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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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



For the fiscal year ended December 31, 2005



OR



| ̈ | 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)



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|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|Delaware                                                       |  | 06-1236189                             
|(State or Other Jurisdiction of Incorporation or Organization) |  | (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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act.    Yes ̈No  x



Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act.    Yes ̈No  x



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



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.  x



*Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated
filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):



Large Accelerated Filer ̈Accelerated Filer  x    Non-Accelerated Filer ̈



Indicate by check mark whether
the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



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 $211.8 million. At February 15, 2006, as reported on the Nasdaq National Market, there were 112,722,744 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 2006 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 triple play (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, including wireless networks, 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 recovery, but showed additional fluctuations in demand. In 2005, while overall demand in our markets was essentially flat versus 2004, we saw a shift in demand towards newer
technologies that we introduced into the market in the last two years. 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 remains 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 services such as video
conferencing, broadband audio and telephone is placing an increased burden on existing public network infrastructure.



We are heavily focused on two modes of efficiently transporting data across the existing WAN infrastructure: Digital Subscriber Line (DSL) and Ethernet
over SONET/SDH (EoS). As a result of new technologies such as Fiber to the Home (FTTH), as well 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.



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Since network growth and investment is increasingly driven by data applications rather than voice
traffic, Ethernet, the ubiquitous standard for data networking, is gaining traction in the public network infrastructure. Similarly, 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 wireless 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, enabling such interoperability across the networks.



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 networks).



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. Our core competencies include the ability to understand these
standards and protocols and our experience in designing these specialized VLSI products.



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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 enterprise WANs that support voice and data information exchange
within medium-sized and large enterprises. As a system-on-a-chip innovation leader, our competitive advantages 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 areas 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 2005, the prices for our products ranged from approximately $10 to $400 per device, depending
on technology, volume, complexity and functionality.



Our
product portfolio continued to expand in 2005, 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 2005, we successfully demonstrated several of our new products, including EtherPhast-24, Envoy XE, EtherMap-PDH, Diplomat-A and Diplomat-E. These data-oriented products have continued their design-win momentum during
2005 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 design win activity of our VTXP family of
products, introduced in 2004, we further enhanced 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.



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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 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 XE in 2005.
These products incorporate 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 our 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 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, 2005, 2004 and 2003 (dollar amounts in thousands), respectively:



|                 |  |                             |        |                           |                             |   |                 |                             |                           |  |     |                 |  |                           |        |  |     |  
|---------------- |  | --------------------------- | ------ | ------------------------- | --------------------------- | - | --------------- | --------------------------- | ------------------------- |  | --- | --------------- |  | ------------------------- | ------ |  | --- | -
|                 |  | Year endedDecember 31, 2005 |        |                           | Year endedDecember 31, 2004 |   |                 | Year endedDecember 31, 2003 |                          
|                 |  | ProductRevenues             |        | Percent ofProductRevenues |                             |   | ProductRevenues |                             | Percent ofProductRevenues |  |     | ProductRevenues |  | Percent ofProductRevenues |       
|SONET/SDH        |  | $                           | 19,382 |                           | 59                          | % |                 | $                           | 15,385                    |  | 46  | %               |  | $                         | 11,155 |  | 49  | %
|ATM/IP           |  |                             | 7,228  |                           | 22                          | % |                 |                             | 9,861                     |  | 29  | %               |  |                           | 8,066  |  | 35  | %
|Asynchronous/PDH |  |                             | 6,281  |                           | 19                          | % |                 |                             | 8,235                     |  | 25  | %               |  |                           | 3,749  |  | 16  | %
|                 |  |                             |        |                           |                             |   |                 |                             |                           |  |     |                 |  |                           |        |  |     |  
|Total            |  | $                           | 32,891 |                           | 100                         | % |                 | $                           | 33,481                    |  | 100 | %               |  | $                         | 22,970 |  | 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 Access portion 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



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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
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. It 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



One of our core competencies is 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 VHSIC 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.



Our Envoy and EtherMap products are multi-million gate
devices, which are implemented in 0.18 and 0.13 micron complementary metal oxide semiconductor (CMOS) silicon technologies. They incorporate high speed mixed signal circuitry. Some of these devices are equipped with embedded processors that provide
added functionality through software.



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. 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.



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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 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 flexibility and functionality at a lower cost than
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.



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 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. 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 produce 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.



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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 design 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, 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, 2005, 2004 and 2003, respectively:



|                            |  |                          |   |  |      |   |  |      |  
|--------------------------- |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                            |  | Years ended December 31, |  
|                            |  | 2005                     |   |  | 2004 |   |  | 2003 |  
|Distributors:               |  |                          |   |  |      |   |  |      |  
|Avnet, Inc. (1)             |  | *                        |   |  | 12   | % |  | 12   | %
|Arrow Electronics, Inc. (2) |  | *                        |   |  | 10   | % |  | 11   | %
|Significant Customers:      |  |                          |   |  |      |   |  |      |  
|Siemens AG                  |  | 17                       | % |  | 24   | % |  | 28   | %
|Nortel                      |  | 11                       | % |  | 12   | % |  | *    |  
|Tellabs, Inc. (2)           |  | *                        |   |  | 10   | % |  | 12   | %

---

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



8



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##### Table of Contents

Information on reportable operating segments for each of the last three years is located in Note 7 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, 2005, we had 123 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, 2005, 2004 and 2003 were $21.3 million,
$46.0 million, and $42.0 million, respectively.In the fiscal year ended December 31, 2003, we also expensed $0.5 million of purchased in-process research and development related to the acquisition of ASIC Design Services, Inc. There
were no charges related to purchased in-process research and development during 2005 and 2004.



All development efforts are performed using documented design processes that have been certified to meet the ISO 9001:2000 international standard.Our design tools and environment are continuously reviewed and
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.



Patents and Licenses



Through the end of 2005, we have been issued or became an assignee of 123 presently maintained patents worldwide with an additional 72 patents pending
worldwide. Of that number, we have been assigned 54 presently maintained United States patents, of which two are co-assigned. Among the worldwide patents pending, there were 31 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, France, Germany, United Kingdom, Belgium, Italy, Sweden, Spain, Ireland, Denmark, The
Netherlands, Portugal, Switzerland (includes Liechtenstein), Luxembourg, Finland and Hong Kong. Internationally, there are 25 patents pending in specific countries with an additional 16 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 18 presently maintained trade or service marks in the United States and we have one more trademark registration
awaiting approval. We have also obtained 4 presently maintained trademark registrations under the European Community Trademark (ECT) procedure and have one pending trademark 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 changes 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 products 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,



9



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##### Table of Contents

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 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.



In 2003, the European Union (EU) published its directive to
restrict the use of certain environmentally hazardous substances and defined the requirements for reducing their impact on the environment. This legislation, which becomes effective July 1, 2006, restricts the use of Lead, Mercury, Cadmium,
Hexavalent Chromium, Polybrominated Biphenyls (PBBs) and Polybrominated Diphenyl Ethers (PBDEs), as well as secondary elements defined in the directive. Since early 2003, TranSwitch has been monitoring the activity of the regulatory initiatives for
Lead-free and Green products in compliance with the Restriction of Hazardous Substances (RoHS) legislation defined by the EUs directive. TranSwitch has incorporated these requirements into its product designs and packaging
technology with cooperation from our suppliers. Our first RoHS device became available during 2004 with many other devices currently being offered using environmentally safe materials.



In order to facilitate a smooth transition without any supply disruptions, TranSwitch will offer RoHS compliant devices
while continuing to offer these same devices in packages containing Lead. The RoHS compliant devices are clearly marked with a unique part number and alloy code to help customers maintain quality and follow appropriate manufacturing practices
required by such devices. TranSwitch marks all RoHS devices according to the JEDEC JESD97 specifications. Additionally, all RoHS compliant devices shipped will be accompanied by a Certificate of Compliance guaranteeing conformance to the RoHS
directive.



TranSwitch Corporation, Shelton, Connecticut, is
registered toISO 9001:2000 by TUV Rheinland of North America, Inc.



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 year ended 2003 through the first quarter of 2006. During the fiscal year ended December 31, 2005 and 2004, there were no acquisitions.



|                           |  |               |  |                                     
|-------------------------- |  | ------------- |  | ------------------------------------
|Acquired Company           |  | Date Acquired |  | Technology / Skill Acquired         
|Mysticom, Ltd.             |  | January 2006  |  | Analog/Mixed signal design resources
|                           |  |              
|ASIC Design Services, Inc. |  | August 2003   |  | SONET/SDH design resources          



10



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##### Table of Contents

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 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. We account for
this investment under the cost method and made our initial investment in April 2004. During the second quarter of 2005, we made the decision to no longer provide additional funding to Metanoia. Subsequent to that decision, we determined that our
investment in Metanoia preferred stock and the bridge loan receivable from Metanoia were impaired. In making this evaluation, we considered changes during the period in Metanoias operations and financial condition. As a result of our
evaluation, we recorded an impairment charge of $1.5 million.



Opulan Technologies Corporationis 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.



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:



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



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



| |  |  | 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.



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 recovery, but showed additional fluctuations in
demand. In 2005, while overall demand in our markets was essentially flat versus 2004, we saw a shifting in demand towards newer technologies that we introduced into the market in the last two years. 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.



11



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##### Table of Contents

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 five 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, 2005 our backlog was $9.2 million, as compared to $7.1 million as of December 31, 2004. Backlog
represents firm orders anticipated to be shipped within the next 12 months. Our business and, to a 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 indicative of future revenues.



Employees



At December 31, 2005, we had 198 full time employees, including 123 in research and development, 45 in marketing and
sales, 16 in operations and quality assurance, and 14 in administration. We have no collective bargaining agreements. We have never experienced any work stoppage and we believe our employee relations are good.



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.



You may read and copy any document we file at the SECs public reference room located at: Headquarters Office, 100F Street N.E., Room 1580,
Washington, DC 20549. You can request copies of these documents by writing to the Public Reference Section of the SEC, 100F Street N.E., Room 1580, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. Our SEC filings are also available at
the SECs website at http://www.sec.gov. This website address is included in this document as an inactive textual reference only.



Item 1A.Risk Factors



Factors that may affect future results are provided in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
beginning on Page 33.



Item 1B.Unresolved Staff
Comments



Not applicable.



12



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##### Table of Contents

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(2)     |  | Product Development                                                                            |  | 10,572        |  | February 2007         
|Bedford, Massachusetts         |  | Product Development                                                                            |  | 10,053        |  | September 2007        
|San Jose, California           |  | Sales and Sales Support                                                                        |  | 2,535         |  | September 2006        
|South Brunswick, New Jersey(3) |  | Product Development                                                                            |  | 6,786         |  | June 2006             
|Toulouse, France               |  | Product Development                                                                            |  | 4,200         |  | December 2007         
|Eclubens, Switzerland(4)       |  | Product Development                                                                            |  | 9,061         |  | April 2006            
|Taipei, Taiwan                 |  | Sales Support                                                                                  |  | 2,500         |  | Less than 1 Year      
|New Delhi, India               |  | Product Development                                                                            |  | 20,000        |  | June 2006May 2007    
|Antony, France                 |  | Sales and Sales Support                                                                        |  | 355           |  | Less than 1 Year      
|Herzelia, Israel               |  | Sales and Sales Support                                                                        |  | 248           |  | Less than 1 Year      

---

Notes



Refer to Note 13Commitments and Contingencies of our Consolidated Financial Statements
for additional disclosures regarding our commitments under lease obligations.Also, refer to Note 12Restructuring and Asset Impairment Charges in our Consolidated Financial Statements regarding our restructuring charges during fiscal
years 2003 through 2005 as we have recorded charges for future rent payments relating to excess office space.



|(1) | Of the space being leased in Shelton, Connecticut, approximately 116,373 feet is considered excess for which we have taken restructuring charges in 2005, 2004, 2003, 2002 and 2001.
Approximately 115,521 square feet of this space is currently being sublet.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | 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.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | 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 12Restructuring and Asset Impairment Charges in our Consolidated Financial Statements.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Approximately 8,100 square feet of this space is currently being sublet.
|--- | ------------------------------------------------------------------------



Item 3.Legal Proceedings



We are not party to any material litigation proceedings.



We were 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. We initially asserted that Galazar Networks, Inc. (Galazar) infringed three of our United States patents, and Galazar counterclaimed alleging that those three patents are not infringed, are
invalid and are unenforceable, and counterclaimed alleging unfair competition. We were allowed to replace the patent infringement counts with a count for false advertising and unfair competition, Galazars patent counterclaims were dismissed,
and Galazar added counterclaims for antitrust law violation and several state law violations. On November 4, 2005, TranSwitch and Galazar announced an agreement to settle this litigation. Under the confidential settlement agreement, all
outstanding claims and counterclaims in this action were dismissed without prejudice.



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 our operations.



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, 2005.



13



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##### Table of Contents

PART II



Item 5.Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities



Our common stock is traded under the symbol TXCC 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, 2005 |  |      |      |     |   |     
|First Quarter                |  | $    | 1.46 |     | $ | 1.10
|Second Quarter               |  | $    | 2.50 |     | $ | 1.20
|Third Quarter                |  | $    | 2.20 |     | $ | 1.49
|Fourth Quarter               |  | $    | 1.83 |     | $ | 1.31
|                             |  |     
|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



As of January 31,
2006 there were approximately 515 holders of record and approximately 23,159 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, 2005
with respect to shares of our common stock that may be issued under our existing equity compensation plans, including our 1995 Fourth 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 2005 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 to beIssued uponExercise ofOutstandingOptions |     |  | WeightedAverageExercise Priceof OutstandingOptions |       |     | Number of SecuritiesRemaining Availablefor Future IssuanceUnder EquityCompensation Plans (excludingSecurities reflectedin Column (a))
|                                                           |  | (a)                                                               |     |  | (b)                                                |       |     | (c)                                                                                                                                  
|Equity Compensation Plans Approved by Stockholders (1)     |  | 18,653,469                                                        | (3) |  | $                                                  | 7.07  | (3) |                                                                                                                                       | 3,013,602
|Equity Compensation Plans Not Approved by Stockholders (2) |  | 6,787,625                                                         |     |  | $                                                  | 10.91 |     |                                                                                                                                       | 2,295,163
|                                                           |  |                                                                   |     |  |                                                    |       |     |                                                                                                                                       |          
|Total                                                      |  | 25,441,094                                                        |     |  | $                                                  | 8.09  |     |                                                                                                                                       | 5,308,765
|                                                           |  |                                                                   |     |  |                                                    |       |     |                                                                                                                                       |          

---

|(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.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Excludes purchase rights accruing under the Purchase Plan which has a stockholder-approved reserve of 1,000,000 shares. Under the Purchase Plan, each eligible employee is able to
purchase up to 1,000 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.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

Repurchases of Equity Securities



On September 30, 2003, we issued $98.0 million in aggregate original principal amount of our Plus Cash Notes. During
the twelve months ended December 31, 2005, we issued an aggregate of 4,186,534 shares of our common stock plus approximately $19.2 million cash in lieu of accrued and unpaid interest in exchange for $25.7 million in aggregate original principal
amount of our 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.



15



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##### Table of Contents

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.



|                                                                                                                            |  |                                                            |         |   |      |   |         |      |  |   |         |   |  |      |          |   |  |   |          |  
|--------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | -------- | - |  | - | -------- | -
|                                                                                                                            |  | Years ended December 31,                                   |        
|                                                                                                                            |  | 2005                                                       |         |   | 2004 |   |         | 2003 |  |   | 2002    |   |  | 2001 |         
|                                                                                                                            |  | (Amounts presented in thousands, except per share amounts) |        
|Selected Statements of Operations Data:                                                                                     |  |                                                            |         |   |      |   |         |      |  |   |         |   |  |      |          |   |  |   |          |  
|                                                                                                                            |  |                                                            |         |   |     
|Net revenues                                                                                                                |  | $                                                          | 32,900  |   |      | $ | 33,687  |      |  | $ | 23,820  |   |  | $    | 16,636   |   |  | $ | 58,682   |  
|                                                                                                                            |  |                                                            |         |   |     
|Gross profit (loss)                                                                                                         |  |                                                            | 23,984  |   |      |   | 23,347  |      |  |   | 15,903  |   |  |      | 5,857    |   |  |   | (1,799   | )
|Operating loss                                                                                                              |  |                                                            | (14,662 | ) |      |   | (43,049 | )    |  |   | (45,739 | ) |  |      | (134,034 | ) |  |   | (141,015 | )
|Loss before extraordinary loss and cumulative effect of adoption of and changes in accounting principle (1)                 |  |                                                            | (23,754 | ) |      |   | (44,347 | )    |  |   | (37,692 | ) |  |      | (165,224 | ) |  |   | (79,426  | )
|                                                                                                                            |  |                                                            |         |   |     
|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 (1)(2)                                                                                                             |  | $                                                          | (23,754 | ) |      | $ | (44,624 | )    |  | $ | (38,580 | ) |  | $    | (165,224 | ) |  | $ | (79,426  | )
|                                                                                                                            |  |                                                            |         |   |      |   |         |      |  |   |         |   |  |      |          |   |  |   |          |  
|Basic and diluted loss per common share before extraordinary loss and cumulative effect of a change in accounting principle |  | $                                                          | (0.23   | ) |      | $ | (0.47   | )    |  | $ | (0.42   | ) |  | $    | (1.84    | ) |  | $ | (0.91    | )
|                                                                                                                            |  |                                                            |         |   |     
|Basic and diluted loss per common share                                                                                     |  | $                                                          | (0.23   | ) |      | $ | (0.47   | )    |  | $ | (0.43   | ) |  | $    | (1.84    | ) |  | $ | (0.91    | )
|                                                                                                                            |  |                                                            |         |   |     
|Shares used in calculation of basic and diluted loss per common share                                                       |  |                                                            | 104,779 |   |      |   | 94,638  |      |  |   | 90,406  |   |  |      | 90,037   |   |  |   | 86,904   |  
|                                                                                                                            | 
|                                                                                                                            |  | December 31,                                               |        
|                                                                                                                            |  | 2005                                                       |         |   | 2004 |   |         | 2003 |  |   | 2002    |   |  | 2001 |         
|Selected Balance Sheet Data:                                                                                                |  |                                                            |         |   |      |   |         |      |  |   |         |   |  |      |          |   |  |   |          |  
|Cash, cash equivalents and short-term investments                                                                           |  | $                                                          | 72,702  |   |      | $ | 102,504 |      |  | $ | 152,051 |   |  | $    | 183,647  |   |  | $ | 409,592  |  
|Total current assets                                                                                                        |  |                                                            | 80,822  |   |      |   | 112,475 |      |  |   | 161,485 |   |  |      | 194,513  |   |  |   | 427,303  |  
|Working capital                                                                                                             |  |                                                            | 73,385  |   |      |   | 76,361  |      |  |   | 147,845 |   |  |      | 176,783  |   |  |   | 402,007  |  
|Long-term investments (marketable securities)                                                                               |  |                                                            |        |   |      |   | 32,178  |      |  |   | 27,300  |   |  |      | 21,819   |   |  |   | 26,582   |  
|Total non-current assets                                                                                                    |  |                                                            | 6,004   |   |      |   | 42,233  |      |  |   | 44,821  |   |  |      | 48,840   |   |  |   | 189,061  |  
|Total assets(1)                                                                                                             |  |                                                            | 86,826  |   |      |   | 154,708 |      |  |   | 206,306 |   |  |      | 243,353  |   |  |   | 616,364  |  
|                                                                                                                            |  |                                                            |         |   |     
|4.50% Convertible Notes due 2005                                                                                            |  |                                                            |        |   |      |   | 24,442  |      |  |   |        |   |  |      |         |   |  |   |         |  
|Total current liabilities                                                                                                   |  |                                                            | 7,437   |   |      |   | 36,114  |      |  |   | 13,640  |   |  |      | 17,730   |   |  |   | 25,296   |  
|4.50% Convertible Notes due 2005                                                                                            |  |                                                            |        |   |      |   |        |      |  |   | 24,442  |   |  |      | 114,113  |   |  |   | 314,050  |  
|5.45% Convertible Plus Cash Notessm due 2007, net of debt discount of $5,685, $13,149 and $21,742                           |  |                                                            | 49,102  |   |      |   | 67,370  |      |  |   | 75,866  |   |  |      |         |   |  |   |         |  
|Derivative liability                                                                                                        |  |                                                            | 6,040   |   |      |   | 8,461   |      |  |   | 20,659  |   |  |      |         |   |  |   |         |  
|Total non-current liabilities                                                                                               |  |                                                            | 76,180  |   |      |   | 97,363  |      |  |   | 143,656 |   |  |      | 139,962  |   |  |   | 340,975  |  
|Total stockholders equity (1)                                                                                              |  |                                                            | 3,209   |   |      |   | 21,231  |      |  |   | 49,010  |   |  |      | 85,661   |   |  |   | 250,093  |  
|Book value per share                                                                                                        |  | $                                                          | 0.03    |   |      | $ | 0.21    |      |  | $ | 0.54    |   |  | $    | 0.95     |   |  | $ | 2.75     |  

---

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

|(2) | 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. 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.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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 to supplement the accompanying consolidated financial statements and notes in Item 8 to help provide an understanding of our financial condition, changes in our financial
condition and results of operations. 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.



Results of
operations. This section provides an analysis of our results of operations for the fiscal years ended December 31, 2005, 2004 and 2003. In addition, a brief description is provided of transactions and events that impact the
comparability of the results.



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 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 recovery, but showed additional fluctuations in demand. In 2005, while overall demand in our markets was
essentially flat versus 2004, we saw a shifting in demand towards newer technologies that we introduced into the market in the last two years. Communication service providers,



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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.



For the years ended December 31, 2005 and 2004, our revenues were $32.9 million and $33.7 million, respectively. This is up from revenues of $23.8
million for the fiscal year 2003. We believe that our investment in product development has positioned us to take advantage of a strengthening market.



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 relating to :



| | (1) | recognizing net revenues, cost of revenues and gross profit;
| | --- | ------------------------------------------------------------



| | (2) | estimating the derivative liability associated with our 5.45% Convertible Plus Cash Notessm due 2007;
| | --- | -----------------------------------------------------------------------------------------------------



| | (3) | estimating excess inventories;
| | --- | ------------------------------



| | (4) | estimating restructuring liabilities; and
| | --- | -----------------------------------------



| | (5) | estimating values 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:



Net
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 a reduction to revenue (with a related
liability) to accrue for future price protection. This liability is established based on historical experience, contractually agreed-to provisions and future shipment forecasts. We had established liabilities totaling approximately zero and $0.4
million as of December 31, 2005 and 2004, 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.



We also record, at the time of shipment, a reduction to revenue (with a related liability) 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, 2005, 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 $0.7 million and an inventory asset of $0.1 million for a stock rotation reserve for future estimated returns totaling $0.6 million as of
December 31, 2004. 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.



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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, 2005 and 2004, we had a
warranty liability established in the amounts of $0.1 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, 2005.
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
Notessm due 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 Notessm due 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, 2005, we recorded other income of $2.5 million, of which, $0.1 million and $2.4 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, 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 31,2005 |       | December 31,2004 |   | December 31,2003
|Closing price of our common stock used to value our derivative liability                                                   |  | $                | 1.83  |                  | $ | 1.54             |  | $ | 2.30  
|                                                                                                                           |  |                  |      
|Estimated fair value of Auto-Conversion Make Whole Provision                                                               |  |                  |      |                  |   | 74               |  |   | 2,186 
|                                                                                                                           |  |                  |      
|Estimated fair value of Holders Conversion Right                                                                          |  |                  | 6,040 |                  |   | 8,461            |  |   | 18,473
|                                                                                                                           |  |                  |       |                  |   |                  |  |   |       
|Total Liability                                                                                                            |  | $                | 6,040 |                  | $ | 8,535            |  | $ | 20,659
|                                                                                                                           |  |                  |       |                  |   |                  |  |   |       
|Total change in fair value determined during the years ended December 31, 2005, 2004 and 2003 and recorded as other
income |  | $                | 2,495 |                  | $ | 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, 2005, the estimated fair value of our derivative
liability was $6.0 million, all of which relates to the holders conversion right. The auto-conversion make-whole provision expired on September 30, 2005, thus there is no value to this provision as of December 31, 2005. 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 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 a lattice (trinomial) 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.



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|                                                                                                                                 |  |   |       |    |  |   |       |    |  |   |       |    |  |   |        |  |   |       |   |  |   |        |   |  |   |        |  
|-------------------------------------------------------------------------------------------------------------------------------- |  | - | ----- | -- |  | - | ----- | -- |  | - | ----- | -- |  | - | ------ |  | - | ----- | - |  | - | ------ | - |  | - | ------ | -
|(Tabular dollars in thousands, except per share amounts)                                                                         |  |   |       |    |  |   |       |    |  |   |       |    |  |   |        |  |   |       |   | 
|% change from our actual common stock price of $1.83 as of December 31, 2005                                                     |  |   | (50   | )% |  |   | (25   | )% |  |   | (10   | )% |  |   | Actual |  |   | 10    | % |  |   | 25     | % |  |   | 50     | %
|                                                                                                                                 |  |   |       |    |  |   |       |    |  |   |       |    |  |   |        |  |   |       |   |  |   |        |   |  |   |        |  
|Closing price of our common stock used to value our derivative liability                                                         |  | $ | 0.92  |    |  | $ | 1.37  |    |  | $ | 1.65  |    |  | $ | 1.83   |  | $ | 2.01  |   |  | $ | 2.29   |   |  | $ | 2.75   |  
|                                                                                                                                 |  |   |       |    |  |   |       |    |  |   |       |    |  |   |        |  |   |       |   |  |   |        |   |  |   |        |  
|Estimated fair value of our derivative liability as of December 31, 2005                                                         |  | $ | 1,861 |    |  | $ | 3,770 |    |  | $ | 5,123 |    |  | $ | 6,040  |  | $ | 6,986 |   |  | $ | 8,505  |   |  | $ | 11,092 |  
|                                                                                                                                 |  |   |       |    |  |   |       |    |  |   |       |    |  |   |        |  |   |       |   |  |   |        |   |  |   |        |  
|Change in fair value of our derivative liability determined during the year ended December 31, 2005 and recorded as other
income |  | $ | 6,674 |    |  | $ | 4,765 |    |  | $ | 3,412 |    |  | $ | 2,495  |  | $ | 1,549 |   |  | $ | 30     |   |  | $ | (2,557 | )
|                                                                                                                                 |  |   |       |    |  |   |       |    |  |   |       |    |  |   |        |  |   |       |   |  |   |        |   |  |   |        |  
|Incremental other income (expense) that would have been recorded in the year ended December 31, 2005                             |  | $ | 4,179 |    |  | $ | 2,270 |    |  | $ | 917   |    |  | $ |       |  | $ | (946  | ) |  | $ | (2,465 | ) |  | $ | (5,052 | )
|                                                                                                                                 |  |   |       |    |  |   |       |    |  |   |       |    |  |   |        |  |   |       |   |  |   |        |   |  |   |        |  



As of
December 31, 2005 and 2004, 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.



Estimated Excess 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 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. We recorded charges for excess and obsolete inventories totaling approximately $0.6 million, $0.6 million, $1.5 million, $4.8 million and
$39.2 million during the fiscal years ended December 31, 2005, 2004, 2003, 2002 and 2001 respectively. Most of these products have not been disposed of and remain in our inventory.



During fiscal 2005, 2004 and 2003, we recorded net product revenues of approximately $12.2 million, $10.9 million and $8.7
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 almost 100% gross margin on these product revenues. Had these products been
sold at our historical average cost basis, gross margin would have been 69%, 60% and 56% in 2005, 2004 and 2003 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 Liabilities. During the fiscal
years ended December 31, 2005, 2004 and 2003, we recorded restructuring charges and asset impairments totaling $2.7 million, $1.1 million and $2.5 million, respectively, related to employee termination benefits and costs to exit certain
facilities, net of sub-lease benefits. At December 31, 2005 and 2004, the restructuring liabilities were $21.8 million and $22.6 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.



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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 $1.5 million, $0.1 million and $1.5 million during the fiscal years ended December 31, 2005, 2004 and 2003,
respectively. The total investment in non-public companies was $1.0 million and $2.1 million as of December 31, 2005 and 2004, respectively, on our consolidated balance sheets. (For further discussion, please refer to Note 4. Investments in
Non-Publicly Traded Companies in our Consolidated Financial Statements). 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.



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, |   
|                                               |  | 2005                     |    |  | 2004 |    |  | 2003 |   
|Net revenues                                   |  |                          |    |  |      |    |  |      |   
|Product revenues                               |  | 100                      | %  |  | 99   | %  |  | 96   | % 
|Service revenues                               |  |                         |    |  | 1    | %  |  | 4    | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Total net revenues                             |  | 100                      | %  |  | 100  | %  |  | 100  | % 
|Cost of revenues:                              |  |                          |    |  |      |    |  |      |   
|Product cost of revenues                       |  | 25                       | %  |  | 29   | %  |  | 26   | % 
|Provision for excess and obsolete inventories  |  | 2                        | %  |  | 2    | %  |  | 6    | % 
|Service cost of revenues                       |  |                         |    |  |     |    |  | 1    | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Total cost of revenues                         |  | 27                       | %  |  | 31   | %  |  | 33   | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Gross profit                                   |  | 73                       | %  |  | 69   | %  |  | 67   | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Operating expenses:                            |  |                          |    |  |      |    |  |      |   
|Research and development                       |  | 65                       | %  |  | 137  | %  |  | 176  | % 
|Marketing and sales                            |  | 29                       | %  |  | 37   | %  |  | 46   | % 
|General and administrative                     |  | 15                       | %  |  | 20   | %  |  | 24   | % 
|Restructuring charge and asset impairment, net |  | 8                        | %  |  | 3    | %  |  | 11   | % 
|Purchased in-process research and development  |  |                         |    |  |     |    |  | 2    | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Total operating expenses                       |  | 117                      | %  |  | 197  | %  |  | 259  | % 
|                                               |  |                          |    |  |      |    |  |      |   
|Operating loss                                 |  | (44                      | )% |  | (128 | )% |  | (192 | )%
|                                               |  |                          |    |  |      |    |  |      |   



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##### Table of Contents

Comparison of Fiscal Years 2005 and 2004



Net Revenues. The following tables summarizes our net product revenue mix by product line for the years
ended December 31, 2005 and 2004 (dollar amounts in thousands), respectively:



|                      |  |                             |        |                           |                             |   |                 |                                        |                           |  |     |   |  |     |   
|--------------------- |  | --------------------------- | ------ | ------------------------- | --------------------------- | - | --------------- | -------------------------------------- | ------------------------- |  | --- | - |  | --- | --
|                      |  | Year endedDecember 31, 2005 |        |                           | Year endedDecember 31, 2004 |   |                 | Percentage Increase in ProductRevenues |                          
|                      |  | ProductRevenues             |        | Percent ofProductRevenues |                             |   | ProductRevenues |                                        | Percent ofProductRevenues |  |    
|SONET/SDH             |  | $                           | 19,382 |                           | 59                          | % |                 | $                                      | 15,385                    |  | 46  | % |  | 26  | % 
|ATM/IP                |  |                             | 7,228  |                           | 22                          | % |                 |                                        | 9,861                     |  | 29  | % |  | (27 | )%
|Asynchronous/PDH 6666 |  |                             | 6,281  |                           | 19                          | % |                 |                                        | 8,235                     |  | 25  | % |  | (24 | )%
|                      |  |                             |        |                           |                             |   |                 |                                        |                           |  |     |   |  |     |   
|Total                 |  | $                           | 32,891 |                           | 100                         | % |                 | $                                      | 33,481                    |  | 100 | % |  | (2  | )%
|                      |  |                             |        |                           |                             |   |                 |                                        |                           |  |     |   |  |     |   



The 2% decrease in
revenues for 2005 compared to 2004 reflects decreased volume of our Asynchronous/PDH and ATM/IP products. In particular, sales of our Aspen products were down considerably due to lower demand from our largest customer. Net revenues were positively
impacted by increased sales of our SONET/SDH products, including our ET-3 product.



Included in total net revenues is service revenues (of approximately zero in 2005 and $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, 2005 international net revenues represent approximately 85% of net revenues compared with approximately 73% of net
revenues for the year ended December 31, 2004, reflecting lower U.S. sales and increased sales to Asia.



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, 2005 and 2004, respectively:



|                                         |  |                              |        |   |                             |     |    |  |   |        |   |  |     |   
|---------------------------------------- |  | ---------------------------- | ------ | - | --------------------------- | --- | -- |  | - | ------ | - |  | --- | --
|                                         |  | Year ended December 31, 2005 |        |   | Year endedDecember 31, 2004 |    
|Gross profit  as reported               |  | $                            | 23,984 |   |                             | 73  | %  |  | $ | 23,347 |   |  | 69  | % 
|                                         |  |                              |        |  
|Excess and obsolete inventory charge(1)  |  |                              | 573    |   |                             | 2   | %  |  |   | 571    |   |  | 2   | % 
|                                         |  |                              |        |  
|Excess and obsolete inventory benefit(2) |  |                              | (3,394 | ) |                             | (11 | )% |  |   | (3,803 | ) |  | (11 | )%
|                                         |  |                              |        |   |                             |     |    |  |   |        |   |  |     |   
|Gross profit  as adjusted               |  | $                            | 21,163 |   |                             | 64  | %  |  | $ | 20,115 |   |  | 60  | % 
|                                         |  |                              |        |   |                             |     |    |  |   |        |   |  |     |   

---

|(1) | During the years ended December 31, 2005 and 2004, we recorded a provision for excess and obsolete inventories of approximately $0.6 million and $0.6 million, respectively.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | During the years ended December 31, 2005 and 2004, 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 profit for the year ended
December 31, 2005 as compared to the year ended December 31, 2004 reflects an increase in sales of our newer products, which generally yield a higher margin than our legacy products. These newer products include our EtherMap and aspen
express devices.



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, 2005, research and development expenses decreased $24.8 million, or 54% over the comparable period
of 2004. This decrease reflects the positive impact of restructuring actions taken during 2005 and the second half of 2004. These restructuring actions included closure of our design centers in Belgium and France, workforce reductions in our U.S.
and Swiss design locations, reductions in sub-contracting resources and our disengagement from development stage entities in Israel. In addition, depreciation costs were down $5.9 million from the year ended December 31, 2004, reflecting our
reduced capital spending in recent periods and the wind-down of depreciation of assets purchased in 2001 and 2002.



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We believe that continued investment in the design and development of future products is vital to
maintain a competitive edge. We have closely monitored our known and forecasted revenue demand and operating expense run rates. Furthermore, in 2004, we completed a significant enhancement to our product portfolio which we believe positions us well
with our customer base. As a result, commencing in 2004 and continuing into 2005, we completed the restructuring actions described above. We continue to seek opportunities to focus our research and development activities and will continue to closely
monitor both our costs and our revenue expectations in future periods. We will continue to concentrate our spending in this area to meet our customer requirements and respond to market conditions.



Marketing and Sales. Marketing and sales expenses consist
primarily of personnel-related, trade show, travel and facilities expenses. During the year ended December 31, 2005, marketing and sales expenses decreased $2.9 million, or 23% as compared to the prior year. The decrease is primarily due to
workforce reductions completed in the first quarter of 2005 and the recovery of written-off receivables in the third quarter of 2005.



We have monitored our known and forecasted sales demand and operating expense run rates closely and, as a result, have taken five restructuring actions
since June 2001. We have added resources in those markets, primarily Asia, where we believe customer requirements warrant the additional operating expense. We will continue to closely monitor both our costs and our revenue expectations in future
periods and will take actions as market conditions dictate. There can be no assurances that future acquisitions, market conditions or unforeseen events will not cause our expenses to rise or fall in future periods



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 of approximately $1.7 million, or 25% for the year ended December 31, 2005
compared to the prior year is primarily due to the workforce reductions completed in the first quarter of 2005 and lower professional service fees.



Restructuring Charges and Asset Impairments. We recorded restructuring and impairments charges of $2.7 million and $1.1 million for the
year ended December 31, 2005 and 2004, respectively.



During the third quarter of 2005 we recorded net restructuring charges of approximately $0.2 million related to an organizational restructuring of our Swiss Design center.



In the second quarter of 2005, we conducted a review of certain patent assets that were acquired in our acquisition of Onex
Communications Corporation (Onex) in 2001. The impairment review was conducted because we determined that we no longer had significant sales expectations for the products related to these patents. As such, we determined that these patent assets were
impaired and recorded an impairment charge of $1.0 million in the second quarter of 2005.



In the first quarter of 2005, we recorded restructuring charges totaling approximately $1.5 million resulting from our disengagement from TranSwitch S.A., a wholly owned research and development subsidiary in
Toulouse, France, workforce reductions in our United States locations, as well as related asset impairments and excess facility costs.



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 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.



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. 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.



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##### Table of Contents

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.



We also had approximately $0.1 million of other net restructuring charges
during the year ended December 31, 2004.



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



Impairment of Investments in Non-Publicly Traded Companies. During the years ended December 31, 2005 and 2004, 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 2005 and 2004, we reduced the carrying value of our investments (including bridge loans) in non-publicly traded companies as follows (in thousands):



|                           |  |                           |       |                           |   |    
|-------------------------- |  | ------------------------- | ----- | ------------------------- | - | ---
|                           |  | InvestmentImpairments2005 |       | InvestmentImpairments2004
|Investee company:          |  |                           |       |                           |   |    
|Metanoia Technologies, Inc |  | $                         | 1,450 |                           | $ |   
|Accordion Networks, Inc    |  |                           |      |                           |   | 123
|                           |  |                           |       |                           |   |    
|Total                      |  | $                         | 1,450 |                           | $ | 123
|                           |  |                           |       |                           |   |    



We own convertible
preferred stock of Opulan Networks, Inc, and Metanoia Technologies, Inc. (Metanoia). In addition, we have a 3% limited partnership interest in Neurone II, a venture capital fund organized as a limited partnership. We held an investment in Accordion
Networks, Inc. (Accordion), which ceased operations in 2004. We account for these investments at cost. The financial condition of these companies is subject to significant changes resulting from their operating performance and their ability to
obtain financing. We continually evaluate our investments in these companies for impairment.



The financial condition of these companies is subject to significant changes resulting from their operating performance and their ability to obtain financing. We continually evaluate our investments in these companies
for impairment.



During 2005, we advanced Metanoia $0.2 million
under a bridge loan agreement. During the second quarter, we made the decision to no longer provide additional funding to Metanoia. Subsequent to that decision, we determined that our investment in Metanoia preferred stock and the bridge loan
receivable from Metanoia were impaired. In making this evaluation, we considered changes during the second quarter of 2005 in Metanoias operations and financial condition. As a result of our evaluation, we recorded an impairment charge related
to Metanoia of approximately $1.5 million in the second quarter of 2005.



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.



Equity in Net Losses of Affiliates. In the first quarter of 2004, we adopted of the provisions of FIN 46R. 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.



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##### Table of Contents

Change in Fair Value of the Derivative Liability.For the years ended December 31,
2005 and 2004, we recorded other income of approximately $2.5 million and $12.1 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 11 
Convertible Notes of our Consolidated Financial Statements).



Loss on Extinguishment of Debt.During the year ended December 31, 2005, we issued an aggregate of 4,186,534 shares of our common stock plus approximately $19.2 million cash in exchange for $25.7 million in aggregate
original principal amount of the Plus Cash Notes and accrued interest. During 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. 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, in 2005 and 2004, we recorded losses of approximately $2.5 million and $3.0 million, respectively. The recorded losses reflect the non-cash write-off of
unamortized debt discount and deferred debt issuance costs.



Interest Expense net.Interest expense, net decreased approximately $3.2 million to $7.3 million in 2005, reflecting lower interest expense and higher interest income.



Interest expense decreased from $12.9 million in 2004 to $10.1 million in
2005 due to lower debt balances resulting from the exchanges of the Plus Cash Notes described above, as well as the maturation of our outstanding 4.50% Notes, which we paid in full on September 12, 2005.



Interest income increased from $2.4 million in 2004 to $2.8 million in 2005,
as higher market yields more than offset the impact of lower cash and investment balances. At December 31, 2005 and 2004, the effective interest rates on our interest-bearing securities were approximately 3.28% and 2.22%, respectively



Income Tax Expense. Income tax expense,
representing income taxes incurred by certain of our foreign subsidiaries, was $0.3 million and $0.2 million for the year ended December 31, 2005 and 2004, respectively. We have incurred taxable losses for U.S. federal and state purposes, but
has recognized no corresponding tax benefits in 2005 and 2004, 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, 2005 and 2004.



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, 2005 and 2004, respectively:



|                                            |  |                          |    |  |       |   
|------------------------------------------- |  | ------------------------ | -- |  | ----- | --
|                                            |  | Years ended December 31, |   
|                                            |  | 2005                     |    |  | 2004  |   
|U.S. federal statutory tax rate             |  | (35.0                    | )% |  | (35.0 | )%
|State taxes                                 |  | (5.6                     | )% |  | 6.8   | % 
|Disallowed interest deduction               |  | 6.2                      | %  |  | 3.9   | % 
|Capital loss on sale of subsidiary          |  |                         |    |  | (17.4 | )%
|Change in valuation allowance               |  | 34.9                     | %  |  | 42.5  | % 
|Permanent differences and other adjustments |  | 0.8                      | %  |  | (0.4  | )%
|                                            |  |                          |    |  |       |   
|Effective income tax rate                   |  | 1.3                      | %  |  | 0.4   | % 
|                                            |  |                          |    |  |       |   



Cumulative
Effect on Prior Years of adoption of and Retroactive Application of FIN 46R.



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



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##### Table of Contents

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 12
 Restructuring and Asset Impairment Charges of our Consolidated Financial Statements.



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 endedDecember 31, 2004 |        |                           | Year endedDecember 31, 2003 |   |                 | PercentageIncrease inProductRevenues |                          
|                      |  | ProductRevenues             |        | Percent ofProductRevenues |                             |   | ProductRevenues |                                      | Percent ofProductRevenues |  |    
|SONET/SDH             |  | $                           | 15,385 |                           | 46                          | % |                 | $                                    | 11,155                    |  | 49  | % |  | 38  | %
|ATM/IP                |  |                             | 9,861  |                           | 29                          | % |                 |                                      | 8,066                     |  | 35  | % |  | 22  | %
|Asynchronous/PDH 6666 |  |                             | 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.



Included in total net revenues is service revenues (approximately $0.2 million 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 73% 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 7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 endedDecember 31, 2004 |        |   | Year endedDecember 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.



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##### Table of Contents

Research and Development. 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 our 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.



Marketing and Sales. 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.



General and Administrative. 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.



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 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.



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. As of the
acquisition date, the VTXP chip was still in its initial stages of development. 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. Accordingly, during 2004 and 2003, we reduced the carrying value of our investments (including bridge loans) in non-publicly traded
companies as follows (in thousands):



|                                                           |  |                           |     |                           |   |      
|---------------------------------------------------------- |  | ------------------------- | --- | ------------------------- | - | -----
|                                                           |  | InvestmentImpairments2004 |     | InvestmentImpairments2003
|Investee company:                                          |  |                           |     |                           |   |      
|Intellectual Capital for Integrated Circuits, Inc (IC4IC). |  | $                         |    |                           | $ | 50   
|Accordion Networks, Inc (Accordion)                        |  |                           | 123 |                           |   | 1,495
|                                                           |  |                           |     |                           |   |      
|Total                                                      |  | $                         | 123 |                           | $ | 1,545
|                                                           |  |                           |     |                           |   |      



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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.



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.



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 11  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, 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. 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, we 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. We did not effect any such exchanges during the year ended December 31, 2003.



Interest Expense net. 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. At December 31, 2004 and 2003, the effective interest rates on our interest-bearing securities were
approximately 2.22% and 1.37%, respectively.



Income Tax
Expense. Income tax expense was $0.2 million in both 2004 and 2003, representing income taxes incurred by our foreign subsidiaries. We have 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.



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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. 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, were eliminated upon consolidation. In September 2004, we liquidated our investment in TeraOp
and deconsolidated TeraOp from our financial statements. For further discussion, refer to Note 12  Restructuring and Asset Impairment Charges of our Consolidated Financial Statements.



Cumulative Effect on Prior Years of adoption of and Retroactive
Application of New Depreciation Method.



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.



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LIQUIDITY AND CAPITAL RESOURCES



As of December 31, 2005, we had total cash, cash equivalents and investments in marketable securities of approximately
$72.7 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, 2005 as well as a summary of our cash,
cash equivalents and investments in marketable securities and future commitments are detailed as follows:



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, 2005 consisted of $38.8 million in cash and cash
equivalents and $33.9 million in short-term investments for total cash, cash equivalents and investments of $72.7 million. Cash equivalents are instruments with original maturities of less than 90 days, short-term investments have original
maturities of greater than 90 days but remaining maturities of less than one year and long-term investments have remaining maturities of greater than one year. Our cash equivalents and investments as of December 31, 2005, consist of U.S.
Treasury Bills, corporate debt, taxable municipal securities, money market instruments and overnight repurchase investments.



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, 2005 and 2004 respectively;



|                           |  |                  |        |                  |   |         |  |   |                  |   |                  |   |         |  |   |         |  |   |         |  
|-------------------------- |  | ---------------- | ------ | ---------------- | - | ------- |  | - | ---------------- | - | ---------------- | - | ------- |  | - | ------- |  | - | ------- | -
|                           |  | December 31,2005 |        | December 31,2004 |   | Change  |  |   | December 31,2004 |   | December 31,2003 |   | Change  | 
|Cash and cash equivalents  |  | $                | 38,841 |                  | $ | 17,311  |  | $ | 21,530           |   |                  | $ | 17,311  |  | $ | 102,869 |  | $ | (85,558 | )
|Short term investments     |  |                  | 33,861 |                  |   | 85,193  |  |   | (51,332          | ) |                  |   | 85,193  |  |   | 49,182  |  |   | 36,011  |  
|Long term investments      |  |                  |       |                  |   | 32,178  |  |   | (32,178          | ) |                  |   | 32,178  |  |   | 27,300  |  |   | 4,878   |  
|                           |  |                  |        |                  |   |         |  |   |                  |   |                  |   |         |  |   |         |  |   |         |  
|Total Cash and Investments |  | $                | 72,702 |                  | $ | 134,682 |  | $ | (61,980          | ) |                  | $ | 134,682 |  | $ | 179,351 |  | $ | (44,669 | )
|                           |  |                  |        |                  |   |         |  |   |                  |   |                  |   |         |  |   |         |  |   |         |  



During the year ended
December 31, 2005, the net increase in cash and cash equivalents was $21.5 million compared to a net decrease of $85.6 million during the year ended December 31, 2004. As reported on our consolidated statements of cash flows, our change in
cash and cash equivalents during the years ended December 31, 2005 and 2004 is summarized as follows (in thousands):



|                                                    |  |                          |         |   |      |   |         |  
|--------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | -
|                                                    |  | Years ended December 31, |        
|                                                    |  | 2005                     |         |   | 2004 |  
|Net cash used in operating activities               |  | $                        | (14,385 | ) |      | $ | (39,980 | )
|Net cash provided by (used in) investing activities |  |                          | 79,207  |   |      |   | (45,978 | )
|Net cash (used in) provided by financing activities |  |                          | (42,953 | ) |      |   | 255     |  
|Effect of foreign exchange rate changes             |  |                          | (339    | ) |      |   | 145     |  
|                                                    |  |                          |         |   |      |   |         |  
|Total change in cash and cash equivalents           |  | $                        | 21,530  |   |      | $ | (85,558 | )
|                                                    |  |                          |         |   |      |   |         |  



Details of our cash
inflows and outflows are as follows during the year ended December 31, 2005:



Operating Activities: During the year ended December 31, 2005, we used $14.4 million in cash and cash equivalents in operating activities. This was comprised primarily of our net loss of $23.8 million
and an increase in our working capital of $3.0 million, partially offset by non-cash charges totaling $12.4 million. Components of our significant non-cash adjustments are as follows:



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|                                              |  |                                                    |        |   |                                  |                                                                                                                                                                                                                                       
|--------------------------------------------- |  | -------------------------------------------------- | ------ | - | -------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Non cash adjustments                          |  | Year endedDecember 31, 2005 (amounts in thousands) |        |   | Explanation of non-cash activity
|Depreciation and amortization                 |  | $                                                  | 9,768  |   |                                  | Consists of depreciation of property and equipment as well as amortization of debt discount, deferred financing fees and patents.                                                                                                     
|Change in fair value of derivative liability  |  |                                                    | (2,495 | ) |                                  | In fiscal 2005, we recorded other income to reflect the change in the fair value of our derivative liability.                                                                                                                         
|Impairment of investments                     |  |                                                    | 1,450  |   |                                  | In fiscal 2005, we recorded an impairment charge related to our investment in Metanoia                                                                                                                                                
|Provision for excess and obsolete inventories |  |                                                    | 573    |   |                                  | In fiscal 2005, we recorded charges for excess and obsolete inventories.                                                                                                                                                              
|Loss on extinguishment of debt                |  |                                                    | 2,528  |   |                                  | In fiscal 2005, we issued an aggregate of 4,186,534 shares of our common stock plus approximately $19.2 million cash in exchange for $25.7 million in aggregate original principal amount of
the Plus Cash Notes and accrued interest.
|Other non-cash items, net                     |  |                                                    | 620    |   |                                  | Other non-cash items include items such as adjustments to our restructuring liability, adjustment to the allowance for doubtful accounts and non-cash stock compensation
expense.                                                     
|                                              |  |                                                    |        |   |                                  |                                                                                                                                                                                                                                       
|Total non-cash adjustments to net loss        |  | $                                                  | 12,444 |   |                                  |                                                                                                                                                                                                                                       
|                                              |  |                                                    |        |   |                                  |                                                                                                                                                                                                                                       



Investing
Activities: Cash provided by investing activities was $79.2 million in fiscal 2005 compared with $46.0 million used in 2004. Specific investing activity is as follows:



| |  |  | During the year ended December 31, 2005, we invested approximately $4.0 million in capital equipment and product licenses. This compares to $3.6 million in fiscal 2004.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We invested approximately $0.3 million in non-publicly traded companies during the year ended December 31, 2005, compared to $1.6 million in fiscal 2004.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our net proceeds from short- and long-term investments was approximately $83.5 million during the year ended December 31, 2005 as compared to a net investment of $40.9 million
in fiscal 2004.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Financing
Activities: During the year ended December 31, 2005, net cash used in financing activities was $42.9 million. In September 2005, we paid in full all of our outstanding 4.50% Notes, which matured on September 12, 2005. The
aggregate principal amount of the Notes outstanding was approximately $24.4 million. In October 2005, we entered into an Exchange Agreement providing for the exchange of approximately $25.7 million in aggregate principal amount of out 5.45% Plus
Cash NotesSM due 2007 and accrued interest in exchange for an aggregate of 4,186,534 shares of our common stock plus approximately $19.2 million in cash. These payments were partially offset by approximately $0.7 million of proceeds from the
issuance of common stock under our employee stock plans.



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 plans.



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. 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.



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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 existing 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 Plus Cash Notes, we expect to accrue and pay
approximately $6.0 million in interest to the holders thereof.



We have outstanding operating lease commitments of $37.7 million, payable over the next twelve years. Some of these commitments are for space that is not being utilized and, for which, we recorded restructuring charges of $0.1 million, $0.0
million and $0.5 million during 2005, 2004 and 2003, respectively, for excess facilities. During 2005 and 2004, 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 $0.4 million and $0.1 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, 2005, we have sub-lease agreements totaling $8.2 million in place to rent portions of our excess facilities over the next five 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                  |         | 2006 |   | 2007 &2008 |  | 2009 & 2010 |        | Thereafter
|Interest on convertible notes                                |  | $                      | 5,973   |      | $ | 2,987      |  | $           | 2,986  |            | $ |      |  | $ |      
|Redemption of convertible notes                              |  |                        | 54,797  |      |   |           |  |             | 54,797 |            |   |      |  |   |      
|Operating lease commitments                                  |  |                        | 37,748  |      |   | 4,435      |  |             | 7,606  |            |   | 7,252 |  |   | 18,455
|Purchase obligations                                         |  |                        | 4,968   |      |   | 2,967      |  |             | 2,001  |            |   |      |  |   |      
|Capital lease and other commitments (principal and interest) |  |                        | 9       |      |   | 9          |  |             |       |            |   |      |  |   |      
|                                                             |  |                        |         |      |   |            |  |             |        |            |   |       |  |   |       
|                                                             |  | $                      | 103,495 |      | $ | 10,398     |  | $           | 67,390 |            | $ | 7,252 |  | $ | 18,455
|                                                             |  |                        |         |      |   |            |  |             |        |            |   |       |  |   |       



We also have pledged
approximately $0.6 million in available cash and cash equivalents as collateral for stand-by letters of credit that guarantee certain long-term property lease obligations.



Subsequent Events



On January 31, 2006, we completed our acquisition of Mysticom Ltd. (Mysticom), an Israel-based
privately-held developer of high-performance, low-power, multi-gigabit Ethernet transceivers for the communications industry. We acquired Mysticom through the issuance of approximately $5.0 million of our common stock. Upon the satisfactory
achievement of stipulated revenues and operating cash flows over the next twelve months, we may pay up to an additional $10.0 million in our common stock or cash, at our option. Mysticom will operate as a wholly owned subsidiary of TranSwitch.



On February 1, 2006, we entered into agreements providing
for the exchange of approximately $24.6 million in aggregate principal amount of our 5.45% Plus Cash NotesSM due 2007 (the Plus Cash Notes) and accrued interest for an aggregate of 1,500,000 shares of our common stock, par value $.001
per share plus approximately $22.6 million. The shares 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 these
transactions. We expect to recognize a debt extinguishment loss in the first quarter of 2006 of approximately $3.1 million associated with this exchange. Approximately $2.9 million of this loss relates to the non-cash write-off of unamortized debt
discount and deferred debt issuance costs. This transaction will also reduce the fair value of our outstanding derivative liability associated with the Plus Cash Notes by approximately $2.7 million, which we expect to recognize as other income in
the first quarter of 2006.



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Recent Accounting Pronouncements



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. We will implement Statement 123R as of the beginning
of fiscal year 2006 using the modified prospective method.



SFAS No. 123(R) does not mandate an option-pricing model to be used in determining fair value, but does require that the model selected consider certain variables. Different models would result in different valuations. Regardless of
the method selected, significant judgment is required for some of the valuation variables. The most significant of these is the volatility of our common stock and the estimated term over which our stock options will be outstanding. The valuation
calculation is sensitive to even slight changes in these estimates.



Although there will be no impact to our overall cash flows, the adoption of SFAS No. 123(R) will have a significant impact on our 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.



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, 2005, 2004 and 2003. Due to current economic conditions, we expect that our
net losses will continue to fluctuate in the future and there is no assurance that we will attain positive net earnings in the future.



Our net revenues may continue to fluctuate.



Our net revenues during the years ended December 31, 2005 and 2004, were $32.9 million and $33.7 million respectively. Net revenue for year ended
December 31, 2003 was $23.8 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, 2005, 2004 and 2003, we recorded write-downs for excess inventories totaling $0.6 million, $0.6 million and $1.5 million, respectively.



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We continue to have substantial indebtedness.



As of December 31, 2005, we have approximately $54.8 million in principal amount of indebtedness outstanding in the
form of our 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 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 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, 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 all or a
significant percentage of our Plus Cash Notes are voluntarily or automatically converted in the future, 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, 2005, we had a total net cash and investment usage of $61.6 million, excluding the effect of exchange rate changes. This is a result of $21.9 million of cash and cash
equivalents generated from our operating, investing and financing activities, which included net proceeds of $83.5 million from short- and long-term investments. The total net cash and investment usage of $61.6 million included the payment of $24.4
million to extinguish the remainder of our 2005 convertible debt and $19.2 million as part of the October 2005 exchange of approximately $25.7 million in aggregate principal amount of our 5.45% Plus Cash NotesSM due 2007.



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.



We anticipate that we will use approximately $4.0 million to $6.0 million
in cash, cash equivalents and investments during the first quarter of 2006 to fund our operations, investments and financing activities. 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 to fund our operations and our other cash 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 Plus Cash Notes or our other obligations, we would be in default under
their respective terms. This would permit the holders of the Plus Cash Notes and our other obligations to accelerate their respective maturities and 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 Plus Cash Notes if payment of those notes
were to be accelerated following the occurrence of an event of default as defined in the Plus Cash Notes indenture.



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



We may incur additional indebtedness,
which may be secured. Upon any distribution of our assets in the event of an insolvency, dissolution or reorganization, the payment of the principal of and interest on our secured indebtedness would 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 Plus Cash Notes then outstanding once payment of the principal and interest on our secured indebtedness has been made.



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 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.



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. However, events in the future may
require us to seek additional capital and, if so required, that capital may not be available on terms favorable or acceptable to us, if at all. 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 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 17, 2006 the price of our shares was $1.82. 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.



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.



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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 board of
directors may elect to exercise its discretion to affect a reverse stock split. There are risks and uncertainties inherent in a reverse stock split.



By resolution approved by our stockholders at the annual meeting of stockholders held on May 19, 2005, our board of directors has the authority, in
its sole discretion, to effect a reverse stock split of our common stock at any time prior to the date of our annual meeting of stockholders to be held in 2006 at a ratio between one for two and one for twenty as selected by the board of directors.
In addition, notwithstanding approval of the reverse stock split by the stockholders, the board of directors may choose, in its sole discretion, not to affect a reverse stock split without further approval or action by or prior notice to the
stockholders.



Although the price of our common stock is
currently above $1.00, failure to implement the reverse stock split may increase the probability that our common stock would be delisted from The NASDAQ National Market in the future due to failure to satisfy the minimum bid price listing condition
discussed above.



There can be no assurance that any increase
in the market price for our common stock resulting from a reverse stock split, if approved and implemented, would be sustainable since there are numerous factors and contingencies that would effect such price, including the market conditions for our
common stock at the time, our reported results of operations in future periods and general economic, geopolitical, stock market and industry conditions. Accordingly, the total market capitalization of our common stock after a reverse stock split may
be lower than the total market capitalization before such reverse stock split and, in the future, the market price of our common stock may not exceed or remain higher than the market price prior to such reverse stock split. Further, there can be no
assurance that after a reverse stock split, we would continue to meet the minimum listing requirements of The NASDAQ National Market.



While a higher share price may help generate investor interest in our common stock, there can be no assurance that a reverse stock split would result in a
per share market price that attracts institutional investors or investment funds, or that such price would satisfy the investing guidelines of institutional investors or investment funds. As a result, the trading liquidity of our common stock may
not improve as a result of a reverse stock split. Furthermore, the liquidity of our common stock could be adversely affected by the reduced number of shares of our common stock that would be outstanding after the reverse stock split.



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, 2005. The closing price was $1.82 on
February 17, 2006. 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 ; and
| | - |  | ---------------------------------------------------------------------------------------------------



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



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We may have to further restructure our business.



During the year ended December 31, 2005, we recorded net restructuring
charges of approximately $0.2 million related to an organizational restructuring of our Swiss design center, $1.0 million to impair certain patent assets that were acquired in our acquisition of Onex Communications Corporation (Onex) in 2001 and
$1.5 million resulting from workforce reductions in the United States, the disengagement from our design center in Toulouse, France and further reductions in our U.S. facilities expenses.



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 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, 2005 and 2004, shipments to our top five customers, including sales to distributors, accounted for approximately 48% and 58% 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;
| | - |  | ------------------------------------------------------------------------------------------------------------------



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| |  |  | 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 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, 2005, 2004 and
2003:



|                           |  |                          |   |  |      |   |  |      |  
|-------------------------- |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                           |  | Years ended December 31, |  
|                           |  | 2005                     |   |  | 2004 |   |  | 2003 |  
|Distributors:              |  |                          |   |  |      |   |  |      |  
|Avnet, Inc.(1)             |  | *                        |   |  | 12   | % |  | 12   | %
|Arrow Electronics, Inc.(2) |  | *                        |   |  | 10   | % |  | 11   | %
|                           |  |                          |  
|Significant Customers:     |  |                          |   |  |      |   |  |      |  
|Siemens AG                 |  | 17                       | % |  | 24   | % |  | 28   | %
|Nortel                     |  | 11                       | % |  | 12   | % |  | *    |  
|Tellabs, Inc.(2)           |  | *                        |   |  | 10   | % |  | 12   | %

---

|(1) | The end customers of the shipments to Avnet, Inc. include: Spirent Communications, Cisco Systems, Inc., Sonus Networks, Inc and Pulse communications, 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.



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 recovery, but showed additional fluctuations in demand. In 2005, while overall demand in our markets was
essentially flat versus 2004, we saw a shifting in demand towards newer technologies that we introduced into the market in the last two years. 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 cannot be certain that the market for our products
will not decline in the future.



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



Foreign markets are a significant part of our net product revenues. For the year ended December 31, 2005, foreign shipments accounted for approximately 85% of our total net product revenues as compared to 73% in the prior year. We
expect foreign markets to continue to account for a significant percentage of our total net product revenues. A significant portion of our total net product 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;
| | - |  | -------------------



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



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



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



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



| |  |  | 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.



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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.



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;
| | - |  | -------------------------------------------------------------------------



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| |  |  | 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 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.
| | - |  | ---------------------------------------------------------------------------------------------------------------



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



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



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If the requirements for the earnout provisions agreed to in connection with the acquisition of Mysticom are met, we may
have to issue a number of shares of our common stock which may be dilutive to our stockholders.



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, other than the current integration of Mysticom 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.



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



During the past three years, we have acquired two privately-held companies, one based in the United States and one in
Israel. The integration of the operations of one of the acquisitions, ASIC Design Services, Inc. (ASIC), acquired in August 2003, has been completed. The integration of Mysticom Ltd. (Mysticom), acquired in January 2006, is in progress.



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, 2005:



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



During the second quarter, 2005, we made the decision to no longer provide
additional funding to Metanoia. Subsequent to that decision, we determined that our investment in Metanoia preferred stock and the bridge loan receivable from Metanoia were



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##### Table of Contents

impaired. In making this evaluation, we considered changes during the quarter in Metanoias operations and financial
condition. As a result of its evaluation, we recorded an impairment charge related to Metanoia of approximately $1.5 million in the quarter ended June 30, 2005.



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, 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.



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##### Table of Contents

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 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 2006, assuming a constant cash balance, would decrease by approximately $0.4 million. We do, however, expect our cash balance to decline during 2006 and expect that our interest
income will therefore also decrease proportionately.



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 2005, operating expenses incurred in foreign currencies were approximately 23% 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, 2005, our long-term debt consisted of convertible notes with interest at a fixed rate of 5.45%. 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 5.45% Plus Cash Notes was approximately $52.6 million and $74.1
million at December 31, 2005 and 2004, 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.



Changes in Market Risk. There has been no significant change in our market risk since December 31, 2004



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##### Table of Contents

Item 8.Financial Statements and Supplementary Data.



TRANSWITCH CORPORATION AND SUBSIDIARIES



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

AND FINANCIAL STATEMENT SCHEDULE



|                                                                                                                                              |  |     
|--------------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                                                              |  | Page
|Financial Statements:                                                                                                                         |  |     
|Report of UHY LLP, Independent Registered Public Accounting Firm                                                                              |  | 48  
|Report of KPMG LLP, Independent Registered Public Accounting Firm                                                                             |  | 49  
|Consolidated Balance Sheets as of December 31, 2005 and 2004                                                                                  |  | 50  
|Consolidated Statements of Operations for each of the years in the three-year period ended December 31, 2005                                  |  | 51  
|Consolidated Statements of Stockholders Equity and Comprehensive Loss for each of the years in the three-year period ended December 31, 2005 |  | 52  
|Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2005                                  |  | 53  
|Notes to Consolidated Financial Statements                                                                                                    |  | 54  
|                                                                                                                                              | 
|Financial Statement Schedule:                                                                                                                 |  |     
|Schedule II, Valuation and Qualifying Accounts                                                                                                |  | 77  



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##### Table of Contents

REPORT OF UHY LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the Stockholders and Board of Directors

TranSwitch Corporation



We have
audited the accompanying consolidated balance sheet of TranSwitch Corporation and subsidiaries (the Company) as of December 31, 2005 and the related consolidated statements of operations, stockholders equity and comprehensive loss, and
cash flows for the year then ended. Our audit also included the financial statement schedule for 2005 listed in the Index at Item 8. We have also audited managements assessment, included in the accompanying Managements Report on
Internal Control Over Financial Reporting under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal ControlIntegrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). These financial statements and schedule are the responsibility of the Companys management. Further, 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 these financial statements and schedule, 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 the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit
of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the
overall financial statement presentation. Our audit of internal control over financial reporting 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 over financial reporting; and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.



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, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of
TranSwitch Corporation and subsidiaries at December 31, 2005 and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of
America. Also, in our opinion, the related financial statement schedule for 2005, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. Further,
in our opinion, managements assessment that TranSwitch Corporation maintained effective internal control over financial reporting as of December 31, 2005, 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). Lastly, in our opinion, TranSwitch Corporation maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2005, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).



/s/ UHY LLP



New Haven, Connecticut

February 20, 2006



48



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##### Table of Contents

Report of KPMG LLP, Independent Registered Public Accounting Firm



To the Board of Directors and Shareholders

TranSwitch Corporation



We have
audited the accompanying consolidated balance sheet of TranSwitch Corporation and subsidiaries as of December 31, 2004 and the related consolidated statements of operations, stockholders equity and comprehensive income (loss), and cash
flows for each of the two years in the period ended December 31, 2004. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as of and for the years ended December 31, 2004
and 2003 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 Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of TranSwitch Corporation and subsidiaries as of December 31, 2004, and the results of their operations and their cash flows for each of the years in the two-year period ended
December 31, 2004, in conformity with US 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.



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



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##### Table of Contents

TRANSWITCH CORPORATION AND SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                          |  | December 31, 2005 |          |   | December 31, 2004 |  
|ASSETS                                                                                                                                                                    |  |                   |          |   |                   |   |          |  
|Current assets:                                                                                                                                                           |  |                   |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                 |  | $                 | 38,841   |   |                   | $ | 17,311   |  
|Short-term investments in marketable securities                                                                                                                           |  |                   | 33,861   |   |                   |   | 85,193   |  
|Accounts receivable, net of allowances of $446 and $731                                                                                                                   |  |                   | 3,784    |   |                   |   | 4,795    |  
|Inventories                                                                                                                                                               |  |                   | 2,375    |   |                   |   | 2,933    |  
|Prepaid expenses and other current assets                                                                                                                                 |  |                   | 1,961    |   |                   |   | 2,243    |  
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|Total current assets                                                                                                                                                      |  |                   | 80,822   |   |                   |   | 112,475  |  
|                                                                                                                                                                          |  |                  
|Long-term investments in marketable securities                                                                                                                            |  |                   |         |   |                   |   | 32,178   |  
|Property and equipment, net                                                                                                                                               |  |                   | 3,508    |   |                   |   | 3,590    |  
|Patents, net of accumulated amortization                                                                                                                                  |  |                   |         |   |                   |   | 1,080    |  
|Investments in non-publicly traded companies                                                                                                                              |  |                   | 970      |   |                   |   | 2,108    |  
|Deferred financing costs, net                                                                                                                                             |  |                   | 1,092    |   |                   |   | 2,647    |  
|Other assets                                                                                                                                                              |  |                   | 434      |   |                   |   | 630      |  
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|Total assets                                                                                                                                                              |  | $                 | 86,826   |   |                   | $ | 154,708  |  
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                      |  |                   |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                      |  |                   |          |   |                   |   |          |  
|Accounts payable                                                                                                                                                          |  | $                 | 490      |   |                   | $ | 1,385    |  
|Accrued expenses and other current liabilities                                                                                                                            |  |                   | 2,816    |   |                   |   | 4,294    |  
|Accrued compensation and benefits                                                                                                                                         |  |                   | 1,946    |   |                   |   | 2,329    |  
|Accrued stock rotation and sales allowances                                                                                                                               |  |                   | 717      |   |                   |   | 1,067    |  
|Accrued interest                                                                                                                                                          |  |                   | 747      |   |                   |   | 1,430    |  
|Restructuring liabilities                                                                                                                                                 |  |                   | 721      |   |                   |   | 1,093    |  
|4.5% Convertible Notes due 2005                                                                                                                                           |  |                   |         |   |                   |   | 24,442   |  
|Derivative liability                                                                                                                                                      |  |                   |         |   |                   |   | 74       |  
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                 |  |                   | 7,437    |   |                   |   | 36,114   |  
|                                                                                                                                                                          |  |                  
|Restructuring liabilities                                                                                                                                                 |  |                   | 21,038   |   |                   |   | 21,532   |  
|5.45% Convertible Plus Cash Notessmdue 2007, net of debt discount of $5,695 and $13,149                                                                                   |  |                   | 49,102   |   |                   |   | 67,370   |  
|Derivative liability                                                                                                                                                      |  |                   | 6,040    |   |                   |   | 8,461    |  
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|Total liabilities                                                                                                                                                         |  |                   | 83,617   |   |                   |   | 133,477  |  
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|Commitments and contingencies                                                                                                                                             |  |                   |          |   |                   |   |          |  
|Stockholders equity:                                                                                                                                                     |  |                   |          |   |                   |   |          |  
|Common stock, $.001 par value; authorized 300,000,000 shares; issued and outstanding, 108,345,342 shares at December 31, 2005 and
103,447,488 shares at December 31, 2004 |  |                   | 108      |   |                   |   | 103      |  
|Additional paid-in capital                                                                                                                                                |  |                   | 314,697  |   |                   |   | 307,876  |  
|Accumulated other comprehensive income                                                                                                                                    |  |                   | (28      | ) |                   |   | 1,066    |  
|Accumulated deficit                                                                                                                                                       |  |                   | (311,568 | ) |                   |   | (287,814 | )
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                |  |                   | 3,209    |   |                   |   | 21,231   |  
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                                |  | $                 | 86,826   |   |                   | $ | 154,708  |  
|                                                                                                                                                                          |  |                   |          |   |                   |   |          |  



See accompanying notes
to consolidated financial statements.



50



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##### Table of Contents

TRANSWITCH CORPORATION AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)



|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------------------ |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                   |  | Years ended December 31, |        
|                                                                                                                   |  | 2005                     |         |   | 2004 |   |         | 2003 | 
|Net revenues:                                                                                                      |  |                          |         |   |      |   |         |      |  |   |         |  
|Product revenues                                                                                                   |  | $                        | 32,891  |   |      | $ | 33,481  |      |  | $ | 22,970  |  
|Service revenues                                                                                                   |  |                          | 9       |   |      |   | 206     |      |  |   | 850     |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Total net revenues                                                                                                 |  |                          | 32,900  |   |      |   | 33,687  |      |  |   | 23,820  |  
|Cost of revenues:                                                                                                  |  |                          |         |   |      |   |         |      |  |   |         |  
|Cost of product revenues                                                                                           |  |                          | 8,343   |   |      |   | 9,609   |      |  |   | 6,086   |  
|Provision for excess and obsolete inventories                                                                      |  |                          | 573     |   |      |   | 571     |      |  |   | 1,498   |  
|Cost of service revenues                                                                                           |  |                          |        |   |      |   | 160     |      |  |   | 333     |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Total cost of revenues                                                                                             |  |                          | 8,916   |   |      |   | 10,340  |      |  |   | 7,917   |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Gross profit                                                                                                       |  |                          | 23,984  |   |      |   | 23,347  |      |  |   | 15,903  |  
|Operating expenses:                                                                                                |  |                          |         |   |      |   |         |      |  |   |         |  
|Research and development                                                                                           |  |                          | 21,280  |   |      |   | 46,030  |      |  |   | 41,998  |  
|Marketing and sales                                                                                                |  |                          | 9,639   |   |      |   | 12,543  |      |  |   | 10,964  |  
|General and administrative                                                                                         |  |                          | 5,003   |   |      |   | 6,697   |      |  |   | 5,630   |  
|Restructuring and asset impairment charges, net                                                                    |  |                          | 2,724   |   |      |   | 1,126   |      |  |   | 2,538   |  
|Purchased in-process research and development                                                                      |  |                          |        |   |      |   |        |      |  |   | 512     |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Total operating expenses                                                                                           |  |                          | 38,646  |   |      |   | 66,396  |      |  |   | 61,642  |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Operating loss                                                                                                     |  |                          | (14,662 | ) |      |   | (43,049 | )    |  |   | (45,739 | )
|Other (expense) income:                                                                                            |  |                          |         |   |      |   |         |      |  |   |         |  
|Other income                                                                                                       |  |                          |        |   |      |   | 378     |      |  |   |        |  
|Impairment of investments in non-publicly traded companies                                                         |  |                          | (1,450  | ) |      |   | (123    | )    |  |   | (1,545  | )
|Equity in net losses of affiliates                                                                                 |  |                          |        |   |      |   |        |      |  |   | (1,933  | )
|Change in fair value of derivative liability                                                                       |  |                          | 2,495   |   |      |   | 12,124  |      |  |   | 2,619   |  
|Gain from exchange and repurchase of 4.50% Convertible Notes due 2005                                              |  |                          |        |   |      |   |        |      |  |   | 14,463  |  
|Loss on extinguishment of debt                                                                                     |  |                          | (2,528  | ) |      |   | (2,987  | )    |  |   |        |  
|Interest:                                                                                                          |  |                          |         |   |      |   |         |      |  |   |         |  
|Interest income                                                                                                    |  |                          | 2,844   |   |      |   | 2,394   |      |  |   | 2,805   |  
|Interest expense                                                                                                   |  |                          | (10,144 | ) |      |   | (12,895 | )    |  |   | (8,116  | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Interest expense, net                                                                                              |  |                          | (7,300  | ) |      |   | (10,501 | )    |  |   | (5,311  | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Total other (expense) income, net                                                                                  |  |                          | (8,783  | ) |      |   | (1,109  | )    |  |   | 8,293   |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Loss before income taxes, extraordinary loss and cumulative effect of a change in accounting principle             |  |                          | (23,445 | ) |      |   | (44,158 | )    |  |   | (37,446 | )
|Income tax expense                                                                                                 |  |                          | 309     |   |      |   | 189     |      |  |   | 246     |  
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Loss before extraordinary loss and cumulative effect of adoption of and changes in accounting principles           |  |                          | (23,754 | ) |      |   | (44,347 | )    |  |   | (37,692 | )
|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                                                                                                           |  | $                        | (23,754 | ) |      | $ | (44,624 | )    |  | $ | (38,580 | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Basic and diluted loss per common share:                                                                           |  |                          |         |   |      |   |         |      |  |   |         |  
|Loss before extraordinary loss and cumulative effect of adoption of and changes in accounting principles           |  | $                        | (0.23   | ) |      | $ | (0.47   | )    |  | $ | (0.42   | )
|Extraordinary loss                                                                                                 |  |                          |        |   |      |   |        |      |  |   |        |  
|Cumulative effect of prior years of adoption of and retroactive application of FIN 46R and new depreciation method |  |                          |        |   |      |   |        |      |  |   | (0.01   | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Net loss                                                                                                           |  | $                        | (0.23   | ) |      | $ | (0.47   | )    |  | $ | (0.43   | )
|                                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Basic and diluted average common shares outstanding                                                                |  |                          | 104,779 |   |      |   | 94,638  |      |  |   | 90,406  |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

TRANSWITCH CORPORATION AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

AND COMPREHENSIVE LOSS

(in thousands, except share data)



|                                                                                           |  |              |  |                            |     |                                               |   |         |                                |   |        |       |  |   |          |   |  |   |         |  
|------------------------------------------------------------------------------------------ |  | ------------ |  | -------------------------- | --- | --------------------------------------------- | - | ------- | ------------------------------ | - | ------ | ----- |  | - | -------- | - |  | - | ------- | -
|                                                                                           |  | Common stock |  | Additional paid-in capital |     | Accumulated other comprehensive (loss) income |   |         | Accumulated earnings (deficit) |   |        | Total | 
|                                                                                           |  | Shares       |  | Amount                     |     |                                               |   |        
|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 | )
|Stock compensation                                                                         |  |             |  |                            |     |                                               |   | 50      |                                |   |        |       |  |   |          |   |  |   | 50      |  
|                                                                                           |  |              |  |                            |     |                                              
|Shares of common stock issued under stock option and stock purchase plans                  |  | 549,139      |  |                            | 1   |                                               |   | 519     |                                |   |       |       |  |   |         |   |  |   | 520     |  
|Shares of common stock issued in purchase transaction                                      |  | 189,475      |  |                            |     |                                               |   | 308     |                                |   |        |       |  |   |          |   |  |   | 308     |  
|Shares of common stock issued upon exchange of 5.45% Convertible Plus Cash Notessmdue 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 | )
|Stock compensation                                                                         |  |             |  |                            |     |                                               |   | 64      |                                |   |        |       |  |   |          |   |  |   | 64      |  
|                                                                                           |  |              |  |                            |     |                                              
|Shares of common stock issued under stock option and stock purchase plans                  |  | 328,629      |  |                            |    |                                               |   | 406     |                                |   |       |       |  |   |         |   |  |   | 406     |  
|Shares of common stock issued upon exchange of 5.45% Convertible Plus Cash Notessmdue 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  |  
|                                                                                           |  |              |  |                            |     |                                              
|Comprehensive loss:                                                                        |  |              |  |                            |     |                                               |   |         |                                |   |        |       |  |   |          |   |  |   |         |  
|Net loss                                                                                   |  |              |  |                            |     |                                               |   |         |                                |   |        |       |  |   | (23,754  | ) |  |   | (23,754 | )
|Currency translation adjustment                                                            |  |              |  |                            |     |                                               |   |         |                                |   | (1,094 | )     |  |   |         |   |  |   | (1,094  | )
|                                                                                           |  |              |  |                            |     |                                               |   |         |                                |   |        |       |  |   |          |   |  |   |         |  
|Total comprehensive loss                                                                   |  |              |  |                            |     |                                               |   |         |                                |   |        |       |  |   |          |   |  |   | (24,848 | )
|Stock compensation                                                                         |  |             |  |                            |     |                                               |   | 459     |                                |   |        |       |  |   |          |   |  |   | 459     |  
|                                                                                           |  |              |  |                            |     |                                              
|Shares of common stock issued under stock option and stock purchase plans                  |  | 711,320      |  |                            | 1   |                                               |   | 714     |                                |   |       |       |  |   |         |   |  |   | 715     |  
|Shares of common stock issued upon exchange of 5.45% Convertible Plus Cash Notessmdue 2007 |  | 4,186,534    |  |                            | 4   |                                               |   | 5,648   |                                |   |       |       |  |   |         |   |  |   | 5,652   |  
|                                                                                           |  |              |  |                            |     |                                               |   |         |                                |   |        |       |  |   |          |   |  |   |         |  
|Balance at December 31, 2005                                                               |  | 108,345,342  |  | $                          | 108 |                                               | $ | 314,697 |                                | $ | (28    | )     |  | $ | (311,568 | ) |  | $ | 3,209   |  
|                                                                                           |  |              |  |                            |     |                                               |   |         |                                |   |        |       |  |   |          |   |  |   |         |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

TRANSWITCH CORPORATION AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|---------------------------------------------------------------------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | -------- | ---- |  | - | ------- | -
|                                                                                                                       |  | Years ended December 31, |        
|                                                                                                                       |  | 2005                     |         |   | 2004 |   |          | 2003 | 
|Operating activities:                                                                                                  |  |                          |         |   |      |   |          |      |  |   |         |  
|Net loss                                                                                                               |  | $                        | (23,754 | ) |      | $ | (44,624  | )    |  | $ | (38,580 | )
|Adjustments required to reconcile net loss to cash flows used in operating activities, net of effects of acquisitions: |  |                          |         |   |      |   |          |      |  |   |         |  
|Depreciation and amortization                                                                                          |  |                          | 9,768   |   |      |   | 17,041   |      |  |   | 13,336  |  
|Non-cash charge for the accelerated vesting of employee stock options                                                  |  |                          | 328     |   |      |   |         |      |  |   |        |  
|Loss on extinguishment of debt                                                                                         |  |                          | 2,528   |   |      |   | 2,987    |      |  |   |        |  
|Provision (benefit) for doubtful accounts                                                                              |  |                          | (181    | ) |      |   | 310      |      |  |   | 10      |  
|Provision for excess and obsolete inventories                                                                          |  |                          | 573     |   |      |   | 571      |      |  |   | 1,498   |  
|Cumulative effect on prior years adoption of and retroactive application of FIN 46R and new depreciation method        |  |                          |        |   |      |   | 277      |      |  |   | 805     |  
|Non-cash portion of restructuring charge, net                                                                          |  |                          | 342     |   |      |   | (1,984   | )    |  |   | (1,002  | )
|Equity in net losses of affiliates                                                                                     |  |                          |        |   |      |   |         |      |  |   | 1,933   |  
|Impairment of investments in non-publicly traded companies                                                             |  |                          | 1,450   |   |      |   | 123      |      |  |   | 1,545   |  
|Purchased in-process research and development                                                                          |  |                          |        |   |      |   |         |      |  |   | 512     |  
|Gain from exchange and repurchase of 4.50% Convertible Notes due 2005                                                  |  |                          |        |   |      |   |         |      |  |   | (14,463 | )
|Change in fair value of derivative liability                                                                           |  |                          | (2,495  | ) |      |   | (12,124  | )    |  |   | (2,619  | )
|Other non-cash items                                                                                                   |  |                          | 131     |   |      |   | 64       |      |  |   | 83      |  
|Changes in operating assets and liabilities:                                                                           |  |                          |         |   |      |   |          |      |  |   |         |  
|Accounts receivable                                                                                                    |  |                          | 1,192   |   |      |   | (1,422   | )    |  |   | (1,461  | )
|Inventories                                                                                                            |  |                          | (15     | ) |      |   | (666     | )    |  |   | 322     |  
|Prepaid expenses and other assets                                                                                      |  |                          | 162     |   |      |   | 424      |      |  |   | 1,926   |  
|Accounts payable                                                                                                       |  |                          | (895    | ) |      |   | 559      |      |  |   | (1,538  | )
|Accrued expenses and other current liabilities                                                                         |  |                          | (2,653  | ) |      |   | (138     | )    |  |   | (1,961  | )
|Restructuring liabilities                                                                                              |  |                          | (866    | ) |      |   | (1,378   | )    |  |   | (1,869  | )
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|Net cash used in operating activities                                                                                  |  |                          | (14,385 | ) |      |   | (39,980  | )    |  |   | (41,523 | )
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|Investing activities:                                                                                                  |  |                          |         |   |      |   |          |      |  |   |         |  
|Purchase of product licenses                                                                                           |  |                          |        |   |      |   |         |      |  |   | (700    | )
|Cash received from dissolution of investment                                                                           |  |                          |        |   |      |   |         |      |  |   | 886     |  
|Cash acquired upon consolidation of variable interest entities                                                         |  |                          |        |   |      |   | 124      |      |  |   | 17      |  
|Capital expenditures                                                                                                   |  |                          | (3,991  | ) |      |   | (3,606   | )    |  |   | (2,607  | )
|Investments in non-publicly traded companies                                                                           |  |                          | (312    | ) |      |   | (1,605   | )    |  |   | (2,672  | )
|Acquisition of businesses, net of cash acquired                                                                        |  |                          |        |   |      |   |         |      |  |   | (390    | )
|Purchases of short and long-term investments in marketable securities                                                  |  |                          | (2,732  | ) |      |   | (159,821 | )    |  |   | (78,280 | )
|Proceeds from sales and maturities of short and long-term investments in marketable securities                         |  |                          | 86,242  |   |      |   | 118,930  |      |  |   | 88,876  |  
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|Net cash (used in) provided by investing activities                                                                    |  |                          | 79,207  |   |      |   | (45,978  | )    |  |   | 5,130   |  
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|Financing activities:                                                                                                  |  |                          |         |   |      |   |          |      |  |   |         |  
|Proceeds from issuance of 5.45% Convertible PlussmCash Notes due 2007                                                  |  |                          |        |   |      |   |         |      |  |   | 24,000  |  
|Repayment of 4.50% convertible Notes due 2005                                                                          |  |                          | (24,442 | ) |      |   |         |      |  |   |        |  
|Issuance of common stock under employee stock plans                                                                    |  |                          | 715     |   |      |   | 406      |      |  |   | 637     |  
|Deferred financing fees                                                                                                |  |                          |        |   |      |   |         |      |  |   | (4,459  | )
|Payments on 5.45% Convertible Plus Cash Notessmdue 2007                                                                |  |                          | (19,226 | ) |      |   | (151     | )    |  |   | (123    | )
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|Net cash provided by (used in) financing activities                                                                    |  |                          | (42,953 | ) |      |   | 255      |      |  |   | 20,055  |  
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                                                           |  |                          | (339    | ) |      |   | 145      |      |  |   | 819     |  
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|Change in cash and cash equivalents                                                                                    |  |                          | 21,530  |   |      |   | (85,558  | )    |  |   | (15,519 | )
|Cash and cash equivalents at beginning of year                                                                         |  |                          | 17,311  |   |      |   | 102,869  |      |  |   | 118,388 |  
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  
|Cash and cash equivalents at end of year                                                                               |  | $                        | 38,841  |   |      | $ | 17,311   |      |  | $ | 102,869 |  
|                                                                                                                       |  |                          |         |   |      |   |          |      |  |   |         |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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



Note 1. Business and Summary of Significant Accounting Policies



Description of Business



TranSwitch Corporation was incorporated in Delaware on April 26, 1988
and is headquartered in Shelton, Connecticut. TranSwitch 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 allowances, depreciation and amortization, income taxes, sales returns allowances, stock rotation allowances 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 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. 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 in marketable securities, consist primarily
of 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. Long-term investments consist of securities with maturity dates greater than one year from the balance sheet date.



Short-term investments at December 31, 2004 include at fair value $52.2 million of auction rate securities, which are
classified as available-for-sale. As of December 31, 2004 there was no cumulative unrealized holding gain or loss since fair value equaled cost. The Company held no auction rate securities at December 31, 2005.



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%



54



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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 $24.3 million at December 31, 2004. The fair value of the outstanding 5.45% Convertible Plus Cash Notessmdue 2007 was approximately $52.6 million and $74.1 million at December 31, 2005 and 2004, respectively.



The fair value of the Companys marketable securities and investments in non-publicly traded companies are disclosed in Note 3Investments in
Marketable Securities and Note 4Investments in Non-Publicly Traded Companies.



Inventories



Inventories are carried at the lower of cost (determined 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 $0.3 million for the fiscal years ended December 31, 2005, 2004 and 2003, respectively. Accumulated amortization of licenses was $1.0 million and $0.7 million as of December 31, 2005 and
2004, 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 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 approximately zero, $0.2 million and $0.2 million for the fiscal years ended December 31, 2005, 2004 and 2003,
respectively. During the second quarter of 2005, the Company conducted a review of certain patent assets that were acquired with the Companys acquisition of Onex Communications Corporation (Onex) in 2001. The impairment review was conducted
because the Company determined that it no longer had significant sales expectations for the products related to these patents. As such, the Company determined that these patent assets were impaired and recorded an impairment charge of $1.0 million
in the second quarter of 2005. Accumulated amortization of patents was $0.5 million as of December 31, 2004.



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Deferred Financing Costs



Deferred financing costs are being amortized using the interest method over the term of the related debt. Accumulated amortization of deferred financing
fees was $19.7 million and $18.1 million as of December 31, 2005 and 2004, respectively. Amortization, included in the consolidated statement of operations as a component of interest expense, was $1.0 million, $1.2 million, and $0.9 million for
the fiscal years ended December 31, 2005, 2004 and 2003, respectively. Refer to Note 11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 is 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 12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 by either the cost or equity method. These investments are reviewed periodically for impairment.
The appropriate reductions in carrying values are recorded when, and if, necessary. Refer to Note 4Investments in Non-Publicly Traded Companies.



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) ownership 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, 2005, approximately 45% 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.



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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



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 for operating loss and tax credit carry forwards. Deferred income tax assets and liabilities are measured using enacted tax rates 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 8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, |        
|                                                                                                       |  | 2005                     |         |   | 2004 |   |         | 2003 | 
|Net loss:                                                                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                            |  | $                        | (23,754 | ) |      | $ | (44,624 | )    |  | $ | (38,580 | )
|Deduct: Total stock-based compensation expense determined under fair value based method for all awards |  | $                        | (2,922  | ) |      | $ | (15,840 | )    |  | $ | (38,152 | )
|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Pro forma                                                                                              |  | $                        | (26,676 | ) |      | $ | (60,464 | )    |  | $ | (76,732 | )
|Basic loss per common share:                                                                           |  |                          |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                            |  | $                        | (0.23   | ) |      | $ | (0.47   | )    |  | $ | (0.43   | )
|Pro forma                                                                                              |  | $                        | (0.25   | ) |      | $ | (0.64   | )    |  | $ | (0.85   | )
|Diluted loss per common share:                                                                         |  |                          |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                            |  | $                        | (0.23   | ) |      | $ | (0.47   | )    |  | $ | (0.43   | )
|Pro forma                                                                                              |  | $                        | (0.25   | ) |      | $ | (0.64   | )    |  | $ | (0.85   | )



Loss Per Common
Share



Basic and diluted loss per common share is based
upon the weighted average common shares outstanding during the periods. All in-the-money stock options and shares issuable upon the conversion of the 4.50% Convertible Notes due 2005 and 5.45% Convertible Plus Cash Notessm due 2007 were
anti-dilutive.



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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.



Recent Accounting Pronouncements



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. The Company will adopt SFAS 123R as of January 1,
2006, using the modified prospective method.



SFAS
No. 123(R) does not mandate an option-pricing model to be used in determining fair value, but does require that the model selected consider certain variables. Different models would result in different valuations. Regardless of the method
selected, significant judgment is required for some of the valuation variables. The most significant of these is the volatility of the Companys common stock and the estimated term over which the stock options will be outstanding. The valuation
calculation is sensitive to even slight changes in these estimates.



Although there will be no impact to the Companys overall cash flows, the adoption of SFAS No. 123(R) will have a significant impact on the Companys results of operations.



Note 2. Business Combinations and Purchased In-process Research and Development



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.



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 |  
|                                              |  |   |     |  



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.



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Note 3. Investments in Marketable Securities.



The following table summarizes investments in marketable securities:



|                                       |  |               |         |                      |   |                         |  |   |            |   |  |   |        
|-------------------------------------- |  | ------------- | ------- | -------------------- | - | ----------------------- |  | - | ---------- | - |  | - | -------
|                                       |  | Amortizedcost |         | Grossunrealizedgains |   | Grossunrealized(losses) |  |   | Fair value
|December 31, 2005                      |  |               |         |                      |   |                         |  |   |            |   |  |   |        
|Money market & certificates of deposit |  | $             | 30,819  |                      | $ |                        |  | $ |           |   |  | $ | 30,819 
|U.S. government & agency obligations   |  |               | 16,500  |                      |   |                        |  |   | (108       | ) |  |   | 16,392 
|Corporate bonds                        |  |               | 17,361  |                      |   |                        |  |   | (63        | ) |  |   | 17,298 
|                                       |  |               |         |                      |   |                         |  |   |            |   |  |   |        
|                                       |  | $             | 64,680  |                      | $ |                         |  | $ | (171       | ) |  | $ | 64,509 
|                                       |  |               |         |                      |   |                         |  |   |            |   |  |   |        
|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 
|                                       |  |               |         |                      |   |                         |  |   |            |   |  |   |        
|                                       |  | $             | 122,347 |                      | $ |                        |  | $ | (469       | ) |  | $ | 121,878
|                                       |  |               |         |                      |   |                         |  |   |            |   |  |   |        



|                                                      |  |              |        |      |   |        
|----------------------------------------------------- |  | ------------ | ------ | ---- | - | -------
|                                                      |  | December 31,
|                                                      |  | 2005         |        | 2004
|Investments in marketable securities are reported as: |  |              |        |      |   |        
|Cash equivalents                                      |  | $            | 30,819 |      | $ | 4,976  
|Short-term investments                                |  |              | 33,861 |      |   | 85,193 
|Long-term investments                                 |  |              |       |      |   | 32,178 
|                                                      |  |              |        |      |   |        
|                                                      |  |              | 64,680 |      |   | 122,347
|                                                      |  |              |        |      |   |        
|Cash                                                  |  |              | 8,022  |      |   | 12,335 
|                                                      |  |              |        |      |   |        
|Total cash, cash equivalents and investments          |  | $            | 72,702 |      | $ | 134,682
|                                                      |  |              |        |      |   |        



Note 4. 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 Networks, Inc. (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. 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.



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).



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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 12  Restructuring and Asset Impairment Charges.



Cost Method Investments



As of December 31, 2004, the Company owned convertible preferred stock of Opulan Networks, Inc. (Opulan) and Metanoia Technologies, Inc. (Metanoia).
In addition, the Company had a 3% limited partnership interest in Neurone II, a venture capital fund organized as a limited partnership. The aggregate cost and carrying value of these investments was $2.1 million as of December 31, 2004. In
2005, the Company provided Metanoia with a bridge loan of $0.2 million and invested an additional $0.1 million in Neurone II. The Companys direct and indirect voting interest in these entities is less than 20%. Further, the Company does not
exercise significant influence (as defined by APB Opinion No. 18 The Equity Method of Accounting for Investments in Common Stock, and other relevant literature) over the management of these entities. The Company accounts for these
investments at cost and monitors the carrying value of these investments for impairment.



The financial condition of these companies is subject to significant changes resulting from their operating performance and their ability to obtain financing. The Company continually evaluates its investments in these
companies for impairment.



During 2005, the Company decided to
no longer provide additional funding to Metanoia. Subsequently, the Company determined that its investment in Metanoia preferred stock and the bridge loan receivable from Metanoia were impaired. In making this evaluation, the Company considered
changes during the period in Metanoias operations and financial condition. As a result of its evaluation, the Company recorded an impairment charge related to its aggregate investment in Metanoia of approximately $1.5 million in 2005. As of
December 31, 2005, the aggregate cost and carrying value of the Companys investments was approximately $1.0 million, consisting of convertible preferred stock of Opulan of $0.7 million and a 3% limited partnership interest in Neurone II
of $0.3 million.



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.The Company recognized impairment losses related to these two investments of
$0.1 million in 2004 and $1.5 million in 2003.



Impairment of Investments
in Non-Publicly Traded Companies



During the years
ended December 31, 2005, 2004 and 2003, 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, 2005, 2004 and 2003, 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.



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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 as referred to above related to investments in
non-publicly traded companies of $1.5 million in 2005 , $0.1 million in 2004 and $1.5 million in 2003.



Note 5. Inventories



The components of inventories are as follows:



|                  |  |              |       |      |   |      
|----------------- |  | ------------ | ----- | ---- | - | -----
|                  |  | December 31,
|                  |  | 2005         |       | 2004
|Raw material      |  | $            | 323   |      | $ | 281  
|Work-in-process   |  |              | 1,079 |      |   | 1,117
|Finished goods    |  |              | 973   |      |   | 1,535
|                  |  |              |       |      |   |      
|Total inventories |  | $            | 2,375 |      | $ | 2,933
|                  |  |              |       |      |   |      



The Company recorded
charges for excess and obsolete inventories totaling approximately $0.6 million, $0.6 million, $1.5 million, $4.8 million and $39.2 million during the fiscal years ended December 31, 2005, 2004, 2003, 2002 and 2001 respectively. The effect of
these inventory provisions was to write inventory down to a new cost basis of zero. During the fiscal years ended December 31, 2005, 2004 and 2003, the Company sold certain products that had previously been written down to a cost basis of zero.
The following table presents the impact on gross profit of excess and obsolete inventory charges and benefits:



|                                      |  |                             |        |   |                             |     |    |                             |   |        |               |  |     |               |  |   |               |   |  |     |   
|------------------------------------- |  | --------------------------- | ------ | - | --------------------------- | --- | -- | --------------------------- | - | ------ | ------------- |  | --- | ------------- |  | - | ------------- | - |  | --- | --
|                                      |  | Year EndedDecember 31, 2005 |        |   | Year EndedDecember 31, 2004 |     |    | Year EndedDecember 31, 2003 |  
|                                      |  | GrossProfit $               |        |   | GrossProfit %               |     |    | GrossProfit $               |   |        | GrossProfit % |  |     | GrossProfit $ |  |   | GrossProfit % |  
|Gross Profitas reported              |  | $                           | 23,984 |   |                             | 73  | %  |                             | $ | 23,347 |               |  | 69  | %             |  | $ | 15,903        |   |  | 67  | % 
|Excess and obsolete inventory charge  |  |                             | 573    |   |                             | 2   | %  |                             |   | 571    |               |  | 2   | %             |  |   | 1,498         |   |  | 6   | % 
|Excess and obsolete inventory benefit |  |                             | (3,394 | ) |                             | (11 | )% |                             |   | (3,803 | )             |  | (11 | )%            |  |   | (3,985        | ) |  | (17 | )%
|                                      |  |                             |        |   |                             |     |    |                             |   |        |               |  |     |               |  |   |               |   |  |     |   
|Gross profitas adjusted              |  | $                           | 21,163 |   |                             | 64  | %  |                             | $ | 20,115 |               |  | 60  | %             |  | $ | 13,416        |   |  | 56  | % 
|                                      |  |                             |        |   |                             |     |    |                             |   |        |               |  |     |               |  |   |               |   |  |     |   



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Note 6. Property and Equipment, Net



The components of property and equipment follow:



|                                                  |  |                       |   |  |              |         |   |      |   |         |  
|------------------------------------------------- |  | --------------------- | - |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                  |  |                       |   |  | December 31, |        
|                                                  |  | EstimatedUseful Lives |   |  | 2005         |         |   | 2004 |  
|Purchased computer software                       |  | 1-3 years             |   |  | $            | 25,456  |   |      | $ | 23,422  |  
|Computers and equipment                           |  | 3-7 years             |   |  |              | 12,063  |   |      |   | 11,665  |  
|Furniture                                         |  | 3-7 years             |   |  |              | 2,264   |   |      |   | 2,730   |  
|Leasehold improvements                            |  | Lease term            | * |  |              | 848     |   |      |   | 812     |  
|Construction in-progress (software and equipment) |  |                       |   |  |              | 1,610   |   |      |   | 163     |  
|                                                  |  |                       |   |  |              |         |   |      |   |         |  
|Gross property and equipment                      |  |                       |   |  | $            | 42,241  |   |      | $ | 38,792  |  
|Less accumulated depreciation and amortization    |  |                       |   |  |              | (38,733 | ) |      |   | (35,202 | )
|                                                  |  |                       |   |  |              |         |   |      |   |         |  
|Property and equipment, net                       |  |                       |   |  | $            | 3,508   |   |      | $ | 3,590   |  
|                                                  |  |                       |   |  |              |         |   |      |   |         |  

---

|* | Estimated useful life of improvement if shorter.
|- | ------------------------------------------------



Depreciation expense was $3.9 million, $9.8 million, and $8.6 million, for the years ended December 31, 2005, 2004 and 2003, respectively.



Note7. Segment Information and Major Customers



The Company has one business segment: communication semiconductor products.
Its VLSI semiconductor devices 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.



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:



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



|                |  |                          |        |      |   |        |  |   |       
|--------------- |  | ------------------------ | ------ | ---- | - | ------ |  | - | ------
|                |  | Years Ended December 31,
|                |  | 2005                     |        | 2004 |   | 2003  
|Net revenues:   |  |                          |        |      |   |        |  |   |       
|China           |  | $                        | 7,832  |      | $ | 5,554  |  | $ | 1,996 
|United States   |  |                          | 5,136  |      |   | 9,014  |  |   | 6,745 
|Israel          |  |                          | 2,995  |      |   | 2,101  |  |   | 1,537 
|Germany         |  |                          | 2,767  |      |   | 5,933  |  |   | 6,509 
|United Kingdom  |  |                          | 2,005  |      |   | 2,686  |  |   | 1,795 
|India           |  |                          | 1,782  |      |   | 596    |  |   | 516   
|Sweden          |  |                          | 1,489  |      |   | 813    |  |   |      
|Belgium         |  |                          | 1,325  |      |   | 1,803  |  |   | 404   
|Canada          |  |                          | 1,311  |      |   | 254    |  |   | 64    
|Malaysia        |  |                          | 1,134  |      |   | 771    |  |   | 588   
|Mexico          |  |                          | 1,105  |      |   | 1,377  |  |   | 632   
|Korea           |  |                          | 996    |      |   | 1,277  |  |   | 1,315 
|Other countries |  |                          | 3,023  |      |   | 1,508  |  |   | 1,719 
|                |  |                          |        |      |   |        |  |   |       
|Total           |  | $                        | 32,900 |      | $ | 33,687 |  | $ | 23,820
|                |  |                          |        |      |   |        |  |   |       



|                   |  |                          |       |      |   |       |  |   |       
|------------------ |  | ------------------------ | ----- | ---- | - | ----- |  | - | ------
|                   |  | Years Ended December 31,
|                   |  | 2005                     |       | 2004 |   | 2003 
|Long-lived assets: |  |                          |       |      |   |       |  |   |       
|United States      |  | $                        | 3,328 |      | $ | 4,696 |  | $ | 11,193
|Other countries    |  |                          | 614   |      |   | 598   |  |   | 1,239 
|                   |  |                          |       |      |   |       |  |   |       
|Total              |  | $                        | 3,942 |      | $ | 5,294 |  | $ | 12,432
|                   |  |                          |       |      |   |       |  |   |       



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 distributors as well as the significant customers:



|                           |  |                          |   |  |      |   |  |      |  
|-------------------------- |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                           |  | Years ended December 31, |  
|                           |  | 2005                     |   |  | 2004 |   |  | 2003 |  
|Distributors:              |  |                          |   |  |      |   |  |      |  
|Avnet, Inc.(1)             |  | *                        |   |  | 12   | % |  | 12   | %
|Arrow Electronics, Inc.(2) |  | *                        |   |  | 10   | % |  | 11   | %
|Significant Customers:     |  |                          |   |  |      |   |  |      |  
|Siemens AG                 |  | 17                       | % |  | 24   | % |  | 28   | %
|Nortel                     |  | 11                       | % |  | 12   | % |  | *    |  
|Tellabs, Inc.(2)           |  | *                        |   |  | 10   | % |  | 12   | %

---

|(1) | The end customers of the shipments to Avnet, Inc. include: Spirent Communications, Cisco Systems, Inc., Sonus Networks, Inc and Pulse communications, 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.
|- | ---------------------------------------------------------------



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Note 8. Income Taxes



The components of the loss before income taxes, extraordinary loss and cumulative effect of a change in accounting principle follow:



|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------ |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                       |  | Years Ended December 31, |        
|                                                                                                       |  | 2005                     |         |   | 2004 |   |         | 2003 | 
|U.S. domestic loss                                                                                     |  | $                        | (23,034 | ) |      | $ | (43,238 | )    |  | $ | (38,282 | )
|Foreign (loss) income                                                                                  |  |                          | (411    | ) |      |   | (920    | )    |  |   | 836     |  
|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Loss before income taxes, extraordinary loss and cumulative effect of a change in accounting principle |  | $                        | (23,445 | ) |      | $ | (44,158 | )    |  | $ | (37,446 | )
|                                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  



The provision for
income taxes consists exclusively of current foreign income taxes.



The Company recorded net state franchise and capital taxes of approximately zero, $0.4 million and $0.1 million in the years ended December 31, 2005, 2004 and 2003 respectively, which is recorded as a component of general and
administrative expenses in the consolidated statements of operations.



The following table summarizes the differences between the U.S. federal statutory rate and the Companys effective income tax rate:



|                                                         |  |                          |    |  |       |    |  |       |   
|-------------------------------------------------------- |  | ------------------------ | -- |  | ----- | -- |  | ----- | --
|                                                         |  | Years Ended December 31, |   
|                                                         |  | 2005                     |    |  | 2004  |    |  | 2003  |   
|U.S. federal statutory tax rate                          |  | (35.0                    | )% |  | (35.0 | )% |  | (35.0 | )%
|State taxes                                              |  | (5.6                     | )  |  | 6.8   |    |  | (4.1  | ) 
|In-process research and development                      |  |                         |    |  |      |    |  | 0.5   |   
|Disallowed interest deduction                            |  | 6.2                      |    |  | 3.9   |    |  | 1.2   |   
|Capital loss on sale of subsidiary                       |  |                         |    |  | (17.4 | )  |  |      |   
|Change in valuation allowance                            |  | 34.9                     |    |  | 42.5  |    |  | 38.7  |   
|Permanent differences, tax credits and other adjustments |  | 0.8                      |    |  | (0.4  | )  |  | (0.3  | ) 
|                                                         |  |                          |    |  |       |    |  |       |   
|Effective income tax rate                                |  | 1.3                      | %  |  | 0.4   | %  |  | 1.0   | % 
|                                                         |  |                          |    |  |       |    |  |       |   



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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 taxes :



|                                                      |  |      |          |   |      |   |          |  
|----------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | -
|                                                      |  | 2005 |          |   | 2004 |  
|Deferred income tax assets:                           |  |      |          |   |      |   |          |  
|Property and equipment                                |  | $    | 1,906    |   |      | $ | 3,381    |  
|Other nondeductible reserves                          |  |      | 588      |   |      |   | 919      |  
|Restructuring reserve                                 |  |      | 8,467    |   |      |   | 8,805    |  
|Capitalized research and development for tax purposes |  |      | 15,803   |   |      |   | 17,258   |  
|Investment impairment                                 |  |      | 38       |   |      |   | 38       |  
|Net operating losses                                  |  |      | 75,620   |   |      |   | 76,245   |  
|Capital losses                                        |  |      | 15,739   |   |      |   | 15,739   |  
|Research and development and other credits            |  |      | 10,993   |   |      |   | 10,906   |  
|Debt discount                                         |  |      | 6,843    |   |      |   | 3,941    |  
|Inventories                                           |  |      | 10,681   |   |      |   |         |  
|Other                                                 |  |      | 1,649    |   |      |   | 1,390    |  
|                                                      |  |      |          |   |      |   |          |  
|Total gross deferred income tax assets                |  |      | 148,327  |   |      |   | 138,622  |  
|Valuation allowance                                   |  |      | (141,029 | ) |      |   | (132,841 | )
|                                                      |  |      |          |   |      |   |          |  
|Net deferred income tax assets                        |  |      | 7,298    |   |      |   | 5,781    |  
|                                                      |  |      |          |   |      |   |          |  
|Deferred income tax liabilities:                      |  |      |          |   |      |   |          |  
|Derivative liability                                  |  |      | (6,708   | ) |      |   | (5,737   | )
|Other                                                 |  |      | (590     | ) |      |   | (44      | )
|                                                      |  |      |          |   |      |   |          |  
|Net deferred income tax liabilities                   |  |      | (7,298   | ) |      |   | (5,781   | )
|                                                      |  |      |          |   |      |   |          |  
|Net deferred income taxes                             |  | $    |         |   |      | $ |         |  
|                                                      |  |      |          |   |      |   |          |  



The Company
continually evaluates its deferred income tax assets to evaluate whether it is more likely than not that such assets will be realized. In assessing the realizability, 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 concerning the recoverability of the deferred income tax assets. As such, a valuation allowance has been provided
for the net deferred income tax assets as of December 31, 2005 and 2004. Of the $141.0 million valuation allowance at December 31, 2005, subsequently recognized income tax benefits, if any, in the amount of $4.2 million will be applied
directly to additional paid-in capital.



At December 31,
2005, the Company had available, for federal income tax purposes, net operating loss (NOL) carry-forwards of approximately $204.9 million, capital loss carry-forwards of approximately $40.4 million and research and development tax credit
carry-forwards of approximately $11.0 million expiring in varying amounts from 2006 through 2025. For state income tax purposes, the Company had available NOL carry-forwards of approximately $90.1 million and capital loss carry-forwards of $41.0
million and state tax credit carry-forwards of $7.0 million expiring in varying amounts from 2006 to 2024.



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 through 2005 will be subject to limitation under Section 382.



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Note 9. 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 10. Employee Benefit Plans



Employee Stock Purchase Plans



Under the Companys employee stock purchase plans, 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 1995 Employee Stock Purchase Plan, 105,199 shares were issued in 2004 and 81,494 shares were issued in 2003. This plan was closed effective
December 31, 2004. On May 19, 2005 the Companys shareholders approved the 2005 Employee Stock Purchase Plan. Under this plan, the Company is authorized to issue 1,000,000 shares of common stock. No shares were issued under this plan
during 2005.



Stock Option Plans



As of December 31, 2005, the Company has two stock options plans: the
1995 Stock Plan, as amended (the 1995 Plan) and the 2000 Stock Option Plan, as amended (the 2000 Plan). The 1995 Non-Employee Director Stock Option Plan, as amended (the Director Plan) expired during 2005.



Under the 1995 Plan, 31,400,000 shares of the Companys
common stock are available to grant to employees in the form of incentive stock options. Also, non-qualified stock options and stock awards may be granted to employees, consultants and directors. 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 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. The 1995 Plan, as amended, expires March 15, 2010. As of December 31, 2005, 2,013,602 shares were available for grant under the 1995 Plan.



The 2000 Plan provides for the granting of non-qualified options to employees
and consultants to purchase up to an aggregate of 10,000,000 shares of common stock. No member of the Board of Directors or executive officers appointed by the Board of Directors are 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 in 2010. 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, 2005, 2,295,163 shares were available
for grant under the 2000 Plan.



The Director Plan expired
during 2005, thus, as of December 31, 2005, no shares were available for grant under this plan. Prior to its expiration, the Director Plan provided for the automatic grant of options to non-employee directors on the anniversary date of each
individual board member joining the Board of Directors to purchase up to an aggregate of 2,075,000 shares. Upon joining the Board of Directors, each director was granted an option to purchase 37,500 shares, one-third of which vested immediately,
one-third after the first year, and the remaining one-third after the second year. Annually thereafter, each director was granted an option to purchase 28,800 shares, which vest fully after one year. The Director Plan was administered by the
Compensation Committee of the Board of Directors. No option granted under the Director Plan is exercisable after the expiration of five years from the date of grant. The exercise price of options under the Director Plan was required to equal the
fair market value of the common stock on the date of grant. Options granted under the Director Plan are generally nontransferable.



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Information regarding stock options follows:



|                                 |  |                              |   |  |                                          |      
|-------------------------------- |  | ---------------------------- | - |  | ---------------------------------------- | -----
|                                 |  | Number of optionsoutstanding |   |  | Weighted averageexercise price per share
|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 
|Granted and assumed              |  | 3,778,100                    |   |  |                                          | 1.52 
|Exercised                        |  | (711,320                     | ) |  |                                          | 1.01 
|Canceled                         |  | (3,119,136                   | ) |  |                                          | 13.84
|Outstanding at December 31, 2005 |  | 25,441,094                   |   |  | $                                        | 8.09 
|                                 |  |                              |   |  |                                          |      



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.



Options outstanding and exercisable at December 31, 2005 follow:



|                         |                |                                             |            |                                 |      |                     |   |                                 |  |            |  |   |      
|------------------------ | -------------- | ------------------------------------------- | ---------- | ------------------------------- | ---- | ------------------- | - | ------------------------------- |  | ---------- |  | - | -----
|Range of Exercise
prices |                | Number outstanding                          |            | Options Outstanding             |      | Options Exercisable
|                         |                | Weighted Average Remaining Contractual Life |            | Weighted average exercise price |      | Number exercisable  |   | Weighted average exercise price
|$                        | 0.28 to 1.12   |                                             | 2,905,437  |                                 | 4.23 |                     | $ | 0.89                            |  | 2,723,816  |  | $ | 0.88 
|                         | 1.13 to 1.50   |                                             | 3,420,157  |                                 | 5.25 |                     |   | 1.39                            |  | 2,705,910  |  |   | 1.38 
|                         | 1.52 to 1.65   |                                             | 2,851,109  |                                 | 5.62 |                     |   | 1.58                            |  | 2,435,163  |  |   | 1.58 
|                         | 1.66 to 2.47   |                                             | 3,275,853  |                                 | 4.91 |                     |   | 2.04                            |  | 2,577,726  |  |   | 2.13 
|                         | 2.50 to 3.39   |                                             | 2,642,017  |                                 | 3.24 |                     |   | 3.14                            |  | 2,618,443  |  |   | 3.14 
|                         | 3.56 to 8.54   |                                             | 2,914,809  |                                 | 2.93 |                     |   | 4.85                            |  | 2,908,234  |  |   | 4.85 
|                         | 8.66 to 10.75  |                                             | 3,000,116  |                                 | 2.79 |                     |   | 9.74                            |  | 3,000,116  |  |   | 9.74 
|                         | 11.04 to 30.94 |                                             | 2,929,397  |                                 | 1.48 |                     |   | 23.91                           |  | 2,929,397  |  |   | 23.91
|                         | 32.48 to 67.81 |                                             | 1,502,199  |                                 | 1.69 |                     |   | 43.74                           |  | 1,502,199  |  |   | 43.74
|                         |                |                                             |            |                                 |      |                     |   |                                 |  |            |  |   |      
|$                        | 0.28 to 67.81  |                                             | 25,441,094 |                                 | 3.72 |                     | $ | 8.09                            |  | 23,401,004 |  | $ | 8.67 
|                         |                |                                             |            |                                 |      |                     |   |                                 |  |            |  |   |      



Stock options
generally expire five, seven or ten years from the date of grant and generally vest ratably over periods ranging from immediately to 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 model with the following assumptions:



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



|                        |  |       |   |  |       |   |  |       |  
|----------------------- |  | ----- | - |  | ----- | - |  | ----- | -
|                        |  | 2005  |   |  | 2004  |   |  | 2003  |  
|Risk-free interest rate |  | 4.01  | % |  | 3.43  | % |  | 3.25  | %
|                        |  |       |  
|Expected life in years  |  | 2.23  |   |  | 2.3   |   |  | 1.9   |  
|                        |  |       |  
|Expected volatility     |  | 97.22 | % |  | 100.7 | % |  | 102.2 | %
|                        |  |       |  
|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 $0.81, $0.97 and $0.73 for the fiscal years ended December 31, 2005, 2004 and 2003, respectively.



As required by SFAS 123, the Company recognized compensation expense related to stock options granted to non-employees of $0.1 million in each of the
fiscal years ended December 31, 2005 and 2004.



In
December 2005, the Companys Board of Directors approved the acceleration of the vesting of certain stock options held by current non-officer employees with two or more years of employment with the Company. As a result, stock options to
purchase approximately 1.5 million shares that would have vested from time to time over the next four years became immediately exercisable. As such, the Company recorded compensation expense of approximately $0.3 million in the fourth quarter
of 2005. The accelerated vesting reduces the amount of compensation expense that the Company would have otherwise been required to recognize in 2006 and later upon the adoption effective January 1, 2006 of Financial Accounting Standards
Statement No. 123 (R), Share-Based Payment. The expected reduction in compensation expense for 2006 is approximately $0.4 million to $0.5 million.



Employee 401(k) Plan



The TranSwitch Corporation 401(k) Retirement 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. Contribution expense related to the Plan was $0.3 million, $0.4 million and
$0.4 million for the fiscal years ended December 31, 2005, 2004 and 2003, respectively.



Note 11. 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 were 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.



During 2001 and 2002, the Company repurchased a total of $345.9 million of the 4.50% Notes. In 2003, the Company completed its exchange offer with and new
money offering to the holders of the 4.50% Notes with the issuance of 5.45% Convertible Plus Cash Notes due September 30, 2007 (the Plus Cash Notes). This resulted in the retirement of $89.7 million of 4.50% Notes. The remaining $24.4 million
of 4.50% Notes were paid at maturity in September 2005.



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



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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  |  
|                                                       |  |   |         |  



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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 had elected an auto-conversion prior to September 30, 2005, the Company would have been obligated to 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 was obligated to 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 were automatically converted by the Company on or prior to
September 30, 2005. The auto-conversion make-whole provision represented an embedded derivative that was required to be accounted for apart from the underlying Plus Cash Notes. At issuance of the Plus 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 is being accreted to par value
through quarterly interest charges over the four-year term of the Plus Cash Notes. The auto-conversion make-whole provision could only be settled in cash, and accordingly, was classified as a derivative liability in the consolidated balance sheets
during the period that the provision was available. The auto-conversion make-whole provision was adjusted to its fair value on a quarterly basis for the first two years that such Plus Cash Notes were 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, 2005, 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 $0.1 million. The auto-conversion make-whole provision expired on September 30, 2005, thus there is no value to this
provision after that date. At December 31, 2004, the estimated fair value of the auto-conversion make-whole provision was approximately $0.1 million.



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



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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 a lattice (trinomial) 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, 2005, 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 $2.4 million. At December 31, 2005, the estimated fair value of the holders conversion
right was approximately $6.0 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, 2005 and 2004, the Company amortized
$4.5 million and $5.6 million, respectively, of debt discount related to the Plus Cash Notes.



Exchanges of the Plus Cash Notes for Shares of Common Stock



During the year ended December 31, 2005, the Company issued an aggregate of 4,186,534 shares of the Companys common stock plus approximately
$19.2 million cash in exchange for $25.7 million in aggregate original principal amount of the Plus Cash Notes and accrued interest. During 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. No commission or other remuneration was paid or given directly or indirectly for
soliciting these transactions. As a result of the exchanges, the Company recorded extinguishment losses of approximately $2.5 million in 2005 and $3.0 million in 2004. The recorded losses reflect the non-cash write-off of unamortized debt discount
and deferred debt issuance costs.



Note 12. Restructuring and Asset
Impairment Charges



The Company reviews long-lived assets,
which are held and used, including purchased intangible assets, for impairment whenever changes in circumstances indicate that the carrying amount may not be recoverable. During the second quarter of 2005, the Company conducted a review of
certain patent assets that were acquired with the Companys acquisition of Onex Communications Corporation (Onex) in 2001. The impairment review was conducted because the Company determined that it no longer had significant sales expectations
for the products related to these patents. As such, the Company determined that these patent assets were impaired and recorded an impairment charge of $1.0 million in the second quarter of 2005.



In January 2005, the Company implemented an organizational restructuring that
included the elimination of 26 positions, primarily in the Companys Shelton, Connecticut and Boston, Massachusetts locations. As a result, the Company recorded restructuring charges of approximately $0.7 million related to employee termination
benefits, $0.2 million related to asset impairments and $0.1 million related to excess facility costs, for a total restructuring charge of approximately $1.0 million. The restructuring is expected to reduce the Companys salary and personnel
expenses by approximately $2.5 million annually.



In March
2005, the Company implemented a plan to disengage from TranSwitch S.A. (formerly, ADV Engineering S.A.), a wholly owned research and development subsidiary in France. This action resulted in the dismissal of 20 employees and is expected to result in
operating savings of approximately $2.0 million annually. As a result of this action, the Company incurred restructuring charges of approximately $1.2 million related to employee termination benefits and $0.3 million related to legal and other
transaction costs. These charges were offset by translation and other gains of $0.6 million, for a net restructuring charge of approximately $0.9 million.



During the third quarter of 2005, the Company recorded net restructuring charges of approximately $0.2 million related to an organizational restructuring
of its Swiss design center. This action resulted in the dismissal of 4 employees and is expected to result in annual savings of approximately $0.6 million.



Also during the year ended December 31, 2005, the Company recorded restructuring benefits of $0.4 million reflecting the Companys new
agreements to sub-lease certain portions of excess facilities that had previously been accrued.



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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 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, 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.



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



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



A summary of the restructuring liabilities and activity follows:



|                              |  |                                          |        |                      |   |       |               |  |   |                         |   |  |                                    |        |   |                                          |   |      |   |  |   |       
|----------------------------- |  | ---------------------------------------- | ------ | -------------------- | - | ----- | ------------- |  | - | ----------------------- | - |  | ---------------------------------- | ------ | - | ---------------------------------------- | - | ---- | - |  | - | ------
|                              |  | Fiscal 2005 Activity                    
|                              |  | RestructuringLiabilitiesDecember 31,2004 |        | RestructuringCharges |   |       | Cash Payments |  |   | Non-cashassetwrite-offs |   |  | Adjustmentsand Changesto Estimates |        |   | RestructuringLiabilitiesDecember 31,2005
|Employee termination benefits |  | $                                        |       |                      | $ | 2,355 |               |  | $ | (2,355                  | ) |  | $                                  |       |   |                                          | $ |     |   |  | $ |      
|Facility lease costs          |  |                                          | 22,625 |                      |   | 161   |               |  |   | (607                    | ) |  |                                    |        |   |                                          |   | (434 | ) |  |   | 21,745
|Asset impairments             |  |                                          |       |                      |   | 1,222 |               |  |   |                        |   |  |                                    | (1,222 | ) |                                          |   |     |   |  |   |      
|Other                         |  |                                          |       |                      |   | (580  | )             |  |   | (285                    | ) |  |                                    | 879    |   |                                          |   |     |   |  |   | 14    
|                              |  |                                          |        |                      |   |       |               |  |   |                         |   |  |                                    |        |   |                                          |   |      |   |  |   |       
|Totals                        |  | $                                        | 22,625 |                      | $ | 3,158 |               |  | $ | (3,247                  | ) |  | $                                  | (343   | ) |                                          | $ | (434 | ) |  | $ | 21,759
|                              |  |                                          |        |                      |   |       |               |  |   |                         |   |  |                                    |        |   |                                          |   |      |   |  |   |       
|                              | 
|                              |  | Fiscal 2004 Activity                    
|                              |  | RestructuringLiabilitiesDecember 31,2003 |        | RestructuringCharges |   |       | Cash Payments |  |   | Non-cashassetwrite-offs |   |  | Adjustmentsand Changesto Estimates |        |   | RestructuringLiabilitiesDecember 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
|                              |  |                                          |        |                      |   |       |               |  |   |                         |   |  |                                    |        |   |                                          |   |      |   |  |   |       



Note 13. Commitments and Contingencies



Lease Agreements



The Company leases buildings
and equipment at its headquarters in Shelton, Connecticut as well as at its subsidiaries locations worldwide. Rental expense under all operating lease agreements was $1.3 million in 2005, $1.4 million in 2004 and $1.3 million in 2003.



During 2005, 2004 and 2003, the Company elected to exit
certain design centers, but continues to have lease obligations for these particular facilities (refer to Note 12Restructuring and Asset Impairment Charges for further disclosure). The following table summarizes as of December 31, 2005
future minimum operating lease commitments, including contractually obligated building operating commitments that have remaining, non-cancelable lease terms in excess of one year and future sublease income:



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



|           |  |                      |        |                    |   |                |  |   |       
|---------- |  | -------------------- | ------ | ------------------ | - | -------------- |  | - | ------
|           |  | OperatingCommitments |        | SubleaseAgreements |   | NetCommitments
|2006       |  | $                    | 4,435  |                    | $ | 2,426          |  | $ | 2,009 
|2007       |  |                      | 3,807  |                    |   | 2,383          |  |   | 1,424 
|2008       |  |                      | 3,799  |                    |   | 2,319          |  |   | 1,480 
|2009       |  |                      | 3,668  |                    |   | 1,041          |  |   | 2,627 
|2010       |  |                      | 3,584  |                    |   | 68             |  |   | 3,516 
|Thereafter |  |                      | 18,455 |                    |   |               |  |   | 18,455
|           |  |                      |        |                    |   |                |  |   |       
|           |  | $                    | 37,748 |                    | $ | 8,237          |  | $ | 29,511
|           |  |                      |        |                    |   |                |  |   |       



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 products 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 2005, 2004 and 2003.



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, 2005, the Company had purchase commitments totaling $5.0 million, of which $2.0 million related to licenses for engineering design tools to be purchased from one vendor in 2007.



Note 14. Supplemental Cash Flow Information



The following represents supplemental cash flow information:



|                           |  |                          |       |      |   |       |  |   |      
|-------------------------- |  | ------------------------ | ----- | ---- | - | ----- |  | - | -----
|                           |  | Years Ended December 31,
|                           |  | 2005                     |       | 2004 |   | 2003 
|Cash paid for interest     |  | $                        | 5,616 |      | $ | 6,264 |  | $ | 5,365
|Cash paid for income taxes |  | $                        | 290   |      | $ | 293   |  | $ | 233  



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



|                                                       |  |   |       |  |   |        |  |   |    
|------------------------------------------------------ |  | - | ----- |  | - | ------ |  | - | ---
|Company common stock issued in acquisitions            |  | $ |      |  | $ |       |  | $ | 308
|Common stock issued upon conversion of Plus Cash Notes |  | $ | 5,652 |  | $ | 16,303 |  | $ | 231



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



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Note 15. Quarterly Information (Unaudited)



The following table shows selected unaudited quarterly information of operating results. The Company believes that this
information reflects all normal recurring adjustments necessary for a fair presentation of the information for the periods presented. Interim operating results are not necessarily indicative of future period results.



|                                                                                                        |  |              |         |   |               |   |         |              |  |   |               |   |  |           |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ------------- | - | ------- | ------------ |  | - | ------------- | - |  | --------- | ------- | - |  | - | ------- | -
|                                                                                                        |  | FirstQuarter |         |   | SecondQuarter |   |         | ThirdQuarter |  |   | FourthQuarter |   |  | Full Year |        
|Year ended December 31, 2005                                                                            |  |              |         |   |               |   |         |              |  |   |               |   |  |           |         |   |  |   |         |  
|Net revenues                                                                                            |  | $            | 9,047   |   |               | $ | 7,951   |              |  | $ | 7,295         |   |  | $         | 8,607   |   |  | $ | 32,900  |  
|Cost of revenues                                                                                        |  |              | 2,803   |   |               |   | 2,077   |              |  |   | 1,625         |   |  |           | 1,838   |   |  |   | 8,343   |  
|Cost of revenuesprovision for excess and obsolete inventories                                          |  |              | 480     |   |               |   | 93      |              |  |   |              |   |  |           |        |   |  |   | 573     |  
|                                                                                                        |  |              |         |   |               |   |         |              |  |   |               |   |  |           |         |   |  |   |         |  
|Gross profit                                                                                            |  |              | 5,764   |   |               |   | 5,781   |              |  |   | 5,670         |   |  |           | 6,769   |   |  |   | 23,984  |  
|Net loss                                                                                                |  |              | (6,323  | ) |               |   | (12,697 | )            |  |   | (1,314        | ) |  |           | (3,420  | ) |  |   | (23,754 | )
|Net loss per common share (1):                                                                          |  |              |         |   |               |   |         |              |  |   |               |   |  |           |         |   |  |   |         |  
|Basic                                                                                                   |  | $            | (0.06   | ) |               | $ | (0.12   | )            |  | $ | (0.01         | ) |  | $         | (0.03   | ) |  | $ | (0.23   | )
|Diluted                                                                                                 |  | $            | (0.06   | ) |               | $ | (0.12   | )            |  | $ | (0.01         | ) |  | $         | (0.03   | ) |  | $ | (0.23   | )
|                                                                                                        |  |              |         |   |              
|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   | )

---

|(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.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Note 16. 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.



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TRANSWITCH CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Note 17. Subsequent Events



On January 31, 2006, the Company completed its acquisition of Mysticom Ltd. (Mysticom), an Israel-based privately-held developer of
high-performance, low-power, multi-gigabit Ethernet transceivers for the communications industry. The Company acquired Mysticom through the issuance of approximately $5.0 million of its common stock. Upon the satisfactory achievement of stipulated
revenues and operating cash flows over the next twelve months, the Company may pay up to an additional $10.0 million in the Companys common stock or cash, at its option. Mysticom will operate as a wholly owned subsidiary of the Company.



On February 1, 2006, the Company entered into agreements
providing for the exchange of approximately $24.6 million in aggregate principal amount of the Companys 5.45% Plus Cash NotesSM due 2007 (the Plus Cash Notes) and accrued interest for an aggregate of 1,500,000 shares of the
Companys common stock, par value $.001 per share plus approximately $22.6 million. The shares 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 these transactions. The Company expects to recognize a debt extinguishment loss in the first quarter of 2006 of approximately $3.1 million associated with this exchange. Approximately $2.9 million of this
loss relates to the non-cash write-off of unamortized debt discount and deferred debt issuance costs. This transaction will also reduce the fair value of the Companys outstanding derivative liability associated with the Plus Cash Notes by
approximately $2.7 million, which the Company expects to recognize as other income in the first quarter of 2006.



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##### Table of Contents

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 |   |  | Balanceat End of Year
|Year ended December 31, 2005:                  |  |                              |         |                             |   |        |                           |  |            |   |  |                       |        |   |  |   |        
|Allowance for losses on:                       |  |                              |         |                             |   |        |                           |  |            |   |  |                       |        |   |  |   |        
|Accounts receivable                            |  | $                            | 731     |                             | $ | (181   | )                         |  | $          |  |  | $                     | (104   | ) |  | $ | 446    
|Inventories (excess and obsolete)              |  |                              |        |                             |   | 573    |                           |  |            |  |  |                       | (573   | ) |  |   |       
|Sales returns and allowance                    |  |                              | 397     |                             |   | 153    |                           |  |            |  |  |                       | (505   | ) |  |   | 45     
|Stock rotation                                 |  |                              | 671     |                             |   | 418    |                           |  |            |  |  |                       | (418   | ) |  |   | 671    
|Warranty                                       |  |                              | 268     |                             |   | (118   | )                         |  |            |  |  |                       |       |   |  |   | 150    
|Deferred income tax assets valuation allowance |  |                              | 132,841 |                             |   | 8,188  |                           |  |            |  |  |                       |       |   |  |   | 141,029
|                                               |  |                              |         |                             |   |        |                           |  |            |   |  |                       |        |   |  |   |        
|                                               |  | $                            | 134,908 |                             | $ | 9,033  |                           |  | $          |  |  | $                     | (1,600 | ) |  | $ | 142,341
|                                               |  |                              |         |                             |   |        |                           |  |            |   |  |                       |        |   |  |   |        
|Year ended December 31, 2004:                  |  |                              |         |                             |   |        |                           |  |            |   |  |                       |        |   |  |   |        
|Allowance for losses on:                       |  |                              |         |                             |   |        |                           |  |            |   |  |                       |        |   |  |   |        
|Accounts receivable                            |  | $                            | 462     |                             | $ | 309    |                           |  | $          |  |  | $                     | (40    | ) |  | $ | 731    
|Inventories (excess and obsolete)              |  |                              |        |                             |   | 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 (excess and obsolete)              |  |                              |        |                             |   | 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
|                                               |  |                              |         |                             |   |        |                           |  |            |   |  |                       |        |   |  |   |        



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



On April 1, 2005, the Audit and Finance Committee
(the Audit Committee) of the Board of Directors of the Company dismissed KPMG LLP (KPMG) as the Companys principal accountants. The Companys Audit Committee engaged UHY LLP (UHY) to serve as the
Companys principal accountants.



The audit reports of
KPMG on the Companys consolidated financial statements as of and for the fiscal years ended December 31, 2004 and 2003 and managements assessment of internal control over financial reporting as of December 31, 2004, and the
effectiveness of internal control over financial reporting as of December 31, 2004, did not contain any adverse opinion or a disclaimer of opinion, nor were such reports qualified or modified as to uncertainty, audit scope or accounting principles,
except as follows: KPMGs report on the consolidated financial statements of the Company as of and for the years ended December 31, 2004 and 2003 contained a separate paragraph stating that the Company changed its method of computing
depreciation during 2003.



In connection with the audits
of the two years ended December 31, 2004 and 2003, and the subsequent interim period through April 1, 2005, there were no disagreements with KPMG on any matter of accounting principles or practices, financial statement disclosure, or auditing scope
or procedures, which disagreement, if not resolved to the satisfaction of KPMG, would have caused KPMG to make reference to the subject matter of the disagreement in their reports on the consolidated financial statements for such fiscal years. There
were no reportable events as that term is described in Item 304(a)(1)(v) of Regulation S-K of the Securities and Exchange Commission (the Commission) for the fiscal years ended December 31, 2004 and 2003 and through the date
of this report.



During the years ended December 31, 2004 and
December 31, 2003, and the subsequent interim period through April 1, 2005, the Company did not consult with UHY regarding (i) the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit
opinion that might be rendered on the Companys consolidated financial statements, or (ii) any matter that was the subject of a disagreement (as defined in Item 304(a)(1)(iv) of Regulation S-K and the related instructions) or a reportable event
(as described in Item 304(a)(1)(v) of Regulation S-K).



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, 2005.



Our managements assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by UHY 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, 2005, that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



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##### Table of Contents

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 18, 2006, 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, 2005. 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 at http://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, 2005.



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 18, 2006 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, 2005.



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 18, 2006 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, 2005.



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
definitive proxy statement for the annual meeting of shareholders of the Company to be held on May 18, 2006, 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, 2005.



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PART IV



Item 15.Exhibits and Financial Statement Schedules



|(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:
|------ | -------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                                                                                          |  |     
|--------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                          |  | PAGE
|FINANCIAL STATEMENTS                                                                                      |  |     
|Consolidated Balance Sheets  December 31, 2005 and 2004                                                  |  | 50  
|Consolidated Statements of Operations - December 31, 2005, 2004 and 2003                                  |  | 51  
|Consolidated Statements of Stockholders Equity and Comprehensive Loss - December 31, 2005, 2004 and 2003 |  | 52  
|Consolidated Statements of Cash Flows - December 31, 2005, 2004 and 2003                                  |  | 53  
|Notes to Consolidated Financial Statements                                                                |  | 54  
|Schedule II                                                                                               |  | 77  



|(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squarterly report on Form 10Q for the quarter ended March 31,
2005 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 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).
|     | 
|4.5  |  | 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).                                                                                                                                       
|     | 
|4.6  |  | 2005 Employee Stock Purchase Plan (filed as Exhibit 4.2 to the Companys registration statement on Form S-8 (File No. 333-126129) and incorporated herein by reference).                                                                                                                                                                                                                             
|     | 
|4.7  |  | Form of Employee Stock Purchase Plan Enrollment Authorization Form (filed as Exhibit 4.3 to the Companys registration statement on Form S-8 (File No. 333-126129) and incorporated herein by
reference).                                                                                                                                                                                            
|     | 
|4.8  |  | Form of Employee Stock Purchase Plan Change / Withdrawal Authorization Form (filed as Exhibit 4.4 to the Companys registration statement on Form S-8 (File No. 333-126129) and incorporated
herein by reference).                                                                                                                                                                                   
|     | 
|10.1 |  | Third Amended and Restated 1995 Stock Option Plan, as amended (previously filed as an exhibit to the companys current report on Form 8-K as filed on May 23, 2005).*                                                                                                                                                                                                                                



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##### Table of Contents

|      |  |                                                                                                                                                                                                                                                                                                                                  
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.2  |  | 1995 Non-Employee Director Stock Option Plan, as amended (previously filed as Exhibit 4.4 to the TranSwitchs RegistrationStatement 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.                                      
|      | 
|10.13 |  | Agreement and Plan of Merger, dated December 6, 2005, by and among TranSwitch Corporation, Malgam Ltd., and Mysticom, Ltd. (previously filed as Exhibit 2.1 to TranSwitchs Registration
Statement on Form S-3 (File No. 333-131772) and incorporated herein by reference).                                                      
|      | 
|10.14 |  | Escrow Agreement, dated January 30, 2006, by and among TranSwitch Corporation, Mysticom, Ltd., certain security holders of Mysticom, Ltd., Bruce Crocker, and U.S. National Bank (previously filed
as Exhibit 2.2 to TranSwitchs Registration Statement on Form S-3 (File No. 333-131772) and incorporated herein by reference).
|      | 
|10.15 |  | Registration Rights Agreement, dated January 30, 2006, by and between TranSwitch Corporation and certain security holders (previously filed as Exhibit 2.3 to TranSwitchs Registration
Statement on Form S-3 (File No. 333-131772) 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).                                                                                                                                                                                                                                                              
|      | 
|16.1  |  | Letter of KPMG LLP to the Securities and Exchange Commission dated April 4, 2005 (previously filed as an exhibit to the Companys current report on Form 8-K as filed on April 6,
2005).                                                                                                                                         
|      | 
|21.1  |  | Subsidiaries of the Company (filed herewith).                                                                                                                                                                                                                                                                                    



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|     |  |                                                                                                                                                                                               
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|23.1 |  | Consent of UHY LLP, Independent Registered Public Accounting Firm (filed herewith).                                                                                                           
|     | 
|23.2 |  | Consent of KPMG LLP, Independent Registered Public Accounting Firm (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) Exhibits



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



(c) 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.



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SIGNATURES



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



TRANSWITCH CORPORATIONBy:

/s/ DR. SANTANU DASDr. Santanu DasPresident and Chief Executive Officer




February 20, 2006



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           |  | President and Chief Executive Officer (principal executive officer)                                       |  | February 20, 2006
|                                             |  |                                                                                                          
|/s/ PETER J. TALLIANMr. Peter J. Tallian     |  | Senior Vice President, Chief Financial Officer and Treasurer (principal financial and accounting officer) |  | February 20, 2006
|                                             |  |                                                                                                          
|Mr. Alfred F. Boschulte                      |  | Director, Chairman of the Board                                                                           |  | February 20, 2006
|                                             |  |                                                                                                          
|/s/ GERALD F. MONTRYMr. Gerald F. Montry     |  | Director                                                                                                  |  | February 20, 2006
|                                             |  |                                                                                                          
|/s/ JAMES M. PAGOSMr. James M. Pagos         |  | Director                                                                                                  |  | February 20, 2006
|                                             |  |                                                                                                          
|/s/ ALBERT E. PALADINODr. Albert E. Paladino |  | Director                                                                                                  |  | February 20, 2006
|                                             |  |                                                                                                          
|Mr. Erik H. van der Kaay                     |  | Director                                                                                                  |  | February 20, 2006
|                                             |  |                                                                                                          
|/s/ HAGEN HULTZSCHDr. Hagen Hultzsch         |  | Director                                                                                                  |  | February 20, 2006



83