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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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ANNUAL REPORT

PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



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

For the fiscal year ended December 31, 2006

OR



| ̈ | 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

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

None

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



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

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



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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ̈

Indicate by check mark whether the
registrant is 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, on
June 30, 2006 was approximately $197.3 million. At February 28, 2007, as reported on the Nasdaq Global Market, there were 132,036,541 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 2007 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 1A. Risk Factors and Item 7. Managements Discussion
and Analysis of Financial Condition and Results of Operations.

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 results in defining and developing 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

In 2006,
there were a number of mergers and acquisitions among North American telecommunication carriers (telcos) and Western Hemisphere communications OEMs. As companies merge or consolidate, the rate of ordering, purchasing and deploying new equipment
typically slows. As these consolidations complete, we are seeing a shift in demand toward newer technologies that we introduced into the market in the last several years. In 2006, we saw demand for legacy network products decline, which is an
indicator that the industry is ready to replace existing networks with new networks. We also saw a good growth in new product revenue, and in fact, the new product growth outpaced the natural decline in older product revenue in 2006.

Communications service providers, Internet service providers, regional Bell operating companies and inter-exchange carriers generally closely monitor
their capital expenditures. Spending on voice-only equipment has been slowing over the last few years, while spending on equipment providing the efficient transport of data services on existing infrastructure continues to



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grow. More importantly to TranSwitch, major infrastructure initiatives are underway where telcos are building new, end-to-end IP-based, next-generation
networks. The clearest example of this is British Telecoms 21stCentury Network. Demand for new, high
bandwidth services such as video conferencing, broadband audio, high speed internet and other data services is placing an increased burden on existing public network infrastructure. Service providers understand that consumers want one provider to
deliver all their services. They have to roll out triple play services and quad play services (voice, data, video and wireless) or risk losing customers. Competition between telcos and cable TV providers offering triple play service is driving
equipment spending for broadband access, carrier-class routers/switches, and metro optical gear. Wire-line equipment vendors and communication IC vendors with the right products and technologies will be major beneficiaries of this spending by
carriers and cable TV service providers.

TranSwitch is 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 the advent 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, further investment in network upgrades will be needed.

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 rapidly
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



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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.

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 2006, the prices for our products ranged from approximately $30 to $400 per device, depending on technology, volume, complexity and functionality.

Our product portfolio continued to expand in 2006, driven by our customers 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 2006, we introduced the VTXP-24 and PacketTrunk-4 Plus. Also introduced in 2006 was the Diplomat-IP (a
device for Digital Subscriber Line Access Multiplexers (DSLAMs) and other broadband aggregation applications) whose design has several advantages including low manufacturing cost, low power dissipation, and high performance. These data-oriented
product families have continued their design-win momentum during 2006 with numerous 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



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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.

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 de-multiplexers, 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 allow our 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.



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The following tables summarize our net product revenue mix by product line for the years ended
December 31, 2006, 2005 and 2004 (dollar amounts in thousands), respectively:



|                 |                 |                             |                           |  |                             |                 |  |                             |        |  |                 |   |                           |   |        |  |     |  
|---------------- | --------------- | --------------------------- | ------------------------- |  | --------------------------- | --------------- |  | --------------------------- | ------ |  | --------------- | - | ------------------------- | - | ------ |  | --- | -
|                 |                 | Year endedDecember 31, 2006 |                           |  | Year endedDecember 31, 2005 |                 |  | Year endedDecember 31, 2004 |       
|                 | ProductRevenues |                             | Percent ofProductRevenues |  |                             | ProductRevenues |  | Percent ofProductRevenues   |        |  | ProductRevenues |   | Percent ofProductRevenues |  
|SONET/SDH        |                 | $                           | 24,554                    |  | 68                          | %               |  | $                           | 19,382 |  | 59              | % |                           | $ | 15,385 |  | 46  | %
|ATM/IP           |                 |                             | 5,837                     |  | 16                          | %               |  |                             | 7,228  |  | 22              | % |                           |   | 9,861  |  | 29  | %
|Asynchronous/PDH |                 |                             | 5,768                     |  | 16                          | %               |  |                             | 6,281  |  | 19              | % |                           |   | 8,235  |  | 25  | %
|                 |                 |                             |                           |  |                             |                 |  |                             |        |  |                 |   |                           |   |        |  |     |  
|Total            |                 | $                           | 36,159                    |  | 100                         | %               |  | $                           | 32,891 |  | 100             | % |                           | $ | 33,481 |  | 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 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 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 other TDM and data oriented equipment.

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



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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.

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 will continue to develop highly
integrated products that combine the use of embedded software-programmable blocks and optimized hardware blocks in order to provide an optimal level of performance and flexibility to our customers. This flexibility enables customers to adapt the
product for their unique needs or to accommodate changes resulting from emerging telecommunications standards.



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Seek Early Market Penetration Through Customer Sponsorship

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

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 wire-line 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.

Note 7 of the Notes to Consolidated Financial Statements provides data on major customers for the last three years.



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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, 2006, we had 160 full-time employees engaged in research and product development
efforts. We employ engineers who have the necessary VLSI, high speed mixed signal, firmware, software, hardware, physical design, verification, and validation expertise and development experience. These engineers are responsible for delivering VLSI
and Evaluation/Demo products for telecommunications and data communications applications.

Research and development expenditures for the
years ended December 31, 2006, 2005 and 2004 were $21.2 million, $21.3 million, and $46.0 million, respectively.

All products
are developed and delivered using documented design processes (product life cycle) that have been certified to meet the ISO 9001:2000 international standard. Our design tools and development environment are continuously reviewed and updated
to improve design, verification, fabrication and validation methodology, design flow and processes of our product life cycle.

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 2006, we have been issued or became an assignee of 127 presently maintained patents worldwide with an additional 74 patents pending worldwide. Of that number, we have been assigned 62 presently
maintained United States patents, of which two are co-assigned. Among the worldwide patents pending, there were 35 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), Finland and
Hong Kong. Internationally, there are 22 patents pending in specific countries with an additional 17 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.



10



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



| |  |  | 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 became 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.



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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 year ended 2003 through the first quarter of 2007. During the years ended December 31, 2005 and 2004, there were no acquisitions.



|                                          |  |               |  |                                      
|----------------------------------------- |  | ------------- |  | -------------------------------------
|Acquired Company                          |  | Date Acquired |  | Technology / Skill Acquired          
|ASIC Design Center Division of Data  JCE |  | January 2007  |  | Custom ASIC Development and Logistics
|Mysticom, Ltd.                            |  | January 2006  |  | Analog/Mixed signal design resources 
|ASIC Design Services, Inc.                |  | August 2003   |  | SONET/SDH design resources           

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. 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.

Information on investments in non-publicly traded companies is in Note 4 of the Notes to Consolidated Financial Statements.

Investments in Venture Capital Funds

TranSwitch
invests in venture capital funds as it provides TranSwitch access to new technologies and relationships integral for maintaining technological advantages in the development of advanced semiconductor products for the communications industry. Neurone
Ventures II (Neurone), 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. In 2006, this trend continued, however, certain deployments were delayed by merger and acquisition activity that took place among both communications service providers as well as
equipment manufacturers.

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



12



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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.

In the period following 2001 when the telecommunications industry suffered a major correction, a
number of our traditional competitors diverted their focus towards alternate markets such as storage and enterprise. TranSwitch, however, made a deliberate decision to remain focused on telecommunications and to improve its competitive standing in
this arena as the market recovered. We concluded that future investment in communications technology would be driven by video, high speed data and mobility services, and adjusted our product focus accordingly to develop products for Ethernet over
SONET and Carrier Ethernet applications.

Presently, many of our traditional competitors are attempting to re-enter the communications
market, since a recovery is underway. However, our sustained focus on this market during the past several years has enabled us to build a robust product portfolio, secure several key design wins and strengthen our relationships with Tier-1
customers. As a result, we believe we are very well positioned on a competitive basis.

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, NEC Corporation and Fujitsu Corporation. New entrants are also likely to attempt to
obtain a share of the market for our current and future products.

Our principal competitors are Applied Micro Circuits Corporation,
Conexant Systems, Inc., Cirrus Logic, Inc., Infineon Technologies, Exar Corporation, Agere Systems, PMC-Sierra Inc., TriQuint Semiconductor, Inc., Mindspeed Technologies 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. Other domestic
and international vendors have announced plans to enter into this market.

Backlog

As of December 31, 2006 our backlog was $7.0 million, as compared to $9.2 million as of December 31, 2005. Backlog represents firm orders
anticipated to be shipped, and service revenue expected to be billed under existing contracts, during 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, 2006, we had 232 full time employees, including 160 in research and development, 42 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.



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|Item 1A. | Risk Factors
|-------- | ------------

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 past several years. Due to current economic conditions, we expect that our revenues 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.

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.

We continue to have substantial indebtedness.

As of December 31, 2006, we have approximately $30.2 million in principal amount of indebtedness outstanding in the form of our Plus Cash Notes.
These notes are due in September, 2007.

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,



14



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and, if certain conditions are met, we have the option of settling this cash amount in additional shares of our common stock. These Plus Cash Notes also
permit us to automatically convert some or all of the Plus Cash Notes into shares of our common stock subject to certain conditions. We may not elect to settle the plus cash amount payable upon voluntary or automatic conversion in additional shares
of our common stock, or we may be restricted from doing so pursuant to the terms of the Plus Cash Notes. If 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 cash equivalents each quarter to fund our operations, investments and financing activities.

We anticipate that we will use approximately $8.0 million to $9.0 million in cash and cash equivalents during the first quarter of 2007 to fund our operations, investments and interest payments on debt.

The Company believes that it has adequate cash and cash equivalents to fund its operations, investments and to meet its debt obligations through at least
December 31, 2007.

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

If our cash, cash equivalents 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.

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.

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



15



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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.

If the trading price of our common stock fails to comply with the continued listing requirements of The NASDAQ Global 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 Global Market and is subject to certain listing requirements, including the requirement that the closing bid price for our shares of common stock exceed $1.00. On
February 28, 2007 the price of our shares was $1.36. 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 Capital Market.

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

If our stock were to trade on the over-the-counter market, selling our common stock
could be more difficult because smaller quantities of shares would likely be bought and sold, transactions could be delayed, and security analysts coverage of us may be reduced. In addition, in the event our common stock is de-listed,
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 Global 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 18, 2006,
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 2007 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 de-listed from The NASDAQ Global 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 Global 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.



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

We
may have to further restructure our business.

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, 2006 and 2005, shipments to our top five customers, including sales to distributors, accounted for
approximately 45% and 48% of our total net revenues, respectively. We expect that a limited number of customers may account for a substantial portion of our total net revenues for the foreseeable future.

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



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



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



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



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

We cannot be certain that our current customers will continue to place orders with us, that orders by existing customers will return to the levels of
previous periods or that we will be able to obtain orders from new customers. We have no long-term volume purchase commitments from any of our significant customers.

The cyclical nature of the communication semiconductor industry affects our business.

In 2004, the
market for our products continued its recovery from prior years, 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. In 2006, the industry was marked by a number of high profile mergers and acquisitions both by service providers as well as by equipment manufacturers. Communication service providers, Internet
service providers, regional Bell operating companies and inter-exchange 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 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,
2006, foreign shipments accounted for approximately 75% of our total net product and services revenues as compared to 85% 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:



17



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



| |  |  | 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 develop products that
utilize new process technologies.

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.



18



---

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

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



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



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



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



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



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

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



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



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



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



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



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

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

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

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

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

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

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

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



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



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



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



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



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



19



---

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

Our products must successfully include industry standards to remain competitive.

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

Our intellectual property indemnification practices may adversely impact our business.

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

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

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

We face intense competition in the communication semiconductor market.

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



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



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



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



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



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



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

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

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



20



---

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



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



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



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



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

The
telecommunications and data communications industries, which are our primary target markets, have become intensely competitive because of deregulation, heightened international competition and significant decreases in demand since 2000. A number of
our customers have internal semiconductor design or manufacturing capability with which we also compete in addition to our other competitors. 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.
| | - |  | ---------------------------------------------------------------------------------------------------------------



21



---

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 involves 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.
| | - |  | -----------------------------------------------------------------------------------------------



22



---

If the requirements for the earn-out provisions agreed to in connection with the acquisition of the ASIC Design Center
Division of Data - JCE 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 the ASIC division of Data  JCE, 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 the ASIC Design Services, Inc. (ASIC), acquired in August 2003, and Mysticom, acquired in January 2006, have been
completed. Additionally, in January of 2007, we acquired substantially all of the assets of the ASIC Design Center Division of Data-JCE in Israel. The integration of this ASIC design center 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.

From time to time we have made investments in early stage venture-backed, start-up companies that develop
technologies that are complementary to our product roadmap. In April 2003, TranSwitch made an initial investment in Opulan Technologies Corp. (Opulan). Opulan develops high performance and cost-effective IP convergence ASSPs from its development
facility in Shanghai, China. 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.



23



---

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

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, and sales, design and engineering
operations in Israel. 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.



|Item 1B. | Unresolved Staff Comments
|-------- | -------------------------

Not applicable.



24



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|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       |  | November 2012April 2017
|Raleigh, North Carolina |  | Product Development                                                                            |  | 10,572        |  | Less than 1 Year        
|Netanya, Israel         |  | Mysticom, Product Development                                                                  |  | 7,804         |  | Less than 1 Year        
|Bedford, Massachusetts  |  | Product Development                                                                            |  | 10,053        |  | Less than 1 Year        
|San Jose, California    |  | Sales and Sales Support                                                                        |  | 2,535         |  | September 2009          
|Toulouse, France        |  | Product Development                                                                            |  | 4,200         |  | Less than 1 Year        
|Eclubens, Switzerland   |  | Product Development                                                                            |  | 961           |  | Less than 1 Year        
|Taipei, Taiwan          |  | Sales Support                                                                                  |  | 2,500         |  | Less than 1 Year        
|New Delhi, India        |  | Product Development                                                                            |  | 48,554        |  | January 2015            
|Herzelia, Israel        |  | Sales and Sales Support                                                                        |  | 248           |  | Less than 1 Year        

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 2006 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 2006, 2005, 2004, 2003, 2002 and
2001. Approximately 115,559 square feet of this space is currently being sublet.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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

We are not party
to any material litigation proceedings.

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, 2006.



25



---

PART II



|Item 5. | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
|------- | ------------------------------------------------------------------------------------------------------------

Our common stock is traded under the symbol TXCC on the Nasdaq Global 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, 2006 |  |      |      |     |   |     
|First Quarter                |  | $    | 2.60 |     | $ | 1.68
|Second Quarter               |  | $    | 2.84 |     | $ | 1.83
|Third Quarter                |  | $    | 2.07 |     | $ | 1.41
|Fourth Quarter               |  | $    | 1.71 |     | $ | 1.26
|                             |  |     
|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

As of January 31, 2007, there were approximately 499 holders of record and approximately
21,764 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, 2006 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 EquityCompensationPlans (excludingSecurities reflectedin Column (a))
|                                                           |  | (a)                                                               |     |  | (b)                                                |      |     | (c)                                                                                                                                 
|Equity Compensation Plans Approved by Stockholders (1)     |  | 17,242,647                                                        | (3) |  | $                                                  | 6.98 | (3) |                                                                                                                                      | 2,792,522
|Equity Compensation Plans Not Approved by Stockholders (2) |  | 7,007,542                                                         |     |  | $                                                  | 9.42 |     |                                                                                                                                      | 1,569,609
|                                                           |  |                                                                   |     |  |                                                    |      |     |                                                                                                                                      |          
|Total                                                      |  | 24,250,189                                                        |     |  | $                                                  | 7.69 |     |                                                                                                                                      | 4,362,131
|                                                           |  |                                                                   |     |  |                                                    |      |     |                                                                                                                                      |          

---

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



26



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Recent Sales of Unregistered Securities

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 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 recognized a debt extinguishment loss in the first quarter of 2006 of
approximately $3.1 million associated with this exchange.

On January 11, 2007, the Company completed the acquisition of the ASIC
Design Center of Data  JCE, an Israel-based publicly held electronics components distribution company. In consideration of this acquisition, the Company issued to Data  JCE 3,746,713 shares of the Companys common stock, par value
$.001. The issuance of this common stock was for the specific purpose of this acquisition and did not involve any public sale of securities. 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.



27



---

|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, |        
|                                                                                                                            | 2006                                                       |                          |         | 2005 |  |   | 2004    |   |  | 2003 |         |   | 2002 |  
|                                                                                                                            | (Amounts presented in thousands, except per share amounts) |                         
|Selected Statements of Operations Data:                                                                                     |                                                            |                          |         |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |          |  
|Net revenues                                                                                                                |                                                            | $                        | 38,920  |      |  | $ | 32,900  |   |  | $    | 33,687  |   |      | $ | 23,820  |   |  | $ | 16,636   |  
|Gross profit                                                                                                                |                                                            |                          | 28,174  |      |  |   | 23,984  |   |  |      | 23,347  |   |      |   | 15,903  |   |  |   | 5,857    |  
|Operating loss                                                                                                              |                                                            |                          | (11,136 | )    |  |   | (14,662 | ) |  |      | (43,049 | ) |      |   | (45,739 | ) |  |   | (134,034 | )
|Loss before extraordinary loss and cumulative effect of adoption of and change in accounting principle                      |                                                            |                          | (10,856 | )    |  |   | (23,754 | ) |  |      | (44,347 | ) |      |   | (37,692 | ) |  |   | (165,224 | )
|Extraordinary loss upon consolidation of TeraOp (USA), Inc.                                                                 |                                                            |                          |        |      |  |   |        |   |  |      |        |   |      |   | (83     | ) |  |   |         |  
|Cumulative effect on prior years adoption of and retroactive application of FIN 46R and new depreciation method             |                                                            |                          |        |      |  |   |        |   |  |      | (277    | ) |      |   | (805    | ) |  |   |         |  
|                                                                                                                            |                                                            |                          |         |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |          |  
|Net loss (1)(2)                                                                                                             |                                                            | $                        | (10,856 | )    |  | $ | (23,754 | ) |  | $    | (44,624 | ) |      | $ | (38,580 | ) |  | $ | (165,224 | )
|                                                                                                                            |                                                            |                          |         |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |          |  
|Basic and diluted loss per common share before extraordinary loss and cumulative effect of a change in accounting principle |                                                            | $                        | (0.09   | )    |  | $ | (0.23   | ) |  | $    | (0.47   | ) |      | $ | (0.42   | ) |  | $ | (1.84    | )
|Basic and diluted loss per common share                                                                                     |                                                            | $                        | (0.09   | )    |  | $ | (0.23   | ) |  | $    | (0.47   | ) |      | $ | (0.43   | ) |  | $ | (1.84    | )
|Shares used in calculation of basic and diluted loss per common share                                                       |                                                            |                          | 124,801 |      |  |   | 104,779 |   |  |      | 94,638  |   |      |   | 90,406  |   |  |   | 90,037   |  



|                                                                                                        |      |              |        |  |      |        |      |   |         |  |   |         |  |   |        
|------------------------------------------------------------------------------------------------------- | ---- | ------------ | ------ |  | ---- | ------ | ---- | - | ------- |  | - | ------- |  | - | -------
|                                                                                                        |      | December 31,
|                                                                                                        | 2006 |              | 2005   |  | 2004 |        | 2003 |   | 2002   
|Selected Balance Sheet Data:                                                                            |      |              |        |  |      |        |      |   |         |  |   |         |  |   |        
|Cash, cash equivalents and short-term investments                                                       |      | $            | 57,723 |  | $    | 72,702 |      | $ | 102,504 |  | $ | 152,051 |  | $ | 183,647
|Total current assets                                                                                    |      |              | 68,236 |  |      | 80,822 |      |   | 112,475 |  |   | 161,485 |  |   | 194,513
|Working capital                                                                                         |      |              | 30,323 |  |      | 73,385 |      |   | 76,361  |  |   | 147,845 |  |   | 176,783
|Long-term investments (marketable securities)                                                           |      |              |       |  |      |       |      |   | 32,178  |  |   | 27,300  |  |   | 21,819 
|Total non-current assets                                                                                |      |              | 14,420 |  |      | 6,004  |      |   | 42,233  |  |   | 44,821  |  |   | 48,840 
|Total assets                                                                                            |      |              | 82,656 |  |      | 86,826 |      |   | 154,708 |  |   | 206,306 |  |   | 243,353
|                                                                                                        |      |              |        |  |     
|Convertible Notes due within one year                                                                   |      |              | 28,811 |  |      |       |      |   | 24.442  |  |   |        |  |   |       
|Derivative liability                                                                                    |      |              | 980    |  |      |       |      |   |        |  |   |        |  |   |       
|Total current liabilities                                                                               |      |              | 37,913 |  |      | 7,437  |      |   | 36,114  |  |   | 13,640  |  |   | 17,730 
|4.50% Convertible Notes due 2005                                                                        |      |              |       |  |      |       |      |   |        |  |   | 24,442  |  |   | 114,113
|5.45% Convertible Plus Cash Notes due 2007, net of debt discount of $1,343, $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                                                                           |      |              | 20,689 |  |      | 76,180 |      |   | 97,363  |  |   | 143,656 |  |   | 139,962
|Total stockholders equity                                                                              |      |              | 24,054 |  |      | 3,209  |      |   | 21,231  |  |   | 49,010  |  |   | 85,661 
|Book value per share                                                                                    |      | $            | 0.19   |  | $    | 0.03   |      | $ | 0.21    |  | $ | 0.54    |  | $ | 0.95   

---

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

|(2) | Effective January 1, 2006, we adopted SFAS No. 123R. As such, the reported net loss for 2006 reflects stock-based compensation expense of $2.4 million.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------



28



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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, 2006, 2005 and 2004. 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.

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 Item 1A Risk Factors 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.

For the years ended December 31, 2006 and 2005, our revenues were $38.9 million and $32.9 million, respectively. This compares with revenues of $33.7 million for the year 2004. We believe that our investment in product development has
positioned us to take advantage of a strengthening market.



29



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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 Notes due 2007;

(3) estimating stock-based compensation;

(4) estimating goodwill value;

(5) estimating excess inventories;

(6) estimating restructuring liabilities; and

(7) 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. Such accruals have been insignificant for the last three years.

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, 2006, we had
established a liability of $0.1 million and an inventory asset of approximately zero for a stock rotation reserve for future estimated returns totaling $0.1 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, 2005. Should our actual experience differ from our estimated liabilities, there could be adjustments (either favorable or unfavorable) to our net
revenues, cost of revenues and gross profits.

We warranty our products for up to one year from the date of shipment. A liability is
recorded for estimated claims to be incurred under product warranties and is based primarily on historical experience. Estimated warranty expense is recorded as cost of product revenues when products are shipped. As of December 31, 2006 and
2005, we had a warranty liability established in the amounts of zero and $0.1 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,
2006. 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 Notes 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



30



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terms governing our 5.45% Convertible Plus Cash Notes 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, 2006, we recorded other income of
$5.1 million, all of which related to the holders conversion right, to reflect the change in fair value of our derivative liability. 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, which is shown
below:



|                                                                                                                           |  |                  |       |                  |   |                  |  |   |       
|-------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ----- | ---------------- | - | ---------------- |  | - | ------
|(Tabular dollars in thousands, except per share amounts)                                                                   |  | December 31,2006 |       | December 31,2005 |   | December 31,2004
|Closing price of our common stock used to value our derivative liability                                                   |  | $                | 1.40  |                  | $ | 1.83             |  | $ | 1.54  
|Estimated fair value of Auto-Conversion Make Whole Provision                                                               |  |                  |      |                  |   |                 |  |   | 74    
|Estimated fair value of Holders Conversion Right                                                                          |  |                  | 980   |                  |   | 6,040            |  |   | 8,461 
|                                                                                                                           |  |                  |       |                  |   |                  |  |   |       
|Total Liability                                                                                                            |  | $                | 980   |                  | $ | 6,040            |  | $ | 8,535 
|                                                                                                                           |  |                  |       |                  |   |                  |  |   |       
|Total change in fair value determined during the years ended December 31, 2006, 2005 and 2004 and recorded as other
income |  | $                | 5,060 |                  | $ | 2,495            |  | $ | 12,124

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, 2006, the estimated fair value of our derivative liability was $1.0 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, 2006 and 2005. 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. 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. 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.



|                                                                                                                                 |  |   |       |  |   |       |  |   |       |  |   |        |  |   |       |   |  |   |       |   |  |   |        |  
|-------------------------------------------------------------------------------------------------------------------------------- |  | - | ----- |  | - | ----- |  | - | ----- |  | - | ------ |  | - | ----- | - |  | - | ----- | - |  | - | ------ | -
|(Tabular dollars in thousands, except per share amounts)                                                                         |  |   |       |  |   |       |  |   |       |  |   |        |  |   |       |   | 
|% change from our actual common stock price of $1.40 as of December 31, 2006                                                     |  |   | (50)% |  |   | (25)% |  |   | (10)% |  |   | Actual |  |   | 10%   |   |  |   | 25%   |   |  |   | 50%    |  
|                                                                                                                                 |  |   |       |  |   |       |  |   |       |  |   |        |  |   |       |   |  |   |       |   |  |   |        |  
|Closing price of our common stock used to value our derivative liability                                                         |  | $ | 0.70  |  | $ | 1.05  |  | $ | 1.26  |  | $ | 1.40   |  | $ | 1.54  |   |  | $ | 1.75  |   |  | $ | 2.10   |  
|                                                                                                                                 |  |   |       |  |   |       |  |   |       |  |   |        |  |   |       |   |  |   |       |   |  |   |        |  
|Estimated fair value of our derivative liability as of December 31, 2006                                                         |  | $ | 118   |  | $ | 435   |  | $ | 735   |  | $ | 980    |  | $ | 1,256 |   |  | $ | 1,728 |   |  | $ | 2,643  |  
|                                                                                                                                 |  |   |       |  |   |       |  |   |       |  |   |        |  |   |       |   |  |   |       |   |  |   |        |  
|Change in fair value of our derivative liability determined during the year ended December 31, 2006 and recorded as other
income |  | $ | 5,922 |  | $ | 5,605 |  | $ | 5,305 |  | $ | 5,060  |  | $ | 4,784 |   |  | $ | 4,312 |   |  | $ | 3,397  |  
|                                                                                                                                 |  |   |       |  |   |       |  |   |       |  |   |        |  |   |       |   |  |   |       |   |  |   |        |  
|Incremental other income (expense) that would have been recorded in the year ended December 31, 2006                             |  | $ | 862   |  | $ | 545   |  | $ | 245   |  | $ |       |  | $ | (276  | ) |  | $ | (748  | ) |  | $ | (1,663 | )
|                                                                                                                                 |  |   |       |  |   |       |  |   |       |  |   |        |  |   |       |   |  |   |       |   |  |   |        |  

As of December 31, 2006 and 2005, 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



31



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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.

Stock-based
Compensation.Determining the amount of stock-based compensation for awards granted includes selecting an appropriate model to calculate fair value. We have used the Black-Scholes option valuation model to value employee stock option awards.
Certain inputs to this valuation model require considerable judgment. These inputs include estimating the volatility of our stock, the expected life of the option awarded and the forfeiture rate. We have estimated volatility, the expected life and
the forfeiture rate based on historical data. Volatility is estimated over a term that approximates the expected life of the option awarded.

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 zero, $0.6 million, $0.6 million and $1.5 million during the fiscal years ended December 31, 2006, 2005, 2004 and 2003, respectively. Most
of these products have not been disposed of and remain in our inventory.

During fiscal 2006, 2005 and 2004, we recorded net product
revenues of approximately $9.1 million, $12.2 million and $10.9 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 68%, 69% and 60% in 2006, 2005 and 2004 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, 2006,
2005 and 2004, we recorded restructuring charges and asset impairments totaling $0.4 million, $2.7 million and $1.1 million, respectively, related to employee termination benefits and costs to exit certain facilities, net of sub-lease benefits. At
December 31, 2006 and 2005, the restructuring liabilities were $21.5 million and $21.8 million, respectively, on our consolidated balance sheets. Certain assumptions are used by us to derive this estimate, including future maintenance costs,
price escalation and sublease income derived from these facilities. Should we negotiate additional sublease rental income agreements or reach a settlement with our lessors to be released from our existing obligations, we could realize a favorable
benefit to our results of future operations. Should future lease, maintenance or other costs related to these facilities exceed our estimates, we could incur additional expenses in future periods.

Valuation of Investments in Non-Publicly Traded Companies. Since 1999, we have been making strategic equity investments in
non-publicly traded companies that develop technologies that are complementary to our product road map. Depending on our level of ownership and whether or not we have the ability to exercise significant influence, we account for these investments on
either the cost or equity method, and review such investments periodically for impairment. The appropriate reductions in carrying values are recorded when, and if, necessary. The process of assessing whether a particular investments net
realizable value is less than its carrying cost requires a significant amount of judgment. In making this judgment, we carefully consider the investees cash position, projected cash flows (both short and long-term), financing needs, most
recent valuation data, the current investing environment, management / ownership changes, and competition. This evaluation process is based on information that we request from these privately held companies. This information is not subject to the
same disclosure and audit requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary. Based on our evaluations, we recorded impairment charges related to our investments in
non-publicly traded companies of $1.5 million and $0.1 million during the fiscal years ended December 31, 2005 and 2004, respectively. The total investment in non-public companies was $3.0 million and $1.0



32



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million as of December 31, 2006 and 2005, respectively. (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 historic 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, |   
|                                               | 2006 |                          |    | 2005 |     |    | 2004 |     
|Net revenues                                   |      |                          |    |      |     |    |      |      |   
|Product revenues                               |      | 93                       | %  |      | 100 | %  |      | 99   | % 
|Service revenues                               |      | 7                        | %  |      |    |    |      | 1    | % 
|                                               |      |                          |    |      |     |    |      |      |   
|Total net revenues                             |      | 100                      | %  |      | 100 | %  |      | 100  | % 
|Cost of revenues:                              |      |                          |    |      |     |    |      |      |   
|Product cost of revenues                       |      | 24                       | %  |      | 25  | %  |      | 29   | % 
|Provision for excess and obsolete inventories  |      |                         |    |      | 2   | %  |      | 2    | % 
|Service cost of revenues                       |      | 3                        | %  |      |    |    |      |     |   
|                                               |      |                          |    |      |     |    |      |      |   
|Total cost of revenues                         |      | 27                       | %  |      | 27  | %  |      | 31   | % 
|                                               |      |                          |    |      |     |    |      |      |   
|Gross profit                                   |      | 73                       | %  |      | 73  | %  |      | 69   | % 
|                                               |      |                          |    |      |     |    |      |      |   
|Operating expenses:                            |      |                          |    |      |     |    |      |      |   
|Research and development                       |      | 55                       | %  |      | 65  | %  |      | 137  | % 
|Marketing and sales                            |      | 30                       | %  |      | 29  | %  |      | 37   | % 
|General and administrative                     |      | 16                       | %  |      | 15  | %  |      | 20   | % 
|Restructuring charge and asset impairment, net |      | 1                        | %  |      | 8   | %  |      | 3    | % 
|                                               |      |                          |    |      |     |    |      |      |   
|Total operating expenses                       |      | 102                      | %  |      | 117 | %  |      | 197  | % 
|                                               |      |                          |    |      |     |    |      |      |   
|Operating loss                                 |      | (29                      | )% |      | (44 | )% |      | (128 | )%
|                                               |      |                          |    |      |     |    |      |      |   



33



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Comparison of Fiscal Years 2006 and 2005

Net Revenues. The following tables summarize our net product revenue mix by product line (dollar amounts in thousands):



|                 |                 |                             |                           |  |                             |                 |  |                                    |        |  |     |   |  |     |   
|---------------- | --------------- | --------------------------- | ------------------------- |  | --------------------------- | --------------- |  | ---------------------------------- | ------ |  | --- | - |  | --- | --
|                 |                 | Year endedDecember 31, 2006 |                           |  | Year endedDecember 31, 2005 |                 |  | PercentageChange inProductRevenues |       
|                 | ProductRevenues |                             | Percent ofProductRevenues |  |                             | ProductRevenues |  | Percent ofProductRevenues          |        | 
|SONET/SDH        |                 | $                           | 24,554                    |  | 68                          | %               |  | $                                  | 19,382 |  | 59  | % |  | 27  | % 
|ATM/IP           |                 |                             | 5,837                     |  | 16                          | %               |  |                                    | 7,228  |  | 22  | % |  | (19 | %)
|Asynchronous/PDH |                 |                             | 5,768                     |  | 16                          | %               |  |                                    | 6,281  |  | 19  | % |  | (8  | %)
|                 |                 |                             |                           |  |                             |                 |  |                                    |        |  |     |   |  |     |   
|Total            |                 | $                           | 36,159                    |  | 100                         | %               |  | $                                  | 32,891 |  | 100 | % |  | 10  | % 
|                 |                 |                             |                           |  |                             |                 |  |                                    |        |  |     |   |  |     |   

The 10% increase in revenue for 2006 compared to 2005 reflects increased volume of our SONET/SDH
products, including increasing sales of our EtherMap family of products. In addition, sales of our Aspen products in ATM/IP were down considerably due to lower demand from our largest customer.

Included in total net revenues is service revenues (of approximately $2.8 million in 2006 and zero in 2005) 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 from period to period, depending on business priorities.

For the year ended December 31, 2006 international net revenues represent approximately 75% of net revenues compared with approximately 85% of net
revenues for the year ended December 31, 2005, reflecting higher U.S. revenues.

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, 2006 and 2005, respectively:



|                                         |  |                             |        |   |                             |    |    |  |   |        |   |  |     |   
|---------------------------------------- |  | --------------------------- | ------ | - | --------------------------- | -- | -- |  | - | ------ | - |  | --- | --
|                                         |  | Year endedDecember 31, 2006 |        |   | Year endedDecember 31, 2005 |   
|Gross profit  as reported               |  | $                           | 28,174 |   |                             | 72 | %  |  | $ | 23,984 |   |  | 73  | % 
|Excess and obsolete inventory charge     |  |                             |       |   |                             |   |    |  |   | 573    |   |  | 2   | % 
|Excess and obsolete inventory benefit(1) |  |                             | (2,803 | ) |                             | (7 | )% |  |   | (3,394 | ) |  | (11 | )%
|                                         |  |                             |        |   |                             |    |    |  |   |        |   |  |     |   
|Gross profit  as adjusted               |  | $                           | 25,371 |   |                             | 65 | %  |  | $ | 21,163 |   |  | 64  | % 
|                                         |  |                             |        |   |                             |    |    |  |   |        |   |  |     |   

---

|(1) | Excess and obsolete inventory benefit results 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, 2006 as compared to the year ended December 31, 2005 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, Aspen Express and Envoy 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, 2006, research and development expenses of $21.2 million were essentially flat with the year ended December 31, 2005 expenses of $21.3 million.

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. We continue to seek opportunities to focus our research and development activities and will continue to closely monitor both our



34



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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, 2006, marketing and sales expenses increased $1.9 million, or 20% as compared to the prior year. The increase is primarily due to Mysticom marketing and sales expense of
$0.6 million and stock compensation expense of $0.7 million.

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 (G&A) expenses consist
primarily of personnel-related expenses, professional and legal fees, and facilities expenses. The increase in general and administrative expenses of approximately $1.1 million, or 23% for the year ended December 31, 2006 compared to the prior
year is primarily due to Mysticom G&A expense of $0.6 million and stock compensation expense of $0.7 million.

Restructuring
Charges. We recorded restructuring charges of $0.4 million and $2.7 million for the years ended December 31, 2006 and 2005, respectively.

Information on restructuring charges and asset impairments for each of the last two years is located in Note 12 of the Notes to Consolidated Financial Statements.

Change in Fair Value of the Derivative Liability.For the years ended December 31, 2006 and 2005, we recorded other income of
approximately $5.1 million and $2.5 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, 2006, we issued an aggregate of
1,500,000 shares of our common stock plus approximately $22.6 million cash in exchange for $24.6 million in aggregate original principal amount of the Plus Cash Notes and accrued interest. During 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. 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 2006 and 2005, we recorded extinguishment losses of
approximately $3.1 million and $2.5 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 $5.7 million to $1.6 million in 2006, reflecting primarily lower
interest expense.

Interest expense decreased from $10.1 million in 2005 to $4.4 million in 2006 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 decreased slightly from $2.8 million in 2005 to $2.7 million in 2006, as higher market yields did not quite offset the impact of lower cash and investment balances. At December 31, 2006 and 2005,
the effective interest rates on our interest-bearing securities were approximately 5.20% and 3.28%, respectively

Income Tax
Expense. Income tax expense, representing income taxes incurred by certain of our foreign subsidiaries, was $0.1 million and $0.3 million for the year ended December 31, 2006 and 2005, respectively. We have incurred taxable losses for
U.S. federal and state purposes, but have recognized no corresponding tax benefits in 2006 and 2005, as such benefits have been offset by an increase in our deferred tax asset valuation allowance.

Information on income taxes for each of the last three years is located in Note 8 of the Notes to Consolidated Financial Statements.



35



---

Comparison of Fiscal Years 2005 and 2004

Net Revenues. The following tables summarize 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 |                 |  | PercentageChange inProductRevenues |       
|                 | 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 |                 |                             | 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 $0.2 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, 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 endedDecember 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, as
costs of revenues.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(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, subcontract 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



36



---

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.

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.



37



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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.

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 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.

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).



38



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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 have 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.

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.



39



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LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2006, we had total cash and cash equivalents of approximately $57.7 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, 2006 as well as a summary of our cash, cash equivalents 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 source of liquidity as of December 31, 2006 consisted of $57.7 million in cash and cash
equivalents. Cash equivalents are instruments with original maturities of less than 90 days. Our cash equivalents as of December 31, 2006 consist of money market instruments and commercial paper.

We believe that our existing cash and cash equivalents 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, 2006 and 2005 respectively;



|                           |  |                  |        |                  |   |        |  |   |                  |   |                  |   |        |  |   |         |  |   |         |  
|-------------------------- |  | ---------------- | ------ | ---------------- | - | ------ |  | - | ---------------- | - | ---------------- | - | ------ |  | - | ------- |  | - | ------- | -
|                           |  | December 31,2006 |        | December 31,2005 |   | Change |  |   | December 31,2005 |   | December 31,2004 |   | Change | 
|Cash and cash equivalents  |  | $                | 57,723 |                  | $ | 38,841 |  | $ | 18,882           |   |                  | $ | 38,841 |  | $ | 17,311  |  | $ | 21,530  |  
|Short term investments     |  |                  |       |                  |   | 33,861 |  |   | (33,861          | ) |                  |   | 33,861 |  |   | 85,193  |  |   | (51,332 | )
|Long term investments      |  |                  |       |                  |   |       |  |   |                 |   |                  |   |       |  |   | 32,178  |  |   | (32,178 | )
|                           |  |                  |        |                  |   |        |  |   |                  |   |                  |   |        |  |   |         |  |   |         |  
|Total Cash and Investments |  | $                | 57,723 |                  | $ | 72,702 |  | $ | (14,979          | ) |                  | $ | 72,702 |  | $ | 134,682 |  | $ | (61,980 | )
|                           |  |                  |        |                  |   |        |  |   |                  |   |                  |   |        |  |   |         |  |   |         |  

During the year ended December 31, 2006, the net decrease in cash, cash equivalents and
investments was $15.0 million compared to a net decrease of $62.0 million during the year ended December 31, 2005.

Information on
cash, cash equivalents and investments for each of the last three years is located in the Consolidated Statements of Cash Flow, Note 3 and Note 14 of the Notes to Consolidated Financial Statements.

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 $1.6 million in interest to the holders thereof.

We have outstanding operating lease commitments of $39.7 million, payable
over the next eleven years. Some of these commitments are for space that is not being utilized and, for which, we recorded restructuring charges in prior years for excess facilities. During 2006 and 2005, we entered into sublease and lease
termination agreements and made changes in estimates for a portion of our excess space and, as a result, we recorded a restructuring charge of $0.2 million and a restructuring benefit of $0.4 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, 2006, we have sub-lease agreements totaling $6.2 million in place to rent portions of our excess
facilities over the next four 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.



40



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A summary of our significant future contractual obligations and their payments follows (in thousands):



|                                |  |                        |        |      |   |             |  |             |       |            |   |       |  |   |       
|------------------------------- |  | ---------------------- | ------ | ---- | - | ----------- |  | ----------- | ----- | ---------- | - | ----- |  | - | ------
|                                |  | Payments Due by Period
|Contractual Obligations         |  | Total                  |        | 2007 |   | 2008 & 2009 |  | 2010 & 2011 |       | Thereafter
|Interest on convertible notes   |  | $                      | 1,643  |      | $ | 1,643       |  | $           |      |            | $ |      |  | $ |      
|Redemption of convertible notes |  |                        | 30,154 |      |   | 30,154      |  |             |      |            |   |      |  |   |      
|Operating lease obligations     |  |                        | 39,710 |      |   | 4,582       |  |             | 8,970 |            |   | 8,658 |  |   | 17,500
|Purchase obligations            |  |                        | 3,439  |      |   | 3,439       |  |             |      |            |   |      |  |   |      
|                                |  |                        |        |      |   |             |  |             |       |            |   |       |  |   |       
|                                |  | $                      | 74,946 |      | $ | 39,818      |  | $           | 8,970 |            | $ | 8,658 |  | $ | 17,500
|                                |  |                        |        |      |   |             |  |             |       |            |   |       |  |   |       

We also have pledged approximately $0.4 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

Subsequent events that potentially impact the Companys financial statements are disclosed in the Notes to Consolidated
Financial Statements of this report.

Recent Accounting Pronouncements

Newly issued accounting pronouncements that potentially impact the Companys financial statements are disclosed in the Notes to Consolidated
Financial Statements of this report.



|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 earns 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 2007, assuming a constant cash balance, would decrease by approximately $0.3
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 2006, operating expenses incurred in foreign currencies were approximately 27% 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, 2006, our debt consisted exclusively of convertible notes due
September 30, 2007 with interest at a fixed rate of 5.45%. Consequently, we do not have significant cash flow exposure on the interest payments on these notes. However, the Company does have considerable exposure in the requirement to redeem
these convertible notes on September 30, 2007. There is no guarantee that the Company will have either significant enough cash to pay



41



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down this debt, or the ability to refinance this debt on terms acceptable to the Company. Since these convertible notes are now considered current
liabilities, the Company believes the notes par value of $30.2 million best represents the fair value today. The fair market value of the convertible notes has historically been 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 at December 31, 2005. 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 Notes due 2007.

Changes in
Market Risk.There has been no significant change in our market risk since December 31, 2005.



42



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

TRANSWITCH CORPORATION AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

AND FINANCIAL STATEMENT SCHEDULE



|                                                                                                                                              |  |     
|--------------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                                                              |  | Page
|Financial Statements:                                                                                                                         |  |     
|Report of UHY LLP, Independent Registered Public Accounting Firm                                                                              |  | 44  
|Report of KPMG LLP, Independent Registered Public Accounting Firm                                                                             |  | 46  
|Consolidated Balance Sheets as of December 31, 2006 and 2005                                                                                  |  | 47  
|Consolidated Statements of Operations for each of the years in the three-year period ended December 31, 2006                                  |  | 48  
|Consolidated Statements of Stockholders Equity and Comprehensive Loss for each of the years in the three-year period ended
December 31, 2006 |  | 49  
|Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2006                                  |  | 50  
|Notes to Consolidated Financial Statements                                                                                                    |  | 51  
|                                                                                                                                              | 
|Financial Statement Schedule:                                                                                                                 |  |     
|Schedule II, Valuation and Qualifying Accounts                                                                                                |  | 73  



43



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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 sheets of TranSwitch Corporation and subsidiaries (the Company) as of
December 31, 2006 and December 31, 2005 and the related consolidated statements of operations, stockholders equity and comprehensive loss, and cash flows for the years then ended. Our audit also included the financial statement
schedule for 2006 and 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, 2006, 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 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 and whether effective
internal control over financial reporting was maintained in all material respects. Our audits 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 audits provide 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, 2006 and December 31, 2005 and the consolidated results of their operations and their cash flows for
the years 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 2006 and 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, 2006, 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



44



---

internal control over financial reporting as of December 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

As discussed in Note 1 to the consolidated financial statements, effective
January 1, 2006, the Company adopted Financial Accounting Standards Board Statement No. 123(R), Share Based Payment.



|                      
|----------------------
|/s/ UHY LLP           
|                      
|New Haven, Connecticut
|March 5, 2007         



45



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Report of KPMG LLP, Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders

TranSwitch Corporation

We have audited the consolidated statements of operations, stockholders equity and comprehensive loss, and cash flows of TranSwitch
Corporation and subsidiaries for the year ended December 31, 2004. In connection with our audit of those consolidated financial statements, we have also audited the financial statement schedule as of and for the year ended December 31,
2004 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 audit.

We conducted our audit in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects, the results of operations of TranSwitch Corporation and subsidiaries and their cash flows for the year 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.

/s/ KPMG LLP

Stamford, Connecticut

March 11, 2005



46



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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands)

|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                                             |  | December 31,2006 |          |   | December 31,2005 |  
|ASSETS                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|Current assets:                                                                                                                                                              |  |                  |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                                                    |  | $                | 57,723   |   |                  | $ | 38,841   |  
|Short-term investments in marketable securities                                                                                                                              |  |                  |         |   |                  |   | 33,861   |  
|Accounts receivable, net of allowances of $473 and $446                                                                                                                      |  |                  | 5,834    |   |                  |   | 3,784    |  
|Inventories                                                                                                                                                                  |  |                  | 3,257    |   |                  |   | 2,375    |  
|Prepaid expenses and other current assets                                                                                                                                    |  |                  | 1,422    |   |                  |   | 1,961    |  
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|Total current assets                                                                                                                                                         |  |                  | 68,236   |   |                  |   | 80,822   |  
|                                                                                                                                                                             |  |                 
|Property and equipment, net                                                                                                                                                  |  |                  | 5,079    |   |                  |   | 3,508    |  
|Goodwill                                                                                                                                                                     |  |                  | 4,893    |   |                  |   |         |  
|Investments in non-publicly traded companies                                                                                                                                 |  |                  | 2,965    |   |                  |   | 970      |  
|Deferred financing costs, net                                                                                                                                                |  |                  | 257      |   |                  |   | 1,092    |  
|Other assets                                                                                                                                                                 |  |                  | 1,226    |   |                  |   | 434      |  
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|Total assets                                                                                                                                                                 |  | $                | 82,656   |   |                  | $ | 86,826   |  
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                         |  |                  |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                                         |  |                  |          |   |                  |   |          |  
|Accounts payable                                                                                                                                                             |  | $                | 1,230    |   |                  | $ | 490      |  
|Accrued expenses and other current liabilities                                                                                                                               |  |                  | 3,051    |   |                  |   | 2,816    |  
|Accrued compensation and benefits                                                                                                                                            |  |                  | 2,431    |   |                  |   | 1,946    |  
|Accrued stock rotation and sales allowances                                                                                                                                  |  |                  | 112      |   |                  |   | 717      |  
|Accrued interest                                                                                                                                                             |  |                  | 411      |   |                  |   | 747      |  
|Restructuring liabilities                                                                                                                                                    |  |                  | 824      |   |                  |   | 721      |  
|Obligation under deferred revenue                                                                                                                                            |  |                  | 63       |   |                  |   |         |  
|5.45% Convertible Plus Cash Notes due 2007, net of debt discount of $1,343                                                                                                   |  |                  | 28,811   |   |                  |   |         |  
|Derivative liability                                                                                                                                                         |  |                  | 980      |   |                  |   |         |  
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|Total current liabilities                                                                                                                                                    |  |                  | 37,913   |   |                  |   | 7,437    |  
|                                                                                                                                                                             |  |                 
|Restructuring liabilities                                                                                                                                                    |  |                  | 20,689   |   |                  |   | 21,038   |  
|5.45% Convertible Plus Cash Notes due 2007, net of debt discount of $5,695                                                                                                   |  |                  |         |   |                  |   | 49,102   |  
|Derivative liability                                                                                                                                                         |  |                  |         |   |                  |   | 6,040    |  
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|Total liabilities                                                                                                                                                            |  |                  | 58,602   |   |                  |   | 83,617   |  
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|                                                                                                                                                                             |  |                 
|Commitments and contingencies                                                                                                                                                |  |                  |          |   |                  |   |          |  
|Stockholders equity:                                                                                                                                                        |  |                  |          |   |                  |   |          |  
|Common stock, $.001 par value: authorized - 300,000,000 shares; issued and outstanding - 128,113,218 shares at December 31, 2006 and
108,345,342 shares at December 31, 2005 |  |                  | 128      |   |                  |   | 108      |  
|Additional paid-in capital                                                                                                                                                   |  |                  | 345,946  |   |                  |   | 314,697  |  
|Accumulated other comprehensive income (loss)  currency translation                                                                                                         |  |                  | 404      |   |                  |   | (28      | )
|Accumulated deficit                                                                                                                                                          |  |                  | (322,424 | ) |                  |   | (311,568 | )
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|Total stockholders equity                                                                                                                                                   |  |                  | 24,054   |   |                  |   | 3,209    |  
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                                                                                   |  | $                | 82,656   |   |                  | $ | 86,826   |  
|                                                                                                                                                                             |  |                  |          |   |                  |   |          |  

See accompanying notes to consolidated financial statements.



47



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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)



|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                       |  | Years ended December 31, |        
|                                                                                       |  | 2006                     |         |   | 2005 |   |         | 2004 | 
|Net revenues:                                                                          |  |                          |         |   |      |   |         |      |  |   |         |  
|Product revenues                                                                       |  | $                        | 36,159  |   |      | $ | 32,891  |      |  | $ | 33,481  |  
|Service revenues                                                                       |  |                          | 2,761   |   |      |   | 9       |      |  |   | 206     |  
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Total net revenues                                                                     |  |                          | 38,920  |   |      |   | 32,900  |      |  |   | 33,687  |  
|Cost of revenues:                                                                      |  |                          |         |   |      |   |         |      |  |   |         |  
|Cost of product revenues                                                               |  |                          | 9,507   |   |      |   | 8,343   |      |  |   | 9,609   |  
|Provision for excess and obsolete inventories                                          |  |                          |        |   |      |   | 573     |      |  |   | 571     |  
|Cost of service revenues                                                               |  |                          | 1,239   |   |      |   |        |      |  |   | 160     |  
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Total cost of revenues                                                                 |  |                          | 10,746  |   |      |   | 8,916   |      |  |   | 10,340  |  
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Gross profit                                                                           |  |                          | 28,174  |   |      |   | 23,984  |      |  |   | 23,347  |  
|Operating expenses:                                                                    |  |                          |         |   |      |   |         |      |  |   |         |  
|Research and development                                                               |  |                          | 21,245  |   |      |   | 21,280  |      |  |   | 46,030  |  
|Marketing and sales                                                                    |  |                          | 11,523  |   |      |   | 9,639   |      |  |   | 12,543  |  
|General and administrative                                                             |  |                          | 6,139   |   |      |   | 5,003   |      |  |   | 6,697   |  
|Restructuring charges, net                                                             |  |                          | 403     |   |      |   | 2,724   |      |  |   | 1,126   |  
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Total operating expenses                                                               |  |                          | 39,310  |   |      |   | 38,646  |      |  |   | 66,396  |  
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Operating loss                                                                         |  |                          | (11,136 | ) |      |   | (14,662 | )    |  |   | (43,049 | )
|Other (expense) income:                                                                |  |                          |         |   |      |   |         |      |  |   |         |  
|Other income                                                                           |  |                          | 85      |   |      |   |        |      |  |   | 378     |  
|Impairment of investments in non-publicly traded companies                             |  |                          |        |   |      |   | (1,450  | )    |  |   | (123    | )
|Change in fair value of derivative liability                                           |  |                          | 5,060   |   |      |   | 2,495   |      |  |   | 12,124  |  
|Loss on extinguishment of debt                                                         |  |                          | (3,124  | ) |      |   | (2,528  | )    |  |   | (2,987  | )
|Interest:                                                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Interest income                                                                        |  |                          | 2,728   |   |      |   | 2,844   |      |  |   | 2,394   |  
|Interest expense                                                                       |  |                          | (4,355  | ) |      |   | (10,144 | )    |  |   | (12,895 | )
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Interest expense, net                                                                  |  |                          | (1,627  | ) |      |   | (7,300  | )    |  |   | (10,501 | )
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Total other (expense) income, net                                                      |  |                          | 394     |   |      |   | (8,783  | )    |  |   | (1,109  | )
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Loss before income taxes and cumulative effect of a change in accounting principle     |  |                          | (10,742 | ) |      |   | (23,445 | )    |  |   | (44,158 | )
|Income taxes                                                                           |  |                          | 114     |   |      |   | 309     |      |  |   | 189     |  
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Loss before cumulative effect of adoption of and change in accounting principles       |  |                          | (10,856 | ) |      |   | (23,754 | )    |  |   | (44,347 | )
|Cumulative effect on prior years adoption of and retroactive application of FIN 46R    |  |                          |        |   |      |   |        |      |  |   | (277    | )
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Net loss                                                                               |  | $                        | (10,856 | ) |      | $ | (23,754 | )    |  | $ | (44,624 | )
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Basic and diluted loss per common share:                                               |  |                          |         |   |      |   |         |      |  |   |         |  
|Loss before cumulative effect of adoption of and change in accounting principles       |  | $                        | (0.09   | ) |      | $ | (0.23   | )    |  | $ | (0.47   | )
|Cumulative effect of prior years of adoption of and retroactive application of FIN 46R |  |                          |        |   |      |   |        |      |  |   |        |  
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Net loss                                                                               |  | $                        | (0.09   | ) |      | $ | (0.23   | )    |  | $ | (0.47   | )
|                                                                                       |  |                          |         |   |      |   |         |      |  |   |         |  
|Basic and diluted average common shares outstanding                                    |  |                          | 124,801 |   |      |   | 104,779 |      |  |   | 94,638  |  

See accompanying notes to consolidated financial statements.



48



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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

AND COMPREHENSIVE LOSS

(in thousands)



|                                                                                          |  |              |  |                          |     |                                            |   |         |                              |   |        |       |  |   |          |   |  |   |         |  
|----------------------------------------------------------------------------------------- |  | ------------ |  | ------------------------ | --- | ------------------------------------------ | - | ------- | ---------------------------- | - | ------ | ----- |  | - | -------- | - |  | - | ------- | -
|                                                                                          |  | Common stock |  | Additionalpaid-incapital |     | Accumulatedothercomprehensive(loss) income |   |         | Accumulatedearnings(deficit) |   |        | Total | 
|                                                                                          |  | Shares       |  | Amount                   |     |                                            |   |         |                              |   |        |       |  |   |         
|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 Notes due 2007 |  | 12,165,654   |  |                          | 12  |                                            |   | 16,291  |                              |   |       |       |  |   |         |   |  |   | 16,303  |  
|                                                                                          |  |              |  |                          |     |                                            |   |         |                              |   |        |       |  |   |          |   |  |   |         |  
|Balance at December 31, 2004                                                              |  | 103,447,488  |  | $                        | 103 |                                            | $ | 307,876 |                              | $ | 1,066  |       |  | $ | (287,814 | ) |  | $ | 21,231  |  
|                                                                                          |  |              |  |                          |     |                                           
|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 Notes due 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   |  
|                                                                                          |  |              |  |                          |     |                                           
|Comprehensive loss:                                                                       |  |              |  |                          |     |                                            |   |         |                              |   |        |       |  |   |          |   |  |   |         |  
|                                                                                          |  |              |  |                          |     |                                           
|Net loss                                                                                  |  |              |  |                          |     |                                            |   |         |                              |   |        |       |  |   | (10,856  | ) |  |   | (10,856 | )
|                                                                                          |  |              |  |                          |     |                                           
|Currency translation adjustment                                                           |  |              |  |                          |     |                                            |   |         |                              |   | 432    |       |  |   |         |   |  |   | 432     |  
|                                                                                          |  |              |  |                          |     |                                            |   |         |                              |   |        |       |  |   |          |   |  |   |         |  
|Total comprehensive loss                                                                  |  |              |  |                          |     |                                            |   |         |                              |   |        |       |  |   |          |   |  |   | (10,424 | )
|                                                                                          |  |              |  |                          |     |                                           
|Stock compensation                                                                        |  |              |  |                          |     |                                            |   | 2,385   |                              |   |        |       |  |   |          |   |  |   | 2,385   |  
|                                                                                          |  |              |  |                          |     |                                           
|Shares of common stock issued in connection with common stock offering                    |  | 13,766,667   |  |                          | 14  |                                            |   | 18,856  |                              |   |       |       |  |   |         |   |  |   | 18,870  |  
|Shares of common stock issued in connection with business acquisition                     |  | 2,621,845    |  |                          | 3   |                                            |   | 4,832   |                              |   |       |       |  |   |         |   |  |   | 4,835   |  
|Shares of common stock issued under stock option and stock purchase plans                 |  | 1,879,364    |  |                          | 2   |                                            |   | 2,462   |                              |   |       |       |  |   |         |   |  |   | 2,464   |  
|Shares of common stock issued upon exchange of 5.45% Convertible Plus Cash Notes due 2007 |  | 1,500,000    |  |                          | 1   |                                            |   | 2,714   |                              |   |       |       |  |   |         |   |  |   | 2,715   |  
|                                                                                          |  |              |  |                          |     |                                            |   |         |                              |   |        |       |  |   |          |   |  |   |         |  
|Balance at December 31, 2006                                                              |  | 128,113,218  |  | $                        | 128 |                                            | $ | 345,946 |                              | $ | 404    |       |  | $ | (322,424 | ) |  | $ | 24,054  |  
|                                                                                          |  |              |  |                          |     |                                            |   |         |                              |   |        |       |  |   |          |   |  |   |         |  

See accompanying notes to consolidated financial statements.



49



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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|---------------------------------------------------------------------------------------------------------------------- | ---- | ------------------------ | ------- | ---- |  | - | ------- | - |  | - | -------- | -
|                                                                                                                       |      | Years ended December 31, |        
|                                                                                                                       | 2006 |                          |         | 2005 |  |   | 2004    |  
|Operating activities:                                                                                                  |      |                          |         |      |  |   |         |   |  |   |          |  
|Net loss                                                                                                               |      | $                        | (10,856 | )    |  | $ | (23,754 | ) |  | $ | (44,624  | )
|Adjustments required to reconcile net loss to cash flows used by operating activities, net of effects of acquisitions: |      |                          |         |      |  |   |         |   |  |   |          |  
|Depreciation and amortization                                                                                          |      |                          | 4,214   |      |  |   | 4,247   |   |  |   | 10,249   |  
|Amortization of debt discount and deferred financing fees                                                              |      |                          | 2,308   |      |  |   | 5,521   |   |  |   | 6,792    |  
|Non-cash charge for the accelerated vesting of employee stock options                                                  |      |                          |        |      |  |   | 328     |   |  |   |         |  
|Loss on extinguishment of debt                                                                                         |      |                          | 3,124   |      |  |   | 2,528   |   |  |   | 2,987    |  
|Provision (benefit) for doubtful accounts                                                                              |      |                          | 27      |      |  |   | (181    | ) |  |   | 310      |  
|Provision for excess and obsolete inventories                                                                          |      |                          |        |      |  |   | 573     |   |  |   | 571      |  
|Cumulative effect on prior years adoption of and retroactive application of FIN 46R                                    |      |                          |        |      |  |   |        |   |  |   | 277      |  
|Non-cash restructuring charges                                                                                         |      |                          | 184     |      |  |   | 342     |   |  |   | (1,984   | )
|Stock-based compensation expense                                                                                       |      |                          | 2,395   |      |  |   | 131     |   |  |   | 64       |  
|Impairment of investments in non-publicly traded companies                                                             |      |                          |        |      |  |   | 1,450   |   |  |   | 123      |  
|Change in fair value of derivative liability                                                                           |      |                          | (5,060  | )    |  |   | (2,495  | ) |  |   | (12,124  | )
|Changes in operating assets and liabilities:                                                                           |      |                          |         |      |  |   |         |   |  |   |          |  
|Accounts receivable                                                                                                    |      |                          | (1,838  | )    |  |   | 1,192   |   |  |   | (1,422   | )
|Inventories                                                                                                            |      |                          | (682    | )    |  |   | (15     | ) |  |   | (666     | )
|Prepaid expenses and other assets                                                                                      |      |                          | 585     |      |  |   | 162     |   |  |   | 424      |  
|Accounts payable                                                                                                       |      |                          | 717     |      |  |   | (895    | ) |  |   | 559      |  
|Accrued expenses and other current liabilities                                                                         |      |                          | (1,181  | )    |  |   | (2,653  | ) |  |   | (138     | )
|Obligation under deferred revenue                                                                                      |      |                          | (562    | )    |  |   |        |   |  |   |         |  
|Restructuring liabilities                                                                                              |      |                          | (247    | )    |  |   | (866    | ) |  |   | (1,378   | )
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|Net cash used by operating activities                                                                                  |      |                          | (6,872  | )    |  |   | (14,385 | ) |  |   | (39,980  | )
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|Investing activities:                                                                                                  |      |                          |         |      |  |   |         |   |  |   |          |  
|Cash acquired upon consolidation of variable interest entities                                                         |      |                          |        |      |  |   |        |   |  |   | 124      |  
|Capital expenditures                                                                                                   |      |                          | (4,636  | )    |  |   | (3,991  | ) |  |   | (3,606   | )
|Investments in non-publicly traded companies                                                                           |      |                          | (1,996  | )    |  |   | (312    | ) |  |   | (1,605   | )
|Acquisition of business, net of cash acquired                                                                          |      |                          | (769    | )    |  |   |        |   |  |   |         |  
|Purchases of short and long-term investments in marketable securities                                                  |      |                          | (4,921  | )    |  |   | (2,732  | ) |  |   | (159,821 | )
|Proceeds from sales and maturities of short and long-term investments in marketable securities                         |      |                          | 38,782  |      |  |   | 86,242  |   |  |   | 118,930  |  
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|Net cash provided (used) by investing activities                                                                       |      |                          | 26,460  |      |  |   | 79,207  |   |  |   | (45,978  | )
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|Financing activities:                                                                                                  |      |                          |         |      |  |   |         |   |  |   |          |  
|Net proceeds from issuance of common stock                                                                             |      |                          | 18,870  |      |  |   |        |   |  |   |         |  
|Issuance of common stock under employee stock plans                                                                    |      |                          | 2,464   |      |  |   | 715     |   |  |   | 406      |  
|Payments to extinguish debt                                                                                            |      |                          | (22,176 | )    |  |   | (43,668 | ) |  |   | (151     | )
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|Net cash (used) provided by financing activities                                                                       |      |                          | (842    | )    |  |   | (42,953 | ) |  |   | 255      |  
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|Effect of exchange rate changes on cash and cash equivalents                                                           |      |                          | 136     |      |  |   | (339    | ) |  |   | 145      |  
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|Change in cash and cash equivalents                                                                                    |      |                          | 18,882  |      |  |   | 21,530  |   |  |   | (85,558  | )
|Cash and cash equivalents at beginning of year                                                                         |      |                          | 38,841  |      |  |   | 17,311  |   |  |   | 102,869  |  
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  
|Cash and cash equivalents at end of year                                                                               |      | $                        | 57,723  |      |  | $ | 38,841  |   |  | $ | 17,311   |  
|                                                                                                                       |      |                          |         |      |  |   |         |   |  |   |          |  

See accompanying notes to consolidated financial statements.



50



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TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

Note 1. 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 Corporation 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 include allowances for uncollectible accounts receivable, excess or slow-moving or 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 when purchased 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 a limited number of
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.

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%



51



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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 Notes due 2007 are determined using quoted market prices
when those securities are greater than one year from maturity, and par value when those securities are one year or less from maturity. The fair value of the outstanding 5.45% Convertible Plus Cash Notes due 2007 was approximately $30.2 million (par
value) and $52.6 million at December 31, 2006 and 2005, 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 $0.2 million, $0.3 million and $0.3 million for the years ended December 31, 2006, 2005 and 2004, respectively. Accumulated amortization of licenses was $1.2 million and $1.0 million as of December 31, 2006 and 2005,
respectively. All product licenses are fully amortized as of December 31, 2006.

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.

Goodwill

Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired. The Company reviews goodwill for potential
impairment at least annually.

Patents

As of December 31, 2006 and 2005 there were no unamortized patent costs. During the year ended December 31, 2005 the Company determined that its remaining unamortized patent costs were impaired and recorded
an impairment charge of $1.0 million. Prior thereto patents were being amortized on a straight line basis over their estimated economic lives of ten years. Amortization expense for patents was less than $0.1 million and approximately $0.2 million
for the years ended December 31, 2005 and 2004, respectively.

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 $20.5 million and $19.7 million as of December 31, 2006 and 2005, respectively. Amortization, included in the consolidated statement of operations as a component of interest expense, was $0.4 million, $1.0 million, and $1.2 million for
the years ended December 31, 2006, 2005 and 2004, respectively. Refer to Note 11Convertible Notes.

Impairment of Intangibles
and Long-Lived Assets

The Company reviews long-lived and intangible assets (including goodwill) for impairment at least annually, or
whenever events or changes in circumstances indicate that the carrying amount of such assets 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.



52



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TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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 the Companys facilities; (2) payment is not contractually or otherwise excused until the product is resold; (3) the Company does 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) services have been
performed in accordance with the contractual obligations; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured.

In 2006, the Company commenced licensing intellectual property. Revenues from licensing arrangements generally consist of multiple elements such as license, implementation and maintenance services. The items
(deliverables) included in the arrangement are evaluated pursuant to EITF Issue No. 00-21 Revenue Arrangements with Multiple Deliverables to determine whether they represent separate units of accounting. The Company performs this
evaluation at the inception of an arrangement and as the Company delivers each item in the arrangement.

Generally, the Company accounts
for a deliverable (or a group of deliverables) separately if (1) the delivered item(s) has standalone value to the customer, (2) there is objective and reliable evidence of the fair value of the undelivered items included in the
arrangement, and (3) if the Company has given the customer a general right of return relative to the delivered items, delivery or performance of the undelivered items or services are probable and substantially in the Companys control.

Also in 2006, the Company commenced recognizing revenue from royalties upon notification of sale by its licensees. The terms of the
royalty agreements generally require licensees to give notification to the Company and to pay royalties within 45 days of the end of the quarter during which the sales by its licensees take place.

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, 2006, approximately 50% 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 uncollectible
accounts based upon factors surrounding the credit risk of specific customers, historical payment trends and other information.



53



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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

Effective
January 1, 2006, the Company adopted FASB Statement No. 123 (revised), Share-Based Payment (SFAS 123R) using the modified prospective approach. Among its provisions, SFAS 123R requires companies to record compensation
expense for share-based awards issued to employees and directors, including employee stock options related to the Companys stock option plans and employee stock purchases related to the 2005 Employee Stock Purchase Plan, in exchange for
services provided. The amount of the compensation expense is based on the estimated fair value of the awards on their grant dates and is recognized over the required service periods.

Prior to the adoption of SFAS 123R, the Company utilized the intrinsic-value based method of accounting under APB Opinion No. 25, Accounting
for Stock Issued to Employees and related interpretations, and adopted the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under the intrinsic-value based method of accounting,
compensation expense for stock options granted to the Companys employees was measured as the excess of the quoted market price of common stock at the grant date over the amount the employee must pay for the stock. The Companys policy is
to grant stock options at fair value on the date of grant. As a result, no compensation expense was historically recognized for stock options.

The modified prospective approach requires the application of the new standard to all share-based awards issued on or after January 1, 2006, and to any outstanding share-based awards that were issued but not vested as of
January 1, 2006. Results for prior periods have not been restated as provided for under the modified prospective approach. For equity awards granted after January 1, 2006, the Company recognizes share-based compensation expense for the
fair value of the awards on the date granted on a straight-line basis over their vesting term.

Compensation expense is recognized only for
share-based payments expected to vest. The Company estimates forfeitures at the date of grant based on the Companys historical experience and future expectations.

The effect of adopting SRAS 123R for the year ended December 31, 2006, was to increase compensation expense and the loss before income taxes and the net loss by $2.4 million or $.02 per basic and diluted share.
There were no effects on either operating or financing cash flows.

As of December 31, 2006, the unrecognized stock-based compensation
cost related to non-vested option awards was $1.5 million. Such amount, reduced for forfeitures, will be recognized in operations over a weighted average period of 1.2 years.

Prior to adopting SFAS 123R, the Company accounted for share-based payment awards using the intrinsic value method of APB 25 and related interpretations.
As such, the Company did not record compensation expense for employee share options, unless the awards were modified. The following table illustrates the effect on reported net loss and loss per share, as if the



54



---

TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Company accounted for all share-based payment awards using the fair value method of SFAS 123R (in thousands, except per share data):



|                                                                                         |      |                          |         |      |  |   |         |  
|---------------------------------------------------------------------------------------- | ---- | ------------------------ | ------- | ---- |  | - | ------- | -
|                                                                                         |      | Years Ended December 31, |        
|                                                                                         | 2005 |                          |         | 2004 | 
|Net loss:                                                                                |      |                          |         |      |  |   |         |  
|As reported                                                                              |      | $                        | (23,754 | )    |  | $ | (44,624 | )
|                                                                                         |      |                         
|Stock-based compensation expense determined under fair value based method for all awards |      | $                        | (2,922  | )    |  | $ | (15,840 | )
|                                                                                         |      |                          |         |      |  |   |         |  
|Pro forma                                                                                |      | $                        | (26,676 | )    |  | $ | (60,464 | )
|                                                                                         |      |                         
|Basic loss per common share:                                                             |      |                          |         |      |  |   |         |  
|                                                                                         |      |                         
|As reported                                                                              |      | $                        | (0.23   | )    |  | $ | (0.47   | )
|                                                                                         |      |                         
|Pro forma                                                                                |      | $                        | (0.25   | )    |  | $ | (0.64   | )
|                                                                                         |      |                         
|Diluted loss per common share:                                                           |      |                          |         |      |  |   |         |  
|                                                                                         |      |                         
|As reported                                                                              |      | $                        | (0.23   | )    |  | $ | (0.47   | )
|                                                                                         |      |                         
|Pro forma                                                                                |      | $                        | (0.25   | )    |  | $ | (0.64   | )

Loss Per Common Share

The basic and diluted loss per common share amount 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 Notes due 2007 were anti-dilutive.

Foreign Currency Translation

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

Recent
Accounting Pronouncements

The Company continually assesses any new accounting pronouncements to determine their applicability to the
Company. In the case where it is determined that a new accounting pronouncement effects the Companys financial reporting, the Company undertakes a study to determine the consequence of the change to its financial reporting, and assures
that there are proper controls in place to ascertain that the Companys financials properly reflect the change. New pronouncements assessed by the Company follow:

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting and
disclosure for uncertain tax positions, as defined, and seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. This interpretation is effective for fiscal
years beginning after December 15, 2006. The Company does not believe that the adoption of FIN 48 will have a significant impact on its financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair
value, and expands disclosure requirements regarding fair value measurement. This statement simplifies and codifies fair value related guidance previously issued and is effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal years. The Company does not believe that SFAS 157 will significantly impact its financial statements.



55



---

TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the
Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides guidance on the consideration of the effects of prior year unadjusted errors in quantifying current year
misstatements for the purpose of a materiality assessment. SAB 108 requires registrants to apply the new guidance the first time that it identifies material errors in existence at the beginning of the first fiscal year ending after November 15,
2006 by correcting those errors through a one-time cumulative effect adjustment to beginning-of-year retained earnings. The Companys financial statements were not effected by SAB 108.

Note 2. Acquisition of Mysticom Ltd.

On
January 30, 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 acquisition
of Mysticom allows TranSwitch to integrate high-speed SerDes and PHY capabilities in the Companys next generation of products as the market for 10-Gbps ports on telecommunications and data communications equipment grows.

TranSwitch acquired all the capital stock of Mysticom through the issuance of 2,378,185 shares of TranSwitch common stock. The common stock issued was
valued at approximately $4.4 million ($1.85 per share). The Company incurred transaction costs of approximately $1.0 million in conjunction with this acquisition, resulting in a total purchase price of approximately $5.4 million.

Under the earn-out provisions of the Mysticom acquisition agreement, the Company could have paid up to an additional $10 million in the form of
TranSwitch common stock or cash, upon Mysticoms achievement of stipulated revenue objectives and a positive operating cash flow over the 12 month period ending January 30, 2007. Based on the operating performance of Mysticom there will be
no earn-out provision payment.

The results of operations of Mysticom have been included in the Companys consolidated financial
results beginning on January 31, 2006, and all significant inter-company balances have been eliminated. The acquisition was accounted for under the purchase method of accounting. The Company has allocated the cost to acquire Mysticom to its
identifiable tangible and intangible assets and liabilities, with the remaining amount classified as goodwill. None of the amount allocated to goodwill is expected to be deductible for tax reporting purposes. The total purchase price of Mysticom has
been allocated as follows:



|                                         |  |   |        |  
|---------------------------------------- |  | - | ------ | -
|Cash                                     |  | $ | 271    |  
|Accounts receivable                      |  |   | 239    |  
|Inventory                                |  |   | 201    |  
|Prepaid and other assets                 |  |   | 606    |  
|Property and equipment                   |  |   | 369    |  
|Intellectual property (1)                |  |   | 894    |  
|Goodwill                                 |  |   | 4,893  |  
|Obligation under deferred revenue (2)    |  |   | (625   | )
|Accounts payable and accrued liabilities |  |   | (1,409 | )
|                                         |  |   |        |  
|Total purchase price                     |  | $ | 5,439  |  
|                                         |  |   |        |  

---

|(1) | The valuation of the purchased intellectual property ($0.9 million) was determined based on its estimated fair value at the acquisition date. The income approach, which includes an
analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing the purchased intellectual property. The purchased intellectual property is primarily being amortized ratably, based upon
the recognition of the associated license revenue. Amortization expense of $0.5 million was recognized during 2006, and $0.3 million is expected to be amortized in 2007.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | In connection with the preliminary purchase price allocation, the Company has estimated the fair value of Mysticoms existing consulting and maintenance obligations related to
deferred revenues. The estimated fair value of these obligations was determined utilizing a cost build-up approach. The cost build-up approach determines fair value by estimating the costs relating to fulfilling the obligations plus a normal profit
margin. The sum of the costs and operating profit approximates the amount that the Company would be required to pay a third party to assume the support obligations. As of December 31, 2006, the remaining obligation under deferred revenue was
$0.1 million.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



56



---

TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Unaudited pro forma results assuming Mysticom was acquired as of January 1, 2005 follows: Net
revenues of $36.3 million; net loss of $28.6 million, and basic and diluted loss per common share of $0.27 for 2005. Unaudited pro forma results for 2006 approximate the reported results included in TranSwitchs consolidated financial
statements.

Note 3. Investments in Marketable Securities

The following table summarizes investments in marketable securities:



|                                          |  |               |        |                      |   |                         |  |   |            |   |  |   |       
|----------------------------------------- |  | ------------- | ------ | -------------------- | - | ----------------------- |  | - | ---------- | - |  | - | ------
|                                          |  | Amortizedcost |        | Grossunrealizedgains |   | Grossunrealized(losses) |  |   | Fair value
|December 31, 2006                         |  |               |        |                      |   |                         |  |   |            |   |  |   |       
|Money market                              |  | $             | 47,986 |                      | $ |                        |  | $ |           |   |  | $ | 47,986
|Commercial paper                          |  |               | 3,974  |                      |   | 16                      |  |   |           |   |  |   | 3,990 
|                                          |  |               |        |                      |   |                         |  |   |            |   |  |   |       
|                                          |  | $             | 51,960 |                      | $ | 16                      |  | $ |           |   |  | $ | 51,976
|                                          |  |               |        |                      |   |                         |  |   |            |   |  |   |       
|December 31, 2005                         |  |               |        |                      |   |                         |  |   |            |   |  |   |       
|Money market and certificates of deposits |  | $             | 30,819 |                      | $ |                        |  | $ |           |   |  | $ | 30,819
|U.S. government and agency obligations    |  |               | 16,500 |                      |   |                        |  |   | (108       | ) |  |   | 16,392
|Corporate bonds                           |  |               | 17,361 |                      |   |                        |  |   | (63        | ) |  |   | 17,298
|                                          |  |               |        |                      |   |                         |  |   |            |   |  |   |       
|                                          |  | $             | 64,680 |                      | $ |                        |  | $ | (171       | ) |  | $ | 64,509
|                                          |  |               |        |                      |   |                         |  |   |            |   |  |   |       



|                                                      |      |              |        |  |   |       
|----------------------------------------------------- | ---- | ------------ | ------ |  | - | ------
|                                                      |      | December 31,
|                                                      | 2006 |              | 2005  
|Investments in marketable securities are reported as: |      |              |        |  |   |       
|Cash equivalents                                      |      | $            | 51,960 |  | $ | 30,819
|Short-term investments                                |      |              |       |  |   | 33,861
|                                                      |      |              |        |  |   |       
|                                                      |      |              | 51,960 |  |   | 64,680
|                                                      |      |              |        |  |   |       
|Cash                                                  |      |              | 5,763  |  |   | 8,022 
|                                                      |      |              |        |  |   |       
|Total cash, cash equivalents and investments          |      | $            | 57,723 |  | $ | 72,702
|                                                      |      |              |        |  |   |       

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.

Cost Method Investments

As of December 31, 2004, the Company owned convertible preferred stock of Opulan Technologies Corp. (Opulan), and Metanoia Technologies, Inc.
(Metanoia). In addition, the Company had a 3% limited partnership interest in Neurone Ventures II



57



---

TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



L.P (Neurone), part of a venture capital fund organized as a limited partnership. The cost and carrying amount of these investments was $2.1 million. During
2005, the Company made additional investments in these companies of $0.3 million.

The Company accounts 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. The Company continually evaluates its investments in these companies for impairment.

During the second quarter of 2005, the Company made the decision to no longer provide funding to Metanoia and determined that its
investment was impaired. As a result, the Company recorded an impairment charge related to Metanoia of approximately $1.5 million in the second quarter of 2005.

As of December 31, 2005, the Companys cost method investments were 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.

During 2006, the Company made additional investments totaling approximately $2.0 million substantially all of
which was invested in Opulan.

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

The Company had held an investment in Accordion Networks, Inc. (Accordion). Accordian ceased operation in 2004.The Company recognized an impairment loss related to this investment of $0.1 million in 2004.

Impairment of Investments in Non-Publicly Traded Companies

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

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 relate to investments in non-publicly traded companies of $1.5
million in 2005 and $0.1 million in 2004. No impairment charge was required for 2006.



58



---

TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Note 5. Inventories

The components of inventories follow:



|                  |      |              |       |  |   |      
|----------------- | ---- | ------------ | ----- |  | - | -----
|                  |      | December 31,
|                  | 2006 |              | 2005 
|Raw material      |      | $            | 580   |  | $ | 323  
|Work-in-process   |      |              | 807   |  |   | 1,079
|Finished goods    |      |              | 1,870 |  |   | 973  
|                  |      |              |       |  |   |      
|Total inventories |      | $            | 3,257 |  | $ | 2,375
|                  |      |              |       |  |   |      

The Company recorded charges for excess and obsolete inventories totaling approximately zero, $0.6
million, $0.6 million and $1.5 million during the fiscal years ended December 31, 2006, 2005, 2004 and 2003 respectively. The effect of these inventory provisions was to write inventory down to a new cost basis of zero. During the years ended
December 31, 2006, 2005 and 2004, 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, 2006 |        |               | Year EndedDecember 31, 2005 |    |               | Year EndedDecember 31, 2004 |  
|                                      | GrossProfit $ |                             |        | GrossProfit % |                             |    | GrossProfit $ |                             |   | GrossProfit % |   |  | GrossProfit $ |    |  | GrossProfit % |       
|Gross Profitas reported              |               | $                           | 28,174 |               |                             | 72 | %             |                             | $ | 23,984        |   |  | 73            | %  |  | $             | 23,347 |   |  | 69  | % 
|Excess and obsolete inventory charge  |               |                             |       |               |                             |   |               |                             |   | 573           |   |  | 2             | %  |  |               | 571    |   |  | 2   | % 
|Excess and obsolete inventory benefit |               |                             | (2,803 | )             |                             | (7 | )%            |                             |   | (3,394        | ) |  | (11           | )% |  |               | (3,803 | ) |  | (11 | )%
|                                      |               |                             |        |               |                             |    |               |                             |   |               |   |  |               |    |  |               |        |   |  |     |   
|Gross profitas adjusted              |               | $                           | 25,371 |               |                             | 65 | %             |                             | $ | 21,163        |   |  | 64            | %  |  | $             | 20,115 |   |  | 60  | % 
|                                      |               |                             |        |               |                             |    |               |                             |   |               |   |  |               |    |  |               |        |   |  |     |   

Note 6. Property and Equipment, Net

The components of property and equipment follow:



|                                                  |  |                       |   |  |              |         |   |  |   |         |  
|------------------------------------------------- |  | --------------------- | - |  | ------------ | ------- | - |  | - | ------- | -
|                                                  |  | EstimatedUseful Lives |   |  | December 31, |        
|                                                  |  | 2006                  |   |  | 2005         |        
|Purchased computer software                       |  | 1-3 years             |   |  | $            | 27,242  |   |  | $ | 25,456  |  
|Computers and equipment                           |  | 3-7 years             |   |  |              | 12,746  |   |  |   | 12,063  |  
|Furniture                                         |  | 3-7 years             |   |  |              | 2,601   |   |  |   | 2,264   |  
|Leasehold improvements                            |  | Lease term            | * |  |              | 954     |   |  |   | 848     |  
|Construction in-progress (software and equipment) |  |                       |   |  |              | 2,333   |   |  |   | 1,610   |  
|                                                  |  |                       |   |  |              |         |   |  |   |         |  
|Gross property and equipment                      |  |                       |   |  | $            | 45,876  |   |  | $ | 42,241  |  
|Accumulated depreciation and amortization         |  |                       |   |  |              | (40,797 | ) |  |   | (38,733 | )
|                                                  |  |                       |   |  |              |         |   |  |   |         |  
|Property and equipment, net                       |  |                       |   |  | $            | 5,079   |   |  | $ | 3,508   |  
|                                                  |  |                       |   |  |              |         |   |  |   |         |  

---

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



59



---

TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Depreciation expense was $3.5 million, $3.9 million, and $9.8 million, for the years ended
December 31, 2006, 2005 and 2004, respectively.

Note 7. 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:



|                |      |                          |        |  |      |        |  |   |       
|--------------- | ---- | ------------------------ | ------ |  | ---- | ------ |  | - | ------
|                |      | Years Ended December 31,
|                | 2006 |                          | 2005   |  | 2004
|Net revenues:   |      |                          |        |  |      |        |  |   |       
|United States   |      | $                        | 9,674  |  | $    | 5,136  |  | $ | 9,014 
|China           |      |                          | 8,630  |  |      | 7,832  |  |   | 5,554 
|Germany         |      |                          | 3,610  |  |      | 2,767  |  |   | 5,933 
|Israel          |      |                          | 2,670  |  |      | 2,995  |  |   | 2,101 
|Korea           |      |                          | 1,960  |  |      | 996    |  |   | 1,277 
|Sweden          |      |                          | 1,958  |  |      | 1,489  |  |   | 813   
|India           |      |                          | 1,409  |  |      | 1,782  |  |   | 596   
|United Kingdom  |      |                          | 1,401  |  |      | 2,005  |  |   | 2,686 
|Singapore       |      |                          | 1,207  |  |      | 239    |  |   |      
|Mexico          |      |                          | 734    |  |      | 1,105  |  |   | 1,377 
|Belgium         |      |                          | 728    |  |      | 1,325  |  |   | 1,803 
|Malaysia        |      |                          | 700    |  |      | 1,134  |  |   | 771   
|Canada          |      |                          | 170    |  |      | 1,311  |  |   | 254   
|Other countries |      |                          | 4,069  |  |      | 2,784  |  |   | 1,508 
|                |      |                          |        |  |      |        |  |   |       
|Total           |      | $                        | 38,920 |  | $    | 32,900 |  | $ | 33,687
|                |      |                          |        |  |      |        |  |   |       



|                                                     |      |                          |        |  |      |       |  |   |      
|---------------------------------------------------- | ---- | ------------------------ | ------ |  | ---- | ----- |  | - | -----
|                                                     |      | Years Ended December 31,
|                                                     | 2006 |                          | 2005   |  | 2004
|Long-lived assets:                                   |      |                          |        |  |      |       |  |   |      
|United States                                        |      | $                        | 4,086  |  | $    | 3,328 |  | $ | 4,696
|Other countries (includes Mysticom goodwill in 2006) |      |                          | 7,111  |  |      | 614   |  |   | 598  
|                                                     |      |                          |        |  |      |       |  |   |      
|Total                                                |      | $                        | 11,197 |  | $    | 3,942 |  | $ | 5,294
|                                                     |      |                          |        |  |      |       |  |   |      



60



---

TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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, |  
|                           | 2006 |                          |   | 2005 |    |   | 2004 |   
|Distributors:              |      |                          |   |      |    |   |      |    |  
|Avnet, Inc.(1)             |      | *                        |   |      | *  |   |      | 12 | %
|Arrow Electronics, Inc.(2) |      | *                        |   |      | *  |   |      | 10 | %
|                           |      |                          |  
|Significant Customers:     |      |                          |   |      |    |   |      |    |  
|Siemens AG                 |      | 11                       | % |      | 17 | % |      | 24 | %
|Alcatel                    |      | 11                       | % |      | *  |   |      | *  |  
|Nortel                     |      | *                        |   |      | 11 | % |      | 12 | %
|Tellabs, Inc.(2)           |      | *                        |   |      | *  |   |      | 10 | %

---

|(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 the Companys net revenues in these years.
|- | -------------------------------------------------------------------------

Note 8. Income Taxes

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



|                                                                                   |      |                          |         |      |  |   |         |   |  |   |         |  
|---------------------------------------------------------------------------------- | ---- | ------------------------ | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                   |      | Years Ended December 31, |        
|                                                                                   | 2006 |                          |         | 2005 |  |   | 2004    |  
|U.S. domestic loss                                                                 |      | $                        | (10,389 | )    |  | $ | (23,034 | ) |  | $ | (43,238 | )
|Foreign (loss) income                                                              |      |                          | (353    | )    |  |   | (411    | ) |  |   | (920    | )
|                                                                                   |      |                          |         |      |  |   |         |   |  |   |         |  
|Loss before income taxes and cumulative effect of a change in accounting principle |      | $                        | (10,742 | )    |  | $ | (23,445 | ) |  | $ | (44,158 | )
|                                                                                   |      |                          |         |      |  |   |         |   |  |   |         |  

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

The Company recorded net state franchise and capital taxes of approximately $0.4 million in 2004, which is recorded as a component of general and
administrative expenses in the consolidated statements of operations. There were no similar taxes for 2005 or 2006.



61



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



|                                                         |      |                          |    |      |       |    |      |       |   
|-------------------------------------------------------- | ---- | ------------------------ | -- | ---- | ----- | -- | ---- | ----- | --
|                                                         |      | Years Ended December 31, |   
|                                                         | 2006 |                          |    | 2005 |       |    | 2004 |      
|U.S. federal statutory tax rate                          |      | (35.0                    | )% |      | (35.0 | )% |      | (35.0 | )%
|State taxes                                              |      | 12.6                     |    |      | (5.6  | )  |      | 6.8   |   
|Disallowed interest deduction                            |      | 6.9                      |    |      | 6.2   |    |      | 3.9   |   
|Capital loss on sale of subsidiary                       |      |                         |    |      |      |    |      | (17.4 | ) 
|Change in valuation allowance                            |      | 13.7                     |    |      | 34.9  |    |      | 42.5  |   
|Permanent differences, tax credits and other adjustments |      | 2.9                      |    |      | 0.8   |    |      | (0.4  | ) 
|                                                         |      |                          |    |      |       |    |      |       |   
|Effective income tax rate                                |      | 1.1                      | %  |      | 1.3   | %  |      | .4    | % 
|                                                         |      |                          |    |      |       |    |      |       |   

The tax effects of temporary differences that give rise to deferred income taxes follow:



|                                                      |  |      |          |   |      |   |          |  
|----------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | -
|                                                      |  | 2006 |          |   | 2005 |  
|Deferred income tax assets:                           |  |      |          |   |      |   |          |  
|Property and equipment                                |  | $    | 645      |   |      | $ | 1,906    |  
|Other nondeductible accruals                          |  |      | 676      |   |      |   | 588      |  
|Restructuring accrual                                 |  |      | 8,057    |   |      |   | 8,467    |  
|Capitalized research and development for tax purposes |  |      | 15,546   |   |      |   | 15,803   |  
|Investment impairment                                 |  |      | 60       |   |      |   | 38       |  
|Net operating loss carry-forwards                     |  |      | 75,791   |   |      |   | 75,620   |  
|Capital losses                                        |  |      | 15,138   |   |      |   | 15,739   |  
|Research and development and other credits            |  |      | 11,207   |   |      |   | 10,993   |  
|Debt discount                                         |  |      | 8,215    |   |      |   | 6,843    |  
|Inventories                                           |  |      | 14,462   |   |      |   | 10,681   |  
|Stock compensation under FAS 123R                     |  |      | 897      |   |      |   |         |  
|Other                                                 |  |      | 1,546    |   |      |   | 1,649    |  
|                                                      |  |      |          |   |      |   |          |  
|Total gross deferred income tax assets                |  |      | 152,240  |   |      |   | 148,327  |  
|Valuation allowance                                   |  |      | (142,791 | ) |      |   | (141,029 | )
|                                                      |  |      |          |   |      |   |          |  
|Net deferred income tax assets                        |  |      | 9,449    |   |      |   | 7,298    |  
|                                                      |  |      |          |   |      |   |          |  
|Deferred income tax liabilities:                      |  |      |          |   |      |   |          |  
|Derivative liability                                  |  |      | (8,351   | ) |      |   | (6,708   | )
|Other                                                 |  |      | (1,098   | ) |      |   | (590     | )
|                                                      |  |      |          |   |      |   |          |  
|Net deferred income tax liabilities                   |  |      | (9,449   | ) |      |   | (7,298   | )
|                                                      |  |      |          |   |      |   |          |  
|Net deferred income taxes                             |  | $    |         |   |      | $ |         |  
|                                                      |  |      |          |   |      |   |          |  



62



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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 Company continually evaluates its deferred income tax assets to determine 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 deferred income tax assets as of December 31, 2006 and 2005. Of the
$142.8 million valuation allowance at December 31, 2006, subsequently recognized income tax benefits, if any, in the amount of $4.4 million will be applied directly to additional paid-in capital.

At December 31, 2006, the Company had available, for federal income tax purposes, net operating loss (NOL) carry-forwards of
approximately $226.3 million, capital loss carry-forwards of approximately $40.9 million and research and development tax credit carry-forwards of approximately $11.2 million expiring in varying amounts from 2006 through 2025. For state income tax
purposes, the Company had available NOL carry-forwards of approximately $94.5 million and capital loss carry-forwards of $40.9 million and state tax credit carry-forwards of $7.2 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 2006 will be subject to limitation under Section 382.

Note 9. 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 (the 1995 ESPP), shares issued for 2005 and 2004 were 48,295 and 87,054,
respectively. The 1995 ESPP was closed effective December 31, 2004. On May 19, 2005 the Companys shareholders approved the 2005 Employee Stock Purchase Plan (the 2005 ESPP). Under the 2005 ESPP, the Company is authorized to issue
1,000,000 shares of common stock. In 2006, 89,077 shares were issued under the 2005 ESPP.

Stock Option Plans

As of December 31, 2006, 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



63



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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 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, 2006, 1,881,599 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 is 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,
2006, 1,569,609 shares were available for grant under the 2000 Plan.

The Director Plan expired during 2005. 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.

Information regarding stock options follows:



|                                 |  |                              |   |  |                                          |      
|-------------------------------- |  | ---------------------------- | - |  | ---------------------------------------- | -----
|                                 |  | Number of optionsoutstanding |   |  | Weighted averageexercise price per share
|Outstanding at December 31, 2003 |  | 22,007,985                   |   |  | $                                        | 11.04
|Granted and assumed              |  | 4,464,150                    |   |  |                                          | 1.85 
|Exercised                        |  | (223,430                     | ) |  |                                          | 0.99 
|Canceled, forfeited or expired   |  | (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, forfeited or expired   |  | (3,119,136                   | ) |  |                                          | 13.84
|                                 |  |                              |   |  |                                          |      
|Outstanding at December 31, 2005 |  | 25,441,094                   |   |  |                                          | 8.09 
|Granted and assumed              |  | 2,814,959                    |   |  |                                          | 1.80 
|Exercised                        |  | (1,790,287                   | ) |  |                                          | 1.30 
|Canceled, forfeited or expired   |  | (2,215,577                   | ) |  |                                          | 10.09
|                                 |  |                              |   |  |                                          |      
|Outstanding at December 31, 2006 |  | 24,250,189                   |   |  | $                                        | 7.69 
|                                 |  |                              |   |  |                                          |      

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.



64



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TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



Options outstanding and exercisable at December 31, 2006 follow:



|                         |  |                                             |  |                                 |  |                     |       |                                 |            |  |   |      
|------------------------ |  | ------------------------------------------- |  | ------------------------------- |  | ------------------- | ----- | ------------------------------- | ---------- |  | - | -----
|Range of Exercise prices |  | Numberoutstanding                           |  | Options Outstanding             |  | Options Exercisable
|                         |  | Weighted Average Remaining Contractual Life |  | Weighted average exercise price |  | Number exercisable  |       | Weighted average exercise price
|$   0.28 to   1.12       |  | 2,292,262                                   |  | 3.25                            |  | $                   | 0.88  |                                 | 2,249,269  |  | $ | 0.87 
|1.13 to   1.50           |  | 2,874,640                                   |  | 4.52                            |  |                     | 1.40  |                                 | 2,513,638  |  |   | 1.39 
|1.52 to   1.65           |  | 2,665,188                                   |  | 4.90                            |  |                     | 1.58  |                                 | 2,283,257  |  |   | 1.58 
|1.66 to   2.47           |  | 4,801,930                                   |  | 4.79                            |  |                     | 1.99  |                                 | 3,340,208  |  |   | 2.05 
|2.50 to   3.39           |  | 2,541,054                                   |  | 2.19                            |  |                     | 3.15  |                                 | 2,531,398  |  |   | 3.15 
|3.56 to   8.54           |  | 2,655,384                                   |  | 2.00                            |  |                     | 4.83  |                                 | 2,652,259  |  |   | 4.83 
|8.66 to 10.75            |  | 2,715,545                                   |  | 1.89                            |  |                     | 9.71  |                                 | 2,715,545  |  |   | 9.71 
|11.04 to 30.94           |  | 2,337,537                                   |  | .62                             |  |                     | 25.29 |                                 | 2,337,537  |  |   | 25.29
|32.48 to 67.81           |  | 1,366,649                                   |  | .70                             |  |                     | 44.09 |                                 | 1,366,649  |  |   | 44.09
|                         |  |                                             |  |                                 |  |                     |       |                                 |            |  |   |      
|$   0.28 to 67.81        |  | 24,250,189                                  |  | 3.09                            |  | $                   | 7.69  |                                 | 21,989,760 |  | $ | 8.37 
|                         |  |                                             |  |                                 |  |                     |       |                                 |            |  |   |      

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.

As of December 31, 2006 both the fair value of options outstanding and
the fair value of options exercisable were less than the exercise price.

Stock compensation charged to operations was $2.4 million in
2006, $0.5 million in 2005 and $0.1 million in 2004. Further, no compensation cost was capitalized as part of inventory, and no income tax benefit was recognized in those years. Lastly, no equity awards were settled in cash.

Stock-Based Compensation Fair Value Disclosures

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:



|                        |  |       |   |  |       |   |  |       |  
|----------------------- |  | ----- | - |  | ----- | - |  | ----- | -
|                        |  | 2006  |   |  | 2005  |   |  | 2004  |  
|Risk-free interest rate |  | 4.83  | % |  | 4.01  | % |  | 3.43  | %
|                        |  |       |  
|Expected life in years  |  | 3.46  |   |  | 2.23  |   |  | 2.3   |  
|                        |  |       |  
|Expected volatility     |  | 94.52 | % |  | 97.22 | % |  | 100.7 | %
|                        |  |       |  
|Expected dividend yield |  |      |   |  |      |   |  |      |  

The weighted average fair value of stock options granted, calculated using the Black-Scholes
option-pricing model, is $1.15, $0.81 and $0.97 for the years ended December 31, 2006, 2005 and 2004, respectively. The total intrinsic value of the options exercised was $1.2 million, $0.4 million, and $0.3 million for the years ended
December 31, 2006, 2005 and 2004, respectively.



65



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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 Company recognized compensation expense related to stock options granted to non-employees of less
than $0.1 million in 2006 and $0.1 million in each of the 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 SFAS123R, Share-Based Payment. The reduction in compensation
expense for 2006 was approximately $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, $0.3 million and
$0.4 million for 2006, 2005 and 2004, respectively.

Note 11. Convertible Notes

4.50% Convertible Notes Due 2005

The outstanding balance of the 4.50% Convertible Notes Due 2005 of $24.4 million as of December 31, 2004 was paid at maturity in September 2005.

5.45% Convertible Plus Cash Notes due 2007

Each 5.45% Convertible Plus Cash Notes due 2007
(Plus Cash Notes) 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 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, 2006, 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 Notes 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 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.



66



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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 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. The
auto-conversion make-whole provision expired on September 30, 2005, thus there is no value to this provision after that date.

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 the Companys common stock determined according to the voluntary
conversion provision equals or exceeds the threshold price of $2.61, the embedded derivative financial instrument related to the holders conversion right will be adjusted to fair value with the corresponding charge or credit to other expense
or income and then reclassified from total liabilities to stockholders equity. Changes in fair value during the period of time that any such Plus Cash Notes are outstanding and classified within stockholders equity, will be made by a
corresponding charge or credit to additional paid-in-capital. The estimated fair value of the holders conversion right was determined using 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, 2006, 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 $5.0 million. At December 31, 2006, the estimated fair value of the holders conversion
right was approximately $1.0 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.

The Company amortized debt discount related to the Plus Cash Notes of $1.9 million in 2006, $4.5 million in 2005 and $5.6 million in 2004.

Exchanges of the Plus Cash Notes for Shares of Common Stock

During 2006, the Company issued an aggregate of 1,500,000 shares of the Companys common stock plus approximately $22.6 million cash in exchange for $24.6 million in aggregate original principal amount of the
Plus Cash Notes and accrued interest. During 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 exchange for $17.0 million in aggregate original principal amount
of the Plus Cash Notes and accrued interest. 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
$3.1 million in 2006, $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.



67



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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 12. Restructuring and Asset Impairment Charges

During 2006 the Company recorded restructuring charges of approximately $0.4 million including $0.2 million of additional costs for changes in estimates
for restructuring actions taken at the Companys European design centers in 2004 and 2005, and $0.2 million for changes in estimates relating to subleases at the Companys facilities in Shelton, Connecticut.

In the first quarter of 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.

Also in the first quarter of 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.

In 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 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.

In the fourth quarter of 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.

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 the third quarter of 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.

Also in the third quarter of 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.

Also 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



68



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TRANSWITCH CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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



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.

A summary of the restructuring liabilities and activity follows:



|                     |                                          |               |                      |  |               |     |  |                         |      |   |                                    |   |                                          |   |  |   |     |  |   |       
|-------------------- | ---------------------------------------- | ------------- | -------------------- |  | ------------- | --- |  | ----------------------- | ---- | - | ---------------------------------- | - | ---------------------------------------- | - |  | - | --- |  | - | ------
|                     |                                          | 2006 Activity
|                     | RestructuringLiabilitiesDecember 31,2005 |               | RestructuringCharges |  | Cash Payments |     |  | Non-cashassetwrite-offs |      |   | Adjustmentsand Changesto Estimates |   | RestructuringLiabilitiesDecember 31,2006
|Facility lease costs |                                          | $             | 21,745               |  | $             |    |  | $                       | (375 | ) |                                    | $ |                                         |   |  | $ |    |  | $ | 21,370
|Other                |                                          |               | 14                   |  |               | 221 |  |                         | (37  | ) |                                    |   | (237                                     | ) |  |   | 182 |  |   | 143   
|                     |                                          |               |                      |  |               |     |  |                         |      |   |                                    |   |                                          |   |  |   |     |  |   |       
|Totals               |                                          | $             | 21,759               |  | $             | 221 |  | $                       | (412 | ) |                                    | $ | (237                                     | ) |  | $ | 182 |  | $ | 21,513
|                     |                                          |               |                      |  |               |     |  |                         |      |   |                                    |   |                                          |   |  |   |     |  |   |       



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

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. In 2006, the Company moved the design center in New Delhi, India to new facilities also in New Delhi. These facilities are
leased until January, 2015 with a total additional minimum lease commitment of $6.1 million. Rental expense under all operating lease agreements was $1.7 million in 2006, $1.3 million in 2005 and $1.4 million in 2004.

In the years before 2006, 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, 2006 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:



69



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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
|2007       |  | $                    | 4,582  |                    | $ | 2,425          |  | $ | 2,157 
|2008       |  |                      | 4,506  |                    |   | 2,531          |  |   | 1,975 
|2009       |  |                      | 4,464  |                    |   | 1,191          |  |   | 3,273 
|2010       |  |                      | 4,329  |                    |   | 68             |  |   | 4,261 
|2011       |  |                      | 4,329  |                    |   |               |  |   | 4,329 
|Thereafter |  |                      | 17,500 |                    |   |               |  |   | 17,500
|           |  |                      |        |                    |   |                |  |   |       
|           |  | $                    | 39,710 |                    | $ | 6,215          |  | $ | 33,495
|           |  |                      |        |                    |   |                |  |   |       

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 have been made under these indemnity
provisions.

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, 2006, the Company had purchase commitments totaling
$3.4 million.

Note 14. Supplemental Cash Flow Information

The following represents supplemental cash flow information:



|                           |      |                          |       |  |      |       |  |   |      
|-------------------------- | ---- | ------------------------ | ----- |  | ---- | ----- |  | - | -----
|                           |      | Years Ended December 31,
|                           | 2006 |                          | 2005  |  | 2004
|Cash paid for interest     |      | $                        | 2,136 |  | $    | 5,616 |  | $ | 6,264
|                           |      |                          |      
|Cash paid for income taxes |      | $                        | 322   |  | $    | 290   |  | $ | 293  

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



|                                                       |  |   |       |  |   |       |  |   |       
|------------------------------------------------------ |  | - | ----- |  | - | ----- |  | - | ------
|Common stock issued in acquisitions                    |  | $ | 4,832 |  | $ |      |  | $ |      
|Common stock issued upon conversion of Plus Cash Notes |  | $ | 2,714 |  | $ | 5,652 |  | $ | 16,303

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



70



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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. Issuance of Common Stock

In connection with the Mysticom acquisition the Company issued 2,621,845 shares of common stock, including 243,600 shares to settle assumed liabilities
under retention agreements with certain Mysticom employees. The aggregate fair value of the common stock issued was approximately $4.8 million.

Also in 2006, the Company completed an offering of shares of common stock that resulted in the sale of 13,766,667 shares, with proceeds to the Company, after placement agency fees and expenses, of $18.9 million. The shares were offered
under the Companys previously filed shelf registration statement, which was declared effective by the Securities and Exchange Commission (SEC) on April 20, 2004, and a final prospectus supplement dated February 27, 2006.

Moreover in 2006, the Company issued an aggregate of 1,500,000 shares of the Companys common stock plus approximately $22.6 million cash in
exchange for $24.6 million in aggregate original principal amount of the Plus Cash Notes and accrued interest.

Note 16. Subsequent Events

On January 11, 2007, the Company acquired the ASIC Design Center Division of DataJCE , an Israel-based publicly held
electronics components distribution company. The ASIC Design Center develops and sells customer-specific semiconductor products. The acquisition was financed with the issuance of 3,746,713 shares of the Companys common stock with an
approximate value of $5.7 million and $1.4 million of cash. The Company may pay additional consideration in its common stock or cash, at its option, of up to $14.5 million if certain revenue and operating profit targets are achieved over the next
twelve months.

On March 5, 2007 the Company announced a workforce reduction of approximately 20 primarily research and development
employees in the Companys Shelton, Connecticut and Bedford, Massachusetts facilities. These reductions represent approximately 16% of the Companys U.S. workforce and would be accomplished by the end of the second quarter of 2007. The
Company expects the cost and operating expense savings to be roughly $2.0 million per year, and that these savings will begin to be recognized by the Companys 2007 third quarter. The Company expects the restructuring costs associated with the
workforce reduction to total approximately $1.0 million in cash, which reflects the costs of employment terminations.



71



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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. Quarterly Information (Unaudited)

The table below 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, 2006                                   |  |              |        |   |               |   |         |              |  |   |               |   |  |           |        |   |  |   |         |  
|Net revenues                                                   |  | $            | 9,646  |   |               | $ | 10,318  |              |  | $ | 9,632         |   |  | $         | 9,324  |   |  | $ | 38,920  |  
|Cost of revenues                                               |  |              | 1,876  |   |               |   | 3,022   |              |  |   | 3,143         |   |  |           | 2,705  |   |  |   | 10,746  |  
|                                                               |  |              |        |   |              
|Gross profit                                                   |  |              | 7,770  |   |               |   | 7,296   |              |  |   | 6,489         |   |  |           | 6,619  |   |  |   | 28,174  |  
|Net loss                                                       |  |              | (5,586 | ) |               |   | (1,323  | )            |  |   | (725          | ) |  |           | (3,222 | ) |  |   | (10,856 | )
|Net loss per common share (1):                                 |  |              |        |   |               |   |         |              |  |   |               |   |  |           |        |   |  |   |         |  
|Basic                                                          |  | $            | (0.05  | ) |               | $ | (0.01   | )            |  | $ | (0.01         | ) |  | $         | (0.03  | ) |  | $ | (0.09   | )
|Diluted                                                        |  | $            | (0.05  | ) |               | $ | (0.01   | )            |  | $ | (0.01         | ) |  | $         | (0.03  | ) |  | $ | (0.09   | )
|                                                               |  |              |        |   |              
|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   | )



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

|(2) | Effective January 1, 2006, the Company adopted SFAS 123R. As such, the reported net loss for 2006 reflects stock-based compensation expense of $2.4 million (Q1 of $0.4 million, Q2
of $0.7 million, Q3 of $0.6 million and Q4 of $0.6 million).
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



72



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SCHEDULE II

TRANSWITCH CORPORATION

VALUATION AND QUALIFYING ACCOUNTS

(in thousands)



|                                               |  |                             |         |           |                         |            |   |  |                       |   |  |   |        |   |  |   |        
|---------------------------------------------- |  | --------------------------- | ------- | --------- | ----------------------- | ---------- | - |  | --------------------- | - |  | - | ------ | - |  | - | -------
|Description                                    |  | Balance atBeginningof Year  |         | Additions |                         | Deductions |   |  | Balanceat End of Year
|                                               |  | Charges toCosts andExpenses |         |           | Chargesto OtherAccounts |            |  
|Year ended December 31, 2006:                  |  |                             |         |           |                         |            |   |  |                       |   |  |   |        |   |  |   |        
|Allowance for losses on:                       |  |                             |         |           |                         |            |   |  |                       |   |  |   |        |   |  |   |        
|Accounts receivable                            |  | $                           | 446     |           | $                       | 27         |   |  | $                     |  |  | $ |       |   |  | $ | 473    
|Sales returns and allowance                    |  |                             | 45      |           |                         | 542        |   |  |                       |  |  |   | (550   | ) |  |   | 37     
|Stock rotation                                 |  |                             | 671     |           |                         | (523       | ) |  |                       |  |  |   | (73    | ) |  |   | 75     
|Warranty                                       |  |                             | 150     |           |                         | (150       | ) |  |                       |  |  |   |       |   |  |   |       
|Deferred income tax assets valuation allowance |  |                             | 141,029 |           |                         | 1,762      |   |  |                       |  |  |   |       |   |  |   | 142,791
|                                               |  |                             |         |           |                         |            |   |  |                       |   |  |   |        |   |  |   |        
|                                               |  | $                           | 142,341 |           | $                       | 1,658      |   |  | $                     |  |  | $ | (623   | ) |  | $ | 143,376
|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
|                                               |  |                             |         |           |                         |            |   |  |                       |   |  |   |        |   |  |   |        



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

None.



|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 upon that evaluation, our



73



---

principal executive officer and principal financial officer concluded that, as of the evaluation date, our disclosure controls and procedures are effective
to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange
Commissions rules and forms.

Managements Annual 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, 2006.

Our managements assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 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, 2006, that materially affected, or
is reasonably likely to materially affect, our internal control over financial reporting.



|Item 9B. | Other Information
|-------- | -----------------

None.



74



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PART III



|Item 10. | Directors, Executive Officers and Corporate Governance
|-------- | ------------------------------------------------------

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 24, 2007, 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, 2006. 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.

Code of Ethics

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. 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.

Corporate Governance Principles and Charters

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.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Companys directors, executive officers, and
persons who own more than ten percent of a registered class of the Companys equity securities to file reports of ownership and changes in ownership with the SEC, and such persons are also required by SEC regulations to furnish the Company with
copies of all Section 16(a) forms they file. Based solely on its review of the copies of such forms received by it, the Company believes that during fiscal 2006 all executive officers, board members and greater than ten percent stockholders of
the Company complied with all applicable filing requirements, with the exception of Theodore Quinlan, who filed a Form 3 on December 6, 2006 to report his becoming an executive officer of the Company on November 13, 2006.



|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 for the annual meeting of
shareholders of the Company to be held on May 24, 2007 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, 2006.



|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 24, 2007 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, 2006.



|Item 13. | Certain Relationships and Related Transactions, and Director Independence
|-------- | -------------------------------------------------------------------------

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 24, 2007 which is to



75



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be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year ended December 31, 2006.



|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 24, 2007, 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, 2006.



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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.
|------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                                                                                          |  |     
|--------------------------------------------------------------------------------------------------------- |  | ----
|FINANCIAL STATEMENTS                                                                                      |  | PAGE
|Consolidated Balance Sheets  December 31, 2006 and 2005                                                  |  | 47  
|Consolidated Statements of Operations - December 31, 2006, 2005 and 2004                                  |  | 48  
|Consolidated Statements of Stockholders Equity and Comprehensive Loss - December 31, 2006, 2005 and 2004 |  | 49  
|Consolidated Statements of Cash Flows - December 31, 2006, 2005 and 2004                                  |  | 50  
|Notes to Consolidated Financial Statements                                                                |  | 51  
|Schedule II                                                                                               |  | 73  



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



|(a) (3) | Exhibits
|------- | --------



|    |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1 |  | Amended and Restated Certificate of Incorporation, as amended to date (previously filed as Exhibit 3.1 to TranSwitchs quarterly report on Form 10Q for the quarter ended 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 Notes due 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) and incorporated herein by reference).                                                                                                
|    | 
|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 (previously 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 (previously filed as Exhibit 4.4 to the Companys registration statement on Form S-8 (File No. 333-126129) and
incorporated herein by reference).                                                                                                                                                                       
|    | 
|4.9 |  | Amendment No. 1 to the Rights Agreement, between TranSwitch and Computershare Trust Company, N.A. (formerly known as Equiserve Trust Company, N.A) as Rights Agent, dated as of
February 24, 2006. (previously filed as Exhibit 1.1 to the companys current report on Form 8-K as filed on February 28, 2006 and incorporated herein by reference).                                                



77



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|      |  |                                                                                                                                                                                                                                                                                                                                     
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|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).*                                                                                                                                                               
|      | 
|10.2  |  | 1995 Non-Employee Director Stock Option Plan, as amended (previously filed as Exhibit 4.4 to the TranSwitchs Registration Statement on Form S-8 (File No. 333-89798) and incorporated herein
by reference).*                                                                                                                       
|      | 
|10.3  |  | Form of Incentive Stock Option Agreement under the 1995 Stock Plan (previously filed as an exhibit to the TranSwitchs Registration Statement on Form S-8 (File No. 33-94234) and
incorporated herein by reference).                                                                                                                
|      | 
|10.4  |  | Form of Non-Qualified Stock Option Agreement under the 1995 Stock Plan (previously filed as an exhibit to the TranSwitchs Registration Statement on Form S-8 (File No. 33-94234) and
incorporated herein by reference).                                                                                                            
|      | 
|10.5  |  | Form of Non-Qualified Stock Option Agreement under the 1995 Non-Employee Director Stock Option Plan (previously filed as an exhibit to the TranSwitchs Registration Statement on Form S-8
(File No. 33-94234) and incorporated herein by reference).                                                                               
|      | 
|10.6  |  | Lease Agreement, as amended, with Robert D. Scinto (previously filed as Exhibit 10.14 to the TranSwitchs Annual Report on Form 10-K for the fiscal year ended December 31, 1997 and
incorporated herein by reference).                                                                                                             
|      | 
|10.7  |  | 2000 Stock Option Plan (previously filed as Exhibit 4.2 to TranSwitchs Registration Statement on Form S-8 (File No. 333-75800) and incorporated by reference herein).*                                                                                                                                                             
|      | 
|10.8  |  | Form of Non-Qualified Stock Option Agreement under the 2000 Stock Option Plan (previously filed as Exhibit 4.3 to TranSwitchs Registration Statement on Form S-8 (File No. 333-75800) and
incorporated by reference herein).                                                                                                       
|      | 
|10.9  |  | 1999 Stock Incentive Plan of Onex Communications Corporation (previously filed as Exhibit 4.2 to TranSwitchs Registration Statement on Form S-8 (File No. 333-70344) and incorporated by
reference herein).                                                                                                                        
|      | 
|10.10 |  | Form of Incentive Stock Option Agreement under the 1999 Stock Incentive Plan of Onex Communications Corporation (previously filed as Exhibit 4.3 to TranSwitchs Registration Statement on
Form S-8 (File No. 333-70344) and incorporated by reference herein).                                                                     
|      | 
|10.11 |  | Dealer Manager Agreement, by and between TranSwitch Corporation and U.S. Bancorp Piper Jaffray, dated August 27, 2003 (previously filed as Exhibit 10.1 to TranSwitch Corporations
quarterly report on Form 10-Q for the quarter ended September 30, 2003 and incorporated herein by reference).                                   
|      | 
|10.12 |  | Placement Agreement, by and between TranSwitch Corporation and U.S. Bancorp Piper Jaffray, dated August 27, 2003 (previously filed as Exhibit 10.2 to TranSwitch Corporations
quarterly report on Form 10-Q for the quarter ended September 30, 2003 and incorporated herein by reference.                                         
|      | 
|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).                                                          
|      | 
|10.16 |  | Placement Agency Agreement, by and among TranSwitch Corporation, Thomas Weisel Partners LLC and Pacific Growth Equities, LLC, dated as of February 27, 2006 (previously filed as
Exhibit 1.1 to the companys current report on Form 8-K as filed on February 28, 2006 and incorporated herein by reference).                       
|      | 
|10.17 |  | Escrow Agreement, by and among TranSwitch Corporation, U.S. Bank National Association, Thomas Weisel Partners LLC and Pacific Growth Equities, LLC, dated as of February 24, 2006 (previously
filed as Exhibit 10.1 to the companys current report on Form 8-K as filed on February 28, 2006 and incorporated herein by reference).



78



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|      |  |                                                                                                                                                                                                                                                                                        
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|10.18 |  | Asset Purchase Agreement by and among TranSwitch Corporation, TranSwitch (Israel) Ltd. and Data-JCE Ltd., dated as of December 5, 2006 (previously filed as Exhibit 2.1 to TranSwitchs
Registration Statement on Form S-3 (File No. 333-140509) and incorporated herein by reference).
|      | 
|10.19 |  | Escrow Agreement by and among TranSwitch Corporation, Data-JCE Ltd. and U.S. Bank National Association, dated as of January 11, 2007 (previously filed as Exhibit 2.2 to TranSwitchs
Registration Statement on Form S-3 (File No. 333-140509) and incorporated herein by reference).  
|      | 
|10.20 |  | Registration Rights Agreement by and among TranSwitch Corporation and Data-JCE Ltd. dated as of January 11, 2007 (previously filed as Exhibit 2.3 to TranSwitchs Registration Statement
on Form S-3 (File No. 333-140509) and incorporated herein by reference).                      
|      | 
|10.21 |  | Exchange Agreements dated February 1, 2006, between TranSwitch Corporation and Triton Offshore Fund, Limited and JMG Capital Partners, LP (filed herewith).                                                                                                                            
|      | 
|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).                                                                                                                                                                                                                                          
|      | 
|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.



79



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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


March 6, 2007

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. Theodore Chung, 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 Registrant and in the capacities and on the dates indicated.



|                                                  |  |                                                                     |  |              
|------------------------------------------------- |  | ------------------------------------------------------------------- |  | -------------
|Name and Signature                                |  | Title(s)                                                            |  | Date         
|                                                  |  |                                                                    
|/s/ DR. SANTANU DAS Dr. Santanu Das               |  | President and Chief Executive Officer (principal executive officer) |  | March 6, 2007
|                                                  |  |                                                                    
|/s/ THEODORE CHUNG Mr. Theodore Chung             |  | Vice President, Interim Chief Financial Officer                     |  | March 6, 2007
|                                                  |  |                                                                    
|/s/ MICHAEL C. MCCOY Mr. Michael C. McCoy         |  | Treasurer (principal financial and accounting officer)              |  | March 6, 2007
|                                                  | 
|                                                  |  |                                                                    
|/s/ ALFRED F. BOSCHULTE Mr. Alfred F. Boschulte   |  | Director, Chairman of the Board                                     |  | March 6, 2007
|                                                  | 
|                                                  |  |                                                                    
|/s/ GERALD F. MONTRY Mr. Gerald F. Montry         |  | Director                                                            |  | March 6, 2007
|                                                  | 
|                                                  |  |                                                                    
|/s/ JAMES M. PAGOS Mr. James M. Pagos             |  | Director                                                            |  | March 6, 2007
|                                                  | 
|                                                  |  |                                                                    
|/s/ ALBERT E. PALADINO Dr. Albert E. Paladino     |  | Director                                                            |  | March 6, 2007
|                                                  | 
|                                                  |  |                                                                    
|/s/ ERIK H. VAN DER KAAY Mr. Erik H. van der Kaay |  | Director                                                            |  | March 6, 2007
|                                                  | 
|                                                  |  |                                                                    
|/s/ HAGEN HULTZSCH Dr. Hagen Hultzsch             |  | Director                                                            |  | March 6, 2007
|                                                  | 



80