 37                       | %  |  | 46   | %  |  | 80   | % 
|General and administrative                     |  | 20                       | %  |  | 24   | %  |  | 44   | % 
|Impairment of goodwill                         |  |                         |    |  |     |    |  | 360  | % 
|Restructuring charge and asset impairment, net |  | 3                        | %  |  | 11   | %  |  | 23   | % 
|Purchased in-process research and development  |  |                         |    |  | 2    | %  |  | 12   | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Total operating expenses                       |  | 197                      | %  |  | 259  | %  |  | 841  | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Operating loss                                 |  | (128                     | )% |  | (192 | )% |  | (806 | )%
|                                               |  |                          |    |  |      |    |  |      |   



Comparison of Fiscal Years 2004 and
2003



Net Revenues. The following tables
summarizes our net product revenue mix by product line for the years ended December 31, 2004 and 2003 (dollar amounts in thousands), respectively:



|                 |  |                              |        |                             |                              |   |                  |                                         |                             |  |     |   |  |     |  
|---------------- |  | ---------------------------- | ------ | --------------------------- | ---------------------------- | - | ---------------- | --------------------------------------- | --------------------------- |  | --- | - |  | --- | -
|                 |  | Year ended December 31, 2004 |        |                             | Year ended December 31, 2003 |   |                  | Percentage Increase in Product Revenues |                            
|                 |  | Product Revenues             |        | Percent of Product Revenues |                              |   | Product Revenues |                                         | Percent of Product Revenues |  |    
|SONET/SDH        |  | $                            | 15,385 |                             | 46                           | % |                  | $                                       | 11,155                      |  | 49  | % |  | 38  | %
|ATM/IP           |  |                              | 9,861  |                             | 29                           | % |                  |                                         | 8,066                       |  | 35  | % |  | 22  | %
|Asynchronous/PDH |  |                              | 8,235  |                             | 25                           | % |                  |                                         | 3,749                       |  | 16  | % |  | 120 | %
|                 |  |                              |        |                             |                              |   |                  |                                         |                             |  |     |   |  |     |  
|Total            |  | $                            | 33,481 |                             | 100                          | % |                  | $                                       | 22,970                      |  | 100 | % |  | 46  | %
|                 |  |                              |        |                             |                              |   |                  |                                         |                             |  |     |   |  |     |  



The increase in
revenues for 2004 compared to 2003 is primarily due to increased volume of shipments across all product lines as our customers platforms increased production as general marketplace conditions improved. The year-to-year increase in
Asynchronous/PDH revenue was primarily due to shipments of our QE1F-Plus product to Nortel Networks, Inc. who used this product in their wireless base station contract in India.



26



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Given the limited visibility in the current market, we cannot predict when, and to what extent,
historical revenue levels or product mix percentages will return, if at all. Included in total net revenues is service revenues (approximately $0.2M in 2004) consisting of design services performed for third parties on a short-term contract basis.
Service revenues are not our primary strategic focus and, as such, will fluctuate up or down from period to period, depending on business priorities.



For the year ended December 31, 2004 international net revenues represent approximately 65% of net revenues compared with approximately 72% of net
revenues for the year ended December 31, 2003. This decrease is attributed to an improvement in the domestic market where certain customers began to increase production. Refer also to Note 8Segment Information and Major Customers in our
Consolidated Financial Statements, which summarizes revenue by country.



Gross Profit. The following table presents the impact to gross profit of the excess and obsolete inventory charges and benefits for the years ended December 31, 2004 and 2003, respectively:



|                                         |  |                              |        |   |                              |     |    |  |   |        |   |  |     |   
|---------------------------------------- |  | ---------------------------- | ------ | - | ---------------------------- | --- | -- |  | - | ------ | - |  | --- | --
|                                         |  | Year ended December 31, 2004 |        |   | Year ended December 31, 2003 |    
|Gross profitas reported                 |  | $                            | 23,347 |   |                              | 69  | %  |  | $ | 15,903 |   |  | 67  | % 
|Excess and obsolete inventory charge(1)  |  |                              | 571    |   |                              | 2   | %  |  |   | 1,498  |   |  | 6   | % 
|Excess and obsolete inventory benefit(2) |  |                              | (3,803 | ) |                              | (11 | )% |  |   | (3,985 | ) |  | (17 | )%
|                                         |  |                              |        |   |                              |     |    |  |   |        |   |  |     |   
|Gross profitas adjusted                 |  | $                            | 20,115 |   |                              | 60  | %  |  | $ | 13,416 |   |  | 56  | % 
|                                         |  |                              |        |   |                              |     |    |  |   |        |   |  |     |   

---

|(1) | During the years ended December 31, 2004 and 2003, we recorded a provision for excess and obsolete inventories of approximately $0.6 million and $1.5 million, respectively, as costs
of revenues.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | During the years ended December 31, 2004 and 2003, we realized an excess and obsolete inventory benefit from the sale of products that had previously been written down to a cost
basis of zero. For the purposes of comparing the change in gross profit on net revenues, we are excluding this benefit and calculating gross profit on these product revenues as if they had been sold at their historical average costs.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The increase in gross margins is due in part to
lower charges for excess and obsolete inventory in 2004 of $ 0.6 million versus $1.5 million in the prior year. Excluding the charges for excess and obsolete inventories as well as the benefit from sales of previously written down inventory in
fiscal 2003, gross profit for 2004 increased by $6.7 million, or 50%. The increase in gross profit dollars for the year ended December 31, 2004 is the result of higher total net revenues.



We anticipate that gross profit will continue to be impacted by fluctuations in the volume and mix of our product shipments
as well as material costs, yield and the fixed cost absorption of our production operations.



Research and Development. Research and development expenses consist primarily of salaries and related costs of employees engaged in research, design and development activities, costs related to
electronic design automation tools, subcontracting and fabrication costs, depreciation and amortization and facilities expenses. During the year ended December 31, 2004, research and development expenses increased $4.0 million, or 9.6% over the
comparable period of 2003 due to increased spending on subcontracting, fabrication and personnel related expenses, as well as the consolidation of OptiX Inc., an Israeli development stage company consolidated in the Companys financial
statements under the guidelines of FIN 46R. Also, during the first half of 2004, we retained additional external resources to complete new product development and to meet customer requirements. In the third quarter of 2004, we began to take the
necessary steps to reduce our research and development expenses. These steps included the decision to discontinue further funding of OptiX, as well as the decision to liquidate our investment in TeraOp. Also, in the fourth quarter of 2004, we
disengaged from Easics N.V., our Belgian design center, which will further reduce our expenses.



27



---

We believe that continued investment in the design and development of future products is vital to
maintain a competitive edge. However, we will continue to closely monitor both our costs and our revenue expectations in future periods. We will continue to balance our spending in this area with meeting our customer requirements and will take
actions as market conditions dictate.



Marketing and
Sales. Marketing and sales expenses consist primarily of personnel-related, trade show, travel and facilities expenses. During the year ended December 31, 2004, marketing and sales expenses increased $1.6 million, or 14.4% as compared to the
prior year. The increase in sales and marketing costs reflects the higher revenue in 2004, which caused our commission expenses to increase. Bad debt expenses also increased in 2004 as accounts receivable rose with revenue. As a percentage of total
net revenues, our marketing and sales costs decreased, reflecting the increase in revenue as well as our continued monitoring of discretionary spending. We will continue to closely monitor both our costs and our revenue expectations in future
periods. We will continue to balance our spending in this area with meeting our customer requirements and will take actions as market conditions dictate.



General and Administrative. General and administrative expenses consist primarily of personnel-related expenses, professional and legal fees
and facilities expenses. The increase in general and administrative expenses of approximately $1.1 million, or 19.0% for the year ended December 31, 2004 compared to the prior year is primarily due to increased professional service fees, including
expenses required to comply with regulations mandated by the Sarbanes-Oxley Act of 2002. As a percentage of total net revenues, our general and administrative costs decreased, reflecting the increase in revenue as well as our continued monitoring of
discretionary spending. We will continue to closely monitor both our costs and our revenue expectations in future periods and will take actions as market conditions dictate.



Restructuring Charges and Asset Impairments. During the year ended December 31, 2004, we recorded
restructuring charges totaling approximately $1.1 million resulting from the liquidation of our investment in TeraOp and the wind-down of the business and operations of OptiX, two Israeli development stage companies consolidated in our financial
statements under FIN 46R, and the disengagement from Easics N.V., our Belgian design center.



In July 2004, we informed OptiX that we planned to discontinue our ongoing funding of OptiXs operations. Consequently, the OptiX Board of Directors voted to wind-down its business and operations. During the year
ended December 31, 2004, we recorded a charge of $0.2 million related to severance, the impairment of assets and lease buy out costs. This charge was offset by a gain of $0.5 million related to the deconsolidation of OptiX, which resulted in a net
restructuring benefit of $0.3 million for the year ended December 31, 2004.



In September 2004, we entered an agreement with TeraOp under which we converted our promissory notes issued and payable by TeraOp into shares of TeraOp common stock. We then sold all of our common share holdings in
TeraOp to an independent third party for a nominal amount. In addition, we paid TeraOp $0.3 million for a royalty on future revenues of TeraOp. Currently, TeraOp has no revenue and may never have revenue in the future. As a result of these
transactions, we no longer hold any equity or debt interest in TeraOp and have no influence over the operations of TeraOp. Accordingly, TeraOp was deconsolidated from our financial statements upon the completion of these transactions, resulting in a
net restructuring charge of $0.2 million.



In the fourth
quarter of 2004, we finalized our plans to disengage from Easics N.V., our Belgian design center. This action resulted in a work force reduction of approximately 9% of our existing personnel and the sale of the business. As a result of this action,
for the year ended December 31, 2004, we incurred restructuring charges of approximately $1.6 million related to employee termination benefits, and $0.1 million related to legal and other transaction costs. These charges were offset by a gain of
$0.5 million on the sale of the Easics for a net restructuring charge of approximately $1.1 million. We estimate future operating expense savings related to this plan to be approximately $2.8 to $3.0 million annually. However, there can be no
assurances that events will not cause the actual savings to rise or fall in future periods.



28



---

In January 2003, we announced a restructuring plan in order to lower our operating expense run-rate due
to then current and anticipated business conditions. This plan resulted in a work-force reduction of approximately 24% of existing personnel. Also, we announced the closing of our South Brunswick, New Jersey (SOSi) design center, and the reduction
of staff in Bedford, Massachusetts and Shelton, Connecticut. This workforce reduction also impacted our Switzerland and Belgium locations. In addition, we postponed the completion of the IAD product line and archived the related intellectual
property until that market returns, if ever. During the year ended December 31, 2003, we incurred approximately $3.4 million in restructuring expenses related to employee termination benefits and $0.5 million related to excess facility costs. In
addition, we recorded a charge for fixed assets that were impaired with a net book value totaling $0.3 million and a patent on our IAD product line with a net book value of $0.2 million. This resulted in a total restructuring and asset impairment
charge for the year ended December 31, 2003 totaling $4.4 million. This restructuring charge was partially off set by a benefit of $1.9 million realized, as we were able to sub-lease portions of our excess facilities, for a net restructuring expense
for the year ended December 31, 2003 of $2.5 million. We estimate that there will be adjustments to our liability for future lease payments as market conditions change.



We will continue to closely monitor both our costs and our revenue expectations in future periods and will take actions as
market conditions dictate.



In-Process Research and
Development. During the year ended December 31, 2003, we recorded a charge for Purchased In-Process Research and Development (IPR&D) of $0.5 million related to the purchase of ASIC Design, Inc. (ADS). There were no such charges in 2004.



At the time of acquisition, ADS had one project that qualified
for IPR&D activities, which is referred to as the VTXP chip. The project was started concurrently with ADSs inception in 2002 and was released during 2004.



The $0.5 million allocated to IPR&D in fiscal 2003 was determined through an independent valuation using established
valuation techniques in the telecommunications and data communications industries. The value allocated to IPR&D was based upon the forecasted operating after-tax cash flows from the technology acquired, giving effect to the stage of completion
at the acquisition date. Future cash flows were adjusted for the value contributed by any core technology and development efforts expected to be completed post acquisition. These forecasted cash flows were then discounted at rates commensurate with
the risks involved in completing the acquired technologies, taking into consideration the characteristics and applications of each product, the inherent uncertainties in achieving technological feasibility, anticipated levels of market acceptance
and penetration, market growth rates and risks related to the impact of potential changes in future target markets. A projects risk is the highest at its inception. As the project progresses, the risk of a project generally decreases. As of
the acquisition date, the VTXP chip was still in its initial stages of development. After considering these factors, the risk-adjusted discount rates for the VTXP chip product was determined to be 50%. As this acquired technology had not yet reached
technological feasibility and for which no alternative future uses existed, it was expensed upon acquisition in accordance with FASB issued Statement No. 2, Accounting for Research and Development Costs.



Impairment of Investments in Non-Publicly Traded Companies.
During the years ended December 31, 2004 and 2003, we determined that there were indicators of impairment to the carrying value of our investments in non-publicly traded companies. The process of assessing whether a particular investments net
realizable value is less than its carrying cost requires a significant amount of judgment. In making this judgment, we carefully consider the investees cash position, projected cash flows (both short and long-term), financing needs, most
recent valuation data, the current investing environment, management/ownership changes, and competition. This evaluation process is based on information that we request from these privately held companies. This information is not subject to the same
disclosure and audit requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary.



29



---

During 2004 and 2003, we reduced the carrying value of our investments (including bridge loans) in
non-publicly traded companies as follows (in thousands):



|                                                          |  |                            |     |                            |   |      
|--------------------------------------------------------- |  | -------------------------- | --- | -------------------------- | - | -----
|                                                          |  | Investment Impairments2004 |     | Investment Impairments2003
|Investee company:                                         |  |                            |     |                            |   |      
|Intellectual Capital for Integrated Circuits, Inc (IC4IC) |  | $                          |    |                            | $ | 50   
|Accordion Networks, Inc (Accordion)                       |  |                            | 123 |                            |   | 1,495
|                                                          |  |                            |     |                            |   |      
|Total                                                     |  | $                          | 123 |                            | $ | 1,545
|                                                          |  |                            |     |                            |   |      



During the year ended
December 31, 2004, we decided to stop funding the operations of Accordion and recorded an impairment charge of $0.1 million for the year ended December 31, 2004 related to our investment in Accordion. The Board of Directors of Accordion voted to
discontinue the operations of Accordion in March 2004.



During
the year ended December 31, 2003, we impaired our remaining convertible bridge loan investment in IC4IC totaling $0.05 million as this company ceased all operations. In addition, we impaired our remaining convertible preferred stock and convertible
debt investments in Accordion totaling $1.5 million based on review of impairment indicators listed below.



We used the modified equity method of accounting to measure the impairment loss for our investments in Accordion and IC4IC, as we determined that no
better current evidence of the value of our cost method investments existed. We believe that this measurement process gave us the best basis for our estimate given the negative cash flows of these companies. The modified equity method of accounting
results in recording an impairment loss on a cost method investment equal to the investors proportionate share of the investees losses as its contributed capital is consumed to fund operating losses of the investee from the inception of
the investors investment.



In addition, we also evaluated
all outstanding bridge loans pursuant to SFAS 114, Accounting by Creditors for Impairment of a Loan (SFAS 114) that we had not already impaired under the modified equity method of accounting. Under SFAS 114, a loan is considered
impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.



The measurement of impaired loans is generally based on the present value of
expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.



We will continue to periodically review all of our investments in
non-publicly traded companies for impairment in future periods. There can be no assurances that future impairment charges will not be necessary.



Equity in Net Losses of Affiliates. The decrease in equity in net losses of affiliates for year the ended December 31, 2004 as compared to
the same period in 2003 was due to our adoption of the provisions of FIN 46R in the first quarter of 2004. As a result of the adoption of FIN 46R, we consolidated the results of our investment in OptiX and recorded a charge of approximately $0.3
million as a cumulative effect of a change in accounting principle in 2004. For the same period in the prior year, we had been accounting for our direct and indirect voting interest (which included certain board members and employees) of greater
than 20% but less than 50% in our investment in OptiX under the equity method of accounting where our pro rata share of net loss from OptiX was recorded on the consolidated statements of operations and accordingly, the carrying value of the
investments was reduced on the consolidated balance sheets.



30



---

Change in Fair Value of the Derivative Liability.For the years ended December 31, 2004 and
2003, we recorded other income of approximately $12.1 million and $2.6 million, respectively, to reflect the change in the fair value of the derivative liability resulting from issuance of the Plus Cash Notes (refer to Note 12Convertible Notes
of our Consolidated Financial Statements).



Gain from the
Exchange and Repurchase of our 4.50% Convertible Notes due 2005.On September 30, 2003, we completed an exchange offer with and new money offering to the holders of our 4.50% Notes. We issued $98.0 million aggregate principal amount of Plus
Cash Notes, which represented $74.0 million of Plus Cash Notes issued in exchange for $89.7 million in principal amount of our 4.50% Notes tendered in the exchange offer and $24.0 million of Plus Cash Notes sold for cash. We recorded a gain on the
exchange of approximately $14.5 million, which is calculated as follows:



|                                                       |  |   |         |  
|------------------------------------------------------ |  | - | ------- | -
|Carrying value of 4.50% Notes exchanged                |  | $ | 89,671  |  
|Less: deferred financing fees                          |  |   | (1,245  | )
|                                                       |  |   |         |  
|Net carrying value of 4.50% Notes                      |  |   | 88,426  |  
|Less: fair value of Plus Cash Notes issued on exchange |  |   | (73,963 | )
|                                                       |  |   |         |  
|Gain on exchange                                       |  | $ | 14,463  |  
|                                                       |  |   |         |  



Loss on
Extinguishment of Debt. During year ended December 31, 2004, the Company issued an aggregate of 12,129,496 shares of the Companys common stock plus approximately $0.1 million cash in lieu of accrued and unpaid interest in exchange for
$17.0 million in aggregate original principal amount of the Plus Cash Notes. The shares issued were exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. No commission or other remuneration was paid or given
directly or indirectly for soliciting these transactions. As a result of the exchange, the Company incurred a non-cash loss of approximately $3.0 million due to the write-off of the unamortized debt discount and deferred financing costs related to
the exchanged Plus Cash Notes. The Company did not effect any such exchanges during the year ended December 31, 2003.



Interest Expense net. At December 31, 2004 and 2003, the effective interest rates on our interest-bearing securities were approximately
2.22% and 1.37%, respectively. The increase in interest expense, net in fiscal 2004 is due primarily to the full year amortization of the debt discount on the Plus Cash Notes. Also contributing to the increase in interest expense, net is lower
interest income due to a lower average cash balance during fiscal 2004 as compared to fiscal 2003.



Income Tax Expense. Income tax expense was $0.2 million in both 2004 and 2003, representing income taxes incurred by our foreign
subsidiaries. The Company has incurred taxable losses for U.S. federal and state purposes, but has recognized no corresponding tax benefits in 2004 and 2003, as such benefits have been offset by an increase in our deferred tax asset valuation
allowance.



We continually evaluate our deferred tax assets as
to whether it is more likely than not that the deferred tax assets will be realized. In assessing the realizability of our deferred tax assets, we consider the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax
planning strategies. Based on this assessment, we believe that significant uncertainty exists surrounding the recoverability of the deferred tax assets and, as such, have recorded a full valuation allowance against our net deferred tax assets as of
December 31, 2004 and 2003.



31



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The following table summarizes the differences between the U.S. federal statutory rate and our effective
income tax rate for financial statement purposes for the years ended December 31, 2004 and 2003, respectively:



|                                            |  |                          |    |  |       |   
|------------------------------------------- |  | ------------------------ | -- |  | ----- | --
|                                            |  | Years ended December 31, |   
|                                            |  | 2004                     |    |  | 2003  |   
|U.S. federal statutory tax rate             |  | (35.0                    | )% |  | (35.0 | )%
|State taxes                                 |  | 6.8                      | %  |  | (4.1  | )%
|In-process research and development         |  |                         |    |  | 0.5   | % 
|Disallowed interest deduction               |  | 3.9                      | %  |  | 1.2   | % 
|Capital loss on sale of subsidiary          |  | (17.4                    | )% |  |      |   
|Change in valuation allowance               |  | 42.5                     | %  |  | 38.7  | % 
|Permanent differences and other adjustments |  | (0.4                     | )% |  | (0.3  | )%
|                                            |  |                          |    |  |       |   
|Effective income tax rate                   |  | 0.4                      | %  |  | 1.0   | % 
|                                            |  |                          |    |  |       |   



Extraordinary
Loss Upon Consolidation of TeraOp (USA), Inc.In January 2003, FIN No. 46 Consolidation of Variable Interest Entities (FIN 46) was issued. The interpretation provides guidance on consolidating variable interest entities and
applies to all variable interests in variable interest entities created after January 31, 2003. The interpretation requires variable interest entities to be consolidated if the equity investment at risk is not sufficient to permit an entity to
finance its activities without support from other parties or if the equity investors lack certain specified characteristics. We applied the provisions of FIN 46 to our investment in TeraOp as of February 1, 2003, which required us to consolidate the
results of TeraOp.



Cumulative Effect on Prior Years of
Adoption of and Retroactive Application of Fin 46R and New Depreciation Method. We adopted the provisions of FIN 46R and changed our accounting accordingly in the first quarter of 2004. As a result of the adoption of FIN 46R, we consolidated
the results of our investment in OptiX and recorded a charge of approximately $0.3 million for the year ended December 31, 2004 as a cumulative effect of an accounting change. As disclosed in our Annual Report on Form 10-K for the year ended
December 31, 2003, we restated prior period results to reflect the change from the cost to the equity method of accounting for our investment in OptiX because during fiscal 2002, we obtained the ability to significantly influence the operating and
financial policies of OptiX through our investments in convertible preferred stock and a bridge loan.



In July 2004, we informed OptiX that we planned to discontinue our ongoing funding of OptiXs operations. Consequently, the OptiX Board of Directors
voted to wind-down its business and operations. As of December 31, 2004 OptiX has completed the wind-down and has permanently closed its operations. For further discussion, refer to Note 13Restructuring and Asset Impairment Charges of our
Consolidated Financial Statements.



Effective January 1, 2003,
we changed the method of depreciating property and equipment to the straight-line method. Depreciation of property and equipment in prior years was computed using the half-year convention method. We evaluated the use and related consumption of all
classes of acquired property and equipment. We have determined that many of our assets are used and consumed on a consistent level over their estimated economic lives. Under the half-year convention method, property and equipment placed in service
during the first year of acquisition was subject to six months of depreciation expense regardless of when the asset was acquired, placed in service and consumed. We believe that the straight-line method results in a better approximation of the
underlying consumption of the asset over its estimated useful life and provides a better matching of revenues and expenses. The effect of the change in depreciation method as of January 1, 2003 was applied retroactively to property and equipment
acquisitions of prior years. The cumulative effect of the change with respect to the retroactive application of the straight-line method is approximately a $0.8 million charge and has been recorded as such on the consolidated statements of
operations for the year ended December 31, 2003. This charge has not been presented net of income taxes as we continue to maintain a full valuation allowance against our net deferred income tax assets.



32



---

Comparison of Fiscal Years 2003 and 2002



Net Revenues. The following tables summarizes our net product revenue mix by product line for the years ended
December 31, 2003 and 2002 (dollar amounts in thousands), respectively:



|                 |  |                              |        |                             |                              |   |                  |                                                      |                             |  |     |   |  |    |   
|---------------- |  | ---------------------------- | ------ | --------------------------- | ---------------------------- | - | ---------------- | ---------------------------------------------------- | --------------------------- |  | --- | - |  | -- | --
|                 |  | Year ended December 31, 2003 |        |                             | Year ended December 31, 2002 |   |                  | Percentage Increase / (Decrease) in Product Revenues |                            
|                 |  | Product Revenues             |        | Percent of Product Revenues |                              |   | Product Revenues |                                                      | Percent of Product Revenues |  |    
|SONET/SDH        |  | $                            | 11,155 |                             | 49                           | % |                  | $                                                    | 6,600                       |  | 42  | % |  | 69 | % 
|ATM/IP           |  |                              | 8,066  |                             | 35                           | % |                  |                                                      | 5,193                       |  | 33  | % |  | 55 | % 
|Asynchronous/PDH |  |                              | 3,749  |                             | 16                           | % |                  |                                                      | 4,037                       |  | 25  | % |  | (7 | )%
|                 |  |                              |        |                             |                              |   |                  |                                                      |                             |  |     |   |  |    |   
|Total            |  | $                            | 22,970 |                             | 100                          | % |                  | $                                                    | 15,830                      |  | 100 | % |  | 45 | % 
|                 |  |                              |        |                             |                              |   |                  |                                                      |                             |  |     |   |  |    |   



The increase in
revenues for 2003 compared to 2002 was primarily due to increased volume shipments in our SONET/SDH and ATM/IP product lines. The increase in volume in our SONET/SDH product line can be attributed to overall increased demand as well as inventory
depletion in the distribution channel. As inventory was being consumed, customers are placing new orders to meet their end demand. The increase in our ATM/IP product line can be attributed primarily to an increase in the volume of shipments of our
ASPEN product, which serves the DSLAM market, where there has been an increase in equipment deployments in 2003.



International net revenues represent approximately 72% of net revenues for the year ended December 31, 2003 as compared with approximately 59% of net
revenues for the year ended December 31, 2002. The increase was attributed to increased volume shipments into Europe and China as customer demand for our products increased and excess inventory decreased. Refer also to Note 8Segment
Information and Major Customers of our Consolidated Financial Statements, which summarizes revenue by country.



Gross Profit. The following table presents the impact to gross profit of the excess and obsolete inventory charges and benefits for the
years ended December 31, 2003 and 2002, respectively:



|                            |  |                              |        |   |                              |     |    |                |   |        |                |  |     |   
|--------------------------- |  | ---------------------------- | ------ | - | ---------------------------- | --- | -- | -------------- | - | ------ | -------------- |  | --- | --
|                            |  | Year ended December 31, 2003 |        |   | Year ended December 31, 2002 |    
|                            |  | Gross Profit $               |        |   | Gross Profit %               |     |    | Gross Profit $ |   |        | Gross Profit % | 
|Gross profitas reported    |  | $                            | 15,903 |   |                              | 67  | %  |                | $ | 5,857  |                |  | 35  | % 
|Excess inventory charge(1)  |  |                              | 1,498  |   |                              | 6   | %  |                |   | 4,832  |                |  | 29  | % 
|Excess inventory benefit(2) |  |                              | (3,985 | ) |                              | (17 | )% |                |   | (2,183 | )              |  | (13 | )%
|                            |  |                              |        |   |                              |     |    |                |   |        |                |  |     |   
|Gross profitas adjusted    |  | $                            | 13,416 |   |                              | 56  | %  |                | $ | 8,506  |                |  | 51  | % 
|                            |  |                              |        |   |                              |     |    |                |   |        |                |  |     |   

---

|(1) | During the years ended December 31, 2003 and 2002, we recorded a provision for excess inventories of approximately $1.5 million and $4.8 million, respectively, as costs of revenues.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | During the years ended December 31, 2003 and 2002, we realized an excess inventory benefit from the sale of products that had previously been written down to a cost basis of zero.
For the purposes of comparing the change in gross profit on net revenues, we are excluding this benefit and calculating gross profit on these product revenues as if they had been sold at their historical average costs.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



33



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The increase in gross margins was due in part to lower charges for excess inventory in 2003 of $1.5
million versus $4.8 million in the prior year as well as an increase in the shipments of previously written down inventory. Excluding the charges for excess inventories as well as the benefit from sales of previously written down inventory in fiscal
2003, gross profit for 2003 increased by $4.9 million, or 58%. The increase in gross profit dollars for the year ended December 31, 2003 was the result of higher total net revenues which in turn resulted from a more favorable product mix over the
prior year.



Research and Development.Research
and development expenses consist primarily of salaries and related costs of employees engaged in research, design and development activities, costs related to electronic design automation tools, subcontracting and fabrication costs, depreciation and
amortization and facilities expenses. The decrease in research and development expense for 2003 compared to 2002 was primarily attributable to payroll and related benefits, depreciation and amortization, and facilities expense. This decrease is a
result of streamlining and prioritizing our product development efforts and the effects of our workforce reductions. We have monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two
restructuring actions in fiscal 2001, one during fiscal 2002 and one during fiscal 2003.



Marketing and Sales. Marketing and sales expenses consist primarily of personnel-related expenses, trade show expenses, travel expenses and facilities expenses. The decrease in marketing and sales
expenses for 2003 compared to 2002 was primarily attributable to headcount reductions, which decreased payroll, commissions and related benefit expenses. There was also a decrease in travel related expenses as we continued to reduce our
discretionary spending during 2003. We have monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two restructuring actions in fiscal 2001, one during fiscal 2002 and one during fiscal 2003.



General and Administrative. General and
administrative expenses consist primarily of personnel-related expenses, professional and legal fees and facilities expenses. The decrease in general and administrative expenses for 2003 compared to 2002 was primarily due to lower professional fees
and savings on facility and other related charges realized from our restructuring actions. We have monitored our known and forecasted revenue demand and operating expense run rates closely and, as a result, took two restructuring actions in fiscal
2001, one during fiscal 2002 and one during fiscal 2003.



Impairment of Goodwill.During 2002, we performed our impairment test for the goodwill related to our one reporting unit as required by SFAS 142. We determined that all of our goodwill was impaired during 2002 because of the
significant decline in our common stock price and our related market capitalization, which was used to determine the fair value of our one reporting unit. Accordingly, we recorded a charge of $59.9 million during 2002 and wrote off all of our
goodwill. During 2003, we did not record any additional goodwill.



Restructuring Charges and Asset Impairments. In January 2003, we announced a restructuring plan as described above. During the year ended December 31, 2002, we announced a restructuring plan due to then current and anticipated
business conditions. As a result of this plan, we eliminated fifty-six positions and announced the closing of our design centers in Milpitas, California and Raleigh, North Carolina. In conjunction with this restructuring, we discontinued the AsTriX
and Sertopia product lines and strategically refocused our research and development efforts. This plan resulted in employee termination benefits of $2.4 million and costs to exit facilities of $3.1 million for a total restructuring expense of
approximately $5.5 million recorded on the consolidated statement of operations. Restructuring charges for the year ended December 31, 2002 were $3.9 million as we recognized a restructuring benefit of approximately $1.6 million related to the
sublease of a portion of our unused excess facilities.



In-Process Research and Development. During the year ended December 31, 2003, we recorded a charge for In-Process Research and Development (IPR&D) of $0.5 million related to the purchase of ADS as described above.



34



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During the year ended December 31, 2002, we recorded a charge for IPR&D of $2.0 million related to
our purchase of SOSi on March 27, 2002. This transaction was recorded in the first quarter of fiscal 2002.



Impairment of Investments in Non-Publicly Traded Companies. During 2003 and 2002, we reduced the carrying value of our investments
(including bridge loans) in non-publicly traded companies as follows (in thousands):



|                  |  |                           |       |                            |   |      
|----------------- |  | ------------------------- | ----- | -------------------------- | - | -----
|                  |  | InvestmentImpairments2003 |       | Investment Impairments2002
|Investee company: |  |                           |       |                            |   |      
|TeraOp            |  | $                         |      |                            | $ | 5,000
|OptiX             |  |                           |      |                            |   | 1,339
|IC4IC             |  |                           | 50    |                            |   | 1,700
|Accordion.        |  |                           | 1,495 |                            |   | 630  
|                  |  |                           |       |                            |   |      
|Total             |  | $                         | 1,545 |                            | $ | 8,669
|                  |  |                           |       |                            |   |      



During the year ended
December 31, 2003, we impaired our remaining convertible bridge loan investment in IC4IC totaling $0.05 million as this company ceased all operations. In addition, we impaired our remaining investments in convertible preferred stock and convertible
debt in Accordion based on review of impairment indicators listed below.



During the years ended December 31, 2003 and 2002, as a result of industry conditions, we determined that there were indicators of impairment to the carrying value of our investments in non-publicly traded companies.
The process of assessing whether a particular investments net realizable value is less than its carrying cost requires a significant amount of judgment. In making this judgment, we carefully consider the investees cash position,
projected cash flows (both short and long-term), financing needs, most recent valuation data, the current investing environment, management/ownership changes, and competition. This evaluation process is based on information that we request from
these privately held companies. This information is not subject to the same disclosure and audit requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary.



During the years ended December 31, 2003 and 2002, we used the modified
equity method of accounting to measure the impairment loss for our investments in non-publicly traded companies as we determined that no better current evidence of the value of our cost method investments existed. We believe that this measurement
process gives us the best basis for our estimate given the negative cash flows of these companies. The modified equity method of accounting results in recording an impairment loss on a cost method investment equal to the investors
proportionate share of the investees losses as its contributed capital is consumed to fund operating losses of the investee from the inception of the investors investment.



In addition, we also evaluated all outstanding bridge loans pursuant to SFAS 114, Accounting by Creditors for
Impairment of a Loan (SFAS 114) that we had not already impaired under the modified equity method of accounting. Under SFAS 114, a loan is considered impaired, based on current information and events, if it is probable that we will be unable
to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.



The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest
rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.



Equity in Net Losses of Affiliates. The decrease in equity losses in 2003 was due to lower overall net losses at OptiX in fiscal 2003
compared to the same period in 2002. In addition, during year ended 2003, we terminated



35



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our investment relationship with GTV and received, as a return of capital, the remaining balance of our investment in GTV of approximately $0.9 million. As a
result, equity losses in GTV ceased after the first quarter of 2003.



Prior to June 30, 2002, we had been accounting for our investment in OptiX under the cost method. However, during the third quarter of fiscal 2002, in connection with a bridge loan of $4.0 million that is convertible to convertible
preferred stock upon OptiX closing its next round of financing, we obtained the ability to exercise significant influence over the financial and operating policies of OptiX, and as a result, switched to the equity method of accounting for our
investment in OptiX. All prior period financial information has been retroactively restated to reflect this change Refer also to Note 1Summary of Significant Accounting Policies of our Consolidated Financial Statement for additional
disclosure. During 2003, we continued to account for OptiX under the equity method of accounting.



Change in Fair Value of the Derivative Liability.For the years ended December 31, 2003, we recorded other income of approximately $2.6
million to reflect the change in the fair value of the derivative liability resulting from issuance of the Plus Cash Notes (refer to Note 12Convertible Notes of our Consolidated Financial Statements).



Gain from the Exchange and Repurchase of our 4.50% Convertible Notes
due 2005.During the year ended December 31, 2003, we did not repurchase any 4.50% Convertible Notes due 2005 (4.50% Notes). However, on September 30, 2003, we completed the exchange offer with and new money offering to the holders of our
4.50% Notes. We recorded a gain on the exchange of approximately $14.5 million, as described above.



During the year ended December 31, 2002, we repurchased, through a tender offer, approximately $199.9 million face value of our outstanding 4.50% Notes
for a cash payment of $139.9 million. This resulted in a gain of $52.0 million, net of transaction costs, $4.8 million in deferred financing fees related to these notes and approximately $19.5 million recorded as income tax expense. Prior to fiscal
year 2003, this gain had been classified as extraordinary on the consolidated statement of operations. However, we adopted SFAS No. 145 Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections effective January 1, 2003, which requires gains from the extinguishment of debt to be included in results from continuing operations. Accordingly, we have reclassified the gains related to the early extinguishment of some of the
4.50% Notes and the related deferred financing fees and income taxes that were previously recorded in the consolidated statements of operations as an extraordinary item to other (expense) income and income tax expense, respectively.



Interest Expense, net. At December 31, 2003 and 2002 the
effective interest rates on our interest-bearing securities were approximately 1.37% and 2.15 %, respectively. Therefore, the increase in interest expense in fiscal 2003, net is due to lower interest income as a result of a lower average cash
balance and lower interest rates during fiscal 2003 compared to fiscal 2002.



Income Tax Expense. The decrease in income tax expense in fiscal 2003 was due to the recording of an additional valuation allowance of $61.4 million during fiscal 2002 to reduce the carrying value of
deferred tax assets. During fiscal 2003 and 2002, we evaluated our deferred tax assets as to whether it is more likely than not that the deferred tax assets will be realized. In our evaluation of the realizability of deferred tax assets,
we considered projections of future taxable income, the reversal of temporary differences and tax planning strategies. We evaluated and determined that it is not more likely than not that all of the deferred tax assets will be realized.
Accordingly, a valuation reserve was recorded in 2002 against all of our net deferred tax assets, which we increased during 2003 primarily for our 2003 net operating loss.



36



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The following table summarizes the differences between the U.S. federal statutory rate and our effective
income tax rate for financial statement purposes for the years ended December 31, 2003 and 2002, respectively:



|                                            |  |                         |    |  |       |   
|------------------------------------------- |  | ----------------------- | -- |  | ----- | --
|                                            |  | Years endedDecember 31, |   
|                                            |  | 2003                    |    |  | 2002  |   
|U.S. federal statutory tax rate             |  | (35.0                   | )% |  | (35.0 | )%
|State taxes                                 |  | (4.1                    | )% |  | (0.8  | )%
|In-process research and development         |  | 0.5                     | %  |  | 0.7   | % 
|Disallowed interest deduction data needed   |  | 1.2                     | %  |  |      |   
|Goodwill impairment                         |  |                        |    |  | 21.9  | % 
|Change in valuation allowance               |  | 38.7                    | %  |  | 85.1  | % 
|Permanent differences and other adjustments |  | (0.3                    | )% |  | 0.4   | % 
|                                            |  |                         |    |  |       |   
|Effective income tax rate                   |  | 1.0                     | %  |  | 72.3  | % 
|                                            |  |                         |    |  |       |   



Extraordinary
Loss Upon Consolidation of TeraOp (USA), Inc.In January 2003, FIN No. 46 Consolidation of Variable Interest Entities (FIN 46) was issued. The interpretation provides guidance on consolidating variable interest entities and
applies to all variable interests in variable interest entities created after January 31, 2003. The interpretation requires variable interest entities to be consolidated if the equity investment at risk is not sufficient to permit an entity to
finance its activities without support from other parties or if the equity investors lack certain specified characteristics. We applied the provisions of FIN 46 to our investment in TeraOp as of February 1, 2003, which required us to consolidate the
results of TeraOp.



During the first quarter of 2003, we loaned
TeraOp $0.5 million under a new convertible loan agreement, which provided us with additional contractual rights over existing debt or equity investors. In addition, we were also in a position, as a result of the loan, to negotiate a more favorable
conversion price of the equity securities of TeraOp and had the ability to control the operations of TeraOp. None of the existing debt or equity investors, other than us, was expected to, or was obligated to, absorb any additional losses from their
investment given that the equity in TeraOp was negative as of January 31, 2003. As a result, the convertible loan was determined to be a variable interest and TeraOp was considered a variable interest entity, as defined by FIN 46. We calculated the
effect of the initial measurement as of January 31, 2003. As a result of this measurement and consolidation of TeraOp, we recognized an extraordinary loss of approximately $0.1 million, as the fair value of TeraOps liabilities exceeded its
assets by this amount. All significant intercompany balances, including our investments in TeraOp, have been eliminated upon consolidation.



Cumulative Effect on Prior Years of Retroactive Application of New Depreciation Method.Effective January 1, 2003, we changed the method of
depreciating property and equipment to the straight-line method as described above. The cumulative effect of the change with respect to the retroactive application of the straight-line method was approximately a $0.8 million charge and has been
recorded as such on the consolidated statement of operations for the year ended December 31, 2003. This charge has not been presented net of income taxes as we continue to maintain a full valuation allowance against our net deferred income tax
assets.



LIQUIDITY AND CAPITAL RESOURCES



As of December 31, 2004, we had total cash, cash equivalents and investments
in marketable securities of approximately $134.7 million. This is our primary source of liquidity, as we are not currently generating positive cash flow from our operations. Details of our cash inflows and outflows for the year ended December 31,
2004 as well as a summary of our cash, cash equivalents and investments in marketable securities and future commitments are detailed as follows:



37



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Cash, Cash Equivalents and InvestmentsWe have financed our operations and have met our
capital requirements since incorporation in 1988 primarily through private and public issuances of equity securities, convertible notes, bank borrowings and cash generated from operations. Our principal sources of liquidity as of December 31, 2004
consisted of $17.3 million in cash and cash equivalents, $85.2 million in short-term investments and $32.2 million in long-term investments in marketable securities for total cash, cash equivalents and investments of $134.7 million. Cash equivalents
are instruments with original maturities of less than 90 days, short-term investments have maturities less than one year and long-term investments have maturities of greater than one year. Our cash equivalents and investments consist of U.S.
Treasury Bills, corporate debt, taxable municipal securities, money market instruments, overnight repurchase investments, commercial paper and auction rate securities.



We believe that our existing cash, cash equivalents and investments will be sufficient to fund operating losses, capital
expenditures and provide adequate working capital for at least the next twelve months. However, there can be no assurance that events in the future will not require us to seek additional capital and, if so required, that capital will be available on
terms favorable or acceptable to us, if at all.



The following
table represents total cash usage for the years ended December 31, 2004 and 2003 respectively;



|                           |  |                  |         |                  |   |         |  |   |                  |   |                  |   |         |  |   |         |  |   |         |  
|-------------------------- |  | ---------------- | ------- | ---------------- | - | ------- |  | - | ---------------- | - | ---------------- | - | ------- |  | - | ------- |  | - | ------- | -
|                           |  | December 31,2004 |         | December 31,2003 |   | Change  |  |   | December 31,2003 |   | December 31,2002 |   | Change  | 
|Cash and cash equivalents  |  | $                | 17,311  |                  | $ | 102,869 |  | $ | (85,558          | ) |                  | $ | 102,869 |  | $ | 118,388 |  | $ | (15,519 | )
|Short term investments     |  |                  | 85,193  |                  |   | 49,182  |  |   | 36,011           |   |                  |   | 49,182  |  |   | 65,259  |  |   | (16,077 | )
|Long term investments      |  |                  | 32,178  |                  |   | 27,300  |  |   | 4,878            |   |                  |   | 27,300  |  |   | 21,819  |  |   | 5,481   |  
|                           |  |                  |         |                  |   |         |  |   |                  |   |                  |   |         |  |   |         |  |   |         |  
|Total Cash and Investments |  | $                | 134,682 |                  | $ | 179,351 |  | $ | (44,669          | ) |                  | $ | 179,351 |  | $ | 205,466 |  | $ | (26,115 | )
|                           |  |                  |         |                  |   |         |  |   |                  |   |                  |   |         |  |   |         |  |   |         |  



During the year ended
December 31, 2004, the net decrease in cash and cash equivalents was $85.6 million compared to a net decrease of $15.5 million during the year ended December 31, 2003. As reported on our consolidated statements of cash flows, our decrease in cash
and cash equivalents during the years ended December 31, 2004 and 2003 is summarized as follows (in thousands):



|                                                    |  |                         |         |   |      |   |         |  
|--------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | -
|                                                    |  | Years ended December31, |        
|                                                    |  | 2004                    |         |   | 2003 |  
|Net cash used in operating activities               |  | $                       | (39,980 | ) |      | $ | (41,523 | )
|Net cash (used in) provided by investing activities |  |                         | (45,978 | ) |      |   | 5,130   |  
|Net cash provided by financing activities           |  |                         | 255     |   |      |   | 20,055  |  
|Effect of foreign exchange rate changes             |  |                         | 145     |   |      |   | 819     |  
|                                                    |  |                         |         |   |      |   |         |  
|Total decrease in cash and cash equivalents         |  | $                       | (85,558 | ) |      | $ | (15,519 | )
|                                                    |  |                         |         |   |      |   |         |  



Details of our cash
inflows and outflows are as follows during the year ended December 31, 2004:



Operating Activities: During the year ended December 31, 2004, we used $40.0 million in cash and cash equivalents in operating activities. This was comprised primarily of our net loss of $44.6 million
and an increase in our working capital of $2.6 million, partially offset by non-cash charges totaling $7.3 million. The increase in working capital reflects an increase in accounts receivable due to higher sales volumes in



38



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2004, and a reduction in restructuring liabilities as payments were made for liabilities recorded in prior years. Components of our significant non-cash
adjustments are as follows:



|                                              |  |                                                     |         |   |                                  |                                                                                                                                                                                                                                                         
|--------------------------------------------- |  | --------------------------------------------------- | ------- | - | -------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Non cash adjustments                          |  | Year ended December 31, 2004 (amounts in thousands) |         |   | Explanation of non-cash activity
|Depreciation and amortization                 |  | $                                                   | 17,041  |   |                                  | Consists of depreciation of property and equipment as well as amortization of deferred financing fees, patents and unearned
compensation.                                                                                                               
|Change in fair value of derivative liability  |  |                                                     | (12,124 | ) |                                  | In fiscal 2004, we recorded other income to reflect the change in the fair value of our derivative liability.                                                                                                                                           
|Non cash restructuring expense                |  |                                                     | (1,984  | ) |                                  | Consists of charges related to restructuring actions involving Easics N.V., OptiX Networks, Inc. and TeraOp, Inc.                                                                                                                                       
|Provision for excess and obsolete inventories |  |                                                     | 571     |   |                                  | In fiscal 2004, we recorded charges for excess and obsolete inventories.                                                                                                                                                                                
|Loss on extinguishment of debt                |  |                                                     | 2,987   |   |                                  | In fiscal 2004, we issued an aggregate of 12,129,496 shares of our common stock plus approximately$ 0.1 million cash in lieu of accrued
and unpaid interest in exchange for $17.0 million in aggregate original principal amount of the Plus Cash Notes.
|Other non-cash items, net                     |  |                                                     | 774     |   |                                  | Other non-cash items include items such as our non-cash charge for cumulative effect on prior years of adoption of FIN 46R, impairments of
investments, adjustment to the allowance for doubtful accounts and non-employee stock compensation expense.  
|                                              |  |                                                     |         |   |                                  |                                                                                                                                                                                                                                                         
|Total non-cash adjustments to net loss        |  | $                                                   | 7,265   |   |                                  |                                                                                                                                                                                                                                                         
|                                              |  |                                                     |         |   |                                  |                                                                                                                                                                                                                                                         



Investing Activities: Cash used in investing activities was $46.0 million in fiscal 2004 compared with $5.1 million generated in 2003. Specific investing activity is as follows:



| |  |  | During the year ended December 31, 2004, we invested approximately $3.6 million in capital equipment and product licenses. This compares to $3.3 million in fiscal 2003.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We invested approximately $1.6 million in non-publicly traded companies during the year ended December 31, 2004, compared to $2.7 million in fiscal 2003.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We invested approximately $40.9 million in short and long-term investments as compared to receiving net proceeds from investments of $10.6 million in fiscal 2003.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



Financing
Activities: During the year ended December 31, 2004, cash flows from financing activities provided $0.3 million, which consisted primarily of proceeds from the issuance of common stock under our employee stock plan. During the year ended
December 31, 2003, cash flows from financing activities provided $20.1 million, which consisted primarily of $24.0 million of proceeds from the issuance of the Plus Cash Notes and partially offset by deferred financing fees of $4.5 million, proceeds
from the exercise of stock options and purchases of shares in our employee stock plan of $0.6 million and the use of $0.1 million in the conversion of the Plus Cash Notes.



On April 6, 2004, the Company filed a shelf registration statement on Form S-3 (Registration No. 333-114238)
with the Securities and Exchange Commission (SEC) providing for the offer, from time to time, of common stock, preferred stock, debt securities and warrants up to an aggregate of $60.0 million. On April 19, 2004, the SEC declared effective the shelf
registration statement. This enables the Company to, at any time in the subsequent two-year period, make an offering of any individual security covered by the shelf registration statement as well as any combination thereof, subject to market
conditions and the Companys capital needs. The Company may use the net proceeds from the sale of these securities for general corporate



39



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purposes, which may include repayment or refinancing of existing indebtedness, acquisitions, investments, capital expenditures, repurchase of its capital
stock and for any other purposes that the Company may specify in any prospectus supplement.



Effect of Exchange Rates and Inflation: Exchange rates and inflation have not had a significant impact on our operations or cash
flows.



Commitments and Significant Contractual
Obligations



We have commitments to make future
interest payments on our existing 4.50% Notes and to redeem these notes in September 2005. We also have commitments to make future interest payments on the Plus Cash Notes and to redeem these notes in September 2007. Over the remaining life of the
outstanding notes, we expect to accrue and pay approximately $14.3 million in interest to the holders of both the 4.50% Notes and the Plus Cash Note.



We have outstanding operating lease commitments of $41.6 million, payable over the next thirteen years. Some of these commitments are for space that is
not being utilized and, for which, we recorded restructuring charges of $0.0, $0.5 million and $3.1 million during 2004, 2003 and 2002, respectively, for excess facilities. During 2004 and 2003, we entered into sublease and lease termination
agreements for a portion of our excess space and, as a result, we reduced our restructuring liability and recorded a restructuring benefit of $0.1 million and $1.9 million, respectively. We are in the process of trying to sublease additional excess
space but it is unlikely that any sublease income generated will offset the entire future commitment. As of December 31, 2004, we have sub-lease agreements totaling $9.8 million in place to rent portions of our excess facilities over the next six
years. We currently believe that we can fund these lease commitments in the future. However, there can be no assurances that we will not be required to seek additional capital or provide additional guarantees or collateral on these obligations.



A summary of our significant future contractual obligations
and their payments by fiscal year is summarized as follows (in thousands):



|                                                             |  |                        |         |      |   |            |  |            |        |            |   |       |  |   |       
|------------------------------------------------------------ |  | ---------------------- | ------- | ---- | - | ---------- |  | ---------- | ------ | ---------- | - | ----- |  | - | ------
|                                                             |  | Payments Due by Period
|Contractual Obligations                                      |  | Total                  |         | 2005 |   | 2006 &2007 |  | 2008 &2009 |        | Thereafter
|Interest on convertible notes                                |  | $                      | 14,265  |      | $ | 5,488      |  | $          | 8,777  |            | $ |      |  | $ |      
|Redemption of convertible notes                              |  |                        | 104,961 |      |   | 24,442     |  |            | 80,519 |            |   |      |  |   |      
|Operating lease commitments                                  |  |                        | 41,589  |      |   | 4,913      |  |            | 7,701  |            |   | 7,204 |  |   | 21,771
|Purchase obligations                                         |  |                        | 5,557   |      |   | 4,159      |  |            | 1,398  |            |   |      |  |   |      
|Capital lease and other commitments (principal and interest) |  |                        | 295     |      |   | 74         |  |            | 221    |            |   |      |  |   |      
|                                                             |  |                        |         |      |   |            |  |            |        |            |   |       |  |   |       
|                                                             |  | $                      | 166,667 |      | $ | 39,076     |  | $          | 98,616 |            | $ | 7,204 |  | $ | 21,771
|                                                             |  |                        |         |      |   |            |  |            |        |            |   |       |  |   |       



We also have pledged
approximately $0.9 million in available cash and cash equivalents as collateral for stand-by letters of credit that guarantee certain long-term property lease obligations.



Related Party Transactions



On a limited basis, we conduct certain related party transactions with the companies in which we have equity or debt
investments. During May 2003, we entered into an agreement with OptiX for them to provide subcontracting services to us. As a result of this agreement, we paid OptiX approximately $1.7 million and $1.0 million for these subcontracting services for
the years ended December 31, 2004 and 2003, respectively. We



40



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eliminated the effect of these transactions on our consolidated financial statements as required under FIN 46R for the year ended December 31, 2004.



In July 2004, we informed OptiX that we planned to discontinue
our ongoing funding of OptiXs operations. Consequently, the OptiX Board of Directors voted to wind-down its business and operations. As of December 31, 2004, OptiX has completed the wind-down and permanently closed its operations. As a result
of this action, we recorded a restructuring charge of $0.2 million related to severance, the impairment of assets and lease buy out costs. This charge was offset by a gain of $0.5 million related to the deconsolidation of OptiX, which resulted in a
net restructuring benefit of $0.3 million.



As of December 31,
2004, we had cumulatively funded $5.0 million to OptiX, relating to our convertible bridge loan with OptiX, including $1.0 million in cash provided to OptiX during 2003 to fund their net losses. For further discussion, please refer to Note
13Restructuring and Asset Impairment Charges of our Consolidated Financial Statements.



Recent Accounting Pronouncements



In November 2004, the FASB issued SFAS 151, Inventory Costs,an amendment of ARB No. 43, Chapter 4.The standard requires that abnormal amounts of idle capacity and spoilage costs should be excluded from
the cost of inventory and expensed when incurred. The provision is effective for fiscal periods beginning after June 15, 2005. We do not expect the adoption of this standard to have a material effect on our financial position, results of operations
or cash flows.



In December 2004, the FASB released its final
revised standard, SFAS No. 123R, Share-Based Payment. SFAS 123R requires that a public entity measure the cost of equity based service awards based on the grant-date fair value of the award. That cost will be recognized over the period during
which an employee is required to provide service in exchange for the award or the vesting period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. A public entity will initially
measure the cost of liability based service awards based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service
period will be recognized as compensation cost over that period. Adoption of SFAS 123R is required for fiscal periods beginning after June 15, 2005. We are evaluating SFAS 123R and believe that it may have a material effect on our financial position
and results of operations.



FACTORS THAT MAY AFFECT FUTURE
RESULTS



From time to time, information provided by us,
statements made by our employees or information included in our filings with the Securities and Exchange Commission (including this Form 10-K) may contain statements that are not historical facts, so-called forward-looking statements,
which involve risks and uncertainties. Such forward-looking statements are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended. In some cases you can identify forward-looking statements by
terminology such as may, should, could, will, expect, intend, plans, predict, anticipate, estimate, continue,
believe or the negative of these terms or other similar words. These statements discuss future expectations, contain projections of results of operations or of financial condition or state other forward-looking information. When
considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements in this Form 10-K.



Our actual future results may differ significantly from those stated in any forward-looking statements. Factors that may cause such differences include,
but are not limited to, the factors discussed below. Each of these factors, and others, are discussed from time to time in our filings with the Securities and Exchange Commission.



41



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Our operating results may fluctuate because of a number of factors, many of which are beyond our control.
If our operating results are below the expectations of public market analysts or investors, then the market price of our common stock could decline. Some of the factors that affect our quarterly and annual results, but which are difficult to control
or predict, are:



We have incurred significant net losses.



Our net losses have been considerable for the years ended December 31,
2004, 2003 and 2002. Due to current economic conditions and a significant decline in our net revenues, we expect that our operating results will continue to fluctuate substantially in the future.



Recent improvements in our net revenues may not continue.



Our net revenues have increased during the years ended December 31, 2004 and
2003, to $33.7 million and $23.8 million respectively. Net revenue for year ended December 31, 2002 was $16.6 million. Due to current economic conditions and slowdowns in purchases of VLSI semiconductor devices, it has become increasingly difficult
for us to predict the purchasing activities of our customers and we expect that our net revenues will continue to fluctuate in the future.



Our business is characterized by short-term orders and shipment schedules, and customer orders typically can be cancelled or rescheduled without
significant penalty to our customers. Because we do not have substantial non-cancelable backlog, we typically plan our production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate
substantially. Future fluctuations to our operating results may also be caused by a number of factors, many of which are beyond our control.



In response to anticipated long lead times to obtain inventory and materials from our foundries, we may order inventory and materials in advance of
anticipated customer demand, which might result in excess inventory levels if the expected orders fail to materialize. As a result, we cannot predict the timing and amount of shipments to our customers, and any significant downturn in customer
demand for our products would reduce our quarterly and annual operating results. As a result of these conditions, during the fiscal years ended December 31, 2004, 2003 and 2002, we recorded write-downs for excess inventories totaling $0.6 million,
$1.5 million and $4.8 million, respectively.



We continue to have
substantial indebtedness.



As of December 31, 2004, we
have approximately $105.0 million in principal amount of indebtedness outstanding in the form of our 4.50% Notes and the Plus Cash Notes.



In addition to this indebtedness, we may incur substantial additional indebtedness in the future. The level of our indebtedness, among other things,
could:



| |  |  | make it difficult for us to make payments on our 4.50% Notes or our Plus Cash Notes;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | make it difficult for us to obtain any necessary future financing for working capital, capital expenditures, debt service requirements or other purposes;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | limit our flexibility in planning for, or reacting to changes in, our business; and
| | - |  | -----------------------------------------------------------------------------------



| |  |  | make us more vulnerable in the event of a downturn in our business.
| | - |  | -------------------------------------------------------------------



There can be no assurance that we will be able to meet our debt service obligations, including our obligations under the 4.50% Notes, which come due in
September 2005, or the Plus Cash Notes. The terms of our Plus Cash Notes permit the holders thereof to voluntarily convert their notes at any time into a certain number of shares of our common stock and receive a certain amount in cash, which we
refer to as the plus cash amount,



42



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and, if certain conditions are met, we have the option of settling this cash amount in additional shares of our common stock. These Plus Cash Notes also
permit us to automatically convert some or all of the Plus Cash Notes into shares of our common stock subject to certain conditions. We may not elect to settle the plus cash amount payable upon voluntary or automatic conversion in additional shares
of our common stock, or we may be restricted from doing so pursuant to the terms of the Plus Cash Notes. If a significant percentage of our Plus Cash Notes are voluntarily or automatically converted, we may be required to use all or a significant
portion of our available cash, which could have a material adverse effect on our business, prospects, financial condition and operating results.



We are using our available cash and investments each quarter to fund our operating activities.



During the year ended December 31, 2004, we used $85.6 million of our available cash and cash equivalents to fund our
operating, investing and financing activities, which included investments of $40.9 million in short and long-term marketable securities for a net cash and investment usage of $44.7 million.



During the year ended December 31, 2003, we used $16.0 million of our
available cash and cash equivalents to fund our operating, investing and financing activities, raised additional cash of $19.5 million through the sale of our Plus Cash Notes, redeemed $10.2 million of short and long-term marketable securities for a
net cash and investment usage of $26.2 million.



We anticipate
that we will use approximately $12.0 million to $13.0 million in cash, cash equivalents and investments during the first quarter of 2005 to fund our operations, investments and financing activities. Also in September of 2005, approximately $24.4
million in principal amount of our 4.50% Notes will become due and payable. We believe that we will continue to use our available cash, cash equivalents and investments in the future although we believe that we have sufficient cash for our needs for
at least the next twelve months. We will continue to experience losses and use our cash, cash equivalents and investments if we do not receive sufficient product orders and our costs are not reduced to offset the decline in revenue.



We may not be able to pay our debt and other obligations.



If our cash, cash equivalents, short and long-term investments and operating
cash flows are inadequate to meet our obligations, we could face substantial liquidity problems. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments on the 4.50% Notes, which come due in
September 2005, the Plus Cash Notes or our other obligations, we would be in default under the terms thereof, which would permit the holders of the 4.50% Notes, the Plus Cash Notes and our other obligations to accelerate their maturities and which
could also cause defaults under any future indebtedness we may incur. Any such default or cross default would have a material adverse effect on our business, prospects, financial condition and operating results. In addition, we cannot be sure that
we would be able to repay amounts due in respect of the 4.50% Notes and the Plus Cash Notes if payment of those notes were to be accelerated following the occurrence of an event of default as defined in the respective indentures of the 4.50% Notes
and Plus Cash Notes.



We may incur additional indebtedness, including
secured indebtedness, which may have rights to payment superior to our 4.50% Notes and Plus Cash Notes.



Our 4.50% Notes and Plus Cash Notes are unsecured obligations. The terms of the 4.50% Notes and the Plus Cash Notes do not limit the amount of additional
indebtedness, including secured indebtedness that we can create, incur, assume or guarantee. Upon any distribution of our assets upon any insolvency, dissolution or reorganization, the payment of the principal of and interest on our secured
indebtedness will be distributed out of our assets, which represent the security for such indebtedness. There may not be sufficient assets remaining to pay amounts due on any or all of the 4.50% Notes or the Plus Cash Notes then outstanding once
payment of the principal and interest on our secured indebtedness has been made.



43



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We may seek to reduce our indebtedness by issuing equity securities, thereby causing dilution of our
stockholders ownership interests.



We may from time
to time seek to exchange our 4.50% Notes and our Plus Cash Notes for shares of our common stock or other securities. These exchanges may take different forms, including exchange offers or privately negotiated transactions. As a result of shares of
our common stock or other securities being issued upon such conversion or pursuant to such exchanges, our stockholders may experience substantial dilution of their ownership interest.



If we seek to secure additional financing we may not be able to do so. If we are able to secure additional financing our stockholders may
experience dilution of their ownership interest or we may be subject to limitations on our operations.



We believe that our existing cash, cash equivalents and short and long-term investments will be sufficient to fund operating losses and capital
expenditures and provide adequate working capital for at least the next twelve months. However, there can be no assurance that events in the future will not require us to seek additional capital and, if so required, that capital will be available on
terms favorable or acceptable to us, if at all.



If we are
unable to generate sufficient cash flows from operations to meet our anticipated needs for working capital and capital expenditures, we may need to raise additional funds. If we raise additional funds through the issuance of equity securities, our
stockholders may experience dilution of their ownership interest, and the newly issued securities may have rights superior to those of common stock. If we raise additional funds by issuing debt, we may be subject to limitations on our operations.



The terms of the Plus Cash Notes include voluntary and
automatic conversion provisions upon which shares of our common stock would be issued, and would also permit us to satisfy certain interest and other payments with additional shares of our common stock. As a result of these shares of our common
stock being issued, our stockholders may experience substantial dilution of their ownership interest.



On April 6, 2004, we filed a shelf registration statement on Form S-3 (Registration No. 333-114238) with the Securities and Exchange Commission (SEC)
providing for the offer, from time to time, of common stock, preferred stock, debt securities and warrants up to an aggregate of $60.0 million. On April 19, 2004, the SEC declared effective the shelf registration statement. This enables us to, at
any time in the subsequent two-year period, make an offering of any individual security covered by the shelf registration statement as well as any combination thereof, subject to market conditions and our capital needs. Such market conditions may
not allow for terms favorable to us. Any such offering, which results in the issuance of shares of our common stock, may cause our stockholders to experience substantial dilution of their ownership interest. We may use the net proceeds from the sale
of these securities for general corporate purposes, which may include repayment or refinancing of existing indebtedness, acquisitions, investments, capital expenditures, repurchase of its capital stock and for any other purposes that we may specify
in any prospectus supplement.



If the trading price of our common
stock fails to comply with the continued listing requirements of The Nasdaq National Market, we would face possible delisting, which would result in a limited public market for our common stock and make obtaining future debt or equity financing more
difficult for us.



Our common stock is listed on The
Nasdaq National Market and is subject to certain listing requirements, including the requirement that the closing bid price for our shares of common stock exceed $1.00. On February 28, 2005 the price of our shares was $1.29. If we do not continue to
comply with the Nasdaq listing requirements, Nasdaq may provide written notification to us regarding the delisting of our securities. At that time, we would have the right to request a hearing to appeal the Nasdaq determination and would also have
the option to apply to transfer our securities to The Nasdaq SmallCap Market.



44



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We cannot be sure that our price will comply with the requirements for continued listing of our common
stock on The Nasdaq National Market, or that any appeal of a decision to delist our common stock will be successful. If our common stock loses its status on The Nasdaq National Market and we are not successful in obtaining a listing on The Nasdaq
SmallCap Market, shares of our common stock would likely trade in the over-the-counter market bulletin board, commonly referred to as the pink sheets.



If our stock were to trade on the over-the-counter market, selling our common stock could be more difficult because smaller
quantities of shares would likely be bought and sold, transactions could be delayed, and security analysts coverage of us may be reduced. In addition, in the event our common stock is delisted, broker-dealers have certain regulatory burdens
imposed upon them, which may discourage broker-dealers from effecting transactions in our common stock, further limiting the liquidity thereof. These factors could result in lower prices and larger spreads in the bid and ask prices for shares of
common stock.



Such delisting from The Nasdaq National
Market or future declines in our stock price could also greatly impair our ability to raise additional necessary capital through equity or debt financing, and could significantly increase the ownership dilution to stockholders caused by our issuing
equity in financing or other transactions.



Our stock price is volatile.



The market for securities for communication semiconductor
companies, including our Company, has been highly volatile. The market sale price of our common stock has fluctuated between a low of $0.21 and a high of $74.69 during the period from June 19, 1995 to December 31, 2004. The closing price was $1.29
on February 28, 2005. It is likely that the price of our common stock will continue to fluctuate widely in the future. Factors affecting the trading price of our common stock include:



| |  |  | responses to quarter-to-quarter variations in operating results;
| | - |  | ----------------------------------------------------------------



| |  |  | announcements of technological innovations or new products by us or our competitors;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | current market conditions in the telecommunications and data communications equipment markets (we are currently and have been experiencing a significant downturn since 2000); and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in earnings estimates by analysts.
| | - |  | ------------------------------------------



We may have to further restructure our business.



On January 17, 2005, we announced that we had implemented an organizational restructuring that included the elimination of 26 positions, representing
approximately 10% of the Companys workforce. Most of the positions eliminated were based in our Shelton and Boston locations. As a result, we expect to record a restructuring charge related to severance of approximately $1.0 million in the
quarter ending March 31, 2005, and anticipate the restructuring to be substantially completed by the end of the first quarter, 2005. The restructuring is expected to reduce our salary and personnel expenses by approximately $2.5 million annually.



During the year ended December 31, 2004, we recorded
restructuring charges totaling approximately $1.1 million resulting from the liquidation of our investment in TeraOp, the wind-down of the business and operations of OptiX, and the disengagement from Easics N.V., our Belgian design center.



In July 2004, we informed OptiX that we planned to discontinue
our ongoing funding of OptiXs operations. Consequently, the OptiX Board of Directors voted to wind-down its business and operations. During the year ended December 31, 2004, we recorded a charge of $0.2 million related to severance, the
impairment of assets and lease buy out costs. This charge was offset by a gain of $0.5 million related to the deconsolidation of OptiX, resulting in a net restructuring benefit of $0.3 million for the year ended December 31, 2004.



In September 2004, we entered an agreement with TeraOp under which we
converted our promissory notes issued and payable by TeraOp into shares of TeraOp common stock. We then sold all of our common share



45



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holdings in TeraOp to an independent third party for a nominal amount. In addition, we paid TeraOp $0.3 million for a royalty on future revenues of TeraOp.
Currently, TeraOp has no revenue and may never have revenue in the future. As a result of these transactions, we no longer hold any equity or debt interest in TeraOp and have no influence over the operations of TeraOp. Accordingly, TeraOp was
deconsolidated from our financial statements upon the completion of these transactions, resulting in a net restructuring charge of $0.2 million.



In the fourth quarter of 2004, we finalized our plans to disengage from Easics N.V. This action resulted in a work force reduction of approximately 9% of
our existing personnel and the sale of the business. As a result of this action, we incurred restructuring charges of approximately $1.6 million related to employee termination benefits and $0.1 million related to legal and other transaction costs.
These charges were offset by a gain of $0.5 million on the sale of Easics N.V., for a net restructuring charge of approximately $1.1 million. We estimate future operating expense savings related to this plan to be approximately $2.8 to $3.0 million
annually. However, there can be no assurances that events will not cause the actual savings to rise or fall in future periods.



In January 2003, we announced a restructuring plan in order to lower our operating expense run-rate due to then current and anticipated business
conditions. This plan resulted in a work force reduction of approximately 24% of existing personnel. Also, we announced the closing of our South Brunswick, New Jersey (SOSi) design center, and reduced staff in Bedford, Massachusetts and Shelton,
Connecticut. This workforce reduction also impacted our Switzerland and Belgium locations. In addition, we postponed the completion of the IAD product line and archived the related intellectual property until that market returns, if ever. During the
year ended December 31, 2003, we incurred approximately $2.5 million in restructuring expenses related to employee termination benefits, excess facility costs and asset impairments.



During fiscal 2002, we announced a restructuring plan due to continued weakness in our business and the industry. As a
result of this plan, we eliminated 56 positions and announced the closing of design centers in Milpitas, California and Raleigh, North Carolina. In conjunction with this restructuring, we discontinued certain product lines and strategically
refocused our research and development efforts. As a result of these plans, we incurred restructuring charges and asset impairments of approximately $5.5 million. We also implemented a restructuring plan in 2001.



We may have to make further restructuring changes if our operating expense
run-rate does not continue to decline in the face of current and anticipated business conditions.



We anticipate that shipments of our products to relatively few customers will continue to account for a significant portion of our total net revenues.



Historically, a relatively small number of customers have accounted for a
significant portion of our total net revenues in any particular period. For the years ended December 31, 2004 and 2003, shipments to our top five customers, including sales to distributors, accounted for approximately 58% and 64% of our total net
revenues, respectively. We expect that a limited number of customers may account for a substantial portion of our total net revenues for the foreseeable future.



Some of the following may reduce our total net revenues or adversely affect our business:



| |  |  | reduction, delay or cancellation of orders from one or more of our significant customers;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | development by one or more of our significant customers of other sources of supply for current or future products;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | loss of one or more of our current customers or a disruption in our sales and distribution channels; and
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | failure of one or more of our significant customers to make timely payment of our invoices.
| | - |  | -------------------------------------------------------------------------------------------



We cannot be certain that our current customers will continue to place orders with us, that orders by existing customers
will return to the levels of previous periods or that we will be able to obtain orders from new



46



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customers. We have no long-term volume purchase commitments from any of our significant customers. The following table sets forth the percentage of net
revenues attributable to our major distributors as well as the significant customers that had total purchases (either direct or through distributors) of greater than 10% of net revenues for the fiscal years ended December 31, 2004, 2003 and 2002:



|                             |  |                          |   |  |      |   |  |      |  
|---------------------------- |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                             |  | Years ended December 31, |  
|                             |  | 2004                     |   |  | 2003 |   |  | 2002 |  
|Distributors:                |  |                          |   |  |      |   |  |      |  
|Insight Electronics, Inc.(1) |  | 12                       | % |  | 12   | % |  | 10   | %
|Arrow Electronics, Inc.(2)   |  | 10                       | % |  | 11   | % |  | 19   | %
|Weone Corporation            |  | *                        |   |  | *    |   |  | 13   | %
|Significant Customers:       |  |                          |   |  |      |   |  |      |  
|Siemens AG                   |  | 24                       | % |  | 28   | % |  | 19   | %
|Nortel                       |  | 12                       | % |  | *    |   |  | *    |  
|Tellabs, Inc.(2)             |  | 10                       | % |  | 12   | % |  | 23   | %
|Cisco Systems, Inc.(1)       |  | *                        |   |  | *    |   |  | 11   | %

---

|(1) | The end customers of the shipments to Insight Electronics, Inc. during 2004 includes: Spirent Communications, Cisco Systems, Inc., and Sonus Networks, Inc.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The primary end customer of the shipments to Arrow Electronics, Inc. is Tellabs, Inc.
|--- | -------------------------------------------------------------------------------------

|* | Revenues were less than 10% of our net revenues in these years.
|- | ---------------------------------------------------------------



The cyclical nature of the communication semiconductor industry affects our business and we have experienced a significant downturn since 2000.



We provide semiconductor devices to the telecommunications and data
communications markets. The semiconductor industry is highly cyclical. After several years of rapid growth our markets experienced a downturn beginning in 2001. Downturns are characterized by:



| |  |  | diminished product demand;
| | - |  | --------------------------



| |  |  | accelerated erosion of average selling prices; and
| | - |  | --------------------------------------------------



| |  |  | production over-capacity.
| | - |  | -------------------------



Our markets began to stabilize in 2003, but experienced additional fluctuations in demand during 2004. We believe that we are now in the early stages of a
market recovery. However, demand remains well below the levels prior to the downturn. We may experience substantial fluctuations in future operating results due to general semiconductor industry conditions, overall economic conditions, seasonality
of customers buying patterns and other factors.



Our international
business operations expose us to a variety of business risks.



Foreign markets are a significant part of our net revenues. For the year ended December 31, 2004, foreign shipments accounted for approximately 65% of our total net revenues as compared to 72% in the prior year. We expect foreign markets to
continue to account for a significant percentage of our total net revenues. A significant portion of our total net revenues will, therefore, be subject to risks associated with foreign markets, including the following:



| |  |  | unexpected changes in legal and regulatory requirements and policy changes affecting the telecommunications and data communications markets;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in tariffs;
| | - |  | -------------------



47



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| |  |  | exchange rates, currency controls and other barriers;
| | - |  | -----------------------------------------------------



| |  |  | political and economic instability;
| | - |  | -----------------------------------



| |  |  | risk of terrorism;
| | - |  | ------------------



| |  |  | difficulties in accounts receivable collection;
| | - |  | -----------------------------------------------



| |  |  | difficulties in managing distributors and representatives;
| | - |  | ----------------------------------------------------------



| |  |  | difficulties in staffing and managing foreign operations;
| | - |  | ---------------------------------------------------------



| |  |  | difficulties in protecting our intellectual property overseas;
| | - |  | --------------------------------------------------------------



| |  |  | natural disasters;
| | - |  | ------------------



| |  |  | seasonality of customer buying patterns; and
| | - |  | --------------------------------------------



| |  |  | potentially adverse tax consequences.
| | - |  | -------------------------------------



Although substantially all of our total net revenues to date have been denominated in U.S. dollars, the value of the U.S. dollar in relation to foreign
currencies also may reduce our total net revenues from foreign customers. To the extent that we expand our international operations or change our pricing practices to denominate prices in foreign currencies, we will expose our margins to increased
risks of currency fluctuations. We have assessed the risks related to foreign exchange fluctuations, and have determined at this time that any such risk is not material.



Our net product revenues depend on the success of our customers products, and our design wins do not necessarily generate revenues
in a timely fashion.



Our customers generally incorporate
our new products into their products or systems at the design stage. However, customer decisions to use our products (design wins), which can often require significant expenditures by us without any assurance of success, often precede the generation
of production revenues, if any, by a year or more. Some customer projects are canceled, and thus will not generate revenues for our products. In addition, even after we achieve a design win, a customer may require further design changes.
Implementing these design changes can require significant expenditures of time and expense by us in the development and pre-production process. Moreover, the value of any design win will largely depend upon the commercial success of the
customers product and on the extent to which the design of the customers systems accommodates components manufactured by our competitors. We cannot ensure that we will continue to achieve design wins in customer products that achieve
market acceptance. Further, most revenue-generating design wins take several years to translate into meaningful revenues.



We must successfully transition to new process technologies to remain competitive.



Our future success depends upon our ability to do the following:



| |  |  | to develop products that utilize new process technologies;
| | - |  | ----------------------------------------------------------



| |  |  | to introduce new process technologies to the marketplace ahead of competitors; and
| | - |  | ----------------------------------------------------------------------------------



| |  |  | to have new process technologies selected to be designed into products of leading systems manufacturers.
| | - |  | --------------------------------------------------------------------------------------------------------



Semiconductor design and process methodologies are subject to rapid technological change and require large expenditures for
research and development. We currently manufacture our products using 0.8, 0.5, 0.35, 0.25, 0.18 and 0.13 micron complementary metal oxide semiconductor (CMOS) processes and a 1.0 micron bipolar CMOS (BiCMOS) process. We continuously evaluate the
benefits, on a product-by-product basis, of migrating to smaller geometry process technologies.Other companies in the industry have experienced difficulty in transitioning to new manufacturing processes and, consequently, have suffered
increased costs, reduced yields



48



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or delays in product deliveries. We believe that transitioning our products to smaller geometry process technologies will be important for us to remain
competitive. We cannot be certain that we can make such a transition successfully, if at all, without delay or inefficiencies.



Our success depends on the timely development of new products, and we face risks of product development delays.



Our success depends upon our ability to develop new VLSI devices and
software for existing and new markets. The development of these new devices and software is highly complex, and from time to time we have experienced delays in completing the development of new products. Successful product development and
introduction depends on a number of factors, including the following:



| |  |  | accurate new product definition;
| | - |  | --------------------------------



| |  |  | timely completion and introduction of new product designs;
| | - |  | ----------------------------------------------------------



| |  |  | availability of foundry capacity;
| | - |  | ---------------------------------



| |  |  | achievement of manufacturing yields; and
| | - |  | ----------------------------------------



| |  |  | market acceptance of our products and our customers products.
| | - |  | --------------------------------------------------------------



Our success also depends upon our ability to do the following:



| |  |  | build products to applicable standards;
| | - |  | ---------------------------------------



| |  |  | develop products that meet customer requirements;
| | - |  | -------------------------------------------------



| |  |  | adjust to changing market conditions as quickly and cost-effectively as necessary to compete successfully;
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | introduce new products that achieve market acceptance; and
| | - |  | ----------------------------------------------------------



| |  |  | develop reliable software to meet our customers application needs in a timely fashion.
| | - |  | ---------------------------------------------------------------------------------------



In addition, we cannot ensure that the systems manufactured by our customers will be introduced in a timely manner or that
such systems will achieve market acceptance.



We sell a range of products
that each has a different gross profit. Our total gross profits will be adversely affected if most of our shipments are of products with low gross profits.



We currently sell more than 50 products. Some of our products have a high gross profit while others do not. If our customers decide to buy more of our
products with low gross profits and fewer of our products with high gross profits, our total gross profits could be adversely affected. We plan our mix of products based on our internal forecasts of customer demand, which are highly unpredictable
and can fluctuate substantially.



The price of our products tends to
decrease over the lives of our products.



Historically,
average selling prices in the communication semiconductor industry have decreased over the life of a product, and, as a result, the average selling prices of our products may decrease in the future. Decreases in the price of our products would
adversely affect our operating results. Our customers are increasingly more focused on price, as semiconductor products become more prevalent in their equipment. We may have to decrease our prices to remain competitive in some situations, which may
negatively impact our gross margins.



Our success depends on the rate of
growth of the global communications infrastructure.



We
derive virtually all of our total net revenues from products for telecommunications and data communications applications. These markets are characterized by the following:



| |  |  | susceptibility to seasonality of customer buying patterns;
| | - |  | ----------------------------------------------------------



| |  |  | subject to general business cycles;
| | - |  | -----------------------------------



49



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| |  |  | intense competition;
| | - |  | --------------------



| |  |  | rapid technological change; and
| | - |  | -------------------------------



| |  |  | short product life cycles.
| | - |  | --------------------------



In addition, although the telecommunications and data communications equipment markets grew rapidly in the late 1990s and 2000, we have experienced a
significant decline in these markets since 2000. We anticipate that these markets will continue to experience significant volatility in the near future.



Our products must successfully include industry standards to remain competitive.



Products for telecommunications and data communications applications are based on industry standards, which are continually
evolving. Our future success will depend, in part, upon our ability to successfully develop and introduce new products based on emerging industry standards, which could render our existing products unmarketable or obsolete. If the telecommunications
or data communications markets evolve to new standards, we cannot be certain that we will be able to design and manufacture new products successfully that address the needs of our customers and include the new standards or that such new products
will meet with substantial market acceptance.



Our intellectual property
indemnification practices may adversely impact our business.



We have historically agreed to indemnify our customers for certain costs and damages of intellectual property rights in circumstances where our product is the factor creating the customers infringement exposure. This practice may
subject us to significant indemnification claims by our customers. In some instances, our products are designed for use in devices manufactured by our customers that comply with international standards. These international standards are often
covered by patent rights held by third parties, which may include our competitors. The costs of obtaining licenses from holders of patent rights essential to such international standards could be high. The cost of not obtaining such licenses could
also be high if a holder of such patent rights brings a claim for patent infringement. We are not aware of any claimed violations on our part. However, we cannot assure you that claims for indemnification will not be made or that if made, such
claims would not have a material adverse effect on our business, results of operations or financial condition.



We continue to expense our new product process development costs when incurred.



In the past, we have incurred significant new product and process development costs because our policy is to expense these costs, including tooling,
fabrication and pre-production expenses, at the time that they are incurred. We may continue to incur these types of expenses in the future. These additional expenses will have a material and adverse effect on our operating results in future
periods.



We face intense competition in the communication semiconductor
market.



The communication semiconductor industry is
intensely competitive and is characterized by the following:



| |  |  | rapid technological change;
| | - |  | ---------------------------



| |  |  | subject to general business cycles;
| | - |  | -----------------------------------



| |  |  | price erosion;
| | - |  | --------------



| |  |  | limited access to fabrication capacity;
| | - |  | ---------------------------------------



| |  |  | unforeseen manufacturing yield problems; and
| | - |  | --------------------------------------------



| |  |  | heightened international competition in many markets.
| | - |  | -----------------------------------------------------



These factors are likely to result in pricing pressures on our products, thus potentially affecting our operating results.



50



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Our ability to compete successfully in the rapidly evolving area of high-performance integrated circuit
technology depends on factors both within and outside our control, including:



| |  |  | success in designing and subcontracting the manufacture of new products that implement new technologies;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | protection of our products by effective use of intellectual property laws;
| | - |  | --------------------------------------------------------------------------



| |  |  | product quality;
| | - |  | ----------------



| |  |  | reliability;
| | - |  | ------------



| |  |  | price;
| | - |  | ------



| |  |  | efficiency of production;
| | - |  | -------------------------



| |  |  | failure to find alternative manufacturing sources to produce VLSI devices with acceptable manufacturing yields;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | the pace at which customers incorporate our products into their products;
| | - |  | -------------------------------------------------------------------------



| |  |  | success of competitors products; and
| | - |  | -------------------------------------



| |  |  | general economic conditions.
| | - |  | ----------------------------



The telecommunications and data communications industries, which are our primary target markets, have become intensely competitive because of
deregulation, heightened international competition and recent significant decreases in demand since 2000. In the communications semiconductor markets, we compete primarily against companies such as Applied Micro Circuits Corporation, Conexant
Systems, Inc., Cirrus Logic, Inc., Infineon Technologies, Exar Corporation, Agere Systems, PMC-Sierra Inc., TriQuint Semiconductor, Inc., Vitesse Semiconductor Corporation and Broadcom Corporation. In addition, there are a number of Applications
Specific Integrated Circuit (ASIC) vendors, including AMI Semiconductor, LSI Logic Corporation and STM Microelectronics Group, which compete with us by supplying customer-specific products to OEMs. In the ATM market, the principal competitors
include all the vendors mentioned above and, in addition, Intel Corporation. A number of our customers have internal semiconductor design or manufacturing capability with which we also compete. Any failure by us to compete successfully in these
target markets, particularly in the communications markets, would have a material adverse effect on our business, financial condition and results of operations.



We rely on outside fabrication facilities, and our business could be hurt if our relationships with our foundry suppliers are damaged.



We do not own or operate a VLSI circuit fabrication facility. Four foundries
currently supply us with all of our semiconductor device requirements. While we have had good relations with these foundries, we cannot be certain that we will be able to renew or maintain contracts with them or negotiate new contracts to replace
those that expire. In addition, we cannot be certain that renewed or new contracts will contain terms as favorable as our current terms. There are other significant risks associated with our reliance on outside foundries, including the following:



| |  |  | the lack of assured semiconductor wafer supply and control over delivery schedules;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | the unavailability of, or delays in obtaining access to, key process technologies; and
| | - |  | --------------------------------------------------------------------------------------



| |  |  | limited control over quality assurance, manufacturing yields and production costs.
| | - |  | ----------------------------------------------------------------------------------



Reliance on third-party fabrication facilities limits our ability to control the manufacturing process.



Manufacturing integrated circuits is a highly complex and
technology-intensive process. Although we try to diversify our sources of semiconductor device supply and work closely with our foundries to minimize the



51



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likelihood of reduced manufacturing yields, our foundries occasionally experience lower than anticipated manufacturing yields, particularly in connection
with the introduction of new products and the installation and start-up of new process technologies. Such reduced manufacturing yields have at times reduced our operating results. A manufacturing disruption at one or more of our outside foundries,
including, without limitation, those that may result from natural disasters, accidents, acts of terrorism or political instability or other natural occurrences, could impact production for an extended period of time.



Our dependence on a small number of fabrication facilities exposes us to risks of
interruptions in deliveries of semiconductor devices.



We
purchase semiconductor devices from outside foundries pursuant to purchase orders, and we do not have a guaranteed level of production capacity at any of our foundries. We provide the foundries with forecasts of our production requirements. However,
the ability of each foundry to provide wafers to us is limited by the foundrys available capacity and the availability of raw materials. Therefore, our foundry suppliers could choose to prioritize capacity and raw materials for other customers
or reduce or eliminate deliveries to us on short notice. Accordingly, we cannot be certain that our foundries will allocate sufficient capacity to satisfy our requirements.



We have been, and expect in the future to be, particularly dependent upon a limited number of foundries for our VLSI device
requirements. In particular, as of the date of this Form 10-K, a single foundry manufactures all of our BiCMOS devices. As a result, we expect that we could experience substantial delays or interruptions in the shipment of our products due to the
any of the following:



| |  |  | sudden demand for an increased amount of semiconductor devices or sudden reduction or elimination of any existing source or sources of semiconductor devices;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | time required to qualify alternative manufacturing sources for existing or new products could be substantial; and
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | failure to find alternative manufacturing sources to produce VLSI devices with acceptable manufacturing yields.
| | - |  | ---------------------------------------------------------------------------------------------------------------



We are subject to risks arising from our using subcontractors to assemble our products.



Contract assembly houses in Asia assemble all of our
semiconductor products. Raw material shortages, natural disasters, political and social instability, service disruptions, currency fluctuations, or other circumstances in the region could force us to seek additional or alternative sources of supply
or assembly. This could lead to supply constraints or product delivery delays.



Our failure to protect our proprietary rights, or the costs of protecting these rights, may harm our ability to compete.



Our success depends in part on our ability to obtain patents and licenses and to preserve other intellectual property rights covering our products and
development and testing tools. To that end, we have obtained certain domestic and foreign patents and intend to continue to seek patents on our inventions when appropriate. The process of seeking patent protection can be time consuming and
expensive. We cannot ensure the following:



| |  |  | that patents will be issued from currently pending or future applications;
| | - |  | --------------------------------------------------------------------------



| |  |  | that our existing patents or any new patents will be sufficient in scope or strength to provide meaningful protection or any commercial advantage to us;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | that foreign intellectual property laws will protect our foreign intellectual property rights; and
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | that others will not independently develop similar products, duplicate our products or design around any patents issued to us.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



52



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Intellectual property rights are uncertain and adjudication of such rights involve complex legal and
factual questions. We may be unknowingly infringing on the proprietary rights of others and may be liable for that infringement, which could result in significant liability for us. We occasionally receive correspondence from third parties alleging
infringement of their intellectual property rights. If we are found to infringe the proprietary rights of others, we could be forced to either seek a license to the intellectual property rights of others or alter our products so that they no longer
infringe the proprietary rights of others. A license could be very expensive to obtain or may not be available at all. Similarly, changing our products or processes to avoid infringing the rights of others may be costly or impractical.



We are responsible for any patent litigation costs. If we were to become
involved in a dispute regarding intellectual property, whether ours or that of another company, we may have to participate in legal proceedings in the United States Patent and Trademark Office or in the United States or foreign courts to determine
any or all of the following issues: patent validity, patent infringement, patent ownership or inventorship. These types of proceedings may be costly and time consuming for us, even if we eventually prevail. If we do not prevail, we might be forced
to pay significant damages, obtain a license, if available, or stop making a certain product. From time to time we may prosecute patent litigation against others and as part of such litigation, other parties may allege that our patents are not
infringed, are invalid and are unenforceable.



We also rely on
trade secrets, proprietary know-how and confidentiality provisions in agreements with employees and consultants to protect our intellectual property. Such parties may not comply with the terms of their agreements with us, and we may not be able to
adequately enforce our rights against these parties.



We could be subject to
class action litigation due to stock price volatility, which if it occurs, will distract our management and could result in substantial costs or large judgments against us.



In the past, securities and class action litigation has often been brought against companies following periods of volatility
in the market prices of their securities. We may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert our managements attention and resources, which could cause serious harm to
our business, operating results and financial condition or dilution to our stockholders.



We may engage in acquisitions that may harm our operating results, dilute our stockholders and cause us to incur debt or assume contingent liabilities.



We may pursue acquisitions from time to time that could provide new
technologies, skills, products or service offerings. Future acquisitions by us may involve the following:



| |  |  | use of significant amounts of cash and cash equivalents;
| | - |  | --------------------------------------------------------



| |  |  | potentially dilutive issuances of equity securities; and
| | - |  | --------------------------------------------------------



| |  |  | incurrence of debt or amortization expenses related to intangible assets with definitive lives.
| | - |  | -----------------------------------------------------------------------------------------------



In addition, acquisitions involve numerous other risks, including:



| |  |  | diversion of managements attention from other business concerns;
| | - |  | -----------------------------------------------------------------



| |  |  | risks of entering markets in which we have no or limited prior experience; and
| | - |  | ------------------------------------------------------------------------------



| |  |  | unanticipated expenses and operational disruptions while acquiring and integrating new acquisitions.
| | - |  | ----------------------------------------------------------------------------------------------------



From time to time, we have engaged in discussions with third parties concerning potential acquisitions of product lines,
technologies and businesses. However, we currently have no commitments or agreements with respect to any such acquisition. If such an acquisition does occur, we cannot be certain that our business, operating results and financial condition will not
be materially adversely affected or that we will realize the anticipated benefits of the acquisition.



53



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Our business could be harmed if we fail to integrate future acquisitions adequately.



During the past four years, we have acquired five privately held companies
based in the United States and Europe. The integration of the operations of our five acquisitions, ADV Engineering S.A., acquired in January 2001, Horizon Semiconductors, Inc., acquired in February 2001, Onex Communications Corporation, acquired in
September 2001, Systems On Silicon, Inc., (SOSi) acquired in March 2002, and ASIC Design Services, Inc., acquired in August 2003 have been completed.



Our management must devote time and resources to the integration of the operations of any future acquisitions. The process of integrating research and
development initiatives, computer and accounting systems and other aspects of the operations of any future acquisitions presents a significant challenge to our management. This is compounded by the challenge of simultaneously managing a larger and
more geographically dispersed entity.



Future acquisitions
could present a number of additional difficulties of integration, including:



| |  |  | difficulties in integrating personnel with disparate business backgrounds and cultures;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | difficulties in defining and executing a comprehensive product strategy; and
| | - |  | ----------------------------------------------------------------------------



| |  |  | difficulties in minimizing the loss of key employees of the acquired company.
| | - |  | -----------------------------------------------------------------------------



If we delay integrating or fail to integrate operations or experience other unforeseen difficulties, the integration process may require a
disproportionate amount of our managements attention and financial and other resources. Our failure to address these difficulties adequately could harm our business or financial results, and we could fail to realize the anticipated benefits of
the transaction.



We have in the past, as a result of industry
conditions, later discontinued or abandoned certain product lines acquired through prior acquisitions.



We have made, and may continue to make, investments in development stage companies, which may not produce any returns for us in the future.



We have made investments in early stage venture-backed, start-up companies that develop technologies that are complementary
to our product roadmap. The following table summarizes these investments as of December 31, 2004:



|                                   |  |                         |  |                                                                                                  
|---------------------------------- |  | ----------------------- |  | -------------------------------------------------------------------------------------------------
|Investee Company                   |  | Initial Investment Date |  | Technology                                                                                       
|Opulan Technologies                |  | April 2003              |  | High performance and cost-effective IP convergence ASSPs (application-specific standard products)
|Metanoia Technologies Incorporated |  | March 2004              |  | XDSL Next Generation Chips                                                                       



We plan to continue to
use our cash to make selected investments in these types of companies. Certain companies in which we invested in the past have failed, and we have lost our entire investment in them. These investments involve all the risks normally associated with
investments in development stage companies. As such, there can be no assurance that we will receive a favorable return on these or any future venture-backed investments that we may make. Additionally, our original and any future investments may
continue to become impaired if these companies do not succeed in the execution of their business plans. Any further impairment or equity losses in these investments could negatively impact our future operating results. Please refer to Item 8, Note
13Restructuring and Asset Impairment Charges for further discussion of impairment of our investments in these types of companies.



54



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The loss of key management could affect our ability to run our business.



Our success depends largely upon the continued service of our executive
officers, including Dr. Santanu Das, Chairman of the Board of Directors, Chief Executive Officer and President, and other key management and technical personnel and on our ability to continue to attract, retain and motivate other qualified
personnel.



Provisions of our certificate of incorporation, by-laws,
stockholder rights plan and Delaware law may discourage take over offers and may limit the price investors would be willing to pay for our common stock.



Delaware corporate law contains, and our certificate of incorporation and by-laws and shareholder rights plan contain, certain provisions that could have
the effect of delaying, deferring or preventing a change in control of our Company even if a change of control would be beneficial to our stockholders. These provisions could limit the price that certain investors might be willing to pay in the
future for shares of our common stock. Certain of these provisions:



| |  |  | authorize the issuance of blank check preferred stock (preferred stock which our Board of Directors can create and issue without prior stockholder approval) with rights
senior to those of common stock;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | prohibit stockholder action by written consent;
| | - |  | -----------------------------------------------



| |  |  | establish advance notice requirements for submitting nominations for election to the Board of Directors and for proposing matters that can be acted upon by stockholders at a
meeting; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | dilute stockholders who acquire more than 15% of our common stock.
| | - |  | ------------------------------------------------------------------



Changes in accounting treatment of stock options will adversely affect our results of operations.



The Financial Accounting Standards Board has announced its decision to require companies to expense employee stock options
in accordance with SFAS No. 123R, Accounting for Stock-Based Compensation, or SFAS 123R, for financial reporting purposes. Such stock option expensing would require us to value our employee stock option grants pursuant to an option valuation
model, and then amortize that value against our reported earnings over the vesting period in effect for those options. We currently account for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and have adopted the disclosure-only alternative of SFAS 123 and SFAS 148. This change in accounting treatment will materially and adversely affect our reported results of operations, as the
stock-based compensation expense would be charged directly against our reported earnings. For an illustration of the effect of such a change on our recent results of operations, Refer to Note 1Summary of Significant Accounting Policies of the
Notes to Consolidated Financial Statements.



Natural disasters or acts of
terrorism affecting our locations, or those of our suppliers, in the United States or internationally may negatively impact our business.



We operate our businesses in the United States and internationally, including the operation of a design center in India. Some of the countries in which we
operate or in which our customers are located have in the past been subject to terrorist acts and could continue to be subject to acts of terrorism. In addition, some of these areas may be subject to natural disasters, such as earthquakes or floods.
If our facilities, or those of our suppliers or customers, are affected by a natural disaster or terrorist act, our employees could be injured and those facilities damaged, which could lead to loss of skill sets and affect the development or
fabrication of our products, which could lead to lower short and long-term revenues. In addition, natural disasters or terrorist acts in the areas in which we operate or in which our customers or suppliers operate could lead to delays or loss of
business opportunities, as well as changes in security and operations at those locations, which could increase our operating costs.



55



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We may have difficulty obtaining adequate director and officer liability insurance.



Like most other public companies, we carry insurance protecting our
directors and officers against claims relating to the conduct of our business. This insurance covers, among other things, the costs incurred by companies and their board of directors and officers to defend against and resolve claims relating to such
matters as securities class action claims. These claims typically are extremely 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. Each year we negotiate with insurers to renew our directors and officers insurance. In the current economic environment, we cannot assure you that in the
future we will be able to obtain sufficient directors and officers liability insurance coverage at acceptable rates or with acceptable terms, conditions and retentions.



Failure to obtain such insurance could have a materially adverse impact on future financial results in the event that we are
required to defend against and resolve any securities claims made against our Company, our board of directors and officers. Further, the inability to obtain such insurance in adequate amounts may impair our future ability to attract or retain
qualified directors and/or officers.



Item 7A.Quantitative and
Qualitative Disclosures About Market Risk



Interest Rate Risk. We have investments in money market accounts, government securities and commercial paper that earn interest income that is a function of the market rates. As a result, we do have exposure to changes in interest
rates. For example, if interest rates were to decrease by one half percentage point from their current levels, our potential interest income for 2004, assuming a constant cash balance, would decrease by approximately $0.5 million. Conversely rising
interest rates would result would negatively impact our borrowing costs. We do, however, expect our cash balance to decline during fiscal 2005 and expect that our interest income will also decrease.



Foreign Currency Exchange Risk. As substantially all of our net
revenues are currently made or denominated in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets. Although we recognize our revenues in U.S. dollars, we incur expenses in currencies other than
U.S. dollars. In fiscal 2004 operating expenses incurred in foreign currencies were approximately 26% of our total operating expenses. Although we have not experienced significant foreign exchange rate losses to date, we may in the future,
especially to the extent that we do not engage in hedging. We do not enter into derivative financial instruments for trading or speculative purposes. The economic impact of currency exchange rate movements on our operating results is complex because
such changes are often linked to variability in real growth, inflation, interest rates, governmental actions and other factors. These changes, if material, may cause us to adjust our financing and operating strategies. Consequently, isolating the
effect of changes in currency does not incorporate these other important economic factors.



Fair Market Value of Financial Instruments. As of December 31, 2004, our long-term debt consisted of convertible notes with interest at fixed rates of 4.50% and 5.45%, respectively. Consequently, we do not have
significant cash flow exposure on our convertible notes. However, the fair market value of the convertible notes is subject to significant fluctuation due to changes in market interest rates and their convertibility into shares of our common stock.
The fair market value of our outstanding 4.50% Notes is approximately $24.3 million and $22.3 million at December 31, 2004 and 2003, respectively. The fair market value of our outstanding 5.45% Plus Cash Notes is approximately $74.1 million and
$96.3 million at December 31, 2004 and 2003, respectively. Among other factors, changes in interest rates and the price our common stock affect the fair value of our convertible notes. Refer to critical accounting policies and use of estimates in
Item 7Managements Discussion and Analysis of Financial Condition and Results of Operations for additional information on and analysis of our derivative liability associated with our 5.45% Convertible Plus Cash Notessmdue 2007.



56



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Item 8.Financial Statements and Supplementary Data.



TRANSWITCH CORPORATION AND SUBSIDIARIES



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

AND FINANCIAL STATEMENT SCHEDULE



|                                                                                                                                                       |  |     
|------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ----
|                                                                                                                                                       |  | Page
|Financial Statements:                                                                                                                                  |  |     
|Reports of Independent Registered Public Accounting Firm                                                                                               |  | 58  
|Consolidated Balance Sheets as of December 31, 2004 and 2003                                                                                           |  | 60  
|Consolidated Statements of Operations for each of the years in the three-year period endedDecember 31, 2004                                            |  | 61  
|Consolidated Statements of Stockholders Equity and Comprehensive Income (Loss) for each of the years in the three-year period ended December 31, 2004 |  | 62  
|Consolidated Statements of Cash Flows for each of the years in the three-year period endedDecember 31, 2004                                            |  | 63  
|Notes to Consolidated Financial Statements                                                                                                             |  | 64  
|                                                                                                                                                       | 
|Financial Statement Schedule:                                                                                                                          |  |     
|Schedule II, Valuation and Qualifying Accounts                                                                                                         |  | 92  



57



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Shareholders

TranSwitch Corporation:



We
have audited the consolidated financial statements of TranSwitch Corporation and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we have also audited the financial statement
schedule as listed in the accompanying index. These consolidated financial statements and the 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 Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of TranSwitch Corporation and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period
ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.



We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of TranSwitch Corporations internal control over financial reporting as
of December 31, 2004, based on criteria established in Internal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 11, 2005 expressed an
unqualified opinion on managements assessment of, and the effective operation of, internal control over financial reporting.



As discussed in Note 1 to the consolidated financial statements, the Company changed its method of computing depreciation during 2003.



/s/ KPMG LLP



Stamford, Connecticut

March 11, 2005



58



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Shareholders

TranSwitch Corporation:



We have audited managements assessment, included in the accompanying Managements Report on Internal Control Over Financial Reporting appearing
under Item 9A, that TranSwitch Corporation (the Company) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal ControlIntegrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control
over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.



We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our
audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures
as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.



A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
(3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.



In our
opinion, managements assessment that TranSwitch Corporation maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, TranSwitch Corporation maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2004, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).



We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of TranSwitch Corporation and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders equity and
comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2004, and our report dated, March 11, 2005 expressed an unqualified opinion on those consolidated financial statements.



/s/ KPMG LLP



Stamford, Connecticut

March 11, 2005



59



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TRANSWITCH CORPORATION AND SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ----------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                         |  | December 31, 2004 |          |   | December 31, 2003 |  
|ASSETS                                                                                                                                                                   |  |                   |          |   |                   |   |          |  
|Current assets:                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                |  | $                 | 17,311   |   |                   | $ | 102,869  |  
|Short-term investments                                                                                                                                                   |  |                   | 85,193   |   |                   |   | 49,182   |  
|Accounts receivable, net of allowances of $731 and $462, respectively                                                                                                    |  |                   | 4,795    |   |                   |   | 3,684    |  
|Inventories                                                                                                                                                              |  |                   | 2,933    |   |                   |   | 2,838    |  
|Prepaid expenses and other current assets                                                                                                                                |  |                   | 2,243    |   |                   |   | 2,912    |  
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|Total current assets                                                                                                                                                     |  |                   | 112,475  |   |                   |   | 161,485  |  
|Long-term investments (marketable securities)                                                                                                                            |  |                   | 32,178   |   |                   |   | 27,300   |  
|Property and equipment, net                                                                                                                                              |  |                   | 3,590    |   |                   |   | 10,262   |  
|Patents, net of accumulated amortization                                                                                                                                 |  |                   | 1,080    |   |                   |   | 1,240    |  
|Investments in non-publicly traded companies                                                                                                                             |  |                   | 2,108    |   |                   |   | 627      |  
|Deferred financing costs, net                                                                                                                                            |  |                   | 2,647    |   |                   |   | 4,462    |  
|Other assets                                                                                                                                                             |  |                   | 630      |   |                   |   | 930      |  
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|Total assets                                                                                                                                                             |  | $                 | 154,708  |   |                   | $ | 206,306  |  
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                     |  |                   |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                     |  |                   |          |   |                   |   |          |  
|Accounts payable                                                                                                                                                         |  | $                 | 1,385    |   |                   | $ | 664      |  
|Accrued expenses and other current liabilities                                                                                                                           |  |                   | 4,294    |   |                   |   | 6,728    |  
|Accrued compensation and benefits                                                                                                                                        |  |                   | 2,329    |   |                   |   | 1,458    |  
|Accrued sales returns, allowances and stock rotation                                                                                                                     |  |                   | 1,067    |   |                   |   | 1,671    |  
|Accrued interest                                                                                                                                                         |  |                   | 1,430    |   |                   |   | 1,665    |  
|Restructuring liabilities                                                                                                                                                |  |                   | 1,093    |   |                   |   | 1,454    |  
|4.5% Convertible Notes due 2005                                                                                                                                          |  |                   | 24,442   |   |                   |   |         |  
|Derivative liability                                                                                                                                                     |  |                   | 74       |   |                   |   |         |  
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                |  |                   | 36,114   |   |                   |   | 13,640   |  
|Restructuring liabilitieslong term                                                                                                                                      |  |                   | 21,532   |   |                   |   | 22,689   |  
|5.45% Convertible Plus Cash Notessmdue 2007, net of debt discount of $13,149 and $21,742 respectively                                                                    |  |                   | 67,370   |   |                   |   | 75,866   |  
|4.50% Convertible Notes due 2005                                                                                                                                         |  |                   |         |   |                   |   | 24,442   |  
|Derivative liability                                                                                                                                                     |  |                   | 8,461    |   |                   |   | 20,659   |  
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|Total liabilities                                                                                                                                                        |  |                   | 133,477  |   |                   |   | 157,296  |  
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|Commitments and contingencies                                                                                                                                            |  |                   |          |   |                   |   |          |  
|Stockholders equity:                                                                                                                                                    |  |                   |          |   |                   |   |          |  
|Common stock, $.001 par value; authorized 300,000,000 shares; issued and outstanding, 103,447,488 shares at December 31, 2004 and 90,953,205
shares at December 31, 2003 |  |                   | 103      |   |                   |   | 91       |  
|Additional paid-in capital                                                                                                                                               |  |                   | 307,876  |   |                   |   | 291,115  |  
|Accumulated other comprehensive income                                                                                                                                   |  |                   | 1,066    |   |                   |   | 994      |  
|Accumulated deficit                                                                                                                                                      |  |                   | (287,814 | ) |                   |   | (243,190 | )
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                               |  |                   | 21,231   |   |                   |   | 49,010   |  
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                               |  | $                 | 154,708  |   |                   | $ | 206,306  |  
|                                                                                                                                                                         |  |                   |          |   |                   |   |          |  



See accompanying notes
to consolidated financial statements.



60



---

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CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share data)



|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|------------------------------------------------------------------------------------------------------------------ |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                                                                   |  | Years ended December 31, |        
|                                                                                                                   |  | 2004                     |         |   | 2003 |   |         | 2002 | 
|Net revenues:                                                                                                      |  |                          |         |   |      |   |         |      |  |   |          |  
|Product revenues                                                                                                   |  | $                        | 33,481  |   |      | $ | 22,970  |      |  | $ | 15,830   |  
|Service revenues                                                                                                   |  |                          | 206     |   |      |   | 850     |      |  |   | 806      |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Total net revenues                                                                                                 |  |                          | 33,687  |   |      |   | 23,820  |      |  |   | 16,636   |  
|Cost of revenues:                                                                                                  |  |                          |         |   |      |   |         |      |  |   |          |  
|Cost of product revenues                                                                                           |  |                          | 9,609   |   |      |   | 6,086   |      |  |   | 4,988    |  
|Provision for excess and obsolete inventories                                                                      |  |                          | 571     |   |      |   | 1,498   |      |  |   | 4,832    |  
|Cost of service revenues                                                                                           |  |                          | 160     |   |      |   | 333     |      |  |   | 959      |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Total cost of revenues                                                                                             |  |                          | 10,340  |   |      |   | 7,917   |      |  |   | 10,779   |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Gross profit                                                                                                       |  |                          | 23,347  |   |      |   | 15,903  |      |  |   | 5,857    |  
|Operating expenses:                                                                                                |  |                          |         |   |      |   |         |      |  |   |          |  
|Research and development                                                                                           |  |                          | 46,030  |   |      |   | 41,998  |      |  |   | 53,523   |  
|Marketing and sales                                                                                                |  |                          | 12,543  |   |      |   | 10,964  |      |  |   | 13,266   |  
|General and administrative                                                                                         |  |                          | 6,697   |   |      |   | 5,630   |      |  |   | 7,306    |  
|Impairment of goodwill                                                                                             |  |                          |        |   |      |   |        |      |  |   | 59,901   |  
|Restructuring charge and asset impairments, net                                                                    |  |                          | 1,126   |   |      |   | 2,538   |      |  |   | 3,895    |  
|Purchased in-process research and development                                                                      |  |                          |        |   |      |   | 512     |      |  |   | 2,000    |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Total operating expenses                                                                                           |  |                          | 66,396  |   |      |   | 61,642  |      |  |   | 139,891  |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Operating loss                                                                                                     |  |                          | (43,049 | ) |      |   | (45,739 | )    |  |   | (134,034 | )
|Other (expense) income:                                                                                            |  |                          |         |   |      |   |         |      |  |   |          |  
|Other Income                                                                                                       |  |                          | 378     |   |      |   |        |      |  |   |         |  
|Impairment of investments in non-publicly traded companies                                                         |  |                          | (123    | ) |      |   | (1,545  | )    |  |   | (8,669   | )
|Equity in net losses of affiliates                                                                                 |  |                          |        |   |      |   | (1,933  | )    |  |   | (3,405   | )
|Change in fair value of derivative liability                                                                       |  |                          | 12,124  |   |      |   | 2,619   |      |  |   |         |  
|Gain from exchange and repurchase of 4.50% Convertible Notes due 2005                                              |  |                          |        |   |      |   | 14,463  |      |  |   | 51,976   |  
|Loss on extinguishment of debt                                                                                     |  |                          | (2,987  | ) |      |   |        |      |  |   |         |  
|Interest (expense) income:                                                                                         |  |                          |         |   |      |   |         |      |  |   |          |  
|Interest income                                                                                                    |  |                          | 2,394   |   |      |   | 2,805   |      |  |   | 6,591    |  
|Interest expense                                                                                                   |  |                          | (12,895 | ) |      |   | (8,116  | )    |  |   | (8,349   | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Interest expense, net                                                                                              |  |                          | (10,501 | ) |      |   | (5,311  | )    |  |   | (1,758   | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Total other (expense) income, net                                                                                  |  |                          | (1,109  | ) |      |   | 8,293   |      |  |   | 38,144   |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Loss before income taxes, extraordinary loss and cumulative effect of a change in accounting principle             |  |                          | (44,158 | ) |      |   | (37,446 | )    |  |   | (95,890  | )
|Income tax expense                                                                                                 |  |                          | 189     |   |      |   | 246     |      |  |   | 69,334   |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Loss before extraordinary loss and cumulative effect of adoption of and changes in accounting principles           |  |                          | (44,347 | ) |      |   | (37,692 | )    |  |   | (165,224 | )
|Extraordinary loss upon consolidation of TeraOp(USA), Inc.                                                         |  |                          |        |   |      |   | (83     | )    |  |   |         |  
|Cumulative effect on prior years adoption of and retroactive application of FIN 46R and new depreciation method    |  |                          | (277    | ) |      |   | (805    | )    |  |   |         |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Net loss                                                                                                           |  | $                        | (44,624 | ) |      | $ | (38,580 | )    |  | $ | (165,224 | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Basic and diluted loss per common share:                                                                           |  |                          |         |   |      |   |         |      |  |   |          |  
|Loss before extraordinary loss and cumulative effect of adoption of and changes in accounting principles           |  | $                        | (0.47   | ) |      | $ | (0.42   | )    |  | $ | (1.84    | )
|Extraordinary loss                                                                                                 |  |                          |        |   |      |   |        |      |  |   |         |  
|Cumulative effect of prior years of adoption of and retroactive application of FIN 46R and new depreciation method |  |                          |        |   |      |   | (0.01   | )    |  |   |         |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Net loss                                                                                                           |  | $                        | (0.47   | ) |      | $ | (0.43   | )    |  | $ | (1.84    | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |          |  
|Basic and diluted average common shares outstanding                                                                |  |                          | 94,638  |   |      |   | 90,406  |      |  |   | 90,037   |  



See accompanying notes
to consolidated financial statements.



61



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY AND COMPREHENSIVE INCOME (LOSS)

(in thousands, except
share data)



|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|--------------------------------------------------------------------------------------------- |  | ------------ | - |  | --------------------------------- | --- | - | -------------------------- | - | ------ | --------------------------------------------- |  | - | ---------------------------- | - |  | ----- | ----- | - |  | - | -------- | - |  | - | -------- | -
|                                                                                              |  | Common stock |   |  | Common stock, in treasury,at cost |     |   | Additional paid-in capital |   |        | Accumulated other comprehensive (loss) income |  |   | Accumulatedearnings(deficit) |   |  | Total |      
|                                                                                              |  | Shares       |   |  | Amount                            |     |   |                            |   |        |                                              
|Balance at December 31, 2001                                                                  |  | 90,932,469   |   |  | $                                 | 91  |   |                            | $ | (4,211 | )                                             |  | $ | 293,902                      |   |  | $     | (303  | ) |  | $ | (39,386  | ) |  | $ | 250,093  |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Comprehensive loss:                                                                           |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Net loss                                                                                      |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   | (165,224 | ) |  |   | (165,224 | )
|Currency translation adjustment                                                               |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       | 477   |   |  |   |          |   |  |   | 477      |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Total comprehensive loss                                                                      |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   | (164,747 | )
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Shares of common stock issued under stock option and stock purchase plans                     |  | 209,203      |   |  |                                   |    |   |                            |   |       |                                               |  |   | 289                          |   |  |       |      |   |  |   |         |   |  |   | 289      |  
|Retirement of 1,010,000 shares of common stock                                                |  | (1,010,000   | ) |  |                                   | (1  | ) |                            |   | 4,211  |                                               |  |   | (4,211                       | ) |  |       |      |   |  |   |         |   |  |   | (1       | )
|Tax benefit from exercise of employee stock options                                           |  |             |   |  |                                   |    |   |                            |   |       |                                               |  |   | 27                           |   |  |       |      |   |  |   |         |   |  |   | 27       |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Balance at December 31, 2002                                                                  |  | 90,131,672   |   |  | $                                 | 90  |   |                            | $ |       |                                               |  | $ | 290,007                      |   |  | $     | 174   |   |  | $ | (204,610 | ) |  | $ | 85,661   |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Comprehensive loss:                                                                           |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Net loss                                                                                      |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   | (38,580  | ) |  |   | (38,580  | )
|Currency translation adjustment                                                               |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       | 820   |   |  |   |          |   |  |   | 820      |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Total comprehensive loss                                                                      |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   | (37,760  | )
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Shares of common stock issued under stock option and stock purchase plans                     |  | 549,139      |   |  |                                   | 1   |   |                            |   |       |                                               |  |   | 569                          |   |  |       |      |   |  |   |         |   |  |   | 570      |  
|Shares of common stock issued in purchase transaction                                         |  | 189,475      |   |  |                                   |     |   |                            |   |        |                                               |  |   | 308                          |   |  |       |       |   |  |   |          |   |  |   | 308      |  
|Shares of common stock issued upon conversion of 5.45% Convertible Plus Cash Notessm due 2007 |  | 82,919       |   |  |                                   |     |   |                            |   |        |                                               |  |   | 231                          |   |  |       |      |   |  |   |         |   |  |   | 231      |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Balance at December 31, 2003                                                                  |  | 90,953,205   |   |  | $                                 | 91  |   |                            | $ |       |                                               |  | $ | 291,115                      |   |  | $     | 994   |   |  | $ | (243,190 | ) |  | $ | 49,010   |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Comprehensive loss:                                                                           |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Net loss                                                                                      |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   | (44,624  | ) |  |   | (44,624  | )
|Currency translation adjustment                                                               |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       | 72    |   |  |   |         |   |  |   | 72       |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Total comprehensive loss                                                                      |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   | (44,552  | )
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Shares of common stock issued under stock option and stock purchase plans                     |  | 328,629      |   |  |                                   |    |   |                            |   |       |                                               |  |   | 470                          |   |  |       |      |   |  |   |         |   |  |   | 470      |  
|Shares of common stock issued upon conversion of 5.45% Convertible Plus Cash Notessm due 2007 |  | 12,165,654   |   |  |                                   | 12  |   |                            |   |       |                                               |  |   | 16,291                       |   |  |       |      |   |  |   |         |   |  |   | 16,303   |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  
|Balance at December 31, 2004                                                                  |  | 103,447,488  |   |  | $                                 | 103 |   |                            | $ |       |                                               |  | $ | 307,876                      |   |  | $     | 1,066 |   |  | $ | (287,814 | ) |  | $ | 21,231   |  
|                                                                                              |  |              |   |  |                                   |     |   |                            |   |        |                                               |  |   |                              |   |  |       |       |   |  |   |          |   |  |   |          |  



See accompanying notes
to consolidated financial statements.



62



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|---------------------------------------------------------------------------------------------------------------------- |  | ------------------------ | -------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                                                                       |  | Years ended December 31, |         
|                                                                                                                       |  | 2004                     |          |   | 2003 |   |         | 2002 | 
|Cash flows from operating activities:                                                                                  |  |                          |          |   |      |   |         |      |  |   |          |  
|Net loss                                                                                                               |  | $                        | (44,624  | ) |      | $ | (38,580 | )    |  | $ | (165,224 | )
|Adjustments required to reconcile net loss to cash flows used in operating activities, net of effects of acquisitions: |  |                          |          |   |      |   |         |      |  |   |          |  
|Depreciation and amortization                                                                                          |  |                          | 17,041   |   |      |   | 13,336  |      |  |   | 14,672   |  
|Deferred income taxes                                                                                                  |  |                          |         |   |      |   |        |      |  |   | 69,038   |  
|Goodwill impairment                                                                                                    |  |                          |         |   |      |   |        |      |  |   | 59,901   |  
|Loss on extinguishment of convertible notes                                                                            |  |                          | 2,987    |   |      |   |        |      |  |   |         |  
|Provision (benefit) for doubtful accounts                                                                              |  |                          | 310      |   |      |   | 10      |      |  |   | (1,100   | )
|Provision for excess and obsolete inventories                                                                          |  |                          | 571      |   |      |   | 1,498   |      |  |   | 4,832    |  
|Cumulative effect on prior years adoption of and retroactive application of FIN 46R and new depreciation method        |  |                          | 277      |   |      |   | 805     |      |  |   |         |  
|Non-cash restructuring expense, net                                                                                    |  |                          | (1,984   | ) |      |   | (1,002  | )    |  |   | (1,273   | )
|Equity in net losses of affiliates                                                                                     |  |                          |         |   |      |   | 1,933   |      |  |   | 3,405    |  
|Impairment of investments in non-publicly traded companies                                                             |  |                          | 123      |   |      |   | 1,545   |      |  |   | 8,669    |  
|Purchased in-process research and development                                                                          |  |                          |         |   |      |   | 512     |      |  |   | 2,000    |  
|Gain from exchange and repurchase of 4.50% Convertible Notes due 2005                                                  |  |                          |         |   |      |   | (14,463 | )    |  |   | (51,976  | )
|Change in fair value of derivative liability and other non-cash items                                                  |  |                          | (12,060  | ) |      |   | (2,536  | )    |  |   | (233     | )
|Increase (decrease) in operating assets:                                                                               |  |                          |          |   |      |   |         |      |  |   |          |  
|Accounts receivable                                                                                                    |  |                          | (1,422   | ) |      |   | (1,461  | )    |  |   | 2,397    |  
|Inventories                                                                                                            |  |                          | (666     | ) |      |   | 322     |      |  |   | (1,264   | )
|Prepaid expenses and other assets                                                                                      |  |                          | 424      |   |      |   | 1,926   |      |  |   | (1,033   | )
|Increase (decrease) in operating liabilities:                                                                          |  |                          |          |   |      |   |         |      |  |   |          |  
|Accounts payable                                                                                                       |  |                          | 559      |   |      |   | (1,538  | )    |  |   | (2,113   | )
|Accrued expenses and other current liabilities                                                                         |  |                          | (138     | ) |      |   | (1,961  | )    |  |   | (5,565   | )
|Restructuring liabilities                                                                                              |  |                          | (1,378   | ) |      |   | (1,869  | )    |  |   | (730     | )
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|Net cash used in operating activities                                                                                  |  |                          | (39,980  | ) |      |   | (41,523 | )    |  |   | (65,597  | )
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|Cash flows from investing activities:                                                                                  |  |                          |          |   |      |   |         |      |  |   |          |  
|Purchase of product licenses                                                                                           |  |                          |         |   |      |   | (700    | )    |  |   | (3,204   | )
|Cash received from dissolution of investment                                                                           |  |                          |         |   |      |   | 886     |      |  |   |         |  
|Cash acquired upon consolidation of TeraOp (USA), Inc.                                                                 |  |                          |         |   |      |   | 17      |      |  |   |         |  
|Cash acquired from consolidation of OptiX Networks, Inc.                                                               |  |                          | 124      |   |      |   |        |      |  |   |         |  
|Capital expenditures                                                                                                   |  |                          | (3,606   | ) |      |   | (2,607  | )    |  |   | (9,037   | )
|Investments in non-publicly traded companies                                                                           |  |                          | (1,605   | ) |      |   | (2,672  | )    |  |   | (4,951   | )
|Acquisition of businesses, net of cash acquired                                                                        |  |                          |         |   |      |   | (390    | )    |  |   | (5,789   | )
|Purchases of short and long-term investments                                                                           |  |                          | (159,821 | ) |      |   | (78,280 | )    |  |   | (96,456  | )
|Proceeds from short and long-term investments                                                                          |  |                          | 118,930  |   |      |   | 88,876  |      |  |   | 117,171  |  
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|Net cash (used in) provided by investing activities                                                                    |  |                          | (45,978  | ) |      |   | 5,130   |      |  |   | (2,266   | )
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|Cash flows from financing activities:                                                                                  |  |                          |          |   |      |   |         |      |  |   |          |  
|Proceeds from issuance of 5.45% Convertible Plus Cash Notessm due 2007                                                 |  |                          |         |   |      |   | 24,000  |      |  |   |         |  
|Repurchase of 4.50% Convertible Notes due 2005                                                                         |  |                          |         |   |      |   |        |      |  |   | (143,156 | )
|Issuance of common stock under employee stock plans                                                                    |  |                          | 406      |   |      |   | 637     |      |  |   | 549      |  
|Deferred financing fees                                                                                                |  |                          |         |   |      |   | (4,459  | )    |  |   |         |  
|Payments on conversion of 5.45% Convertible Plus Cash Notessm due 2007                                                 |  |                          | (151     | ) |      |   | (123    | )    |  |   |         |  
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|Net cash provided by (used in) financing activities                                                                    |  |                          | 255      |   |      |   | 20,055  |      |  |   | (142,607 | )
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|Effect of exchange rate changes on cash and cash equivalents                                                           |  |                          | 145      |   |      |   | 819     |      |  |   | 477      |  
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|Decrease in cash and cash equivalents                                                                                  |  |                          | (85,558  | ) |      |   | (15,519 | )    |  |   | (209,993 | )
|Cash and cash equivalents at beginning of year                                                                         |  |                          | 102,869  |   |      |   | 118,388 |      |  |   | 328,381  |  
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  
|Cash and cash equivalents at end of year                                                                               |  | $                        | 17,311   |   |      | $ | 102,869 |      |  | $ | 118,388  |  
|                                                                                                                       |  |                          |          |   |      |   |         |      |  |   |          |  



See accompanying notes
to consolidated financial statements.



63



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



(Tabular dollars in thousands, except share and per share amounts)



Note 1. Summary of Significant Accounting Policies



Description of Business



TranSwitch
Corporation (TranSwitch or the Company) was incorporated in Delaware on April 26, 1988 and is headquartered in Shelton, Connecticut. The Company and its subsidiaries (collectively, TranSwitch or the
Company) design, develop, market and support highly integrated digital and mixed-signal semiconductor devices for the telecommunications and data communications markets.



Principles of Consolidation



The consolidated financial statements include the accounts of TranSwitch Corporation and its subsidiaries. All significant
intercompany accounts and transactions have been eliminated.



Use of Estimates



The preparation of
financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and revenues and expenses during the period reported. Actual results could differ from those estimates. Estimates are used in accounting for,
among other things, allowances for uncollectable receivables, excess or slow-moving inventories, obsolete inventories, impairment of assets, product warranty reserves, depreciation and amortization, income taxes, sales returns, stock rotation and
contingencies. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary.



Cash, Cash Equivalents and Investments in Marketable Securities



All highly liquid investments with an original
maturity of three months or less are considered cash equivalents. Cash equivalents were approximately $17.3 million and $102.9 million as of December 31, 2004 and 2003, respectively. Cash equivalents consist of overnight bank repurchase agreements,
certificates of deposit, U.S. Treasury Bills, commercial paper and U.S. agency notes. The majority of the Companys cash and cash equivalents are maintained with three major financial institutions. The cash, cash equivalents and investment
balances at institutions may, at times, be above the Federal Deposit Insurance Corporation insured limit of $0.1 million per account.



Short and long-term investments are comprised of marketable securities, primarily U.S. Treasury Bills, auction rate securities, commercial paper, and
corporate debt securities. Investments with remaining maturities greater then ninety days, but less than one year, as of the date of the balance sheet and securities classified as available-for-sale are considered short-term. Short-term investments
were approximately $85.2 million and $49.2 million as of December 31, 2004 and 2003, respectively. Long-term investments consist of securities with maturity dates greater than one year from the balance sheet date. Long-term investments were
approximately $32.2 million and $27.3 million as of December 31, 2004 and 2003, respectively.



At December 31, 2004 and 2003, the Company had $52.2 million and $22.1 million of auction rate securities, respectively, which are classified as available-for-sale and are stated at fair value, with any unrealized
gains and losses, net of deferred income taxes, reported in other comprehensive income affecting stockholders



64



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



equity. All of the Companys other marketable securities are classified as held-to-maturity. Held-to-maturity securities are those securities in which
the Company has the ability and intent to hold to maturity. Held-to-maturity securities are recorded at amortized cost.



Fair Value of Financial Instruments



The carrying amounts for cash and cash equivalents, short-term investments, accounts receivable, and accounts payable approximate fair value because of
their short maturities. The fair values of long-term investments (marketable securities), 4.50% Convertible Notes due 2005 and 5.45% Convertible Plus Cash Notessmdue 2007 are determined using quoted market prices for those securities or similar financial instruments. The fair value of the outstanding 4.50% Convertible Notes due 2005 was approximately $24.3
million and $22.3 million at December 31, 2004 and 2003, respectively. The fair value of the outstanding 5.45% Convertible Plus Cash Notessmdue 2007 was approximately $74.1 million and $96.3 million at December 31, 2004 and 2003, respectively.



The fair value of the Companys marketable securities and investments in non-publicly traded companies are disclosed in Note 4Investments in
Marketable Securities and Note 5Investments in Non-Publicly Traded Companies.



Inventories



Inventories are carried at the lower of cost (on a weighted-average cost basis) or estimated net realizable value.



Product Licenses



Product licenses are amortized using the greater of: (1) the amount computed using the ratio of a products current gross revenues to the
products total of current and estimated future gross revenues; or (2) the straight-line method over the estimated useful life of the asset, generally three to five years, not to exceed the term of the license. Amortization of product licenses
amounted to $0.3 million, $0.3 million and $0.1 million for the fiscal years ended December 31, 2004, 2003 and 2002, respectively. Accumulated amortization of licenses was $0.7 million and $0.4 million as of December 31, 2004 and 2003, respectively.



Property and Equipment



Property and equipment are carried at cost less accumulated depreciation and
amortization. Any gain or loss resulting from sale or retirement is included in the consolidated statement of operations. Repairs and maintenance are expensed as incurred while renewals and betterments are capitalized. Costs incurred for assets
being constructed or installed but not yet placed in service at the balance sheet date are recorded as construction in progress.



Effective January 1, 2003, the Company changed the method of depreciating property and equipment to the straight-line method. Depreciation of property and
equipment in prior years was computed using the half-year convention method. The Company evaluated the use and related consumption of all classes of acquired property and equipment and determined that many assets are used and consumed on a
consistent level over their estimated economic lives. Under the half-year convention method, property and equipment placed in service during the first year of acquisition was subject to six months of depreciation expense regardless of when the asset
was



65



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



acquired, placed in service and consumed. The Company believes that the straight-line method results in a better approximation of the underlying consumption
of the asset over its estimated useful life and provides a better matching of revenues and expenses. The effect of the change in depreciation method as of January 1, 2003 was applied retroactively to property and equipment acquisitions of prior
years. The cumulative effect of the change with respect to the retroactive application of the straight-line method is an approximately $0.8 million charge (or $0.01 loss per basic and diluted common share) and has been recorded as such on the
consolidated statement of operations. This charge has not been presented net of income taxes as the Company continues to maintain a full valuation allowance against its net deferred tax assets. Pro forma amounts have not been presented because the
effects of this change in accounting principle were not material to the consolidated financial statements.



Patents



Patents are carried at cost less accumulated amortization, and are being amortized on a straight line basis over their estimated economic lives of ten
years. Amortization expense for patents was $0.2 million in each of the three years ended December 31, 2004, 2003 and 2002. Accumulated amortization of patents was $0.5 million and $0.4 million as of December 31, 2004 and 2003, respectively. Refer
also to Note 3Business Combinations for additional disclosure.



Deferred Financing Costs



Deferred
financing costs on the Companys 4.50% Convertible Notes due 2005 (the 4.5% Notes) and 5.45% Convertible Plus Cash Notessmdue 2007 (the Plus Cash Notes) are amortized using the interest method over the term of the related notes. Accumulated amortization of deferred financing fees was $18.1 million and $16.3 million as of December 31, 2004 and 2003,
respectively. Amortization, included in the consolidated statement of operations as a component of interest expense, was $1.2 million, $0.9 million, and $1.1 million for the fiscal years ended December 31, 2004, 2003 and 2002, respectively. Refer to
Note 12Convertible Notes.



Impairment of
Intangibles and Long-Lived Assets



The Company reviews
long-lived and certain intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. When factors indicate that a long-lived asset should be evaluated for possible
impairment, an estimate of the related assets undiscounted future cash flows over the remaining life of the asset will be made to measure whether the carrying value is recoverable. Any impairment is measured based upon the excess of the
carrying value of the asset over its estimated fair value which is generally based on an estimate of future discounted cash flows. A significant amount of management judgment is used in estimating future discounted cash flows. Refer to Note
13Restructuring and Asset Impairment Charges.



Investments in Non-Publicly Traded Companies



The Company has certain minority investments in the convertible preferred stock and debt of several non-publicly traded companies. Depending on the Companys level of ownership and whether or not the Company has the ability to exercise
significant influence, these investments are accounted for on either the cost or equity method, and they are reviewed periodically for impairment. The appropriate reductions in carrying values are recorded when, and if, necessary. Refer to Note
5Investments in Non-Publicly Traded Companies.



66



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Revenue Recognition



Net revenues from product sales are recognized at the time of product shipment when the following criteria are met: (1)
persuasive evidence of an arrangement exists; (2) title and risk of loss transfers to the customer; (3) the selling price is fixed or determinable; and (4) collectibility is reasonably assured.



Agreements with certain distributors provide price protection and return and
allowance rights. With respect to recognizing revenues from distributors: (1) the prices are fixed at the date of shipment from our facilities; (2) payment is not contractually or otherwise excused until the product is resold; (3) we do not have any
obligations for future performance relating to the resale of the product; and (4) the amount of future returns, allowances, refunds and costs to be incurred can be reasonably estimated and are accrued at the time of shipment.



Service revenues are recognized when the following criteria are met: (1)
persuasive evidence of an arrangement exists; (2) we have performed a service in accordance with our contractual obligations; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured.



Concentrations of Credit Risk



Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash and cash equivalents, marketable securities, and accounts receivable.



Cash, cash equivalents, and marketable securities are maintained in investment-grade financial instruments with high-quality financial institutions,
thereby reducing credit risk concentrations. In addition, the Company limits the amount of credit exposure to any one financial institution and to any one type of investment.



At December 31, 2004, approximately 69% of accounts receivable were due from five customers. The majority of the
Companys sales are to customers in the telecommunications and data communications industries. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. The Company establishes an allowance for
potentially uncollectable accounts based upon factors surrounding the credit risk of specific customers, historical payment trends and other information.



Product Warranties



The Company provides warranties on its products for up to one year from the date of shipment. A liability is recorded for estimated costs to be incurred
under product warranties, which is based on various inputs including historical experience. Estimated warranty expense is recorded as cost of revenues as products are shipped.



Research and Development Costs



Research and development costs are expensed as incurred.



Income Taxes



Income taxes are accounted for under the asset and liability method. Deferred income tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred income tax assets and liabilities
are measured using enacted tax rates



67



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred income
tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. To the extent that it is more likely than not that the Company will not be able to utilize deferred income tax assets in the
future, a valuation allowance is established. Refer to Note 9Income Taxes.



Stock-Based Compensation



As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, (SFAS 123), the Company accounts for employee stock-based compensation in accordance with Accounting Principles Board Opinion No. 25 (APB 25),
Accounting for Stock Issued to Employees, and FASB Interpretation No. 44 (FIN 44), Accounting for Certain Transactions Involving Stock-Based Compensation, an interpretation of APB Opinion No. 25 and related interpretations in
accounting for its stock-based compensation plans. Stock-based compensation related to non-employees is based on the fair value of the related stock or options in accordance with SFAS 123 and its interpretations. Expense associated with stock-based
compensation is amortized over the vesting period of each individual award. The following table illustrates the effect on net loss and loss per common share as if the Black-Scholes fair value method described in SFAS No. 123, Accounting for
Stock-Based Compensation had been applied to the Companys long-term compensation equity plans:



|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |          |  
|------------------------------------------------------------------------------------------------------ |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                                                       |  | Years Ended December 31, |        
|                                                                                                       |  | 2004                     |         |   | 2003 |   |         | 2002 | 
|Net loss:                                                                                              |  |                          |         |   |      |   |         |      |  |   |          |  
|As reported                                                                                            |  | $                        | (44,624 | ) |      | $ | (38,580 | )    |  | $ | (165,224 | )
|Deduct: Total stock-based compensation expense determined under fair value based method for all awards |  | $                        | (15,840 | ) |      | $ | (38,152 | )    |  | $ | (47,460  | )
|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |          |  
|Pro forma                                                                                              |  | $                        | (60,464 | ) |      | $ | (76,732 | )    |  | $ | (212,684 | )
|Basic loss per common share:                                                                           |  |                          |         |   |      |   |         |      |  |   |          |  
|As reported                                                                                            |  | $                        | (0.47   | ) |      | $ | (0.43   | )    |  | $ | (1.84    | )
|Pro forma                                                                                              |  | $                        | (0.64   | ) |      | $ | (0.85   | )    |  | $ | (2.36    | )
|Diluted loss per common share:                                                                         |  |                          |         |   |      |   |         |      |  |   |          |  
|As reported                                                                                            |  | $                        | (0.47   | ) |      | $ | (0.43   | )    |  | $ | (1.84    | )
|Pro forma                                                                                              |  | $                        | (0.64   | ) |      | $ | (0.85   | )    |  | $ | (2.36    | )



Loss Per Common
Share



Basic loss per common share is based upon the
weighted average common shares outstanding during the period. Diluted loss per common share assumes exercise of all outstanding in-the-money stock options and the conversion of the 4.50% Convertible Notes due 2005 and 5.45% Convertible
Plus Cash Notessmdue 2007 into common stock at the beginning of the period or the date of issuance, if later,
unless they are anti-dilutive.



Foreign Currency
Translation



All foreign subsidiaries use their local
currency as their functional currency. Therefore, assets and liabilities of foreign subsidiaries are translated at exchange rates in effect at the balance sheet date and revenue and expense accounts are translated at average exchange rates during
the year. The resulting translation adjustments are recorded in accumulated other comprehensive income (loss). Gains and losses related to monetary assets and liabilities denominated in a currency different than a subsidiarys functional
currency are included in the consolidated statements of operations.



68



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Reclassifications



Certain prior year amounts have been reclassified to conform to the current-year presentation. Auction rate securities and
certain other investment securities totaling $40.1 million $32.2 million and $41.9 million in 2003, 2002 and 2001, respectively, which were previously reported on the Consolidated Balance Sheets as cash equivalents, have been reclassified as
short-term investments. These reclassifications had no impact on the Companys results of operations, total assets or changes in shareholders equity.



The following is a summary of the impact of these reclassifications on the Companys Consolidated Balance Sheets and Consolidated Statements of
Cash Flows:



|                                                                     |  |      |         |   |      |   |          |  
|-------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | -------- | -
|                                                                     |  | 2003 |         |   | 2002 |  
|Impact on Consolidated Balance Sheets                                |  |      |         |   |      |   |          |  
|Cash and equivalents, as reported                                    |  | $    | 142,950 |   |      | $ | 150,548  |  
|Cash and equivalents, as reclassified                                |  |      | 102,869 |   |      |   | 118,388  |  
|                                                                     |  |      |         |   |      |   |          |  
|Net change                                                           |  | $    | (40,081 | ) |      | $ | (32,160  | )
|                                                                     |  |      |         |   |      |   |          |  
|Short-term investments, as reported                                  |  | $    | 9,101   |   |      | $ | 33,099   |  
|Short-term investments, as reclassified                              |  |      | 49,182  |   |      |   | 65,259   |  
|                                                                     |  |      |         |   |      |   |          |  
|Net change                                                           |  | $    | 40,081  |   |      | $ | 32,160   |  
|                                                                     |  |      |         |   |      |   |          |  
|Impact on Consolidated Statements of Cash Flows                      |  |      |         |   |      |   |          |  
|Net cash (used in) provided by investing activities, as reported     |  | $    | 13,051  |   |      | $ | (11,973  | )
|Net cash (used in) provided by investing activities, as reclassified |  |      | 5,130   |   |      |   | (2,266   | )
|                                                                     |  |      |         |   |      |   |          |  
|Net change                                                           |  | $    | (7,921  | ) |      | $ | 9,707    |  
|                                                                     |  |      |         |   |      |   |          |  
|Decrease in cash and cash equivalents, as reported                   |  | $    | (7,598  | ) |      | $ | (219,700 | )
|Decrease in cash and cash equivalents, as reclassified               |  |      | (15,519 | ) |      |   | (209,993 | )
|                                                                     |  |      |         |   |      |   |          |  
|Net change                                                           |  | $    | (7,921  | ) |      | $ | 9,707    |  
|                                                                     |  |      |         |   |      |   |          |  



Restatements



Accounting principles generally accepted in the
United States of America (U.S. GAAP) requires retroactive restatement where an equity investment previously accounted for under the cost method of accounting qualifies for use of the equity method. The Company has restated prior period results to
reflect the change from the cost to the equity method of accounting for its investment in OptiX Networks, Inc. (OptiX) as the Company, during fiscal 2002, obtained the ability to significantly influence the operating and financial policies of OptiX
through its investments in convertible preferred stock and a bridge loan. This restatement reduced the investment balance in OptiX (included in investments in non-publicly traded companies on the consolidated balance sheet), as if accounted for on
the equity method, since inception.



Recent Accounting
Pronouncements



In November 2004, the FASB issued SFAS
151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 Inventory Pricing. The standard requires that abnormal amounts of idle capacity and spoilage costs be excluded from the cost of inventory and expensed when incurred. Additionally,
the statement requires that the allocation of fixed production overheads to the cost of conversion be based on normal capacity of the production facilities.



69



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



The provision is effective for fiscal periods beginning after June 15, 2005. We do not expect the adoption of this standard to have a material effect on our
financial position, results of operations or cash flows.



In
December 2004, the FASB released its final revised standard, SFAS No. 123R, Share-Based Payment. SFAS 123R requires that a public entity measure the cost of equity based service awards based on the grant-date fair value of the award. That
cost will be recognized over the period during which an employee is required to provide service in exchange for the award or the vesting period. No compensation cost is recognized for equity instruments for which employees do not render the
requisite service. A public entity will initially measure the cost of liability based service awards based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date.
Changes in fair value during the requisite service period will be recognized as compensation cost over that period. Adoption of SFAS 123R is required for fiscal periods beginning after June 15, 2005. We are evaluating SFAS 123R and believe it may
have a material effect on our financial position and results of operations.



Note 2. Goodwill and Purchased Intangible Assets



The Company adopted SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), on January 1, 2002, and accordingly, ceased amortizing goodwill totaling $54.5 million as of January 1, 2002.



As required by SFAS 142, the Company performed an initial impairment review
of its goodwill balance as of January 1, 2002 upon the adoption of SFAS 142. Under SFAS 142, goodwill impairment is deemed to exist if the net asset value of a reporting unit exceeds its estimated fair value. This impairment analysis determined that
as of January 1, 2002, there was no impairment to the carrying value of goodwill. At the time this analysis was performed, the daily average closing price of the Companys common stock was $4.19 for the quarter ended December 31, 2001. The
Company operates a single reporting unit; therefore, no goodwill is allocated.



The Company is required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances. As a result of industry conditions, the Company determined that there were indicators
of impairment to the carrying value of goodwill during the quarter ended September 30, 2002. At the time this analysis was performed, the daily average closing price of the Companys common stock was $0.67 for the quarter ended September 30,
2002. Accordingly, the Company performed an impairment review of its goodwill in accordance with SFAS 142 and, as a result, recorded a goodwill impairment charge of $59.9 million during the quarter ended September 30, 2002 to reduce the carrying
value of goodwill to zero. The amount of goodwill impairment primarily reflects the decline in the Companys stock price during 2002 and related market capitalization. For the fiscal years ended December 31, 2004 and 2003, the Company had no
goodwill recorded on its consolidated balance sheets.



Note 3. Business
Combinations



On August 18, 2003, the Company acquired
ASIC Design Services, Inc. (ADS) located in Massachusetts. ADS was developing a product for existing and next generation SONET/SDH and data communications switching solutions. As a result of this acquisition, the Company acquired all intellectual
property of ADS and is using this intellectual property to develop next generation SONET/SDH products.



The Company paid $0.5 million, which consisted of approximately $0.3 million in cash (which was used to extinguish ADSs liabilities) and $0.2
million in common stock for the outstanding shares of stock in ADS. The Company incurred transaction fees of approximately $0.1 million in conjunction with this purchase.



70



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



The results of operations of ADS have been included in the Companys consolidated financial
results beginning on August 18, 2003, the date of acquisition, and all significant intercompany balances have been eliminated. The acquisition was accounted for under the purchase method of accounting for business combinations. ADS is a wholly owned
subsidiary of TranSwitch.



The Company allocated purchase price
of and investment in ADS as shown in the following table:



|                                              |  |   |     |  
|--------------------------------------------- |  | - | --- | -
|Purchased in-process research and development |  | $ | 512 |  
|Cash                                          |  |   | 19  |  
|Other current assets and software licenses    |  |   | 173 |  
|Accrued liabilities                           |  |   | (26 | )
|                                              |  |   |     |  
|Investment In ADS                             |  | $ | 678 |  
|                                              |  |   |     |  



Purchased
in-process research and development



At the time of
acquisition, ADS had one project that qualified for in-process research and development activities, which is referred to as the VTXP chip. The project was started concurrently with ADSs inception in 2002 and was first released in 2004.



The $0.5 million allocated to in-process research and
development (IPR&D) was determined through an independent valuation using established valuation techniques in the telecommunications and data communications industries. The value allocated to IPR&D was based upon the forecasted
operating after-tax cash flows from the technology acquired, giving effect to the stage of completion at the acquisition date. Future cash flows were adjusted for the value contributed by any core technology and development efforts expected to be
completed post acquisition. These forecasted cash flows were then discounted at rates commensurate with the risks involved in completing the acquired technologies taking into consideration the characteristics and applications of each product, the
inherent uncertainties in achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. A projects risk is the
highest at its inception. As the project progresses, the risk of a project generally decreases. As of the acquisition date, the VTXP chip was still in its initial stages of development. After considering these factors, the risk-adjusted discount
rates for the VTXP chip product was determined to be 50%. The acquired technology that had not yet reached technological feasibility, and for which no alternative future uses existed, it was expensed upon acquisition in accordance with FASB issued
Statement No. 2, Accounting for Research and Development Costs.



Pro forma financial information



Pro forma results of operations for ADS have not been presented because the effects of this acquisition are not material to the consolidated financial statements.



71



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Note 4. Investments in Marketable Securities.



The following table summarizes investments in securities classified as cash and cash equivalents, short-term and long-term
investments at December 31, 2004 and 2003, respectively:



|                                       |  |                |         |                        |   |                           |  |   |            |   |  |   |        
|-------------------------------------- |  | -------------- | ------- | ---------------------- | - | ------------------------- |  | - | ---------- | - |  | - | -------
|                                       |  | Amortized cost |         | Gross unrealized gains |   | Gross unrealized (losses) |  |   | Fair value
|Fiscal Year Ended December 31, 2004    |  |                |         |                        |   |                           |  |   |            |   |  |   |        
|Money market & certificates of deposit |  | $              | 10,070  |                        | $ |                          |  | $ | (45        | ) |  | $ | 10,025 
|U.S. government & agency obligations   |  |                | 44,757  |                        |   |                           |  |   | (323       | ) |  |   | 44,434 
|Corporate bonds & commercial paper     |  |                | 15,320  |                        |   |                          |  |   | (101       | ) |  |   | 15,219 
|Auction rate securities                |  |                | 52,200  |                        |   |                          |  |   |           |   |  |   | 52,200 
|                                       |  |                |         |                        |   |                           |  |   |            |   |  |   |        
|Total at December 31, 2004             |  | $              | 122,347 |                        | $ |                          |  | $ | (469       | ) |  | $ | 121,878
|                                       |  |                |         |                        |   |                           |  |   |            |   |  |   |        
|Fiscal Year Ended December 31, 2003    |  |                |         |                        |   |                           |  |   |            |   |  |   |        
|Money market & certificates of deposit |  | $              | 80,957  |                        | $ |                          |  | $ |           |   |  | $ | 80,957 
|U.S. government & agency obligations   |  |                | 41,418  |                        |   | 12                        |  |   |           |   |  |   | 41,430 
|Corporate bonds & commercial paper     |  |                | 12,964  |                        |   |                          |  |   | (235       | ) |  |   | 12,729 
|Auction rate securities                |  |                | 22,100  |                        |   |                          |  |   |           |   |  |   | 22,100 
|                                       |  |                |         |                        |   |                           |  |   |            |   |  |   |        
|Total at December 31, 2003             |  | $              | 157,439 |                        | $ | 12                        |  | $ | (235       | ) |  | $ | 157,216
|                                       |  |                |         |                        |   |                           |  |   |            |   |  |   |        



|                                                      |  |              |         |      |   |        
|----------------------------------------------------- |  | ------------ | ------- | ---- | - | -------
|                                                      |  | December 31,
|                                                      |  | 2004         |         | 2003
|Reported as:                                          |  |              |         |      |   |        
|Cash equivalents                                      |  | $            | 4,976   |      | $ | 80,957 
|Short-term investments                                |  |              | 85,193  |      |   | 49,182 
|Long-term investments                                 |  |              | 32,178  |      |   | 27,300 
|                                                      |  |              |         |      |   |        
|Subtotal investments                                  |  |              | 122,347 |      |   | 157,439
|                                                      |  |              |         |      |   |        
|Operating cash                                        |  |              | 12,335  |      |   | 21,912 
|                                                      |  |              |         |      |   |        
|Total cash, cash equivalents, L/T and S/T investments |  | $            | 134,682 |      | $ | 179,351
|                                                      |  |              |         |      |   |        



In addition to the
marketable securities noted above, the Company also held $12.3 million and $21.9 million in operating cash accounts as of December 31, 2004 and 2003, respectively (recorded as cash and cash equivalents on the consolidated balance sheets). The total
cash and marketable investment securities balances were $134.7 million and $179.4 million as of December 31, 2004 and 2003, respectively.



At December 31, 2004, the Company had $52.2 million of auction rate securities. Auction rate securities generally have long-term stated maturities of 20
to 30 years. However, these securities have certain economic characteristics of short-term investments due to a rate-setting mechanism and the ability to liquidate them through a Dutch auction process that occurs on pre-determined intervals of less
than 90 days. As such, these investments are classified as short-term investments. The Companys auction rate securities are classified as available-for-sale securities due to managements intent regarding these securities. As of December
31, 2003 and 2004, there were no unrealized gains or losses associated with these investments and the adjusted fair market value equaled the adjusted cost. All of the Companys other marketable securities are classified as held-to-maturity.
Held-to-maturity securities are those securities in which the Company has the ability and intent to hold



72



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



to maturity. Held-to-maturity securities are recorded at amortized cost. Maturities of debt securities classified as available for sale and held to maturity
were as follows at December 31, 2004:



|                                         |  |                |  |           
|---------------------------------------- |  | -------------- |  | ----------
|                                         |  | Amortized Cost |  | Fair Value
|Available for Sale:                      |  |                |  |           
|Due under one year                       |  | 1,000          |  | 1,000     
|Due after one year through ten years     |  | 5,500          |  | 5,500     
|Due after ten years through twenty years |  | 750            |  | 750       
|Due after twenty years                   |  | 44,950         |  | 44,950    
|                                         |  |                |  |           
|                                         |  | 52,200         |  | 52,200    
|                                         |  |                |  |           
|                                         |  |               
|                                         |  | Amortized Cost |  | Fair Value
|Held to Maturity:                        |  |                |  |           
|Due under one year                       |  | 37,969         |  | 37,771    
|Due one year through ten years           |  | 32,178         |  | 31,907    
|Due ten years through twenty years       |  |                |  |           
|                                         |  |                |  |           
|Due after twenty years                   |  |               |  |          
|                                         |  |                |  |           
|                                         |  | 70,147         |  | 69,678    
|                                         |  |                |  |           



Note 5. Investments in Non-Publicly
Traded Companies



Variable Interest Entities



The Company adopted the provisions of FIN 46R and
changed its accounting accordingly in the first quarter of 2004. As a result of the adoption of FIN 46R, the Company consolidated the results of its investment in OptiX and recorded a charge of approximately $0.3 million for the year ended December
31, 2004 as a cumulative effect of this accounting change. In July 2004, the Company informed OptiX that it planned to discontinue funding of OptiXs operations. Consequently, The Board of Directors of OptiX voted to wind-down its business and
operations. The completion of the wind-down took place in the fourth quarter of 2004 and as of December 31, 2004 the Company recorded a restructuring benefit of approximately $0.3 million resulting from the deconsolidation of OptiX from the
Companys financial statements. As disclosed in the Companys Annual Report on Form 10-K for the year ended December 31, 2003, the Company restated prior period results to reflect the change from the cost to the equity method of accounting
for its investment in OptiX as the Company, during fiscal 2002, obtained the ability to significantly influence the operating and financial policies of OptiX through its investments in convertible preferred stock and a bridge loan. This investment
restatement reduced the investment balance in OptiX (included in investments in non-publicly traded companies on the consolidated balance sheets), as if accounted for on the equity method, since inception. For further discussion, please refer to
Note 13Restructuring and Asset Impairment Charges.



In
January 2003, FIN 46, Consolidation of Variable Interest Entities (FIN 46) was issued. The interpretation provided guidance on consolidating variable interest entities and applied to all variable interests created after January 31, 2003.
The interpretation required variable interest entities to be consolidated if the equity investment at risk was not sufficient to permit an entity to finance its activities without support from other parties or the equity investors lack certain
specified characteristics. The Company adopted FIN 46 as of February 1, 2003, which resulted in the Company consolidating the results of TeraOp (USA), Inc. (TeraOp).



73



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



During the first quarter of 2003, the Company loaned TeraOp $0.5 million under a new convertible loan
agreement, which provided the Company with additional contractual rights over existing debt or equity investors. In addition, the Company also was in a position, as a result of the loan, to negotiate a more favorable conversion price of the equity
securities of TeraOp and acquired the ability to control the operations of TeraOp. None of the existing debt or equity investors, other than the Company, was expected to absorb any additional losses from their investment given that the value of the
equity in TeraOp was negative as of January 31, 2003. As a result, the convertible loan was determined to be a variable interest and TeraOp was considered a variable interest entity, as defined by FIN 46. The Company calculated the effect of the
initial measurement as of January 31, 2003. As a result of this measurement and consolidation of TeraOp, the Company recognized an extraordinary loss of approximately $0.1 million in 2003, as the fair value of TeraOps liabilities exceeded its
assets by this amount. All significant intercompany balances, including the Companys investments in TeraOp, have been eliminated in consolidation. In September 2004, the Company liquidated its investment in TeraOp and deconsolidated TeraOp
from the Companys financial statements. For further discussion, please refer to Note 13Restructuring and Asset Impairment Charges.



Cost Method Investments



The Company owns convertible preferred stock of Opulan Networks, Inc, (Opulan) and Metanoia Technologies, Inc. (Metanoia). In addition, the Company has a
3% limited partnership interest in Neurone II, a venture capital fund organized as a limited partnership. The Company also has provided Metanoia with a bridge loan as of December 31, 2004. The Companys direct and indirect (which include
certain board members and employees) voting interest is less than 20% of the total ownership of each of these companies, and the Company does not exercise significant influence over the management of these companies as defined by APB Opinion No. 18
The Equity Method of Accounting for Investments in Common Stock, and other relevant literature. The Company accounts for these investments at cost and monitors the carrying value of these investments for impairment.



The Company had held investments in Accordion Networks, Inc. (Accordion) and
Intellectual Capital for Integrated Circuits, Inc. (IC4IC). IC4IC ceased operations in 2003 and Accordion ceased operations in 2004.



Impairment of Investments in Non-Publicly Traded Companies



During the years ended December 31, 2004, 2003 and 2002, as a result of Company-specific and industry conditions, the
Company determined that there were indicators of impairment to the carrying value of certain of its investments in non-publicly traded companies. The process of assessing whether a particular investments net realizable value is less than its
carrying cost requires a significant amount of judgment. In making this judgment, the Company considers the investees cash position, projected cash flows (both short and long-term), financing needs, most recent valuation data, the current
investing environment, management/ownership changes, and competition. This evaluation process is based on information that the Company requests from these privately held companies. This information is not subject to the same disclosure and audit
requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary. During the years ended December 31, 2004, 2003 and 2002, the Company used the modified equity method of accounting to
determine the impairment loss for its investments in non-publicly traded companies, as the Company determined that no better current evidence of the value of its cost method investments existed and it believes that this measurement process gives the
Company the best basis for an estimate given the negative cash flows of these companies. The modified equity method of accounting results in recording an impairment loss on a cost method investment equal to the investors proportionate share of
the investees losses as its contributed capital is consumed to fund operating losses of the investee from the inception of the investors investment.



74



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



In addition, the Company also evaluated all outstanding bridge loans under SFAS 114, Accounting
by Creditors for Impairment of a Loan (SFAS 114) which it had not already impaired under the modified equity method of accounting. Under SFAS 114, a loan is considered impaired, based on current information and events, if it is probable that
the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future
cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.



Based upon its evaluations, the Company recorded impairment charges related to investments in non-publicly traded companies
of $0.1 million, $1.5 million and $8.7 million during the years ended December 31, 2004, 2003 and 2002, respectively.



Note 6. Inventories



The components of inventories at December 31, 2004 and 2003 are as follows:



|                  |  |              |       |      |   |      
|----------------- |  | ------------ | ----- | ---- | - | -----
|                  |  | December 31,
|                  |  | 2004         |       | 2003
|Raw material      |  | $            | 281   |      | $ | 643  
|Work-in-process   |  |              | 1,117 |      |   | 488  
|Finished goods    |  |              | 1,535 |      |   | 1,707
|                  |  |              |       |      |   |      
|Total inventories |  | $            | 2,933 |      | $ | 2,838
|                  |  |              |       |      |   |      



The Company recorded
charges for excess and obsolete inventories totaling approximately $0.6 million, $1.5 million and $4.8 million during the fiscal years ended December 31, 2004, 2003 and 2002, respectively. The effect of these inventory provisions was to write
inventory down to a new cost basis of zero. During each of the three years ended December 31, 2004, the Company sold certain products that had previously been written down to a cost basis of zero. The following table presents the impact to gross
profit of the excess and obsolete inventory charges and benefits for the fiscal years ended December 31, 2004, 2003 and 2002:



|                                         |  |                              |        |   |                              |     |    |                              |   |        |               |  |     |               |  |   |               |   |  |     |   
|---------------------------------------- |  | ---------------------------- | ------ | - | ---------------------------- | --- | -- | ---------------------------- | - | ------ | ------------- |  | --- | ------------- |  | - | ------------- | - |  | --- | --
|                                         |  | Year Ended December 31, 2004 |        |   | Year Ended December 31, 2003 |     |    | Year Ended December 31, 2002 |  
|                                         |  | GrossProfit $                |        |   | GrossProfit %                |     |    | GrossProfit $                |   |        | GrossProfit % |  |     | GrossProfit $ |  |   | GrossProfit % |  
|Gross Profitas reported                 |  | $                            | 23,347 |   |                              | 69  | %  |                              | $ | 15,903 |               |  | 67  | %             |  | $ | 5,857         |   |  | 35  | % 
|Excess and obsolete inventory charge(1)  |  |                              | 571    |   |                              | 2   | %  |                              |   | 1,498  |               |  | 6   | %             |  |   | 4,832         |   |  | 29  | % 
|Excess and obsolete inventory benefit(2) |  |                              | (3,803 | ) |                              | (11 | )% |                              |   | (3,985 | )             |  | (17 | )%            |  |   | (2,183        | ) |  | (13 | )%
|                                         |  |                              |        |   |                              |     |    |                              |   |        |               |  |     |               |  |   |               |   |  |     |   
|Gross profitas adjusted                 |  | $                            | 20,115 |   |                              | 60  | %  |                              | $ | 13,416 |               |  | 56  | %             |  | $ | 8,506         |   |  | 51  | % 
|                                         |  |                              |        |   |                              |     |    |                              |   |        |               |  |     |               |  |   |               |   |  |     |   

---

|(1) | During the fiscal years ended December 31, 2004, 2003 and 2002, respectively, the Company recorded a provision for excess and obsolete inventories of approximately $0.6 million,
$1.5 million and $4.8 million, respectively, as costs of revenues. (2) During the fiscal years ended December 31, 2004, 2003 and 2002, respectively, the Company realized an excess and obsolete inventory benefit from the sale of products, which had
previously been written down to a cost basis of zero. For the purposes of comparing the change in gross profit on net revenues, the Company is excluding this benefit and calculating gross profit on these product revenues as if they had been sold at
their historical average costs.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



75



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Note 7. Property and Equipment, Net



The components of property and equipment, net at December 31, 2004 and 2003 are as follows:



|                                                  |  |                        |      |              |         |      |  |   |         |  
|------------------------------------------------- |  | ---------------------- | ---- | ------------ | ------- | ---- |  | - | ------- | -
|                                                  |  | Estimated Useful Lives |      | December 31, |        
|                                                  |  |                        | 2004 |              |         | 2003 | 
|Purchased computer software                       |  | 1-3 years              |      | $            | 23,422  |      |  | $ | 23,745  |  
|Computers and equipment                           |  | 3-7 years              |      |              | 11,665  |      |  |   | 12,666  |  
|Furniture                                         |  | 3-7 years              |      |              | 2,730   |      |  |   | 2,823   |  
|Leasehold improvements                            |  | Lease term*            |      |              | 812     |      |  |   | 1,516   |  
|Construction in-progress (software and equipment) |  |                        |      |              | 163     |      |  |   | 25      |  
|                                                  |  |                        |      |              |         |      |  |   |         |  
|Gross property and equipment                      |  |                        |      | $            | 38,792  |      |  | $ | 40,775  |  
|Less accumulated depreciation and amortization    |  |                        |      |              | (35,202 | )    |  |   | (30,513 | )
|                                                  |  |                        |      |              |         |      |  |   |         |  
|Property and equipment, net                       |  |                        |      | $            | 3,590   |      |  | $ | 10,262  |  
|                                                  |  |                        |      |              |         |      |  |   |         |  

---

|* | Shorter of estimated useful life or lease term.
|- | -----------------------------------------------



Depreciation expense was $9.8 million, $8.6 million, and $10.8 million, for the years ended December 31, 2004, 2003 and 2002, respectively.



Note 8. Segment Information and Major Customers



Under SFAS No. 131, Disclosures about Segments of an Enterprise and
Related Information, (SFAS 131), the Company uses the management approach to reporting segments. The management approach designates the internal organization that is used by management for making operating decisions and assessing
performance as the source of the Companys reportable segments. SFAS 131 also requires disclosures about products and services, geographic areas, and major customers. Under SFAS 131, there is one business segment: communication semiconductor
products.



Products and Services



TranSwitchs products are VLSI semiconductor devices that provide core
functionality of communications network equipment. The integration of various technologies and standards in these devices result in a homogeneous product line for management and measurement purposes.



76



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Enterprise-wide Information



Enterprise-wide information provided on geographic net revenues is based on
the customers ordering location. Long-lived asset information is based on the physical location of the assets. The following tables present net revenues and long-lived assets information for geographic areas:



|                   |  |                          |        |      |   |        |  |   |       
|------------------ |  | ------------------------ | ------ | ---- | - | ------ |  | - | ------
|                   |  | Years Ended December 31,
|                   |  | 2004                     |        | 2003 |   | 2002  
|Net revenues:      |  |                          |        |      |   |        |  |   |       
|United States      |  | $                        | 9,014  |      | $ | 6,745  |  | $ | 6,813 
|Germany            |  |                          | 5,933  |      |   | 6,509  |  |   | 3,226 
|China              |  |                          | 5,554  |      |   | 1,996  |  |   | 954   
|United Kingdom     |  |                          | 2,686  |      |   | 1,795  |  |   | 42    
|Israel             |  |                          | 2,101  |      |   | 1,537  |  |   | 655   
|Belgium            |  |                          | 1,803  |      |   | 404    |  |   | 456   
|Mexico             |  |                          | 1,377  |      |   | 632    |  |   |      
|Korea              |  |                          | 1,277  |      |   | 1,315  |  |   | 2,154 
|Other countries    |  |                          | 3,942  |      |   | 2,887  |  |   | 2,336 
|                   |  |                          |        |      |   |        |  |   |       
|Total              |  | $                        | 33,687 |      | $ | 23,820 |  | $ | 16,636
|                   |  |                          |        |      |   |        |  |   |       
|                   | 
|                   |  | Years Ended December 31,
|                   |  | 2004                     |        | 2003 |   | 2002  
|Long-lived assets: |  |                          |        |      |   |        |  |   |       
|United States      |  | $                        | 4,696  |      | $ | 11,193 |  | $ | 21,151
|Other countries    |  |                          | 598    |      |   | 1,239  |  |   | 1,689 
|                   |  |                          |        |      |   |        |  |   |       
|Total              |  | $                        | 5,294  |      | $ | 12,432 |  | $ | 22,840
|                   |  |                          |        |      |   |        |  |   |       



Information
about Major Customers



The Company ships its products
to distributors and directly to end customers. The following table sets forth the percentage of net revenues attributable to all of the Companys major distributors as well as the significant customers that had total purchases (either direct or
through distributors) of greater than 10% of net revenues for the fiscal years ended December 31, 2004, 2003 and 2002:



|                             |  |                          |   |  |      |   |  |      |  
|---------------------------- |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                             |  | Years Ended December 31, |  
|                             |  | 2004                     |   |  | 2003 |   |  | 2002 |  
|Distributors:                |  |                          |   |  |      |   |  |      |  
|Insight Electronics, Inc.(1) |  | 12                       | % |  | 12   | % |  | 10   | %
|Arrow Electronics, Inc.(2)   |  | 10                       | % |  | 11   | % |  | 19   | %
|Weone Corporation            |  | *                        |   |  | *    |   |  | 13   | %
|Significant Customers:       |  |                          |   |  |      |   |  |      |  
|Siemens AG                   |  | 24                       | % |  | 28   | % |  | 19   | %
|Nortel                       |  | 12                       | % |  | *    |   |  | *    |  
|Tellabs, Inc.(2)             |  | 10                       | % |  | 12   | % |  | 23   | %
|Cisco Systems, Inc.(1)       |  | *                        |   |  | *    |   |  | 11   | %

---

|(1) | The end customers of the shipments to Insight Electronics, Inc. during 2004 includes: Spirent Communications, Cisco Systems, Inc., and Sonus Networks, Inc.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The primary end customer of the shipments to Arrow Electronics, Inc. is Tellabs, Inc.
|--- | -------------------------------------------------------------------------------------

|* | Revenues were less than 10% of the Companys net revenues in these years.
|- | -------------------------------------------------------------------------



77



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Note 9. Income Taxes



The components of loss before income taxes, extraordinary loss and cumulative effect of a change in accounting principle for the fiscal years ended
December 31, 2004, 2003 and 2002 are as follows:



|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------ |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                       |  | Years Ended December 31, |        
|                                                                                                       |  | 2004                     |         |   | 2003 |   |         | 2002 | 
|U.S. domestic loss                                                                                     |  | $                        | (43,238 | ) |      | $ | (38,282 | )    |  | $ | (97,018 | )
|Foreign (loss) income                                                                                  |  |                          | (920    | ) |      |   | 836     |      |  |   | 1,128   |  
|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Loss before income taxes, extraordinary loss and cumulative effect of a change in accounting principle |  | $                        | (44,158 | ) |      | $ | (37,446 | )    |  | $ | (95,890 | )
|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  



The provision for
income taxes is comprised of the following:



|                      |  |                          |     |      |   |      |  |   |       
|--------------------- |  | ------------------------ | --- | ---- | - | ---- |  | - | ------
|                      |  | Years Ended December 31,
|                      |  | 2004                     |     | 2003 |   | 2002
|Federal income taxes: |  |                          |     |      |   |      |  |   |       
|Current               |  | $                        |    |      | $ |     |  | $ |      
|Deferred              |  |                          |    |      |   |     |  |   | 62,534
|State income taxes:   |  |                          |     |      |   |      |  |   |       
|Current               |  |                          |    |      |   |     |  |   |      
|Deferred              |  |                          |    |      |   |     |  |   | 6,132 
|Foreign income taxes: |  |                          |     |      |   |      |  |   |       
|Current               |  |                          | 189 |      |   | 246  |  |   | 668   
|Deferred              |  |                          |    |      |   |     |  |   |      
|                      |  |                          |     |      |   |      |  |   |       
|Income tax expense    |  | $                        | 189 |      | $ | 246  |  | $ | 69,334
|                      |  |                          |     |      |   |      |  |   |       



The Company recorded
state franchise and capital taxes of $0.4 million, $0.1 million and $0.2 million in the years ended December 31, 2004, 2003 and 2002 respectively, which is recorded as a component of general and administrative expenses on the consolidated statement
of operations.



The following table summarizes the differences
between the U.S. federal statutory rate and the Companys effective income tax rate for financial statement purposes for the fiscal years ended December 31, 2004, 2003 and 2002:



|                                                         |  |                          |    |  |       |    |  |       |   
|-------------------------------------------------------- |  | ------------------------ | -- |  | ----- | -- |  | ----- | --
|                                                         |  | Years Ended December 31, |   
|                                                         |  | 2004                     |    |  | 2003  |    |  | 2002  |   
|U.S. federal statutory tax rate                          |  | (35.0                    | )% |  | (35.0 | )% |  | (35.0 | )%
|State taxes                                              |  | 6.8                      |    |  | (4.1  | )  |  | (0.8  | ) 
|In-process research and development                      |  |                         |    |  | 0.5   |    |  | 0.7   |   
|Disallowed interest deduction                            |  | 3.9                      |    |  | 1.2   |    |  |      |   
|Capital loss on sale of subsidiary                       |  | (17.4                    | )  |  |      |    |  |      |   
|Goodwill impairment                                      |  |                         |    |  |      |    |  | 21.9  |   
|Change in valuation allowance                            |  | 42.5                     |    |  | 38.7  |    |  | 85.1  |   
|Permanent differences, tax credits and other adjustments |  | (0.4                     | )  |  | (0.3  | )  |  | 0.4   |   
|                                                         |  |                          |    |  |       |    |  |       |   
|Effective income tax rate                                |  | 0.4                      | %  |  | 1.0   | %  |  | 72.3  | % 
|                                                         |  |                          |    |  |       |    |  |       |   



78



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



The tax effect of temporary differences that give rise to deferred income tax assets and deferred
income tax liabilities at December 31, 2004 and 2003 are presented below:



|                                                        |  |      |          |   |      |   |          |  
|------------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | -
|                                                        |  | 2004 |          |   | 2003 |  
|Deferred income tax assets:                             |  |      |          |   |      |   |          |  
|Property and equipment                                  |  | $    | 3,381    |   |      | $ | 2,866    |  
|Other nondeductible reserves                            |  |      | 919      |   |      |   | 872      |  
|Restructuring reserve                                   |  |      | 8,805    |   |      |   | 9,395    |  
|Capitalized research & development for tax purposes     |  |      | 17,258   |   |      |   | 5,383    |  
|Investment impairment                                   |  |      | 38       |   |      |   | 7,238    |  
|Capitalized start up costs for tax purposes             |  |      |         |   |      |   | 456      |  
|Net operating losses                                    |  |      | 76,245   |   |      |   | 77,320   |  
|Capital losses                                          |  |      | 15,739   |   |      |   |         |  
|Research & development and other credits                |  |      | 10,906   |   |      |   | 10,250   |  
|Derivative liability                                    |  |      | 3,321    |   |      |   |         |  
|Other                                                   |  |      | 1,390    |   |      |   | 1,331    |  
|                                                        |  |      |          |   |      |   |          |  
|Total gross deferred income tax assets                  |  |      | 138,002  |   |      |   | 115,111  |  
|Less valuation allowance                                |  |      | (132,841 | ) |      |   | (114,071 | )
|                                                        |  |      |          |   |      |   |          |  
|Net deferred income tax assets                          |  |      | 5,161    |   |      |   | 1,040    |  
|                                                        |  |      |          |   |      |   |          |  
|Deferred income tax liabilities:                        |  |      |          |   |      |   |          |  
|Debt Discount                                           |  |      | (5,117   | ) |      |   |         |  
|Other                                                   |  |      | (44      | ) |      |   | (1,040   | )
|                                                        |  |      |          |   |      |   |          |  
|Net deferred income tax liabilities                     |  |      | (5,161   | ) |      |   | (1,040   | )
|                                                        |  |      |          |   |      |   |          |  
|Total deferred income taxes, net of valuation allowance |  | $    |         |   |      | $ |         |  
|                                                        |  |      |          |   |      |   |          |  



The Company
continually evaluates its deferred tax assets as to whether it is more likely than not that the deferred tax assets will be realized. In assessing the realizability of its deferred tax assets, management considers the scheduled reversal of deferred
tax liabilities, projected future taxable income, and tax planning strategies. Based on this assessment, management believes that significant uncertainty exists surrounding the recoverability of the deferred tax assets and, as such, has recorded a
full valuation allowance against its net deferred tax assets as of December 31, 2004 and 2003. Of the $132.8 million valuation allowance at December 31, 2004, subsequently recognized income tax benefits, if any, in the amount of $4.1 million will be
applied directly to additional paid-in capital.



At December
31, 2004, the Company had available, for federal income tax purposes, net operating loss (NOL) carry-forwards of approximately $231.2 million, capital loss carry-forwards of approximately $40.4 million and research and development
tax credit carry-forwards of approximately $10.9 million expiring in varying amounts from 2005 through 2024. For state income tax purposes, the Company had available NOL carry-forwards of approximately $79.2 million and capital loss carry-forwards
of $41.0 million and state tax credit carry-forwards of $5.5 million expiring in varying amounts from 2005 to 2023.



Certain transactions involving the Companys beneficial ownership have occurred in prior years, which resulted in a stock ownership change for
purposes of Section 382 of the Internal Revenue Code of 1986, as amended. Consequently, approximately $21.9 million of the NOL carry-forwards and $1.4 million of research and development tax credit carry-forwards are subject to these limitations.
The Company has not yet determined if any of the NOL and credits generated from 1998 to 2004 will be subject to limitation under Section 382.



79



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Note 10. Stockholders Equity



Stockholders Rights Plan



On October 1, 2001, the Board of Directors enacted a stockholder rights plan and declared a dividend of one preferred share
purchase right for each outstanding share of TranSwitch common stock outstanding at the close of business on October 1, 2001 to the stockholders of record on that date. Each stockholder of record as of October 1, 2001 received a summary of the
rights and any new stock certificates issued after the record date contain a legend describing the rights. Each preferred share purchase right entitles the registered holder to purchase from the Company one one-thousandth of a share of Series A
Junior Participating Preferred Stock, par value $0.01 per share, of the Company, at a price of $50.00 per one one-thousandth of a Preferred Share, subject to adjustment, upon the occurrence of certain triggering events, including the purchase of 15%
or more of the Companys outstanding common stock by a third party. Until a triggering event occurs, the common stockholders have no right to purchase shares under the stockholder rights plan. If the right to purchase the preferred stock is
triggered, the common stockholders will have the ability to purchase sufficient stock to significantly dilute the 15% or greater holder.



Note 11. Employee Benefit Plans



Employee Stock Purchase Plan



To provide employees with an opportunity to purchase common stock through payroll deductions, the Company established the 1995 Employee Stock Purchase
Plan (the Purchase Plan), as amended on May 23, 2002, under which 700,000 shares of common stock have been reserved for issuance. Under the Purchase Plan, eligible employees may purchase a limited number of shares of common stock at 85%
of the fair market value at either the date of enrollment or the date of purchase, whichever is less. Under the Purchase Plan, 105,199, 81,494 and 104,626 shares were issued in 2004, 2003, and 2002, respectively. This plan was closed effective
December 31, 2004.



Stock Option Plans



The Company has three stock options plans: the 1995
Stock Plan, as amended (the 1995 Plan); the 2000 Stock Option Plan (the 2000 Plan); and the 1995 Non-Employee Director Stock Option Plan (the Director Plan).



With respect to the 1995 Plan, in connection with the May 2000 annual
shareholders meeting, the shareholders approved an increase to the maximum number of shares reserved and authorized for issuance to 31,400,000 shares of TranSwitch common stock, pursuant to the grant to employees of incentive stock options and the
grant of non-qualified stock options, stock awards or opportunities to make direct purchases of common stock to employees, consultants, directors and executive officers. The terms of the options granted are subject to the provisions of the 1995 Plan
as determined by the Compensation Committee of the Board of Directors. The 1995 Plan will terminate ten years after its adoption unless terminated earlier by the Board of Directors. The exercise price of options under the 1995 Plan must be equal to
the fair market value of the common stock on the date of grant. Options granted under the 1995 Plan are generally nontransferable. As of December 31, 2004 the number of shares available for grant under the 1995 Plan was 2,889,874.



The 2000 Plan, adopted by the Board of Directors on July 14, 2000 and amended
on December 21, 2001, provides for the grant of non-qualified options to purchase shares of common stock, up to an aggregate of



80



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



10,000,000 shares, to employees and consultants. No member of the Board of Directors or executive officers as appointed by the Board of Directors shall be
eligible for grants of options under the 2000 Plan. The terms of the options granted are subject to the provisions of the 2000 Plan as determined by the Compensation Committee of the Board of Directors. Each non-qualified stock option shall either
be fully exercisable on the date of grant or shall become exercisable thereafter in such installments as the Board of Directors may specify. The 2000 Plan will terminate ten years after its adoption. No option granted under the 2000 Plan may be
exercised after the expiration of seven years from the date of grant. The exercise price of options under the 2000 Plan must be equal to the fair market value of the common stock on the date of grant. Options granted under the 2000 Plan are
generally nontransferable. As of December 31, 2004, the number of shares available for grant under the 2000 Plan was 2,351,137.



The Director Plan, as amended on May 23, 2002, provides for the automatic grant of options to purchase shares of common stock, up to an aggregate of
2,075,000 shares, to non-employee directors on the anniversary date of each individual board member joining the Board of Directors. Upon joining the Board of Directors, each director is granted an option to purchase 37,500 shares, one-third of which
vest immediately, one-third after the first year, and the remaining one-third after the second year. Annually thereafter, each director is granted an option to purchase 28,800 shares, which vest fully after one year. The Director Plan is
administered by the Compensation Committee of the Board of Directors. No option granted under the Director Plan may be exercised after the expiration of five years from the date of grant. The exercise price of options under the Director Plan must be
equal to the fair market value of the common stock on the date of grant. Options granted under the Director Plan are generally nontransferable. As of December 31, 2004, the number of shares available for grant under the Director Plan was 155,299.



Information regarding stock options is set forth as follows:



|                                 |  |                              |   |  |                                          |      
|-------------------------------- |  | ---------------------------- | - |  | ---------------------------------------- | -----
|                                 |  | Number of optionsoutstanding |   |  | Weighted averageexercise price per share
|Outstanding at December 31, 2001 |  | 21,544,855                   |   |  | $                                        | 16.61
|Granted and assumed              |  | 3,558,058                    |   |  |                                          | 2.61 
|Exercised                        |  | (174,046                     | ) |  |                                          | 2.12 
|Canceled                         |  | (3,108,962                   | ) |  |                                          | 18.08
|                                 |  |                              |   |  |                                          |      
|Outstanding at December 31, 2002 |  | 21,819,905                   |   |  |                                          | 14.16
|Granted and assumed              |  | 5,474,630                    |   |  |                                          | 1.42 
|Exercised                        |  | (456,441                     | ) |  |                                          | 1.21 
|Canceled                         |  | (4,830,109                   | ) |  |                                          | 14.16
|                                 |  |                              |   |  |                                          |      
|Outstanding at December 31, 2003 |  | 22,007,985                   |   |  | $                                        | 11.04
|Granted and assumed              |  | 4,464,150                    |   |  |                                          | 1.85 
|Exercised                        |  | (223,430                     | ) |  |                                          | 0.99 
|Canceled                         |  | (755,255                     | ) |  |                                          | 10.11
|Outstanding at December 31, 2004 |  | 25,493,450                   |   |  | $                                        | 9.49 
|                                 |  |                              |   |  |                                          |      



The Company has, in
connection with the acquisitions of various companies, assumed the stock option plans of each acquired company, and the related options are included in the preceding table.



81



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Options outstanding and exercisable at December 31, 2004 are as follows:



|                         |                |                     |            |                                             |      |                                 |   |                    |  |                                 |  |   |      
|------------------------ | -------------- | ------------------- | ---------- | ------------------------------------------- | ---- | ------------------------------- | - | ------------------ |  | ------------------------------- |  | - | -----
|                         |                | Options Outstanding |            | Options Exercisable                        
|Range of Exercise prices |                | Number outstanding  |            | Weighted Average Remaining Contractual Life |      | Weighted average exercise price |   | Number exercisable |  | Weighted average exercise price
|$                        | 0.28 to 0.92   |                     | 2,606,502  |                                             | 4.89 |                                 | $ | 0.82               |  | 2,235,714                       |  | $ | 0.84 
|                         | 0.92 to 1.50   |                     | 3,246,660  |                                             | 6.72 |                                 |   | 1.34               |  | 1,878,939                       |  |   | 1.28 
|                         | 1.52 to 2.12   |                     | 2,759,660  |                                             | 6.27 |                                 |   | 1.65               |  | 1,398,065                       |  |   | 1.74 
|                         | 2.14 to 3.26   |                     | 3,876,301  |                                             | 4.64 |                                 |   | 2.79               |  | 3,168,367                       |  |   | 2.83 
|                         | 3.32 to 4.13   |                     | 3,094,586  |                                             | 4.51 |                                 |   | 3.92               |  | 2,654,784                       |  |   | 3.98 
|                         | 4.21 to 9.45   |                     | 3,155,167  |                                             | 3.97 |                                 |   | 8.62               |  | 2,976,311                       |  |   | 8.59 
|                         | 9.46 to 19.78  |                     | 3,052,326  |                                             | 2.56 |                                 |   | 15.13              |  | 2,946,283                       |  |   | 15.27
|                         | 20.06 to 39.10 |                     | 2,592,573  |                                             | 2.77 |                                 |   | 31.28              |  | 2,561,969                       |  |   | 31.30
|                         | 39.13 to 67.81 |                     | 1,109,675  |                                             | 2.54 |                                 |   | 48.13              |  | 1,098,370                       |  |   | 48.20
|                         |                |                     |            |                                             |      |                                 |   |                    |  |                                 |  |   |      
|$                        | 0.28 to 67.81  |                     | 25,493,450 |                                             | 4.48 |                                 | $ | 9.49               |  | 20,918,802                      |  | $ | 11.00
|                         |                |                     |            |                                             |      |                                 |   |                    |  |                                 |  |   |      



Stock options
generally expire five, seven or ten years from the date of grant and generally vest ratably over a period of either two or four years.



Stock-Based Compensation Fair Value Disclosures



As permitted by SFAS 123, Accounting for Stock-Based Compensation (SFAS 123), the Company applies APB 25 and related interpretations in
accounting for stock-based awards. Under APB 25, no compensation expense is recognized in the consolidated financial statements for employee stock options because the exercise price of the option equals the market price of the underlying stock on
the date of grant. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing with the following assumptions:



|                        |  |       |   |  |       |   |  |      |  
|----------------------- |  | ----- | - |  | ----- | - |  | ---- | -
|                        |  | 2004  |   |  | 2003  |   |  | 2002 |  
|Risk-free interest rate |  | 3.43  | % |  | 3.25  | % |  | 3.0  | %
|Expected life in years  |  | 2.3   |   |  | 1.9   |   |  | 2.3  |  
|Expected volatility     |  | 100.7 | % |  | 102.2 | % |  | 100  | %
|Expected dividend yield |  |      |   |  |      |   |  |     |  



A table illustrating
the effect on net loss and loss per common share as if the Black-Scholes fair value method had been applied to compensation plans is presented in Note 1Summary of Significant Accounting Policies.



The weighted average fair value of stock options granted, calculated using
the Black-Scholes option-pricing model, is $0.97, $0.73 and $1.42 for the fiscal years ended December 31, 2004, 2003 and 2002, respectively.



As required by SFAS 123, the Company recognized compensation expense related to stock options granted to non-employees of $0.1 million, zero, and $.01
million for the fiscal years ended December 31, 2004, 2003 and 2002, respectively.



82



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Employee 401(k) Plan



TranSwitch sponsors a 401(k) plan known as the TranSwitch Corporation 401(k) Retirement Plan (the Plan). The
Plan provides tax-deferred salary deductions for eligible employees. Employees may contribute from 1% to 15% of their annual compensation to the Plan, limited to an annual maximum amount as set periodically by the Internal Revenue Service. The
Company provides matching contributions equal to 50% of the employees contributions, up to a maximum of 6% of the employees annual compensation. Company contributions begin vesting after two years and are fully vested after three years.
The contribution expense related to the Plan amounted to $0.4 million, $0.4 million and $0.6 million for the years ended December 31, 2004, 2003 and 2002, respectively.



Note 12. Convertible Notes



4.50% Convertible Notes Due 2005



In September 2000, the Company issued $460.0 million of 4.50% Convertible Notes due September 12, 2005 (the 4.50% Notes), and received proceeds of $444.0
million, net of debt issuance costs. The notes are convertible, at the option of the holder, at any time on or prior to maturity, into shares of common stock at a conversion price of $61.9225 per share.



The notes are unsecured and unsubordinated obligations and rank on parity in
right of payment with all existing and future unsecured and unsubordinated indebtedness.



On February 11, 2002, the Companys Board of Directors approved a tender offer to purchase up to $200.0 million aggregate principal of the Companys then outstanding 4.50% Notes at a price not greater than
$700 nor less than $650 per $1,000 principal amount, plus accrued and unpaid interest thereon to, but not including, the date of the purchase. As a result of this offer, the Company repurchased $199.9 million face value of the then outstanding notes
at the price of $700 per $1,000 principal amount for a cash payment of $139.9 million. During 2001, the Company repurchased some of its outstanding 4.50% Notes on the open market. The gain on these repurchases, net of deferred financing fees and
income taxes, has been recorded in other income in the consolidated statement of operations. Details of the repurchase and resulting gain on these notes for the year ended December 31, 2002, is as follows:



|                                                    |  |                              |          |  
|--------------------------------------------------- |  | ---------------------------- | -------- | -
|                                                    |  | Year Ended December 31, 2002 |         
|4.50% Convertible Notes due 2005 repurchased at par |  | $                            | 199,937  |  
|Tender offer transaction and professional fees      |  |                              | (3,201   | )
|Write-off of related deferred financing fees        |  |                              | (4,805   | )
|Cash paid to repurchase notes                       |  |                              | (139,955 | )
|                                                    |  |                              |          |  
|Gain on repurchase of notes                         |  | $                            | 51,976   |  
|                                                    |  |                              |          |  



The Company funded the
repurchases of the 4.50% Notes from available cash, cash equivalents and short-term investments. During 2003, the Company completed its exchange offer with and new money offering to the holders of its 4.50% Notes with the issuance of 5.45%
Convertible Plus Cash Notessmdue September 30, 2007 (the Plus Cash Notes). As of December 31, 2004 and 2003, the
remaining outstanding principal balance of the 4.50% Notes was $24.4 million.



83



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



5.45% Convertible Plus Cash Notessmdue 2007



On September 30, 2003, the Company completed its exchange offer with and new money offering to holders of the 4.50% Notes. The Company issued $98.0
million aggregate principal amount of the Plus Cash Notes, which represented $74.0 million of Plus Cash Notes issued in exchange for 4.50% Notes tendered in the exchange offer and $24.0 million of additional Plus Cash Notes sold for cash to holders
of existing notes (the new money offering). The net proceeds from the new money offering are being used for general corporate purposes, including working capital and research and development. The Company recorded a gain on the exchange of
approximately $14.5 million, which was calculated as follows:



|                                                       |  |   |         |  
|------------------------------------------------------ |  | - | ------- | -
|Carrying value of 4.50% Notes exchanged                |  | $ | 89,671  |  
|Less: deferred financing fees                          |  |   | (1,245  | )
|                                                       |  |   |         |  
|Net carrying value of 4.50% Notes                      |  |   | 88,426  |  
|Less: fair value of Plus Cash Notes issued on exchange |  |   | (73,963 | )
|                                                       |  |   |         |  
|Gain on exchange                                       |  | $ | 14,463  |  
|                                                       |  |   |         |  



Each Plus Cash Note
may be converted by the holders thereof into 182.71 shares of the Companys common stock (the base shares) plus $500 in cash (the plus cash amount), which the Company may elect to pay with shares of its common stock subject to the terms and
conditions of the Plus Cash Notes indenture. Interest on the Plus Cash Notes is payable at a rate of 5.45% per year, payable on March 31 and September 30 of each year, commencing on March 31, 2004. The Company may elect to pay interest in cash or
common stock, subject to the terms and conditions of the Plus Cash Notes. At any time prior to maturity, the Company may, at its option, elect to automatically convert (an auto-conversion) the Plus Cash Notes if the closing price of its common stock
exceeds $5.47 for 20 trading days during any consecutive 25 trading day period, subject to the terms and conditions of the Plus Cash Notes. The Company may elect to satisfy the plus cash amount issuable in connection with any auto-conversion in cash
or common stock, subject to the terms and conditions of the Plus Cash Notes. If the Company effects an auto-conversion prior to September 30, 2005, the Company will pay the additional interest in cash as described in the terms and conditions of the
Plus Cash Notes indenture.



Derivative Liability Related
to 5.45% Convertible Plus Cash Notessmdue 2007



In accordance with Statement of Financial Accounting Standards No. 133,
Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS 133), the auto-conversion make-whole provision and the holders conversion right (collectively, the features) contained in the terms
governing the Plus Cash Notes are not clearly and closely related to the characteristics of the Plus Cash Notes. Accordingly, the features qualified as embedded derivative instruments at issuance and, because they do not qualify for any scope
exception within SFAS 133, they were required by SFAS 133 to be accounted for separately from the debt instrument and recorded as derivative financial instruments.



Auto-Conversion Make-Whole Provision



Pursuant to the terms of the Plus Cash Notes, the Company will pay additional interest equal to two full years of interest
on the Plus Cash Notes (the auto-conversion make-whole provision), less any interest actually paid or provided for on the Plus Cash Notes if the Plus Cash Notes are automatically converted by the Company on or prior to September 30, 2005. The
auto-conversion make-whole provision represents an embedded derivative that is required to be accounted for apart from the underlying Plus Cash Notes. At issuance of the Plus



84



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Cash Notes, the auto-conversion make-whole provision had an estimated initial fair value of $3.0 million, which was recorded as a discount to the Plus Cash
Notes and a derivative liability on the consolidated balance sheet. The discount on the Plus Cash Notes will be accreted to par value through quarterly interest charges over the four-year term of the Plus Cash Notes. The auto-conversion make-whole
provision can only be settled in cash, and accordingly, will remain classified as a derivative liability in the consolidated balance sheet as long as the provision is available. The auto-conversion make-whole provision will be adjusted to its fair
value on a quarterly basis for the first two years that any such Plus Cash Notes are outstanding, with the corresponding charge or credit to other expense or income. The estimated fair value of the auto-conversion make-whole provision was determined
using the Monte Carlo simulation model. The model uses several assumptions including: historical stock price volatility, risk-free interest rate, remaining maturity, and the closing price of the Companys common stock to determine estimated
fair value of the derivative liability. For the year ended December 31, 2004, the Company recorded other income on the consolidated statement of operations for the change in fair value of the auto-conversion make-whole provision of approximately
$2.1 million. At December 31, 2004, the estimated fair value of the auto-conversion make-whole provision was approximately $0.1 million. The recorded value of the auto-conversion make-whole provision related to the Plus Cash Notes can fluctuate
significantly based on fluctuations in the fair value of the Companys common stock.



Holders Conversion Right



Pursuant to the terms of the Plus Cash Notes, these notes are convertible at the option of the holder, at anytime on or prior to maturity, other than an auto-conversion date or a redemption date. The holders
conversion right represents an embedded derivative that is required to be accounted for apart from the underlying Plus Cash Notes. At issuance of the Plus Cash Notes, the holders conversion right had an estimated initial fair value of $20.3
million, which was recorded as a discount to the Plus Cash Notes and a derivative liability on the consolidated balance sheet. The discount on the Plus Cash Notes will be accreted to par value through quarterly interest charges over the four-year
term of the Plus Cash Notes. Assuming the daily volume weighted price determined according to the voluntary conversion provision is or remains below the threshold price of $2.61, the derivative related to the holders conversion right will be
adjusted quarterly for changes in fair value during the period of time that any such Plus Cash Notes are outstanding and classified as a derivative liability, with the corresponding charge or credit to other expense or income. In subsequent periods,
if the daily volume weighted average price of our common stock determined according to the voluntary conversion provision equals or exceeds the threshold price of $2.61, the embedded derivative financial instrument related to the holders
conversion right will be adjusted to fair value with the corresponding charge or credit to other expense or income and then reclassified from total liabilities to stockholders equity. Changes in fair value during the period of time that any
such Plus Cash Notes are outstanding and classified within stockholders equity, will be made by a corresponding charge or credit to additional paid-in-capital. The estimated fair value of the holders conversion right was determined using
the Black-Scholes option-pricing model. The model uses several assumptions including: historical stock price volatility, risk-free interest rate, remaining maturity, and the closing price of the Companys common stock to determine estimated
fair value of the derivative liability. For the year ended December 31, 2004, the Company recorded other income on the consolidated statement of operations for the change in fair value of the holders conversion right of approximately $10.0
million. At December 31, 2004, the estimated fair value of the holders conversion right was approximately $8.4 million. The recorded value of the holders conversion right related to the Plus Cash Notes can fluctuate significantly based
on fluctuations in the fair value of the Companys common stock.



For the years ended December 31, 2004 and 2003, the Company amortized $5.6 million and $1.5 million, respectively, of debt discount related to the Plus Cash Notes



85



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Exchanges of the Plus Cash Notes for Shares of Common Stock



During the year ended December 31, 2004, the Company issued an aggregate of
12,129,496 shares of the Companys common stock plus approximately $0.1 million cash in lieu of accrued and unpaid interest in exchange for $17.0 million in aggregate original principal amount of the Plus Cash Notes. The shares issued were
exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. No commission or other remuneration was paid or given directly or indirectly for soliciting these transactions. As a result of the exchanges, the Company
incurred a non-cash loss of approximately $3.0 million due to the write-off of the unamortized debt discount and deferred financing costs related to the exchanged Plus Cash Notes. The Company did not effect any such exchanges during the year ended
December 31, 2003.



Note 13. Restructuring and Asset Impairment Charges



During the year ended December 31, 2004, the Company
recorded restructuring charges totaling approximately $1.1 million resulting from the wind-down of the business and operations of OptiX, the liquidation of its investment in TeraOp, , the impairment of certain long-lived assets and the disengagement
from Easics N.V., its Belgian design center.



In July 2004, the
Company informed OptiX that it planned to discontinue its ongoing funding of OptiXs operations. Consequently, the OptiX Board of Directors voted to wind-down its business and operations. During the year ended December 31, 2004, the Company
recorded a charge of $0.2 million related to severance, the impairment of assets and lease buy out costs. This charge was offset by a gain of $0.5 million related to the deconsolidation of OptiX, which resulted in a net restructuring benefit of $0.3
million for the year ended December 31, 2004.



In September
2004, the Company entered an agreement with TeraOp under which the Company converted its promissory notes issued and payable by TeraOp into shares of TeraOp common stock. The Company then sold all of its common share holdings in TeraOp to an
independent third party for a nominal amount. In addition, the Company paid TeraOp $0.3 million for a royalty on future revenues of TeraOp. Currently, TeraOp has no revenue and may never have revenue in the future. As a result of these transactions,
the Company no longer holds any equity or debt interest in TeraOp and has no influence over the operations of TeraOp. Accordingly, TeraOp was deconsolidated from the Companys financial statements upon the completion of these transactions,
resulting in a net restructuring charge of $0.2 million.



In
the fourth quarter of 2004, the Company recorded a charge of $0.2 million related certain engineering design tool assets that were determined to be impaired under the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets.



In the fourth quarter of 2004, the
Company finalized its plans to disengage from Easics N.V. This action resulted in a work force reduction of approximately 9% of the Companys existing personnel and the sale of the business. As a result of this action, the Company incurred
restructuring charges of approximately $1.6 million related to employee termination benefits and $0.1 million related to legal and other transaction costs. These charges were offset by a gain of $0.5 million on the sale of Easics N.V., for a net
restructuring charge of approximately $1.1 million.



In January
2003, the Company announced a restructuring plan to lower its operating expenses. This plan resulted in a work-force reduction of approximately 24% of existing personnel. Also, the Company announced the closing of its South Brunswick, New Jersey
(SOSi) design center, and the reduction of staff in Bedford,



86



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Massachusetts and Shelton, Connecticut. This workforce reduction also impacted the Switzerland and Belgium locations. In addition, the Company postponed the
completion of the IAD product line and archived the related intellectual property until that market returns, if ever. During the year ended December 31, 2003, the Company incurred approximately $3.4 million in restructuring expenses related to
employee termination benefits and $0.5 million related to excess facility costs. In addition, the Company recorded a charge for fixed assets that were impaired with a net book value totaling $0.3 million and a patent on the IAD product line
with a net book value of $0.2 million. This resulted in a total restructuring and asset impairment charge for the year ended December 31, 2003 totaling $4.4 million. This restructuring charge was partially off set by a benefit of
$1.9 million realized, as the Company was able to sub-lease portions of excess facilities, for a net restructuring expense for the year ended December 31, 2003 of $2.5 million. The Company estimates that there will be future adjustments to the
liability for future lease payments as market conditions change.



During the year ended December 31, 2002, the Company announced a restructuring plan under which the Company eliminated fifty-six positions and announced the closing of its design centers in Milpitas, California and Raleigh, North Carolina.
In conjunction with this restructuring, the Company discontinued the AsTriX and Sertopia product lines and strategically refocused its research and development efforts. This plan resulted in employee termination benefits of $2.4 million and costs to
exit facilities of $3.1 million, for a total restructuring expense of approximately $5.5 million. Restructuring charges for the year ended December 31, 2002 were $3.9 million as the Company recognized a restructuring benefit of approximately $1.6
million related to the sublease of a portion of excess facilities.



The Company will continue to closely monitor both its costs and revenue expectations in future periods and will take actions as market conditions dictate.



A summary of the restructuring liabilities and the activity for the years ended December 31, 2004 and December 31, 2003 is
as follows:



|                              |  |                                             |        |                                                                            |   |       |                                                   |  |   |                           |   |  |                                      |      |   |                                             |   |        |   |  |   |       
|----------------------------- |  | ------------------------------------------- | ------ | -------------------------------------------------------------------------- | - | ----- | ------------------------------------------------- |  | - | ------------------------- | - |  | ------------------------------------ | ---- | - | ------------------------------------------- | - | ------ | - |  | - | ------
|                              |  | Fiscal 2004 Activity                       
|                              |  | Restructuring Liabilities December 31, 2003 |        | Restructuring Charges                                                      |   |       | Cash Payments January 1, 2004  December 31, 2004 |  |   | Non-cash asset write-offs |   |  | Adjustments and Changesto Estimates  |      |   | Restructuring Liabilities December 31,2004 
|Employee termination benefits |  | $                                           |       |                                                                            |   | 1,730 |                                                   |  | $ | (1,730                    | ) |  | $                                    |     |   |                                             | $ |       |   |  | $ |      
|Facility lease costs          |  |                                             | 24,144 |                                                                            |   | 43    |                                                   |  |   | (1,395                    | ) |  |                                      |     |   |                                             |   | (167   | ) |  |   | 22,625
|Asset impairments             |  |                                             |       |                                                                            |   | 242   |                                                   |  |   |                          |   |  |                                      | (242 | ) |                                             |   |       |   |  |   |      
|Other                         |  |                                             |       |                                                                            |   | (722  | )                                                 |  |   |                          |   |  |                                      | 722  |   |                                             |   |       |   |  |   |      
|                              |  |                                             |        |                                                                            |   |       |                                                   |  |   |                           |   |  |                                      |      |   |                                             |   |        |   |  |   |       
|Totals                        |  | $                                           | 24,144 |                                                                            |   | 1,293 |                                                   |  | $ | (3,125                    | ) |  | $                                    | 480  |   |                                             | $ | (167   | ) |  | $ | 22,625
|                              |  |                                             |        |                                                                            |   |       |                                                   |  |   |                           |   |  |                                      |      |   |                                             |   |        |   |  |   |       
|                              | 
|                              |  | Fiscal 2003 Activity                       
|                              |  | Restructuring Liabilities December 31, 2002 |        | Restructuring Charges Incurred with the January 15,2003 Restructuring
Plan |   |       | Cash Payments January 1, 2003 December 31, 2003  |  |   | Non-cash asset write-offs |   |  | Adjustments and Changes to Estimates |      |   | Restructuring Liabilities December 31, 2003
|Employee termination benefits |  | $                                           |       |                                                                            | $ | 3,428 |                                                   |  | $ | (3,077                    | ) |  | $                                    | (77  | ) |                                             | $ | (274   | ) |  | $ |      
|Facility lease costs          |  |                                             | 27,557 |                                                                            |   | 467   |                                                   |  |   | (2,172                    | ) |  |                                      |     |   |                                             |   | (1,708 | ) |  |   | 24,144
|Asset impairments             |  |                                             |       |                                                                            |   | 466   |                                                   |  |   |                          |   |  |                                      | (466 | ) |                                             |   |       |   |  |   |      
|                              |  |                                             |        |                                                                            |   |       |                                                   |  |   |                           |   |  |                                      |      |   |                                             |   |        |   |  |   |       
|Totals                        |  | $                                           | 27,557 |                                                                            | $ | 4,361 |                                                   |  | $ | (5,249                    | ) |  | $                                    | (543 | ) |                                             | $ | (1,982 | ) |  | $ | 24,144
|                              |  |                                             |        |                                                                            |   |       |                                                   |  |   |                           |   |  |                                      |      |   |                                             |   |        |   |  |   |       



87



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Note 14. Commitments and Contingencies



Lease Agreements



The Company leases buildings and equipment at its headquarters in Shelton, Connecticut as well as at its subsidiaries worldwide. Total rental costs
expensed under all operating lease agreements was $1.4 million, $1.3 million and $1.7 million for the fiscal years ended December 31, 2004, 2003 and 2002, respectively.



During 2004, 2003 and 2002, the Company elected to exit certain design centers, but continues to have obligations on these
particular facilities (refer to Note 13Restructuring and Asset Impairment Charges for further disclosure). The following table summarizes future minimum operating lease commitments, including contractually obligated building operating
commitments, that have remaining, non-cancelable lease terms in excess of one year at December 31, 2004, and future sublease income where the Company has leases in place:



|           |  |                      |        |                    |   |                 |  |   |       
|---------- |  | -------------------- | ------ | ------------------ | - | --------------- |  | - | ------
|           |  | OperatingCommitments |        | SubleaseAgreements |   | Net Commitments
|2005       |  | $                    | 4,913  |                    | $ | 2,261           |  | $ | 2,652 
|2006       |  |                      | 4,148  |                    |   | 2,227           |  |   | 1,921 
|2007       |  |                      | 3,553  |                    |   | 2,133           |  |   | 1,420 
|2008       |  |                      | 3,593  |                    |   | 2,081           |  |   | 1,512 
|2009       |  |                      | 3,611  |                    |   | 1,048           |  |   | 2,563 
|Thereafter |  |                      | 21,771 |                    |   | 68              |  |   | 21,703
|           |  |                      |        |                    |   |                 |  |   |       
|           |  | $                    | 41,589 |                    | $ | 9,818           |  | $ | 31,771
|           |  |                      |        |                    |   |                 |  |   |       



Patent Indemnity



Under the terms of substantially all of its sales
agreements, the Company has agreed to indemnify its customers for costs and damages arising from claims against such customer based on, among other things, allegations that the Companys products infringed upon the intellectual property
rights of a third party. In the event of an infringement claim, the Company retains the right to (i) procure for the customer the right to continue using the product; (ii) replace the product with a non-infringing item which shall give equally good
service; (iii) modify the product so that it becomes non-infringing; or (iv) remove the product and, on return of the product to the Company, the Company shall refund the buyers purchase price. Due to the nature of these indemnification agreements,
the maximum potential future payments the Company could be required to make under these guarantees, when and if such claims may arise, cannot be reliably determined. No amounts have been accrued for any estimated losses with respect to these
guarantees for customer indemnifications since it is not probable that a loss will be incurred. No claims were made under these indemnity provisions in 2004, 2003 and 2002.



Purchase Commitments



In the normal course of business, the Company makes various commitments to purchase goods or services from specific suppliers, including those related
to capital expenditures. As of December 31, 2004, the Company had purchase commitments totaling $5.6 million, of which $2.3 million related to licenses for engineering design tools to be purchased from one vendor in 2005 and 2006.



88



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Note 15. Supplemental Cash Flow Information



The following represents supplemental cash flow information:



|                           |  |                          |       |      |   |       |  |   |      
|-------------------------- |  | ------------------------ | ----- | ---- | - | ----- |  | - | -----
|                           |  | Years Ended December 31,
|                           |  | 2004                     |       | 2003 |   | 2002 
|Cash paid for interest     |  | $                        | 6,264 |      | $ | 5,365 |  | $ | 9,661
|Cash paid for income taxes |  | $                        | 293   |      | $ | 233   |  | $ | 683  



The following
represents a supplemental schedule of non-cash investing and financing activities:



|                                                                    |  |   |        |  |   |     |  |   |    
|------------------------------------------------------------------- |  | - | ------ |  | - | --- |  | - | ---
|Company common stock issued in acquisitions                         |  | $ |       |  | $ | 308 |  | $ |   
|Capital lease obligations in connection with property and equipment |  | $ |       |  | $ |    |  | $ | 133
|Common stock issued upon conversion of Plus Cash Notes              |  | $ | 16,303 |  | $ | 231 |  | $ |   



The Company includes
capital lease obligations as part of accrued expenses in the consolidated balance sheets.



89



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Note 16. Quarterly Information (Unaudited)



The following table contains selected unaudited consolidated statement of operations data for each quarter of fiscal years
2004 and 2003. The Company believes that the following information reflects all normal recurring adjustments necessary for a fair presentation of the information for the periods presented. The operating results for any quarter are not necessarily
indicative of results to be expected for any future period.



|                                                                                                                           |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | -------------- | - | ------- | ------------- |  | - | -------------- | - |  | --------- | ------- | - |  | - | ------- | -
|                                                                                                                           |  | First Quarter |         |   | Second Quarter |   |         | Third Quarter |  |   | Fourth Quarter |   |  | Full Year |        
|Year ended December 31, 2004                                                                                               |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|Net revenues                                                                                                               |  | $             | 8,205   |   |                | $ | 8,687   |               |  | $ | 8,348          |   |  | $         | 8,447   |   |  | $ | 33,687  |  
|Cost of revenues                                                                                                           |  |               | 2,146   |   |                |   | 2,404   |               |  |   | 2,500          |   |  |           | 2,719   |   |  |   | 9,769   |  
|Cost of revenuesprovision for excess and obsolete inventories                                                             |  |               |        |   |                |   |        |               |  |   | 571            |   |  |           |        |   |  |   | 571     |  
|                                                                                                                           |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|Gross profit                                                                                                               |  |               | 6,059   |   |                |   | 6,283   |               |  |   | 5,277          |   |  |           | 5,728   |   |  |   | 23,347  |  
|Loss before extraordinary loss and cumulative effect of adoption of and changes in accounting principle                    |  |               | (14,987 | ) |                |   | (7,173  | )             |  |   | (8,254         | ) |  |           | (13,933 | ) |  |   | (44,347 | )
|Net loss                                                                                                                   |  |               | (15,264 | ) |                |   | (7,173  | )             |  |   | (8,254         | ) |  |           | (13,933 | ) |  |   | (44,624 | )
|Net loss and cumulative effect of adoption of and changes in accounting principle(1):                                      |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|Basic                                                                                                                      |  |               | (0.17   | ) |                |   | (0.08   | )             |  |   | (0.09          | ) |  |           | (0.13   | ) |  |   | (0.47   | )
|Diluted                                                                                                                    |  |               | (0.17   | ) |                |   | (0.08   | )             |  |   | (0.09          | ) |  |           | (0.13   | ) |  |   | (0.47   | )
|Net loss per common share(1):                                                                                              |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|Basic                                                                                                                      |  |               | (0.17   | ) |                |   | (0.08   | )             |  |   | (0.09          | ) |  |           | (0.13   | ) |  |   | (0.47   | )
|Diluted                                                                                                                    |  |               | (0.17   | ) |                |   | (0.08   | )             |  |   | (0.09          | ) |  |           | (0.13   | ) |  |   | (0.47   | )
|Year ended December 31, 2003                                                                                               |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|Net revenues                                                                                                               |  | $             | 4,098   |   |                | $ | 6,607   |               |  | $ | 5,685          |   |  | $         | 7,430   |   |  | $ | 23,820  |  
|Cost of revenues                                                                                                           |  |               | 1,340   |   |                |   | 1,772   |               |  |   | 1,612          |   |  |           | 1,695   |   |  |   | 6,419   |  
|Cost of revenuesprovision for excess and obsolete inventories                                                             |  |               |        |   |                |   | 1,498   |               |  |   |               |   |  |           |        |   |  |   | 1,498   |  
|                                                                                                                           |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|Gross profit                                                                                                               |  |               | 2,758   |   |                |   | 3,337   |               |  |   | 4,073          |   |  |           | 5,735   |   |  |   | 15,903  |  
|(Loss) income before extraordinary loss and cumulative effect of a change in accounting principle                          |  |               | (16,552 | ) |                |   | (12,561 | )             |  |   | 2,620          |   |  |           | (11,199 | ) |  |   | (37,692 | )
|Net (loss) income                                                                                                          |  | $             | (17,440 | ) |                | $ | (12,561 | )             |  | $ | 2,620          |   |  | $         | (11,199 | ) |  | $ | (38,580 | )
|Net (loss) income per common share before extraordinary loss and cumulative effect of a change in accounting principle(1): |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|Basic                                                                                                                      |  | $             | (0.18   | ) |                | $ | (0.14   | )             |  | $ | 0.03           |   |  | $         | (0.12   | ) |  | $ | (0.42   | )
|Diluted                                                                                                                    |  | $             | (0.18   | ) |                | $ | (0.14   | )             |  | $ | 0.03           |   |  | $         | (0.12   | ) |  | $ | (0.42   | )
|Net (loss) income per common share(1):                                                                                     |  |               |         |   |                |   |         |               |  |   |                |   |  |           |         |   |  |   |         |  
|Basic                                                                                                                      |  | $             | (0.19   | ) |                | $ | (0.14   | )             |  | $ | 0.03           |   |  | $         | (0.12   | ) |  | $ | (0.43   | )
|Diluted                                                                                                                    |  | $             | (0.19   | ) |                | $ | (0.14   | )             |  | $ | 0.03           |   |  | $         | (0.12   | ) |  | $ | (0.43   | )

---

|(1) | The sum of quarterly per share amounts may not equal per share amounts reported for year-to-date periods. This is due to changes in the number of weighted average shares outstanding
and the effects of rounding for each period.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



90



---

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(Tabular dollars in thousands, except share and per
share amounts)



Note 17. Fourth Quarter



In the fourth quarter of 2004, the Company recorded a number of non-cash items, which impacted its operating results. These
items included: (1) a loss of $1.7 million reflecting the write-off of the unamortized debt discount associated with the exchange of $11.5 million face value of the Plus Cash Notes that were exchanged for approximately 8.9 million shares of common
stock, (2) interest expense of approximately $1.3 million relating to the on-going amortization of the debt discount related to the Plus Cash Notes, (3) restructuring charges totaling approximately $0.8 million resulting from the Companys
disengagement from Easics N.V., the deconsolidation of OptiX and asset impairments; and (5) other expense of approximately $0.7 million to reflect the change in the fair value of the derivative liability relating to the Plus Cash Notes. Refer also
to Note 1Summary of Significant Accounting Policies, Note 12Convertible Notes, Note 13Restructuring and Asset Impairment Charges and Note 16Quarterly Information. (unaudited)



Note 18. Related Party Transactions



In 2003, the Company entered into an agreement with OptiX under which OptiX
agreed to provide subcontracting services to the Company. As a result of this agreement, the Company paid OptiX approximately $1.7 million and $1.0 million for these subcontracting services in 2004 and 2003, respectively. In 2004, the effect of
these transactions was eliminated in the consolidated financial statements as required under FIN 46R.



Note 19. Subsequent Event



On January 17, 2005, the Company announced that it had implemented an organizational restructuring that included the elimination of 26 positions, representing approximately 10% of the Companys workforce. Most of the positions
eliminated were based in the Companys Shelton and Boston locations. As a result, the Company expects to record a restructuring charge related to severance of approximately $1.0 million in the quarter ending March 31, 2005, and anticipates the
restructuring to be substantially completed by the end of the first quarter, 2005.



91



---

SCHEDULE II



TRANSWITCH
CORPORATION



VALUATION AND QUALIFYING ACCOUNTS

(in thousands)



|                                               |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|---------------------------------------------- |  | ---------------------------- | ------- | --------------------------- | - | ------------------------- |  | - | ---------- | - |  | ---------------------- | ------ | - |  | - | -------
|                                               |  |                              |         | Additions                   |   |                           |  |   |            |  
|Description                                    |  | Balance at Beginning of Year |         | Charges toCosts andExpenses |   | Charges to Other Accounts |  |   | Deductions |   |  | Balance at End of Year
|Year ended December 31, 2004:                  |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|Allowance for losses on:                       |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|Accounts receivable                            |  | $                            | 462     |                             | $ | 309                       |  | $ |           |   |  | $                      | (40    | ) |  | $ | 731    
|Inventories(1)                                 |  |                              |        |                             |   | 571                       |  |   |           |   |  |                        | (571   | ) |  |   |       
|Sales returns and allowance                    |  |                              | 694     |                             |   | 201                       |  |   |           |   |  |                        | (498   | ) |  |   | 397    
|Stock rotation                                 |  |                              | 978     |                             |   | 832                       |  |   |           |   |  |                        | (1,139 | ) |  |   | 671    
|Warranty                                       |  |                              | 261     |                             |   | 7                         |  |   |           |   |  |                        |       |   |  |   | 268    
|Deferred income tax assets valuation allowance |  |                              | 114,071 |                             |   | 18,770                    |  |   |           |   |  |                        |       |   |  |   | 132,841
|                                               |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|                                               |  | $                            | 116,466 |                             | $ | 20,690                    |  | $ |            |   |  | $                      | (2,248 | ) |  | $ | 134,908
|                                               |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|Year ended December 31, 2003:                  |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|Allowance for losses on:                       |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|Accounts receivable                            |  | $                            | 452     |                             | $ | 150                       |  | $ |           |   |  | $                      | (140   | ) |  | $ | 462    
|Inventories(1)                                 |  |                              |        |                             |   | 1,498                     |  |   |           |   |  |                        | (1,498 | ) |  |   |       
|Sales returns and allowance                    |  |                              | 969     |                             |   | 485                       |  |   |           |   |  |                        | (760   | ) |  |   | 694    
|Stock rotation                                 |  |                              | 510     |                             |   | 1,309                     |  |   |           |   |  |                        | (841   | ) |  |   | 978    
|Warranty                                       |  |                              | 226     |                             |   | 313                       |  |   |           |   |  |                        | (278   | ) |  |   | 261    
|Deferred income tax assets valuation allowance |  |                              | 97,359  |                             |   | 16,712                    |  |   |           |   |  |                        |       |   |  |   | 114,071
|                                               |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|                                               |  | $                            | 99,516  |                             | $ | 20,467                    |  | $ |           |   |  | $                      | (3,517 | ) |  | $ | 116,466
|                                               |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|Year ended December 31, 2002:                  |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|Allowance for losses on:                       |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|Accounts receivable                            |  | $                            | 1,601   |                             | $ |                          |  | $ | (49        | ) |  | $                      | (1,100 | ) |  | $ | 452    
|Inventories(1)                                 |  |                              |        |                             |   | 4,832                     |  |   |           |   |  |                        | (4,832 | ) |  |   |       
|Sales returns and allowance                    |  |                              | 1,900   |                             |   |                          |  |   |           |   |  |                        | (931   | ) |  |   | 969    
|Stock rotation                                 |  |                              | 400     |                             |   | 789                       |  |   |           |   |  |                        | (679   | ) |  |   | 510    
|Warranty                                       |  |                              | 150     |                             |   | 27                        |  |   | 49         |   |  |                        |       |   |  |   | 226    
|Deferred income tax assets valuation allowance |  |                              | 12,289  |                             |   | 85,070                    |  |   |           |   |  |                        |       |   |  |   | 97,359 
|                                               |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        
|                                               |  | $                            | 16,340  |                             | $ | 90,718                    |  | $ |           |   |  | $                      | (7,542 | ) |  | $ | 99,516 
|                                               |  |                              |         |                             |   |                           |  |   |            |   |  |                        |        |   |  |   |        

---

|(1) | During the fiscal years ended December 31, 2004, 2003 and 2002, the Company recorded charges to its inventory position for inventories, which were determined to be excess and
obsolete. Refer to Note 6Inventories in the Consolidated Financial Statements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



92



---

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



Not applicable.



Item 9A.Controls and Procedures



Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures



Under the supervision and with the participation of our
management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act
of 1934, as amended (the Exchange Act). Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this
annual report.



Managements Report on Internal Control Over Financial
Reporting



Our management is responsible for establishing
and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal
financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of
the Treadway Commission. Based on our evaluation under the framework in Internal ControlIntegrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2004.



Our managements assessment of the effectiveness of our internal
control over financial reporting as of December 31, 2004 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.



Changes in Internal Control Over Financial Reporting



No change in our internal control over financial reporting occurred during
the fiscal quarter ended December 31, 2004, that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



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PART III



Item 10.Directors and Executive Officers of the Registrant.



Information with respect to directors, the Audit Committee of the Board of Directors, Audit Committee financial experts and
named executive officers is incorporated herein by reference to the section entitled Proposal No. 1 Election of Directors, Audit and Finance Committee Report and Compensation and Other Information Concerning Named
Executive Officers, respectively, contained in our definitive proxy statement for the annual meeting of shareholders of the Company to be held on May 19, 2005 which is to be filed with the Securities and Exchange Commission not later than 120
days after the close of the fiscal year ended December 31, 2004. Information concerning Section 16(a) compliance is incorporated by reference to the section of our definitive proxy statement entitled Section 16(a) Beneficial Ownership
Reporting Compliance.



The Company has a code of ethics
that applies to all its directors, officers, employees and representatives. This code is publicly available at the investor relations section of the Companys website located athttp://www.transwitch.com. Amendments to the code of ethics
and any grant of a waiver from a provision of the code requiring disclosure under applicable SEC rules will be disclosed within the investor relations section of the Companys website located at http://www.transwitch.com. The
Companys corporate governance principles and the charters of its Board of Directors Audit and Finance Committee, Nominations and Corporate Governance Committee and Compensation Committee are available at the investor relations section of
the Companys website at http://www.transwitch.com. These materials may also be requested in print by writing to the Companys Investor Relations department at TranSwitch Corporation, Attention: Investor Relations, Three Enterprise
Drive, Shelton, CT 06484.



Item 11.Executive
Compensation.



Information with respect to
executive compensation is incorporated herein by reference to the section entitled Compensation and Other Information Concerning Named Executive Officers contained in our definitive proxy statement to be filed with the Securities and
Exchange Commission not later than 120 days after the close of the fiscal year ended December 31, 2004.



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



Information regarding security ownership of certain
beneficial owners, directors and executive officers is incorporated herein by reference to the information in the section entitled Security Ownership of Certain Beneficial Owners and Management, Related Party Transactions and
Indemnification Matters contained in our definitive proxy statement for the annual meeting of shareholders of the Company to be held on May 19, 2005 which is to be filed with the Securities and Exchange Commission not later than 120 days
after the close of the fiscal year ended December 31, 2004.



Item 13.Certain Relationships and Related Transactions.



Information regarding certain relationships and related transactions of the Company is incorporated herein by reference to the sections entitled Compensation Committee Interlocks and Insider Participation
and Related Party Transactions contained in our definitive proxy statement for the annual meeting of shareholders of the Company to be held on May 19, 2005 which is to be filed with the Securities and Exchange Commission not later than
120 days after the close of the fiscal year ended December 31, 2004.



Item
14.Principal Accountant Fees and Services.



Information regarding principal accountant fees and services is incorporated herein by reference to the section entitled, under the headings Information about the Corporations Independent Auditors contained in our



94



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definitive proxy statement for the annual meeting of shareholders of the Company to be held on May 19, 2005 which is to be filed with the Securities and
Exchange Commission not later than 120 days after the close of the fiscal year ended December 31, 2004.



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



(a)(1)The following financial statements of TranSwitch Corporation are filed as part of this Form 10-K under Item 8 Financial
Statements and Supplementary Data:



|                                                                                                                 |  |     
|---------------------------------------------------------------------------------------------------------------- |  | ----
|Financial Statement                                                                                              |  | Page
|Consolidated Balance SheetsDecember 31, 2004 and 2003                                                           |  | 60  
|Consolidated Statements of OperationsDecember 31, 2004, 2003 and 2002                                           |  | 61  
|Consolidated Statements of Stockholders Equity and Comprehensive Income (Loss)December 31, 2004, 2003 and 2002 |  | 62  
|Consolidated Statements of Cash FlowsDecember 31, 2004, 2003 and 2002                                           |  | 63  
|Notes to Consolidated Financial Statements                                                                       |  | 64  
|Schedule II                                                                                                      |  | 92  



(a)(2)All
other schedules are omitted because they are either not applicable, not required or because the information is presented in the Consolidated Financial Statements and Financial Statement Schedule or the notes thereto.



(a) (3) Exhibits



|    |  |                                                                                                                                                                                                                                                                                                                                                                                    
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1 |  | Amended and Restated Certificate of Incorporation, as amended to date (previously filed as Exhibit 3.1 to TranSwitchs quarterly report on Form 10Q for the quarter ended September 30,
2001 and incorporated herein by reference).                                                                                                                                                
|    | 
|3.2 |  | By-Laws, as amended and restated, (previously filed as Exhibit 3.2 to TranSwitchs annual report on Form 10-K for the fiscal year ended December 31, 2001 and incorporated herein by
reference).                                                                                                                                                                                   
|    | 
|4.1 |  | Amended and Restated Certificate of Incorporation, as amended to date (previously filed as Exhibit 3.1 to TranSwitchs quarterly report on Form 10-Q for the quarter ended September 30,
2001 and incorporated herein by reference).                                                                                                                                               
|    | 
|4.2 |  | Specimen certificate representing the common stock of TranSwitch Corporation (previously filed as Exhibit 4.1 to TranSwitchs quarterly report on Form 10-Q for the quarter ended
September 30, 2001 and incorporated herein by reference).                                                                                                                                        
|    | 
|4.3 |  | Rights Agreement, dated as of October 1, 2001, between TranSwitch Corporation and EquiServe Trust Company, N.A., which includes the form of Rights Certificate and the Summary of Rights to
Purchase Preferred Shares (previously filed as Exhibit 1 to TranSwitchs Registration Statement No. 0-25996 on Form 8-A filed on October 2, 2001 and incorporated by reference herein).
|    | 
|4.4 |  | Indenture, by and between TranSwitch Corporation and State Street Bank and Trust Company, as trustee, relating to TranSwitch Corporations 41⁄2% Convertible Notes, due September 12,
2005, dated September 12, 2000, (previously filed as Exhibit 4.1 to TranSwitch Corporations Registration Statement on Form S-3 (Registration No. 333-49980).                                  
|    | 
|4.5 |  | Form of 41⁄2% Convertible Note due September 12, 2005 (previously filed as Exhibit A to Exhibit 4.6 to TranSwitch Corporations Registration Statement on Form S-3 (Registration No.
333-105332) and Form S-4 (Registration No. 333-105330).                                                                                                                                         



95



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|      |  |                                                                                                                                                                                                                                                                                                                                                                                                      
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|4.6   |  | Indenture, by and between TranSwitch Corporation and U.S. Bank National Association, as trustee, relating to TranSwitch Corporations 5.45% Convertible Plus Cash Notessmdue September 30, 2007, dated September 30, 2003 (previously filed as Exhibit 10.1 to TranSwitch Corporations quarterly
report on Form 10-Q for the quarter ended September 30, 2003 and incorporated herein by reference).
|      | 
|4.7   |  | Revised Form of 5.45% Convertible Plus Cash Note due September 30, 2007 (previously filed as Exhibit A to Exhibit 4.2 to TranSwitch Corporations Registration Statement on Form S-3
(Registration No. 333-105332) and Form S-4 (Registration No. 333-105330).                                                                                                                                       
|      | 
|10.1  |  | Third Amended and Restated 1995 Stock Option Plan, as amended (previously filed as an exhibit to the TranSwitchs Definitive Proxy Statement on Schedule 14A dated April 26, 1999 and
incorporated herein by reference).*                                                                                                                                                                            
|      | 
|10.2  |  | 1995 Non-Employee Director Stock Option Plan, as amended (previously filed as Exhibit 4.4 to the TranSwitchs Registration Statement on Form S-8 (File No. 333-89798) and incorporated
herein by reference).*                                                                                                                                                                                        
|      | 
|10.3  |  | Form of Incentive Stock Option Agreement under the 1995 Stock Plan (previously filed as an exhibit to the TranSwitchs Registration Statement on Form S-8 (File No. 33-94234) and
incorporated herein by reference).                                                                                                                                                                                 
|      | 
|10.4  |  | Form of Non-Qualified Stock Option Agreement under the 1995 Stock Plan (previously filed as an exhibit to the TranSwitchs Registration Statement on Form S-8 (File No. 33-94234) and
incorporated herein by reference).                                                                                                                                                                             
|      | 
|10.5  |  | Form of Non-Qualified Stock Option Agreement under the 1995 Non-Employee Director Stock Option Plan (previously filed as an exhibit to the TranSwitchs Registration Statement on Form S-8
(File No. 33-94234) and incorporated herein by reference).                                                                                                                                                
|      | 
|10.6  |  | Lease Agreement, as amended, with Robert D. Scinto (previously filed as Exhibit 10.14 to the TranSwitchs Annual Report on Form 10-K for the fiscal year ended December 31, 1997 and
incorporated herein by reference).                                                                                                                                                                              
|      | 
|10.7  |  | 2000 Stock Option Plan (previously filed as Exhibit 4.2 to TranSwitchs Registration Statement on Form S-8 (File No. 333-75800) and incorporated by reference herein).*                                                                                                                                                                                                                              
|      | 
|10.8  |  | Form of Non-Qualified Stock Option Agreement under the 2000 Stock Option Plan (previously filed as Exhibit 4.3 to TranSwitchs Registration Statement on Form S-8 (File No. 333-75800) and
incorporated by reference herein).                                                                                                                                                                        
|      | 
|10.9  |  | 1999 Stock Incentive Plan of Onex Communications Corporation (previously filed as Exhibit 4.2 to TranSwitchs Registration Statement on Form S-8 (File No. 333-70344) and incorporated by
reference herein).                                                                                                                                                                                         
|      | 
|10.10 |  | Form of Incentive Stock Option Agreement under the 1999 Stock Incentive Plan of Onex Communications Corporation (previously filed as Exhibit 4.3 to TranSwitchs Registration Statement on
Form S-8 (File No. 333-70344) and incorporated by reference herein).                                                                                                                                      
|      | 
|10.11 |  | Dealer Manager Agreement, by and between TranSwitch Corporation and U.S. Bancorp Piper Jaffray, dated August 27, 2003 (previously filed as Exhibit 10.1 to TranSwitch Corporations
quarterly report on Form 10-Q for the quarter ended September 30, 2003 and incorporated herein by reference).                                                                                                    
|      | 
|10.12 |  | Placement Agreement, by and between TranSwitch Corporation and U.S. Bancorp Piper Jaffray, dated August 27, 2003 (previously filed as Exhibit 10.2 to TranSwitch Corporations quarterly
report on Form 10-Q for the quarter ended September 30, 2003 and incorporated herein by reference.                                                                                                          
|      | 
|11.1  |  | Computation of Loss Per Share (filed herewith).                                                                                                                                                                                                                                                                                                                                                      
|      | 
|12.1  |  | Computation of Ratio of Earnings to Fixed Charges (filed herewith).                                                                                                                                                                                                                                                                                                                                  



96



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|     |  |                                                                                                                                                                                               
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|21.1 |  | Subsidiaries of the Company (filed herewith).                                                                                                                                                 
|     | 
|23.1 |  | Consent of KPMG LLP (filed herewith).                                                                                                                                                         
|     | 
|31.1 |  | CEO Certification pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|     | 
|31.2 |  | CFO Certification pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|     | 
|32.1 |  | CEO Certification pursuant to Rule 13a-14(b) and Rule 15d-14(b) of the Securities Exchange Act of 1934, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|     | 
|32.2 |  | CFO Certification pursuant to Rule 13a-14(b) and Rule 15d-14(b) of the Securities Exchange Act of 1934, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed
herewith).

---

|* | Indicates management contract or compensatory plan, contract or arrangement identified as required in Item 15(a)(3) of Form 10-K
|- | --------------------------------------------------------------------------------------------------------------------------------



(b) Reports on Form 8-K.



On October 18, 2004, the Company filed a Current Report on Form 8-K, dated
October 18, 2004, under Item 2.02, attaching a press release announcing financial results for the third quarter of 2004.



On November 19, 2004, the Company filed a Current Report on Form 8-K, dated November 16, 2004, under Item 2.05, disclosing the finalization of the
Companys plans to disengage from Easics N.V. (Easics), a wholly-owned research and development subsidiary in Belgium.



On November 19, 2004, the Company filed a Current Report on Form 8-K, dated November 18, 2004, under Item 3.02, disclosing the Companys agreement to
issue an aggregate of 8,850,556 shares of the Companys common stock plus approximately $100,000 of cash in lieu of accrued and unpaid interest in exchange for $11.5 million in aggregate original principal amount of the Companys Plus Cash
Notes in separately negotiated transactions.



(c) Exhibits



We hereby file as exhibits to this Form 10-K, those exhibits listed in
Item 15 (a) (3) above.



(d) Financial Statement Schedule



TranSwitch files as a financial statement schedule to this Form 10-K, the
financial statement schedule listed in Item 8 and 15(a) (2) above.



97



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SIGNATURES



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



TRANSWITCH CORPORATIONBy:

/S/    DR. SANTANU
DASDr. Santanu Das Chairman of the Board, President and Chief Executive Officer




March 11, 2005



POWER OF ATTORNEY AND SIGNATURES



We, the undersigned named executive officers and directors
of TranSwitch Corporation, hereby severally constitute and appoint Dr. Santanu Das and Mr. Peter J. Tallian, and each of them singly, our true and lawful attorneys, with full power to them and each of them singly, to sign for us in our names in the
capacities indicated below, all amendments to this report, and generally to do all things in our names and on our behalf in such capacities to enable TranSwitch Corporation to comply with the provisions of the Securities Exchange Act of 1934, as
amended and all requirements of the Securities and Exchange Commission.



Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.



|                                                    |  |                                                                                                           |  |               
|--------------------------------------------------- |  | --------------------------------------------------------------------------------------------------------- |  | --------------
|Name and Signature                                  |  | Title(s)                                                                                                  |  | Date          
|                                                    |  |                                                                                                          
|/S/    DR. SANTANU
DASDr. Santanu
Das               |  | Chairman of the Board, President and Chief Executive Officer (principal executive officer)                |  | March 11, 2005
|                                                    |  |                                                                                                          
|/S/    PETER J.
TALLIANMr. Peter J.
Tallian         |  | Senior Vice President, Chief Financial Officer and Treasurer (principal financial and accounting officer) |  | March 11, 2005
|                                                    |  |                                                                                                          
|/S/    ALFRED F.
BOSCHULTEMr. Alfred F.
Boschulte   |  | Director                                                                                                  |  | March 11, 2005
|                                                    |  |                                                                                                          
|/S/    GERALD F.
MONTRYMr. Gerald F.
Montry         |  | Director                                                                                                  |  | March 11, 2005
|                                                    |  |                                                                                                          
|/S/    JAMES M.
PAGOSMr. James M.
Pagos             |  | Director                                                                                                  |  | March 11, 2005
|                                                    |  |                                                                                                          
|/S/     ALBERT E.
PALADINODr. Albert E.
Paladino    |  | Director                                                                                                  |  | March 11, 2005
|                                                    |  |                                                                                                          
|/S/    ERIK H. VAN DER
KAAYMr. Erik H. van der
Kaay |  | Director                                                                                                  |  | March 11, 2005
|                                                    |  |                                                                                                          
|/S/    HAGEN
HULTZSCHDr. Hagen
Hultzsch             |  | Director                                                                                                  |  | March 11, 2005



98