UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

        |X|   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                      For the year ended December 31, 2004

        |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                        Commission File Number: 0-220-20

                                    CASTELLE
             (Exact name of Registrant as specified in its charter)

               California                                77-0164056
    (State or other jurisdiction of           (IRS Employer Identification No.)
     incorporation or organization)

           855 Jarvis Drive, Suite 100, Morgan Hill, California 95037
          (Address of principal executive offices, including zip code)

                                 (408) 852-8000
              (Registrant's telephone number, including area code)

        Securities registered pursuant to Section 12(b) of the Act: None

           Securities registered pursuant to Section 12(g) of the Act:
                           Common Stock, No Par Value

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 any  amendment  to this  Form  10-K or in
definitive proxy or information statements incorporated by reference in Part III
of the From 10-K. |_|

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

The   approximate   aggregate   market   value  of  the  common  stock  held  by
non-affiliates  of the Registrant,  based upon the last sale price of the common
stock reported on the Nasdaq SmallCap Market on June 30, 2004 was $10,086,628.

The  number  of  shares  of  common  stock  outstanding  at March  14,  2005 was
3,832,796.

                       DOCUMENTS INCORPORATED BY REFERENCE

The  information  required by Part III of this Form 10-K will be incorporated by
reference from certain  portions of Castelle's  proxy statement  relating to its
2004 Annual Meeting of Shareholders to be filed with the SEC or will be provided
in an  amendment  to this Form 10-K to be filed with the SEC no later than April
30, 2005.

<PAGE>

Castelle
Table of Contents

                                                                            PAGE

PART I.........................................................................3

   ITEM 1.  BUSINESS...........................................................3
   ITEM 2.  PROPERTIES........................................................12
   ITEM 3.  LEGAL PROCEEDINGS.................................................12
   ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS.............13

PART II.......................................................................14

   ITEM 5.  MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED
            SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES....14
   ITEM 6.  SELECTED FINANCIAL DATA...........................................15
   ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
            CONDITION AND RESULTS OF OPERATIONS...............................19
   ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........37
   ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................37
   ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
            FINANCIAL DISCLOSURE..............................................38
   ITEM 9A. CONTROLS AND PROCEDURES...........................................38
   ITEM 9B. OTHER INFORMATION.................................................39

PART III......................................................................40

   ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................40
   ITEM 11. EXECUTIVE COMPENSATION............................................40
   ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....40
   ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................40
   ITEM 14. PRINCIPAL AUDITOR FEES AND SERVICES...............................40

PART IV.......................................................................41

   ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K...41

SIGNATURES....................................................................44

FINANCIAL STATEMENTS.........................................................F-3


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<PAGE>

                   SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements,  within the
meaning of Section  27A of the  Securities  Act of 1933 and  Section  21E of the
Securities  Exchange  Act of 1934,  that are based on our  current  expectations
about  our  company  and our  industry.  All of our  forward-looking  statements
involve risks and uncertainties.  Our actual results could differ  significantly
from our  expectations  and from the  results  expressed  in or implied by these
forward-looking statements.  Factors that might cause such a difference include,
but are not limited to, those discussed  elsewhere in this Annual Report on Form
10-K.  We  urge  you  to  consider  these  cautionary  statements  carefully  in
evaluating  our  forward-looking  statements.  Except  as  required  by law,  we
undertake no obligation  to publicly  update any  forward-looking  statements to
reflect  subsequent events and  circumstances.  Important factors that may cause
results to differ from  expectations  include  those  discussed  in Risk Factors
beginning on page 28 in this document.

                                EXPLANATORY NOTE

This Annual  Report on Form 10-K for the year ended  December 31, 2004  includes
restated  financial  statements  as of December 31, 2003 and for each of the two
fiscal years in the period ended December 31, 2003.

In April 2005, the Company  completed a review of its accounting  practices with
respect to the historical classification of cost of service revenues, procedures
for  recognizing   revenue   associated  with  extended  support  contracts  and
procedures for establishing the accrual for  paid-time-off,  and determined that
its historical  financial  statements as of and for the years ended December 31,
2002 and 2003 contained certain errors in the application of generally  accepted
accounting principles as described below:

      1.    Classification of cost of service revenues

            The Company has concluded that its historical classification of cost
            of service revenues did not conform to Generally Accepted Accounting
            Principles.  Historically,  such costs have been improperly included
            as a component  of sales and  marketing  expenses  on the  Company's
            consolidated   statements  of  earnings;   however  under  generally
            accepted  accounting  principles,  such  costs  are  required  to be
            classified as cost of service revenues. The Company has reclassified
            $711,000  and  $729,000  in  fiscal  2002 and 2003 out of sales  and
            marketing and included these amounts within cost of service revenues
            in its statements of earnings. The reclassification had no impact on
            reported sales,  net income,  earnings per share, or cash flows from
            operations  for  the  respective  periods.  The   misclassification,
            however,  did result in cost of sales being  understated,  and gross
            profit and operating expenses being overstated by equal amounts. The
            Company has concluded that the internal control  deficiency that led
            to the errors in the  historical  classification  of cost of service
            revenues is a "material  weakness" as defined by the Public  Company
            Accounting Oversight Board's Auditing Standard No. 2.

            Effective  January 1, 2005, the Company  established a separate cost
            center to capture solely the cost of service revenues and such costs
            will be classified as a component of cost of sales.

            The  Company's  review  of such  costs was  prompted  in part by the
            receipt  in  November  2004 and  thereafter  of a series of  comment
            letters  issued  by  the  Division  of  Corporation  Finance  of the
            Securities and Exchange Commission to the Company.


                                       1
<PAGE>

      2.    Revenue recognition related to extended support contracts

            The Company has determined  that as a result of an internal  control
            deficiency,   service  revenues  attributable  to  extended  support
            contracts were overstated by  approximately  $39,000 and $34,000 for
            fiscal 2002 and fiscal 2003, respectively. These amounts should have
            been  deferred  and  recognized  as service  revenues in  subsequent
            periods.  Such errors were the result of  inadequate  procedures  in
            place to  correctly  recognize  sales  related to  extended  support
            contracts.  The revenue overstatements represent less than 1% of the
            Company's total sales for the respective periods. In connection with
            their audit of the Company's  consolidated  financial statements for
            the  year  ended  December  31,  2004,  the  Company's   independent
            registered  public  accounting firm,  Grant Thornton LLP,  concluded
            that the internal control  deficiency that led to the aforementioned
            revenue  recognition  errors is a "material  weakness" as defined by
            the Public Company  Accounting  Oversight  Board's Auditing Standard
            No. 2.

            During the first quarter of 2005, the Company  enhanced its internal
            accounting  system to ensure  that  revenue is  recognized  over the
            actual contract term.

      3.    Accrual for paid-time-off

            The  Company  has also  identified  an  error  that  resulted  in an
            overstatement of its accrual for paid-time-off beginning in 2002 and
            continuing through 2004. This error resulted in the overstatement of
            expenses  by  approximately  $15,000  and $7,000 in fiscal  2002 and
            2003,  respectively.  During the first quarter of 2005,  the Company
            corrected  the  error  that  led to such over-accrual.  The reported
            results as of and for the year ended  December  31, 2004 reflect the
            appropriate accrual and expense for paid-time-off.

The Company has restated its consolidated  financial  statements for fiscal 2002
and 2003 in this 2004 Annual  Report on Form 10-K to correct  for these  errors.
The Company has also restated the  unaudited  quarterly  consolidated  financial
statements for each of the 2003 and 2004 periods included in Item 8 in this 2004
Annual Report on Form 10-K to correct for the  quarterly  impact of such errors.
Consequently,   the  historical   financial  statements  and  related  financial
information  contained  in  Castelle's  Annual  Report on Form 10-K for the year
ended  December  31, 2003 and each of  Castelle's  Forms 10-Q for the year ended
December  31,  2004 should no longer be relied  upon and are  superceded  by the
financial  statements  and financial  information  in this Annual Report on Form
10-K.

Note 3, Restatement of Previously Issued Financial  Statements,  to the notes to
the consolidated  financial  statements  discloses the impact of the adjustments
arising from the accounting errors described above on the statements of earnings
and balance sheets for the restated annual periods.  In addition,  Note 3 to the
consolidated  financial  statements  discloses the effect of the  restatement on
opening retained  earnings as of January 1, 2002, which adjustment  reflects the
impact of the restatement on periods prior to 2002.  This  adjustment  decreased
previously reported accumulated deficit by $27,000 with a corresponding decrease
to deferred revenue relating to extended support  contracts.  For information on
the impact of the restatement on fiscal 2000 and 2001, reference is made to Item
6, Selected Financial Data, in Part II of this Form 10-K.


                                       2
<PAGE>

                                     PART I

ITEM 1. BUSINESS

      The following summary should be read in conjunction with, and is qualified
in its entirety by, the more detailed  information  and  Consolidated  Financial
Statements and Notes thereto  appearing  elsewhere in this Annual Report on Form
10-K.

                                    OVERVIEW

      Castelle was incorporated in California in 1987, and its principal offices
are located at 855 Jarvis  Drive,  Suite 100,  Morgan  Hill,  California  95037.
Unless the context  otherwise  requires,  references  in this Form 10-K to "we,"
"us,"  or the  "Company"  refer  to  Castelle.  Our  telephone  number  is (408)
852-8000. Castelle(R),  LANpress(R) and JetPress(R) are registered tradeMARKS of
the Company.  FaxPressTM,  FaxPress  PremierTM and InfoPressTM are trademarks of
the Company. This Annual Report on Form 10-K includes trademarks and trade names
of other  companies.  Our common stock is listed on the Nasdaq  SmallCap  Market
under the symbol CSTL. We maintain a Website with the address  www.castelle.com.
We are not including the  information  contained on our website as a part of, or
incorporating  it by reference  into,  this Annual  Report on Form 10-K. We make
available free of charge through our website our Annual Reports on Form 10-K and
Quarterly  Reports  on Form  10-Q as soon as  reasonably  practicable  after  we
electronically  file such  material  with,  or  furnish  such  material  to, the
Securities and Exchange  Commission.  In addition,  we intend to disclose on our
website any  amendments  to, or waivers from,  our code of business  conduct and
ethics,  that are  required  to be publicly  disclosed  pursuant to rules of the
Securities and Exchange Commission and the Nasdaq Stock Market.

      We develop, manufacture, market and support office automation systems that
allow  organizations  to  implement  faxing  over  local area  networks  and the
Internet. A market leader in fax solutions for small to medium sized workgroups,
our  FaxPress  fax  servers  provide a simple way to  integrate  fax with email,
desktop and back-end  applications.  Our products are designed to be easy to use
and  maintain,  and provide an economical  way for companies to share  resources
over their networks.

      Our  products  have  historically  centered  on fax and print  servers and
related  technologies.  Beginning in 1997, our revenues  declined as competition
increased,  primarily with the print server products in the Asia Pacific region,
while at the same time the Internet and other networking  technologies advanced.
As a result,  we experienced  annual  operating losses during 1997 through 1999.
During the past eight years,  management  has redirected our efforts to focus on
server  appliances and on development  efforts to integrate  existing and future
products with the Internet and emerging networking technologies. During 2004, we
discontinued  our LANpress print server and InfoPress  product  lines,  but will
continue  to provide  support to our  customers  during  the  warranty  periods.
Through the  introduction  of enhanced fax  automation  products  that  generate
higher gross profits,  restructuring and cost reductions, we were able to report
operating profits in the fourth quarter of 1999 and in each of the four quarters
of 2000. In 2000, we recorded a profit of $732,000 with sales at $14.8  million.
We  incurred a loss of $591,000  in 2001 with sales of $9.4  million,  resulting
from a decrease in demand for our  products  due in part to the  slowness of the
economy. Our sales and profitability rebounded beginning in the third quarter of
2001,  and  since  then,  we  have  recorded   fourteen   straight  quarters  of
profitability.


                                       3
<PAGE>

Industry Background

      In the mid-1980s,  organizations began to interconnect  personal computers
into local area networks (known as "LANs") in order to allow workgroups to share
files, peripherals such as printers, and other specialized applications. As LANs
have proliferated throughout organizations and client/server  architectures have
gained acceptance,  they have become  increasingly  complex and the applications
operating on computer  networks  have become more critical to the success of the
business enterprise. The further proliferation of the Internet and Intranets and
popularity of electronic  communications expanded the role of LANs as a means to
provide  common  access  to the  Internet,  email and  other  office  automation
applications.  Installation,  maintenance  and  administration  of LAN equipment
required a staff of highly skilled professionals. The costs associated with LANs
and related equipment,  server-class  hardware,  specialized  software,  network
integration and support  services are significant and typically  affordable only
by  larger  organizations.  Many  businesses  were  not  able to  afford  office
automation  applications  beyond basic email, such as integrating fax technology
into the network.  This has created the opportunity  for specialized  networking
equipment  that  would  perform a single  application  very  well,  known in the
industry as a "server appliance." It is similar to using a toaster instead of an
oven, as it does a specific job better and it costs less. A server  appliance is
an integrated  hardware and software  product  designed to reduce the complexity
and  cost for a  specific  server-based  application.  Internet  routers,  email
servers,  remote access servers,  communication  servers,  fax servers and print
servers are examples of server appliances used by businesses today.

      We are a pioneer  in  server  appliances,  establishing  a  benchmark  for
"plug-and-play" and ease of use with our fax and print server product families.

      Fax Office Automation Products: Fax machines have become a basic method of
doing business  worldwide.  Fax is ubiquitous in business;  many homes even have
fax machines. While computers have automated many business applications,  faxing
remains as a basic method of business  communication.  We believe fax is here to
stay,  just as the  computer,  in its quest for the paperless  society,  has not
replaced  paper.  Fax servers  integrate  legacy fax  business  methods into the
network to improve office productivity. Fax servers also provide the opportunity
for new business  applications to be developed to take advantage of the inherent
strength and prevalence of fax machines.  Virtually  every business in the world
has a fax  machine  that can be used to receive  information.  Sending  purchase
orders,  invoices,  order  confirmations,  etc.  directly to a fax  machine,  as
compared to using the mail, is a growing segment of the fax server market.

      The  increasing  popularity of email and the Internet has provided a boost
to all types of electronic communications as many users and organizations become
more  comfortable  and accustomed to their use. To further  simplify and improve
inter- and intra-organizational communications, corporate Management Information
Services  departments  are  looking  for ways to  integrate  different  types of
messaging  into a unified  messaging  environment.  Fax  remains  one of the key
business  communication  tools  and is one of the  essential  components  of the
corporate messaging environment. In corporate communication infrastructures, fax
is being integrated into email. To facilitate this capability  companies install
email-integrated fax server systems.

      Fax servers  allow  users to send and  receive  faxes as easily as emails,
using the same email  application  for both types of messages.  A fax server can
sort incoming faxes directly and deliver them  electronically and confidentially
to the electronic mailboxes of the intended recipients. A fax server can also be
used as an independent  network shared system in environments  that require high
volume  incoming and outgoing  faxes.  Users are able to send and receive  faxes
directly from their computers or  workstations,  eliminating the need to print a
document,  take it to a stand-alone  fax machine and wait for its  transmission.
Fax servers can help reduce fax transmission  costs by sending  non-urgent faxes
at "off-


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<PAGE>

peak" telephone rates and by utilizing fax over the Internet technology.

      Many fax servers are implemented  using complex software that requires the
installation  of a Windows or UNIX  network  operating  system,  a  server-class
computer,  and specialized  expensive fax modems. Our fax servers,  FaxPress and
FaxPress Premier,  are self-contained  units with all the necessary hardware and
software  to  integrate   fax  into   network,   desktop,   email  and  back-end
applications.  As server  appliances,  they are  designed  to be easy to use and
maintain and we believe that they are more economical than other solutions.

      Server appliances, such as communications/messaging  servers, have emerged
and  gained  market  acceptance  due to their  ability to  significantly  reduce
complexity  and  cost  associated  with  the  installation  and  maintenance  of
networking  systems.  These  appliances also make the complex  functionality  of
Internet  and  Intranet  communications  available  and  affordable  to  smaller
businesses.  As  professionals  in  enterprises  and small  organizations  alike
continue to recognize the benefits of server appliances,  such as remote access,
scanning,  faxing,  electronic mail and related  functions,  we believe that the
demand for such network systems will increase.

Our Strategy

      Our  objective  is to be a leading  worldwide  supplier of network  server
appliances.  We established a benchmark for "plug-and-play" and ease of use with
our fax server product  family.  Our products are installed in many Fortune 1000
firms,  small and medium sized  businesses  worldwide,  integrating  desktop fax
automation, email, Internet connectivity and other shared services.

      Focus on Server Appliances:  We focus exclusively on providing innovative,
reliable,  easy-to-use network products. Since our inception, we have focused on
developing  networking  products  that tightly  integrate  proprietary  hardware
systems  with  standard  computing  platforms.  As a result,  we believe we have
developed  a high  level  of  expertise  in  networking,  software  development,
hardware  design  and  telephony  technology.  We plan to  capitalize  on  these
attributes by continuing to focus on providing network enhancement products that
enable users to communicate more effectively.

      Focus on Application Solutions and Communications:  We focus on developing
application  solutions for inter and  intra-company  communications.  We believe
that our focus on  application  servers  rather than on  infrastructure  systems
enables us to offer  products that bring higher value  services to customers and
provide a higher margin to us.

      Expand Product Line: We are leveraging our expertise in server  appliances
to offer new easy-to-use,  cost-effective  solutions.  We continue to expand our
fax server products and apply our proven technology to other areas.

      Focus on E-commerce and Other High Volume Distribution  Channels:  We have
established  a  two-tier  domestic  and  international  distribution  network of
leading  national  and  regional  network  product  distributors  and  resellers
including  Ingram Micro and Tech Data.  Our products are well suited for sale by
e-commerce  vendors and we have been successful  working with leading  resellers
such as CDW and Insight.  We are focused on maintaining  and  strengthening  our
current distribution network in North America, Europe and Pacific Rim.

      Leverage  Strategic  Relationships:  We augment our product  offerings  by
establishing  relationships  with  companies  able to provide  products in areas
outside  of our core  technical  competencies  or in  instances  where  internal
development  of  such  products  is  not   cost-effective.   We  also  establish
relationships with numerous leaders in hardware and software  technology to keep
abreast of, and respond


                                       5
<PAGE>

quickly  to,  technological  changes  that may  affect the  network  enhancement
market.

Products

      We develop and market a range of server  appliances  that enhance  network
productivity, performance and functionality.

      Fax Server Products:  We offer the FaxPress family of network fax servers.
We position  FaxPress and FaxPress Premier as the easiest way to add faxing to a
company's  network and integrate fax with email.  FaxPress and FaxPress  Premier
allow network users to send, receive, route, print, store, edit and retrieve fax
transmissions  from their own  personal  computers  on a network.  FaxPress  and
FaxPress  Premier  can be  integrated  into an email  system  creating a unified
fax/email  environment.  FaxPress and FaxPress  Premier enable users to transmit
documents directly to a fax device as easily as if they were printing to a laser
printer  or  sending  an  email  message.  The  product  also  provides  network
administration features such as, monitoring, logging or configuring FaxPress and
FaxPress  Premier  users.  Our fax server  products  are designed to comply with
current regulatory  standards in the United States,  Europe and the Pacific Rim.
During  2004,  2003,  and 2002,  fax  products  represented  99%,  97%, and 95%,
respectively, of total net sales.

      Key features of FaxPress and FaxPress  Premier  products  (configured with
      its current software versions) include:

            o     Easy  Installation  and  maintenance:  FaxPress  and  FaxPress
                  Premier are network fax servers that include all the necessary
                  hardware and  software.  The hardware  system is a box with an
                  integrated  10/100  Base-T  Ethernet   interface  and  one  to
                  seventy-two  fax  channels.   FaxPress  and  FaxPress  Premier
                  include all required server and client software.

            o     Support for popular network operating  environments:  FaxPress
                  and FaxPress  Premier  operate in any local area network based
                  on Microsoft Windows 98, ME, 2000 and 2003; Windows NT/XP, and
                  NT Terminal Server; Novell NetWare; or Linux servers.

            o     Ability to create a unified fax/email  messaging  environment:
                  FaxPress  and  FaxPress  Premier have the ability to integrate
                  fax into a corporate email system,  allowing users to send and
                  receive  faxes in the same  manner  as  emails.  FaxPress  and
                  FaxPress  Premier support  Microsoft  Exchange/Outlook,  Lotus
                  Notes,  Novell  GroupWise,  Netscape and other SMTP compatible
                  email systems.  Our unique Outlook Direct  interface  offloads
                  fax  processing  from  the  Microsoft  Exchange  Server  while
                  maintaining tight integration with the Outlook client.

            o     Integration   with  many  popular   accounting   and  Customer
                  Relationship  Management  applications:  FaxPress and FaxPress
                  Premier are available  with the  Reform-for-FaxPress  software
                  package from FabSoft that allows users to send faxes from many
                  popular  accounting,  financial and payroll systems  including
                  Oracle,  SAP,  PeopleSoft,  Great  Plains,  ACCPAC and Macola.
                  Reform  can  support  any   application   that  supports  form
                  printing.

            o     Ability  to send  faxes from many  applications:  Faxing  from
                  within  any  Windows,  Windows  95/98 and  Windows  NT/2000/XP
                  application such as Microsoft Office and Lotus Smart Suite.

            o     Electronic  delivery  of  faxes  to  desktops:   FaxPress  and
                  FaxPress  Premier support several


                                       6
<PAGE>

                  methods to deliver  incoming  faxes direct to the email or fax
                  inbox of the intended  recipient.  Such methods include Direct
                  Inward Dialing, Dual Tone Multifrequency, T.30 sub-addressing,
                  and line routing.

            o     Internet  faxing   capabilities   reduce  transmission  costs:
                  FaxPress and FaxPress  Premier enable users to connect several
                  units  via the  Internet  or the  Intranet  to form a  private
                  Fax-over-IP network that can significantly  reduce the cost of
                  fax transmissions.

            o     Integration  into custom  applications:  We provide a software
                  development  kit that  allows  programmers  to  integrate  fax
                  functions  into their  current  applications  or to create new
                  customized  applications  that use the  FaxPress  or  FaxPress
                  Premier servers.

            o     Software  Options:  We offer a range of  value-added  software
                  options that  increase the  functionality  of our FaxPress and
                  FaxPress  Premier systems and enable the FaxPress and FaxPress
                  Premier  to  address  specialized  applications  as  mentioned
                  above.  Software  upgrades  and options are  available  to the
                  installed  base of  FaxPress  and  FaxPress  Premier  units at
                  prices starting at $495.

      We offer a family of FaxPress  and  FaxPress  Premier  fax server  systems
ranging from entry-level  products targeted for small businesses with fewer than
50 users  to  high-end  fax  solutions  capable  of  supporting  enterprise-wide
installations.  The suggested list prices for FaxPress and FaxPress  Premier fax
servers range from $1,495 to $48,995. Server pricing is based on hardware model,
with no per-user costs.  The FaxPress 2500, 5000 and 7000 families come with the
FaxPress  8.X network fax software  that adds  integration  with  popular  email
packages,  and many  advanced  fax  management  and  integration  features.  Our
FaxPress  Small  Business  Edition  ("SBE") fax server  does not  include  email
integration  started with our FaxPress 7.1.1 network fax software.  The FaxPress
Premier  family comes with the FaxPress  Premier 3.X network fax  software.  The
following table summarizes our FaxPress and FaxPress Premier system products:

<TABLE>
<CAPTION>
                                                                            ----------------------------------
                                                                                     Network Environment
  ------------------------------------------------------------------------------------------------------------
                                                                               NetWare
                                   Number of        Email        Network    3.x, 4.x, 5.x,         Windows
          Product Model            Channels      Integration     Topology    6.x (IPX,IP)      NT/2000/XP/2003
  ------------------------------------------------------------------------------------------------------------
<S>                         <C>                 <C>              <C>             <C>                 <C>
  FaxPress SBE                         1        Not available    Ethernet         x                   x
  FaxPress 2500                        2              x          Ethernet         x                   x
  FaxPress 5000                    2, 4 or 8          x          Ethernet         x                   x
  FaxPress 7000                        8              x          Ethernet         x                   x
  FaxPress 7500                        8              x          Ethernet         x                   x
  FaxPress Premier Analog        4, 8, 12, 16         x          Ethernet        n/a                  x
  FaxPress Premier Digital T1    8, 24, 48, 72        x          Ethernet        n/a                  x
  FaxPress Premier ISDN            4, 8, 12           x          Ethernet        n/a                  x
  FaxPress Premier Digital E1   10, 30, 60, 90        x          Ethernet        n/a                  x
  ------------------------------------------------------------------------------------------------------------
</TABLE>

Research and Product Development

      We have invested  substantially in research and product  development since
inception.  We believe our future  performance  will depend in large part on our
ability to enhance our current  products,  to expand


                                       7
<PAGE>

our product offerings,  to maintain  technological  competitiveness  and meet an
expanding range of customer  requirements.  We spent $1.7 million,  $1.6 million
and $1.4 million in research and product  development  activities in 2004,  2003
and 2002, respectively.

      We continue to invest in enhancing our server  appliance  product lines by
developing new versions of client and server software and server  hardware.  The
product  feature set is driven by the increasing  complexity of user needs.  The
changing  corporate  communications/messaging  environment and increasing demand
for easy-to-use  networking systems define these needs. The development  efforts
are focused on enhancing functionality of existing products and developing other
systems to expand our product offerings. Our development efforts are focusing on
high  value  applications,  while  relying  on our  partners  to  provide  basic
functionality for some of our product lines.

      In 2004,  we developed and released  version 8.0 of our FaxPress  software
and version 3.0 of our FaxPress Premier  software.  The new releases of FaxPress
8.0 and  FaxPress  Premier 3.0 Network Fax  Software  offer a new level of email
integration,  expanded operating environments and fax automation.  It includes a
new gateway for IBM Lotus Notes email  integration,  improved  integration  with
Microsoft  Exchange,  enhanced  Windows  XP and  Citrix  MetaFrame  XP  support,
improved Novell client support, production faxing and fax automation made easy.

      The current  FaxPress and FaxPress  Premier fax server  product  lines are
continuously  being  enhanced  to  offer  greater   integration  into  corporate
networking environments.

Sales, Marketing and Distribution

      We sell our products through multiple channels, determined by the product,
market  and  customer  need.  We  have  an  established  two-tier  domestic  and
international  distribution  network of leading  national and  regional  network
product  distributors  and  resellers.  Software  enhancements  and options that
complement  the  FaxPress  products  are  primarily  marketed  directly by us to
registered end users. The direct sales group works closely with distributors and
value-added  resellers  ("VARs") in qualifying sales  opportunities  for the fax
server products. We also sell some products through the on-line store on our Web
site.  Demand  for our  products  is  created  through  a variety  of  marketing
programs.  These programs are targeted toward  end-users to stimulate demand for
the products and toward distributors,  resellers, VARs and e-commerce vendors to
promote the product in the sales channel.  These programs  include  targeted and
active  participation in industry  networking and communication  trade shows, as
well as advertising  in associated  publications.  We increase  awareness of our
products  by Internet  marketing  via  targeted  e-advertising,  publishing  and
sponsoring email  newsletters,  enhancing our Web presence,  print  advertising,
conducting   direct  mail  campaigns,   offering   seminars,   trade  shows  and
conferences,  and other forms of public relations efforts. Our Web site has been
updated and  designed to assist  customers in  obtaining  information  about our
products and contacting our sales personnel.

      Our products are well suited for sale by e-commerce  vendors,  and we have
experienced success working with leading resellers such as CDW and Insight.

      In 2004, Ingram Micro and Tech Data  individually  accounted for more than
10% of our  sales  and  collectively  represented  approximately  44% of our net
sales. In 2003 and 2002, the same  distributors  accounted for approximately 50%
and 51% of our net sales for the  respective  years.  Total  sales to  customers
located in the Pacific Rim, Europe and rest of Americas comprised  approximately
18%, 19%, and 21% of our net sales in 2004, 2003 and 2002, respectively.


                                       8
<PAGE>

Customer Service and Support

      We provide customers with support services,  which are available to assist
customers  with  installation,  use and operation  issues in an effort to ensure
smooth and reliable operation of our products. Our network engineers, located at
corporate headquarters,  provide technical support via telephone,  fax and email
during normal Company business days from 6:00 a.m. to 5:00 p.m.  (Pacific Time).
As part of our global partner program,  VARs have access to "priority  technical
support" via a special  toll-free  number that provides  immediate access to our
network  engineers.  Support is provided under warranty terms as well as through
extended  warranty  agreements  sold  directly  to the  customer  by us. We also
provide other customer  support  through our Web site. We have an automated call
management  distribution system that provides improved levels of support to help
resolve customer issues.

Manufacturing

      Our  current  in-house  manufacturing   operations  consist  primarily  of
material planning,  assembly, final testing, quality control and service repair.
Most of our products are manufactured by third-party  manufacturers that provide
customized,    integrated   manufacturing   services,   including   procurement,
manufacturing,   printed  circuit  board  assembly  and  final  testing.   These
arrangements  enable  us to  shift  certain  costs  to such  providers,  thereby
allowing us to focus resources on our product development  efforts.  The failure
of such manufacturers,  to meet their contractual  commitments to us could cause
delays  in  product  shipments,  thereby  potentially  adversely  affecting  our
business, operating results and financial condition.

      We do not currently have any material  long-term supply contracts with any
of our manufacturing subcontractors or component suppliers. We purchase finished
products  and  components  on a purchase  order basis.  We own all  engineering,
sourcing   documentation,   functional   test  equipment  and  tooling  used  in
manufacturing  our products and believe that we could shift product  assembly to
alternate  suppliers  if  necessary.  Certain key  components  of our  products,
including  a modem  chip  set  from  Conexant,  microprocessors  from  Motorola,
integrated  circuits from Intel and Kendin, are currently  available from single
sources.  Other  components of our products are currently  available from only a
limited number of sources. In addition, certain manufacturers have announced the
end-of-life of certain standard off-the-shelf components which are being used by
us in the making of our FaxPress Products.  However,  we have purchased at least
two years worth of supplies of these end-of-life components,  and are constantly
replenishing our inventory from secondary markets too, in an effort to guarantee
an uninterrupted  supply of FaxPress  Products to our customers for the next two
years,   while  we  decide  whether  to   re-engineer   our  Products  with  the
manufacturers' suggested replacement parts, or develop new replacement products.

Competition

      The network enhancement  products and computer software markets are highly
competitive,  and we believe that such competition will intensify in the future.
The competition is  characterized by rapid change and improvements in technology
along with  constant  pressure to reduce the prices of  products.  We  currently
compete  principally  in the market for network  fax  servers and  fax-on-demand
software.

      The principal  competitive  factors  affecting the market for our products
include product functionality,  performance,  quality, reliability, ease of use,
quality  of  customer  training  and  support,  name  recognition,   price,  and
compatibility  and conformance  with industry  standards and changing  operating
system  environments.  Several of our existing and potential  competitors,  have
substantially  greater  financial,  engineering,   manufacturing  and  marketing
resources  than  us.  We also  experience  competition  from a  number  of other
software,   hardware  and  service   companies.   In  addition  to  our  current
competitors,  we may face  substantial  competition  from new entrants  into the
network  enhancement


                                       9
<PAGE>

market,  including  established  and  emerging  computer,  computer  peripheral,
communications and software companies.  In the fax server market we compete with
companies such as Captaris,  Inc., Omtool, Ltd. and Esker Software. In addition,
certain competing  methods of communications  such as the Internet or electronic
mail could adversely affect the market for fax products.

Proprietary Rights

      Our success depends to a certain extent upon our  technological  expertise
and proprietary software  technology.  We rely upon a combination of contractual
rights and  copyright,  trademark and trade secret laws to establish and protect
our  technologies.   Additionally,   we  generally  enter  into  confidentiality
agreements with those employees, distributors,  customers and suppliers who have
access to sensitive  information  and limits access to and  distribution  of our
software documentation and other proprietary  information.  Because of the rapid
pace of technological change in the LAN product industry, we believe that patent
protection  for our  products  is  less  significant  to our  success  than  the
knowledge,  ability and experience of our employees,  the frequent  introduction
and  market  acceptance  of new  products  and  product  enhancements,  and  the
timeliness and quality of our support services. We may not be able to obtain the
necessary  intellectual  property  rights  and other  parties  may  contest  our
intellectual property rights.

Government Regulation

      Certain  aspects  of the  networking  industry  in  which we  compete  are
regulated  both in the United  States and in foreign  countries.  Imposition  of
public  carrier  tariffs,  taxation  of  telecommunications   services  and  the
necessity of incurring substantial costs and expenditure of managerial resources
to obtain regulatory  approvals,  particularly in foreign countries could have a
material,  adverse  effect on our  business,  operating  results  and  financial
condition.  Additionally,  our products must comply with a variety of equipment,
interface and installation  standards  promulgated by communications  regulatory
authorities in different countries.

Employees

      As of March 1,  2005,  we  employed  a total  of 48  full-time  equivalent
personnel, 9 in operations,  13 in sales and marketing, 9 in engineering,  11 in
customer service and 6 in finance and administration.  We have not experienced a
work  stoppage,  no employees are  represented  by a labor  organization  and we
consider our employee relations to be good.

Executive Officers

      The names and ages of our  executive  officers as of February 28, 2005 are
set forth below:


                                       10
<PAGE>

              Name             Age                  Position
       Scott C. McDonald        51   President, Chief Executive Officer

       Eric Chen                52   Senior Vice President, Engineering
                                     and Business Development

       Paul Cheng               56   Vice President, Finance and Administration,
                                     Chief Financial Officer and Secretary

       Richard Fernandez        45   Vice President, Operations

       Edward J. Heinze         59   Vice President, Sales, U.S.

       Michael Petrovich        43   Vice President, Sales, International

Scott C. McDonald

            Mr. McDonald has served as our President and Chief Executive Officer
      since April 2002. Mr.  McDonald has served as a director since April 1999.
      From May 2001 to the first  quarter of 2002,  Mr.  McDonald  served on the
      board of directors for Octant  Technologies and Digital Power  Corporation
      and  provided  consulting  services.  Mr.  McDonald  served  as the  Chief
      Financial and Administrative Officer at Conxion Corporation, a network and
      Internet services company,  from December 1999 to April 2001. From 1997 to
      1999, Mr. McDonald served on the board of directors for CIDCO, Inc, Octant
      Technologies Inc. and Digital Power Corporation;  in addition to providing
      consulting  services to CIDCO,  Inc. Mr. McDonald  currently serves on the
      board of  directors  of  privately  held  Octant  Technologies,  Inc.  Mr.
      McDonald holds a BS in Accounting  from the University of Akron and an MBA
      from Golden Gate University.

Eric Chen

            Mr. Chen has served as our Senior Vice  President,  Engineering  and
      Business  Development  since May 2002. From May 2000 to May 2002, Mr. Chen
      served as our Vice President,  Engineering. Upon joining us i(n) 1989, Mr.
      Chen  initially  worked  on  software   development   projects   including
      developing  the  first  FaxPress  e-mail  gateways,  porting  FaxPress  to
      non-Novell   platforms,   and  the  first  menu-driven   installation  and
      configuration programs for both FaxPress and LANpress.  Most recently, Mr.
      Chen served as the Director of Print Server Product Marketing and Business
      Unit  and  has  managed  the  engineering  development  and  manufacturing
      business relationships with our partners.  Before joining our company, Mr.
      Chen was with 3COM,  a network  solutions  provider.  Mr. Chen has a BS in
      Engineering  from Taiwan and an MS in Computer Science from the University
      of Massachusetts.

Paul Cheng

            Mr. Cheng has served as our Vice President, Finance and
      Administration since April 2000. In March 2001, Mr. Cheng was appointed as
      Chief Financial Officer and Secretary. Mr. Cheng brings more than 20 years
      of financial experience from a career that was launched in Hong Kong where
      he was the Plant Controller of Fairchild Semiconductor Hong Kong Ltd.
      Before joining our company, he served as the Vice President of Finance and
      Administration at Eclipse International, Inc., a systems development
      company, from April 1997 to March 2000. In addition, he has held various
      executive positions including Vice President of Finance at Quintus
      Corporation, a developer of customer relations management software from
      1993 to 1995 and Corporate Controller at Power Integration, Inc., a
      semiconductor manufacturer from 1995 to 1997. Mr. Cheng is a member of the
      Chartered Certified Accountants and holds a BS in Accounting from Hong
      Kong.


                                       11
<PAGE>

Richard Fernandez

            Mr.  Fernandez has served as our Vice President of Operations  since
      December 2002.  From June 2002 to December 2002, Mr.  Fernandez  served as
      our  Director  of  Operations.  Mr.  Fernandez  has more  than 22 years of
      manufacturing  and  materials  planning  experience  prior to joining  the
      Company.   Prior  to  joining  our  company,  Mr.  Fernandez  managed  the
      acquisition of servers and storage  devices for Conxion  Corporation  from
      June  2000 to May  2002.  Prior to  joining  Conxion,  Mr.  Fernandez  was
      Director of Operations with CIDCO, Inc. since March 1994. In addition, Mr.
      Fernandez has held various  management  positions  with Computer  Products
      Inc., MAD Intelligent Systems and Sperry Univac.

Edward J. Heinze

            Mr.  Heinze  has served as our Vice  President,  Sales,  U.S.  since
      January  2000.  From 1994 to January  2000,  Mr.  Heinze served in several
      capacities including Product Manager of the Fax Product Line, and Regional
      Sales Manager.  Before  joining our company,  Mr. Heinze served in several
      capacities at Visual/White Pine Software, a software developer,  including
      Vice  President of Sales.  Prior to his tenure at White Pine, he was Chief
      Operations  Officer for XMARK, a computer systems  manufacturer,  and Vice
      President of Sales and Marketing at EIT, Millicom,  Olympia, and Ontel. He
      holds a BS degree from Waynesburg College.

Michael Petrovich

            Mr. Petrovich has served as our Vice President, Sales, International
      since  October  2000  and has  been  with us  since  1992.  Mr.  Petrovich
      concentrates on developing the sales channels for all sales outside of the
      Americas,  including  Asia, the Asia Pacific and Europe.  Prior to joining
      us, Mr.  Petrovich was the marketing  communications  manager for Novell's
      National  Reseller  Organization,  a  software  company.  In this role Mr.
      Petrovich  focused on  business  strategies  and  development  of Novell's
      direct reseller sales channel.  Before joining Novell,  Mr. Petrovich held
      sales  and  marketing  positions  at  Excelan,  a  LAN  manufacturer,  and
      International  Microcircuits  Incorporated,  a semiconductor  company. Mr.
      Petrovich  holds  a  BA  in  Behavioral   Sciences  from  San  Jose  State
      University.

ITEM 2. PROPERTIES

      Our   headquarters,   including  our   executive   offices  and  corporate
administration,  development,  manufacturing,  marketing,  sales  and  technical
services/support   facilities,   are  located  in  Morgan  Hill,  California  in
approximately 16,600 square-feet of leased office space. We occupy this facility
under a lease,  the term of which  expires in May 31, 2009 with one  conditional
three-year option,  which if exercised,  would extend the lease to May 31, 2012.
We also rent office space for sales and customer support in Illinois. We believe
our  existing  facilities  will be  adequate  to meet our  requirements  for the
foreseeable future.

ITEM 3. LEGAL PROCEEDINGS

      From time to time and in the ordinary course of business,  we are involved
in various legal  proceedings and third party  assertions of patent or trademark
infringement  claims  against  us in the  form of  letters  and  other  forms of
communication.  We are not currently  involved in any litigation  which,  in our
opinion,  would  have a  material  adverse  effect  on our  business,  operating
results, cash flows or financial condition;  however,  there can be no assurance
that any such proceeding  will not escalate or otherwise  become material to our
business in the future.


                                       12
<PAGE>

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS

      Subsequent  to our Annual  Meeting of  Shareholders  held on May 28, 2004,
there were no  matters  submitted  to a vote of  securities  holders  during the
remainder of 2004.


                                       13
<PAGE>

                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS,
        AND ISSUER PURCHASES OF EQUITY SECURITIES

      Our  common  stock  (Nasdaq  symbol  "CSTL")  began  trading on the Nasdaq
National  Market on December 20, 1995 and was transferred to the Nasdaq SmallCap
Market as of April 1999. The following table shows the closing high and low sale
prices per share of our common stock as reported on the Nasdaq SmallCap  Market.
Such quotations do not include retail markups, markdowns or commissions.

              2003                          HIGH         LOW
                   First Quarter           $2.91        $1.03
                   Second Quarter          $3.86        $1.95
                   Third Quarter           $4.90        $3.01
                   Fourth Quarter          $3.50        $2.61

              2004                          HIGH         LOW
                   First Quarter           $7.80        $2.95
                   Second Quarter          $5.35        $2.77
                   Third Quarter           $3.39        $2.31
                   Fourth Quarter          $4.29        $2.71

      The market price of our common stock has been volatile.  See "Risk Factors
- Our stock price has been volatile, and is likely to continue to be volatile in
the future."

      As of April 12, 2005 there were 700 holders of record of our common stock.
On April 12, 2005 the last sale price reported on the Nasdaq SmallCap Market for
our common stock was $3.25 per share.

Stock Buyback

      In the fourth quarter of 2002, our Board of Directors  authorized us, from
time to time, to repurchase at market prices,  up to $2.25 million of our common
stock for cash in open market,  negotiated or block transactions.  The timing of
these transactions will depend on market conditions,  other corporate strategies
and will be at the  discretion  of  management.  No time  limit  was set for the
completion  of  this  program.  At the  time of the  approval  by the  Board  of
Directors,  we had  approximately 4.8 million shares of common stock outstanding
and as of the end of the third  quarter  2002,  cash and cash  equivalents  were
approximately  $4.8 million.  During the fourth  quarter of 2002, we repurchased
from open market and negotiated  transactions a total of 1.62 million shares for
$1.8 million,  at an average per share price of $1.10.  During the first quarter
of 2003, we repurchased  from open market  transactions a total of 46,500 shares
for $48,000,  at an average per share price of $1.04. We have performed no stock
repurchases since then.  However, we may continue to execute our buyback program
as we deem necessary.

Dividend Policy

      We have  not  paid  cash  dividends  on our  common  stock.  The  Board of
Directors  currently  intends  to  retain  any and all  earnings  for use in our
business  and we do not  anticipate  paying cash  dividends  in the  foreseeable
future.


                                       14
<PAGE>

Equity Compensation Plan Information

      The following table sets forth a summary of our equity  compensation plans
as of December  31,  2004.  Details of the plans are  discussed in Note 7 to the
Consolidated Financial Statements.

<TABLE>
<CAPTION>
                                           Number of securities to        Weighted average
                                           be issued upon exercise        exercise price of             Number of
                                           of outstanding options,      outstanding options,      securities remaining
                                             warrants and rights         warrants and rights      for future issuance
                                             -------------------         -------------------      -------------------
<S>                                                <C>                           <C>                     <C>
1988 Equity compensation plan
approved by security holders                           7,000                     $2.38                        -0-

1998 (1988) Equity compensation
plan (As Amended) approved by
security holders                                     896,391                     $0.98                        -0-

2002 Equity compensation plan
approved by security holders                         389,205                     $3.07                   460,045

Equity compensation plans not
approved by security holders                              -0-                      n/a                        -0-
                                        -------------------------------------------------------------------------
         Total                                     1,292,596                     $1.61                   460,045
</TABLE>

ITEM 6. SELECTED FINANCIAL DATA

      The five-year financial summary in this Item 6 has been revised to reflect
the  Company's  restatement  of previously  reported  results (see Note 3 to the
consolidated financial statements).

      The information  set forth below is not necessarily  indicative of results
of future  operations,  and  should be read in  conjunction  with  "Management's
Discussion and Analysis of Financial  Condition and Results of  Operations"  and
the  Consolidated  Financial  Statements  and  related  Notes  thereto  included
elsewhere in this Annual Report on Form 10-K.


                                       15
<PAGE>

<TABLE>
<CAPTION>
                                                                                Years ended December 31,
                                                        ----------------------------------------------------------------------
                                                          2004            2003             2002          2001            2000
                                                        -------         -------         ---------      -------         -------
                                                                      (Restated)       (Restated)      (Restated)      (Restated)
                                                                        (in thousands, except per share amounts)
<S>                                                     <C>             <C>             <C>            <C>             <C>
STATEMENT OF EARNINGS DATA:
   Net Sales                                            $10,457         $10,180         $ 9,720        $ 9,381(5)      $14,832

   Gross Profit                                         $ 7,075         $ 6,969         $ 6,180        $ 5,479(6)      $ 8,360(6)
   Gross Profit as a % of Net Sales                          68%             68%             64%            58%             56%

   Net income (loss)                                    $ 2,119(1)      $ 1,606(2)      $   635          ($564)(4)     $   732
   Net income (loss) as a % of Net Sales                     20%(1)          16%(2)           7%            (6%)             5%

   Net income (loss) per share - diluted                $  0.48(1)      $  0.38(2)      $  0.14         ($0.12)        $  0.14

BALANCE SHEET DATA:
   Cash and Cash Equivalents                            $ 5,599         $ 4,614         $ 3,460(3)     $ 4,568         $ 3,893
   Working Capital                                      $ 5,750         $ 4,156         $ 2,437        $ 3,587         $ 3,969
   Total Assets                                         $10,147         $ 7,803         $ 5,635        $ 7,010         $ 8,543
   Long-term Liabilities                                $    14         $    29         $    44        $    64         $    63
   Shareholders' Equity                                 $ 7,281         $ 4,752         $ 2,926(3)     $ 4,229         $ 4,776
</TABLE>

      (1) In 2004, we recorded a non-cash tax benefit of $1.1 million,  or $0.24
per diluted share. This was a result of releasing a portion of our tax valuation
allowance due to our continued profitability and a determination that it is more
likely than not that certain future tax benefits will be realized.

      (2) In the fourth  quarter of 2003,  we recorded a non-cash tax benefit of
$526,000, or $0.12 per diluted share, resulting from the release of a portion of
our tax  valuation  allowance.  Prior to the fourth  quarter of 2003, we had not
reported  significant  income tax expenses because we had utilized available Net
Operating  Loss  ("NOL")  and tax  credit  carryforwards.  These NOLs were fully
reserved by a valuation allowance due to uncertainly  surrounding the likelihood
of  their  realization.  Due to our  continued  profitability  over the past ten
quarters  and a  determination  that it was more  likely  than not that  certain
future tax benefits will be realized,  a portion of the deferred tax assets were
recognized in the fourth quarter.

      (3) In 2002, cash and cash  equivalents and  shareholders'  equity reflect
the use of $2 million of cash for the  repurchase of 1.62 million  shares of our
common stock and the associated expenses.

      (4) Net loss for 2001  includes  net charges for  restructuring  and other
non-recurring items of $239,000.

      (5) Net sales in 2001 have been restated to increase  service  revenues by
$27,000 as compared to previously reported net sales in relation to the extended
support contracts adjustment.  Consequently,  the net loss for 2001 decreased to
$564,000 as compared to the previously reported net loss of $591,000.  There was
no impact on previously reported net loss per share for 2001.

      (6)  Gross  profit  and  operating  expenses  for 2001 and 2000  have been
restated to reduce such  balances by equal  amounts of $813,000  and $1 million,
respectively,  as compared to previously  reported  amounts,  as a result of the
reclassification  of cost of service revenues from operating expenses to cost of
sales.

Unaudited Quarterly Results of Operations

The following table sets forth certain consolidated quarterly financial data for
the eight quarters ended December 31, 2004. This  information is unaudited,  but
in our opinion,  has been prepared on the same basis as the audited consolidated
financial  statements  appearing  elsewhere  in this report,  and all  necessary
adjustments, consisting only of normal recurring adjustments, have been included
in the amounts stated


                                       16
<PAGE>

below to present fairly the unaudited interim results. The results of operations
for any quarter are not necessarily  indicative of the results of operations for
any future period.

The  consolidated   quarterly   financial  data  presented  below  reflects  the
restatement of the periods through  September 30, 2004 to reflect the adjustment
for  certain  errors  noted by the Company  during the fourth  quarter of fiscal
2004.  For a  description  of the  restatement  items  and the  effect on annual
periods  for  fiscal  2003 and 2002,  see Note 3 to the  Company's  consolidated
financial statements.

Selected Quarterly Data (unaudited)

<TABLE>
<CAPTION>
                                                           Year 2004, Quarter Ended
                                                -------------------------------------------------
                                                 Mar 31        Jun 30        Sep 30       Dec 31
                                                ----------    ----------   ----------   ----------
                                                      (in thousands, except per share data)
                                                (Restated)    (Restated)   (Restated)
<S>                                               <C>           <C>           <C>        <C>
            Net sales (1)                         $2,539        $2,691        $2,685     $2,542
            Gross profit (2)                       1,702         1,883         1,804      1,686
            Operating income (3)                     228           272           236        330
            Net income(4)                            129           146           130      1,714(5)
            Net income per share, basic (4)         0.04          0.04          0.04       0.46(5)
            Net income per share, diluted (4)       0.03          0.03          0.03       0.39(5)
</TABLE>

      (1)   Net sales in the 2004 quarters ended March 31, June 30 and September
            30 have been restated to reduce service revenues by $19,000, $26,000
            and $13,000,  respectively,  as compared to previously  reported net
            sales in relation to the extended support contract adjustments.

      (2)   Gross profit and operating expenses for the quarters ended March 31,
            June 30 and  September  30,  2004 have been  restated to reduce such
            balances  by equal  amounts  of  $198,000,  $216,000  and  $207,000,
            respectively,  as  compared to  previously  reported  amounts,  as a
            result of the  reclassification  of cost of  service  revenues  from
            operating expenses to cost of sales.

      (3)   Operating  income  for the  quarters  ended  March 31,  June 30, and
            September  30, 2004 has been  increased by an  additional  $1,000 in
            each of the three  quarters,  as  compared  to  previously  reported
            amounts to correct the overstatement of the Company's  paid-time-off
            accrual.

      (4)   The  restatement  adjustments  referred to above reduced  previously
            reported net income by $18,000,  $25,000 and $12,000 in 2004 for the
            quarters  ended March 31, June 30 and  September  30,  respectively.
            Both basic and diluted net income per share as restated decreased by
            $0.01 for the quarter ended June 30, 2004 as compared to the amounts
            previously  reported. Basic  and  diluted  net  income  per share as
            restated did not change from the amounts previously reported for the
            quarters ended March 31 and September 30.

      (5)   Includes a non-cash tax benefit of $1.4 million,  or $0.37 per basic
            share, and $0.31 per diluted share,  resulting from the release of a
            portion of our tax valuation allowance.

<TABLE>
<CAPTION>
                                                             Year 2003, Quarter Ended
                                                --------------------------------------------------
                                                  Mar 31        Jun 30      Sep 30        Dec 31
                                                ----------   ----------   ----------    ----------
                                                        (in thousands, except per share data)
                                                (Restated)   (Restated)   (Restated)    (Restated)
<S>                                               <C>          <C>          <C>           <C>
            Net sales (1)                         $2,495       $2,501       $2,561        $2,623
            Gross profit (2)                       1,626        1,752        1,814         1,777
            Operating income (3)                     252          232          238           357
            Net income (4)                           239          220          238           909(5)
            Net income per share, basic (4)         0.07         0.07         0.07          0.27(5)
            Net income per share, diluted (4)       0.06         0.05         0.05          0.21(5)
</TABLE>


                                       17
<PAGE>

(1)   Net sales in the 2003 quarters  ended March 31, June 30,  September 30 and
      December  31 have been  restated  to  reflect  the  reduction  of  service
      revenues by $5,000, $10,000, $5,000 and $14,000, respectively, as compared
      to  previously  reported  amounts  in  relation  to the  extended  support
      contract adjustments.

(2)   Gross profit and operating  expenses for the quarters ended March 31, June
      30,  September 30 and December 31, 2003 have been  restated to reduce such
      balances by equal  amounts of $172,000,  $177,000,  $193,000 and $187,000,
      respectively,  as compared to previously  reported amounts, as a result of
      the  reclassification  of cost of service revenues from operating expenses
      to cost of sales.

(3)   Operating  income has been  increased by $1,000 in the quarter ended March
      31, 2003 and $2,000 in each of the remaining quarters of 2003, as compared
      to  previously  reported  amounts,  to correct  the  overstatement  of the
      Company's paid-time-off accrual.

(4)   The restatement  adjustments referred to above reduced previously reported
      net income by $4,000,  $8,000,  $3,000 and $12,000 for the quarters  ended
      March 31, June 30, September 30 and December 31,  respectively.  Basic net
      income per share as  restated  decreased  by $0.01 for the  quarter  ended
      March 31 and did not change for the quarters  ended June 30,  September 30
      or December 31, as compared to the amounts  previously  reported.  Diluted
      net income per share as restated decreased by $0.01 for the quarters ended
      June 30 and  September 30 and did not change for the quarters  ended March
      31 or December 31, as compared to the amounts previously reported.

(5)   Includes a non-cash tax benefit of $526,000, or $0.16 per basic share, and
      $0.12 per diluted  share,  resulting  from the release of a portion of our
      tax valuation allowance.


                                       18
<PAGE>

ITEM 7. MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

    (All tabular amounts in thousands except per share amounts and as noted)

      This  Management's  Discussion  and  Analysis of Financial  Condition  and
Results of Operations  contains  forward-looking  statements that are subject to
many  risks  and  uncertainties  that  could  cause  actual  results  to  differ
significantly  from  expectations.   For  more  information  on  forward-looking
statements,  refer to the "Special Note on Forward  Looking  Statements"  at the
front of this Annual Report on Form 10-K.

      Our  products  have  historically  centered  on fax and print  servers and
related  technologies.  Starting  in 1997,  our  revenues  began to  decline  as
competition  increased,  primarily  with the print  server  products in the Asia
Pacific  Region,  while  at the same  time the  Internet  and  other  networking
technologies  advanced.  As a result,  we experienced  annual  operating  losses
beginning in 1997 through  1999.  We  redirected  our efforts to focus on server
appliances and on development  efforts to integrate existing and future products
with the Internet and emerging  networking  technologies.  We introduced our new
products,  the FaxPress 5000 in February  1999,  FaxPress 2500 in November 1999,
FaxPress  SBE in February  2000 and the  FaxPress  7500 in  September  2000.  In
September  2003,  we  launched  our newest  enterprise  level fax  servers,  the
FaxPress  Premier Analog and FaxPress  Premier  Digital.  Today,  our analog fax
servers can provide up to 16 fax channels,  the digital  servers up to 71 T1 fax
channels, the ISDN servers up to 12 fax channels and the E1 servers up to 90 fax
channels.  Our current FaxPress and FaxPress  Premier software  versions are 8.0
and 3.0, respectively, to support our hardware.

      In April 2005,  we  completed a review of our  accounting  practices  with
respect to the historical classification of cost of service revenues, procedures
for  recognizing   revenue   associated  with  extended  support  contracts  and
procedures for establishing the accrual for  paid-time-off,  and determined that
our historical  financial  statements as of and for the years ended December 31,
2002 and 2003 contained certain errors in the application of generally  accepted
accounting principles. Consequently, we have restated our consolidated financial
statements  for fiscal 2002 and 2003 in this 2004 Annual  Report on Form 10-K to
correct for these errors. This Management's Discussion and Analysis of Financial
Condition and Results of Operations reflects the restated amounts. Note 3 to the
consolidated  financial  statements  discloses  the  impact  of the  adjustments
arising from the accounting errors described above on the statements of earnings
and balance sheets for the restated annual periods.

      Improved  cash  management  and  operating  results  resulted  in positive
operating  cash flows in 2002,  2003 and 2004.  Cash balances  increased to $5.6
million at December  31, 2004 from $4.6 million and $3.5 million at December 31,
2003 and December 31, 2002, respectively.

      From time to time,  component  manufacturers  announce  the end of life of
certain of their products and at the same time introduce replacement  components
which are usually more  efficient or cost  effective.  We have been  informed by
several of our component  suppliers that new components are available to replace
certain of their end-of-life components currently used in our FaxPress products.
We have been replenishing,  through secondary markets, and keeping approximately
two years  worth of these  end-of-life  components  in an effort to  guarantee a
smooth supply of our FaxPress  Products to our  customers.  We believe this will
give us ample  time to decide  whether  to  re-engineer  our  Products  with the
manufacturers' suggested replacement parts, or develop new replacement products.
We believe  that most of these  end-of-life  components  will be utilized in the
following two years,  resulting in insignificant amounts of excessive inventory,
or none at all. We believe  that  Castelle's  liquidity  continues  to be strong
despite these purchases,  as our cash reserves have increased during the periods
when the parts were  purchased.  Even though we believe we have  secured  enough
components for the next two years, there is no assurance that we will be able to
secure additional  components in the future, or be able to redesign new products
in a timely manner.  These end-of-life products represent $675,000 of the ending
inventory balance.


                                       19
<PAGE>

Critical Accounting Policies

      We  have  identified  the  policies  below  as  critical  to our  business
operations  and to the  understanding  of our  results  of  operations.  We have
defined  a  critical  accounting  policy  as one that is both  important  to the
portrayal of our financial  condition and results of operations and requires our
management to make difficult,  subjective or complex  judgments.  For a detailed
discussion on the application of these and other accounting policies, see Note 2
in the Notes to the Consolidated  Financial  Statements of this Annual Report on
Form 10-K, beginning on page F-7. Note that preparation of this Annual Report on
Form 10-K requires us 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 our financial  statements,  and reported  amounts of
revenue and expenses during the reporting period.  Estimates about future events
and their  effects  cannot be made with  certainty.  We based our  estimates  on
historical  experience and on various other  assumptions that are believed to be
reasonable  under the  circumstances,  the  results  of which form the basis for
making  judgments.  These  estimates  may  change as new events  occur,  as more
experience  is  acquired,  as  additional  information  is  obtained  and as our
operating environment changes.

Revenue recognition

      We recognize revenue based on the provisions of Staff Accounting  Bulletin
No. 104 "Revenue Recognition," AICPA Statement of Position No. 97-2 ("SOP 97-2")
"Software  Revenue  Recognition,"  as amended by SOP 98-9,  "Modification of SOP
97-2,  Software Revenue  Recognition with Respect to Certain  Transactions," and
Statement of Financial Accounting Standards ("SFAS") No. 48 "Revenue Recognition
When Right of Return Exits."

      The  Company  uses  the  residual  method  to  recognize  revenue  when an
agreement  includes one or more  elements to be  delivered at a future date.  If
there is an  undelivered  element  under the  arrangement,  the  Company  defers
revenue  based on  vendor-specific  objective  evidence of the fair value of the
undelivered element, as determined by the price charged when the element is sold
separately.  If vendor-specific  objective evidence of fair value does not exist
for all undelivered  elements,  the Company defers all revenue until  sufficient
evidence exists or all elements have been delivered.

      Product revenue is recognized when all of the following  criteria are met:
persuasive evidence of an arrangement exists;  delivery has occurred; the fee is
fixed or  determinable;  collection  is probable;  and returns can be reasonably
estimated.  If an  acceptance  period or other  contingency  exists,  revenue is
recognized  upon  satisfaction  of  the  contingency,   customer  acceptance  or
expiration of the acceptance  period.  Shipment  generally  occurs and title and
risk of loss is transferred when the product is delivered to a common carrier.

      We enter into agreements with some of our distributors that permit limited
stock  rotation  rights.  These stock rotation  rights allow the  distributor to
return  products for credit but require the purchase of  additional  products of
equal value.  Customers who purchase products directly from us also have limited
return rights,  which expire 30 days from product shipment.  Revenues subject to
stock  rotation  or  other  return  rights  are  reduced  by  our  estimates  of
anticipated exchanges and returns.

      Pursuant  to  our  agreements  with  distributors,  we  also  protect  our
distributors'  exposure related to the impact of price reductions.  Future price
adjustments  are  estimated  and accrued at the time of sale as a  reduction  in
revenue.

      We  generally  provide our  distributors  the  opportunity  to earn volume
incentive  rebates  based on sales volume  achieved  during the fiscal  quarter.
These  incentive  rebates are accrued in the quarter  incurred and recorded as a
reduction in revenue.

      We also provide co-op and market  development  funds to our  distributors.
These incentives are accrued at the time revenue is recognized and recorded as a
reduction in revenue.


                                       20
<PAGE>

      We offer a standard  trade-in  discount to all of our  end-user  customers
under which the customer,  upon trade-in of any previously purchased product, is
entitled to a discount from our published price list on any product  included in
our current product offerings. We require our customers to physically return the
previously  purchased products to qualify for the trade-in discount.  We account
for the  trade-in  discount as a reduction of revenue at the time the product is
traded in and a new product is purchased.

      Payment terms to our distributors and customers are generally thirty days,
cash in advance, or by credit card.

      We evaluate  product  sales  through  our  distribution  channels  and the
related  reserve  requirement  to establish  an estimate  for our sales  returns
reserve by  reviewing  detailed  point-of-sales  and on-hand  inventory  reports
provided to us by our channel  partners.  Based on a  combination  of historical
return  experience,  the sales  activities to end-user  customers by our channel
partners  and the  level of  inventories  on hand at the  channel  partners,  we
determine our returns reserve at the end of each financial period, and increases
or reduce the reserve balance accordingly.

      We provide  standard  support to our  customers  for an initial  period of
sixty days, which includes advance swap of the defective  hardware and software,
bug fixes,  software  upgrades and  technical  support.  In addition to standard
support,  we also offer our customers the option to purchase extended support at
the time of product  purchase or anytime  thereafter.  Extended  support  covers
hardware  and  software  for  a  period  of  one  year.   We  have   established
vendor-specific  objective  evidence  with  respect  to the  fair  value  of the
standard  support  contracts  based on  standalone  sales  and  renewals  of our
one-year  extended  support  contracts.  The fair value of our sixty day support
contracts  included with product  sales is determined by pro-rating  the related
one-year extended support contracts.  We recognize revenue from extended support
contracts ratably over the period of the contract.

      We do  not  sell  software,  which  is  incorporated  into  our  hardware,
separately,  other than for our  customers  to  purchase  as an upgrade to their
existing products when we announce a major release of the software.

Product Warranty

      Hardware is  warranted  for one year from the date of sale and is repaired
free-of-charge. Provisions for estimated warranty costs are recorded at the time
products are shipped as a charge to cost of sales.  While we engage in extensive
product quality programs and processes,  our warranty  obligation is affected by
product  failure rates,  material  usage and service  delivery costs incurred in
correcting a product  failure.  Should product failure rates,  material usage or
service  delivery  cost differ  from our  estimates,  revision to the  estimated
warranty  liability  would be  required,  which could affect the amount of gross
profit reported.

Distributor Programs and Incentives

      We enter into agreements with some of our distributors that permit limited
stock  rotation  rights.  These stock rotation  rights allow the  distributor to
return  products for credit but require the purchase of  additional  products of
equal value. We also protect our distributors' exposure related to the impact of
price reductions.  We generally provide our distributors the opportunity to earn
volume  incentive  rebates based upon the amount of sales volume achieved during
the fiscal quarter.  We also provide co-op and market  development  funds to our
distributors.

      If market  conditions  were to change,  we may take  actions  to  increase
distributor  incentive offerings possibly resulting in an incremental  reduction
of  revenues  at the time the  incentive  is  offered.  Moreover,  if the actual
incentive offerings are different from our estimates, or if the actual incentive
claims are significantly higher than our historical  experience,  then revisions
to the  estimated  incentive  programs may be required  resulting in  additional
reductions to revenue.


                                       21
<PAGE>

      We record estimated  reductions to revenues for these distributor programs
and incentive  offerings  including special pricing  agreements,  promotions and
other volume-based incentives.

Credit, collection and allowance for doubtful accounts

      We  perform  ongoing  customer  credit  evaluations  based on a number  of
factors,   including  past  transaction   history  with  the  customer  and  the
credit-worthiness of the customer.  When credit criteria are not met, we require
cash-on-delivery  or payment by credit card before  products are  shipped.  On a
quarterly  basis, we specifically  analyze accounts  receivable,  historical bad
debts,  customer  concentration,  and changes in our customer payment terms when
evaluating the adequacy of the allowance for doubtful accounts. Such losses have
generally  been  within our  expectations.  If the  financial  condition  of our
customers  were to  deteriorate,  resulting in an impairment of their ability to
make payments,  additional allowances may be required. Three customers accounted
for 60%, 69% and 68% of accounts receivable at December 31, 2004, 2003 and 2002,
respectively.

Inventories and related write-downs for excess and obsolete inventory

      Inventories  are stated at the lower of standard cost (which  approximates
cost on a first-in, first-out basis) or market. We record write downs for excess
and obsolete inventory equal to the difference between the cost of inventory and
the estimated fair value based on assumptions about future product  life-cycles,
product demand and market  conditions.  If actual  product life cycles,  product
demand  and  market  conditions  are less  favorable  than  those  projected  by
management,  additional inventory  write-downs may be required.  At the point of
the loss recognition, a new, lower-cost basis for that inventory is established,
and  subsequent  changes  in  facts  and  circumstances  do  not  result  in the
restoration or increase in that newly established cost basis.

      In light of the approximately two years worth of end-of-life components we
have  purchased  to  ensure a smooth  supply  of our  FaxPress  Products  to our
customers,  our management  periodically reviews the usage, supply and inventory
levels of these parts to  determine  whether  additional  purchases or excessive
inventory   provisions  are  necessary.   As  of  December  31,  2004,  we  have
approximately  $675,000 worth of  end-of-life  components on hand and we believe
that most of these  components  will be  utilized  in the  following  two years,
resulting in insignificant amounts of excessive inventory, or none at all.

Income taxes

      We account for income taxes in accordance with the liability method. Under
the liability method,  deferred assets and liabilities are recognized based upon
anticipated  future  tax  consequences   attributable  to  differences   between
financial  statement  carrying  amounts  of  assets  and  liabilities  and their
respective tax bases. The provision for income taxes is comprised of the current
tax liability and the change in deferred tax assets and  liabilities.  We assess
the  likelihood  that our  deferred  tax assets  will be  recovered  from future
taxable income and to the extent we believe that recovery is not likely, we must
establish a valuation allowance against these tax assets. Significant management
judgment is required  in  determining  the  provision  for income  taxes and any
valuation  allowance recorded against our deferred tax assets. The establishment
or  reversal  of any  valuation  allowance  is based in large part on  projected
future taxable income.


                                       22
<PAGE>

Results of Operations

      Comparison of Years Ended December 31, 2004 and 2003

           Net Sales

<TABLE>
<CAPTION>
                                                                              Year Ended December 31,
                                                                    -----------------------------------------
                                                                       2004            2003            2002
                                                                    ---------       ---------       ---------
               Net Sales:                                                          (Restated)       (Restated)
<S>                                                                 <C>             <C>             <C>
                    Products                                        $   8,011       $   8,337       $   8,617
                    Services                                            2,446           1,843           1,103
                                                                    ---------       ---------       ---------

                      Total net sales                               $  10,457       $  10,180       $   9,720
                                                                    =========       =========       =========

<CAPTION>
                                                                              Year Ended December 31,
                                                                    -----------------------------------------
                                                                       2004            2003            2002
                                                                    ---------       ---------       ---------
             Net Sales:                                                            (Restated)       (Restated)
<S>                                                                 <C>             <C>             <C>
                    United States                                   $   8,574       $   8,222       $   7,660
                    Europe                                                785             704             826
                    Pacific Rim                                           804             883             887
                    Rest of Americas, excluding United States             294             371             347
                                                                    ---------       ---------       ---------

                      Total net sales                               $  10,457       $  10,180       $   9,720
                                                                    =========       =========       =========
</TABLE>

            Net sales  increased 3% to $10.5  million in 2004 from $10.2 million
      in 2003.  The  increase of $277,000 was  primarily  from  increased  sales
      derived from services of $603,000, offset by a reduction in products sales
      of $326,000.

            Products  sales of $8.0  million in 2004,  which  represents  77% of
      total  sales,  declined by 4% as compared to $8.3  million in 2003,  which
      represents 82% of total sales.  The lower sales in 2004 are due largely to
      the  Company's  decision  to divest  its  legacy  products  as part of its
      overall  strategy  to  transition  to its new  generation  of network  fax
      servers, FaxPress Premier. We anticipate sales of our FaxPress Premier fax
      servers  to grow as we  continue  to  expand  into  Japan,  Hong  Kong and
      Mainland  China  markets.  Product  sales in 2004 also included a one-time
      pre-tax benefit of $126,000 from an adjustment of certain accruals related
      to a sales development program.

            Service  revenues  are  comprised  of extended  warranty and support
      programs as well as 60-days of maintenance  included with initial  product
      sales.  Revenue related to these  arrangements is recognized  ratably over
      the period of the arrangement.  Service revenues in 2004, which represents
      23% of total  sales,  increased  33% to $2.4  million from $1.8 million in
      2003,  which  represents  18% of total  sales.  The  increase  in  service
      revenues  was  primarily  due to  increased  sales  of  extended  warranty
      contracts due to an increase in our installed customer base as well as the
      launch of our FaxPress  Premier fax server  products in the second half of
      2003. We anticipate  service revenue to increase as more FaxPress  Premier
      fax servers are sold.

            Domestic sales were $8.6 million in 2004 as compared to $8.2 million
      in 2003,  representing 82% and 81%, respectively,  of total net sales. The
      increase in sales was mostly  attributable to the  introduction of the new
      FaxPress Premier fax server  products,  which carry higher selling prices,
      an


                                       23
<PAGE>

      increase  in  service  revenues  and a benefit  of  $126,000  from a sales
      development program adjustment.

            International  sales  (excluding  sales to the rest of the Americas)
      were  $1.6   million  in  2004  and  2003,   representing   15%  and  16%,
      respectively,  of total net  sales.  Most of our  international  sales are
      denominated  in U.S.  dollars  and thus,  could be  adversely  affected by
      changes in demand resulting from fluctuations in currency exchange rates.

            Sales to the rest of the Americas, excluding the United States, were
      $294,000 in 2004, as compared to $371,000 in 2003,  representing 3% and 4%
      of total net sales in 2004 and 2003,  respectively.  The decrease in sales
      was mostly due to lower sales of our FaxPress fax server products.

            In  2004,  Ingram  Micro,  Tech  Data  and  Macnica,  our top  three
      customers  accounted for  approximately 51% of our net sales. In 2003, the
      same three distributors accounted for 57% of net sales.

      Cost of Sales; Gross profit

<TABLE>
<CAPTION>
                                                   Year Ended December 31
                                          -------------------------------------------
                                             2004             2003             2002
                                          ---------        ---------        ---------
         Cost of sales:                                   (Restated)        (Restated)
<S>                                       <C>              <C>              <C>
              Products                    $   2,556        $   2,485        $   2,833
              Services                          826              726              707
                Total cost of sales           3,382            3,211            3,540
         Gross profit                     $   7,075        $   6,969        $   6,180
         Gross profit as % of sales              68%              68%              64%
</TABLE>

            Gross profit is equal to net sales less cost of sales. Cost of sales
      includes  cost of materials,  including  components,  manuals,  diskettes,
      packaging materials and shipping. Cost of sales also includes compensation
      costs and  overhead  related to our  manufacturing  operations,  inventory
      obsolescence and warranty expenses.  Gross profit from service revenues in
      fiscal 2004  increased  by $503,000  from fiscal 2003 due mostly to higher
      sales while cost of sales  increased  moderately.  The higher gross profit
      from service  revenues  was offset by lower gross profit of $397,000  from
      product  sales due to  product  mix.  Gross  profit in 2004  included  the
      benefit of $126,000 from the sales development program adjustment.

            Periodically  we review  obsolete and  unmarketable  products in our
      inventory  and  make  appropriate   allowances  for  excess  and  obsolete
      inventory.  Products that are  determined to be obsolete and  unmarketable
      are physically scrapped when it is determined that such inventories are no
      longer usable or salable.  In 2004, we identified  $35,000 of unmarketable
      products,   which  were  scrapped,   as  compared  to  $154,000  worth  of
      unmarketable products scrapped in 2003.

      Research and Development

<TABLE>
<CAPTION>
                                                                              Year Ended December 31
                                                                  -------------------------------------------
                                                                     2004             2003             2002
                                                                  ---------        ---------        ---------
                                                                                   (Restated)       (Restated)
<S>                                                               <C>              <C>              <C>
            Research and development expenses                     $   1,722        $   1,590        $   1,379
            Research and development expenses as % of sales              17%              15%              14%
</TABLE>


                                       24
<PAGE>

            Research and development  expenses  represent costs  associated with
      the development of new products and consist primarily of  employee-related
      expenses, material costs and allocated facility costs. The higher research
      and  development  expenses  in 2004  were  mostly  due to  higher  outside
      consulting  expenses of $154,000 to enhance our current  product  features
      and $71,000 in higher compensation due to increased headcount, offset by a
      decrease in materials expense of $61,000. The employment of consultants is
      expected to continue until the short-term projects are completed. Research
      and  development  spending has supported  both  existing  products and the
      development  of  new  server  appliances.   We  remain  committed  to  the
      development of highly  competitive  new products and services  through the
      efficient utilization of our engineering resources.

      Sales and Marketing

<TABLE>
<CAPTION>
                                                                      Year Ended December 31
                                                             -------------------------------------------
                                                                2004             2003             2002
                                                             ---------        ---------        ---------
                                                                              (Restated)       (Restated)
<S>                                                          <C>              <C>              <C>
            Sales and marketing expenses                     $   2,486        $   2,398        $   2,301
            Sales and marketing expenses as % of sales              24%              24%              23%
</TABLE>

            Sales and marketing  expenses consist primarily of  employee-related
      expenses,   commissions  to  sales   representatives,   product  promotion
      expenses, and allocated facilities expenses, including expenses associated
      with our  regional  sales and support  offices.  The increase in sales and
      marketing expenses was largely due to increased  compensation  expenses of
      $216,000  related  to  headcount  additions,   offset  in  part  by  lower
      advertising  and  promotional  expenses of $129,000.  Sales and  marketing
      expenses are anticipated to remain relatively stable.

      General and Administrative

<TABLE>
<CAPTION>
                                                                                Year Ended December 31
                                                                    -------------------------------------------
                                                                       2004             2003             2002
                                                                    ---------        ---------        ---------
                                                                                     (Restated)       (Restated)
<S>                                                                 <C>              <C>              <C>
            General and administrative expenses                     $   1,801        $   1,902        $   1,943
            General and administrative expenses as % of sales              17%              18%              20%
</TABLE>

            General   and   administrative   expenses   consist   primarily   of
      employee-related expenses for administration, finance, human resources and
      general  management,  as well as consulting,  outside services,  legal and
      accounting expenses, and allocated facilities expenses. The lower expenses
      in  2004,  as  compared  to  2003,  were  mainly   attributable  to  lower
      compensation  expenses  of  $88,000  mostly  because  of  lower  incentive
      payments  due  to  performance  goals  that  were  not  met.  General  and
      administrative  expenses  are  expected  to  increase  in  fiscal  2005 in
      relation to Sarbanes-Oxley internal control compliance.

      Interest and Other Income (Expenses)

            Interest and other income (expense)  consists  primarily of interest
      income earned from our invested cash balances, interest expense on capital
      leases, bank service fees, and miscellaneous income and expenses. Interest
      and other  income  (expense)  for 2004 was $14,000 as compared  $10,000 in
      2003.

      Provision for Income Tax

            In fiscal 2004 and 2003,  we recorded  non-cash tax benefits of $1.1
      million and $526,000,  respectively,  as a result of releasing portions of
      our tax  valuation  allowance.  Consequently,  as of December 31, 2004, we
      have recorded a total of $1.5 million of deferred tax assets.  We have not


                                       25
<PAGE>

      reported  significant  income  tax  expenses  because we have been able to
      utilize available Net Operating Loss ("NOL") and tax credit  carryforwards
      to offset taxable  income.  Prior to December 31, 2003, the Company's NOLs
      were fully offset by a valuation allowance due to uncertainly  surrounding
      the likelihood of their  realization.  Due to our continued  profitability
      over the past 14 quarters and a determination  that it is more likely than
      not that certain  future tax benefits  will be realized,  a portion of the
      Company's  deferred  tax  assets  have been  recognized  during the fourth
      quarters of fiscal 2003 and 2004.

Comparison of Years Ended December 31, 2003 and 2002

      Net Sales

            Net sales increased 5% to $10.2 million in 2003 from $9.7 million in
      2002. The increase of $460,000  resulted  primarily  from increased  sales
      derived from  services of $740,000  offset by a reduction in product sales
      of $280,000.

            Products  sales of $8.3  million in 2003,  which  represents  82% of
      total  sales,  declined by 3% as compared to $8.6  million in 2002,  which
      represents  89% of total sales,  mostly due to lower sales of our FaxPress
      fax servers.

            Service  revenues  in 2003,  which  represents  18% of total  sales,
      increased 67% to $1.8 million from $1.1 million in 2002,  which represents
      11% of total sales.  The increase in service revenues was primarily due to
      increased sales of extended  warranty  contracts due to an increase in our
      installed customer base.

            Domestic sales were $8.2 million in 2003 as compared to $7.7 million
      in 2002,  representing 81% and 79%, respectively,  of total net sales. The
      increase in sales was mostly  attributable to the  introduction of the new
      FaxPress  Premier fax server products in the fourth quarter of 2003, which
      carry higher selling prices, and an increase in service revenues.

            International  sales  (excluding  sales to the rest of the Americas)
      were  $1.6   million  in  2003  as  compared  to  $1.7  million  in  2002,
      representing 16% and 18%, respectively,  of total net sales. International
      sales  were  lower  largely  due to  lower  sales of our  FaxPress  server
      products to Europe.

            Sales to the rest of the Americas, excluding the United States, were
      $371,000 in 2003,  as compared  to  $347,000 in 2002,  representing  4% of
      total net sales in both 2003 and 2002.

            In  2003,  Ingram  Micro,  Tech  Data  and  Macnica,  our top  three
      customers  accounted for  approximately 57% of our net sales. In 2002, the
      same three distributors accounted for 56% of net sales.

      Cost of Sales; Gross profit

            Gross  profit  was  $7.0  million,  or 68% of net  sales,  in  2003,
      compared to $6.2 million,  or 64% of net sales, in 2002. Gross profit from
      service revenues in fiscal 2003 increased by $721,000 from fiscal 2002 due
      mostly to higher sales while cost of sales was relatively flat. Continuous
      product cost reductions in 2003 and increased outsourcing of manufacturing
      contributed to the  improvement in gross profit from product sales in 2003
      by $68,000.

            In 2003, we identified $154,000 of unmarketable products, which were
      scrapped, as compared to $158,000 in 2002.

      Research and Development


                                       26
<PAGE>

            Research and product development expenses were $1.6 million in 2003,
      as  compared to $1.4  million in 2002,  and  represent  15% and 14% of net
      sales for those periods, respectively. The higher research and development
      expenses in 2003 were mostly due to additional  material costs of $106,000
      used in the development of our FaxPress  Premier server products that were
      launched in September 2003, and higher compensation expense of $82,000 due
      to increased headcount.

      Sales and Marketing

            Sales and marketing  expenses were $2.4 million and $2.3 million for
      2003 and 2002,  respectively,  and  represent 24% and 23% of net sales for
      those  periods.  The slight  increase in sales and marketing  expenses was
      largely  due to  increased  promotional  and travel  related  expenses  of
      $235,000  and higher  compensation  expenses of $76,000  due to  increased
      headcount, offset in part by lower consulting expenses of $173,000.

      General and Administrative

            General and  administrative  expenses were $1.9 million in both 2003
      and 2002,  and represent 18% and 20% of net sales for those  periods.  The
      slightly   lower  expenses  in  2003  as  compared  to  2002  were  mainly
      attributable  to lower  consulting  expenses  of  $180,000  and  legal and
      accounting  fees of  $166,000,  offset  partially  by higher  compensation
      expenses of $151,000 and investor  relation  expenses of $86,000.  General
      and  administrative  expenses in 2002 included  legal expenses of $128,000
      and  outside   consulting   expenses  of  $209,000,   which  were  chiefly
      attributable to our stock repurchase and Nasdaq listing issues.

      Interest and Other Income(Expenses)

            Interest  and other  expenses  for 2003 were  $10,000 as compared to
      income of $44,000 in 2002.  The  decrease in interest and other income was
      chiefly  due to a  $29,000  reduction  in  interest  income  due to  lower
      interest rates and decreased miscellaneous income of $26,000.

      Provision for Income Tax

            In the fourth quarter of 2003, we recorded a non-cash tax benefit of
      $526,000,  resulting  from the  release of a portion of our tax  valuation
      allowance.  Prior to the fourth quarter,  we had not reported  significant
      income tax expenses  because we had utilized  available Net Operating Loss
      ("NOL") and tax credit carryforwards.  These NOLs were fully reserved by a
      valuation allowance due to uncertainly surrounding the likelihood of their
      realization.  Due to our continued  profitability and a determination that
      it is more  likely  than not that  certain  future  tax  benefits  will be
      realized,  a portion of the  deferred  tax assets were  recognized  in the
      fourth quarter of fiscal 2003.

            In 2002,  our  provision  for income taxes was $6,000,  representing
      state income taxes.  The tax provision for federal income taxes was offset
      by utilization of our net operating loss carryforwards.

LIQUIDITY AND CAPITAL RESOURCES

                                          December 31, 2004    December 31, 2003
                                          -----------------    -----------------
                                                   (dollars in thousands)
                                                                 (Restated)
            Cash and cash equivalents          $   5,599          $   4,614
            Working capital                    $   5,750          $   4,156
            Working capital ratio                    3.0                2.4


                                       27
<PAGE>

      Since our initial  public  offering of common stock in December  1995, our
principal source of funding has been cash from our operations, with some funding
from capital equipment lease lines. As of December 31, 2004, we had $5.6 million
of cash and cash  equivalents,  an increase of $985,000  from December 31, 2003.
The increase in cash and cash  equivalents  was primarily  attributable  to cash
provided by operating  activities  of $626,000 and $410,000 in proceeds from the
exercise of stock options.

      Even though cash and cash  equivalents  in 2004 improved  over 2003,  cash
provided by operating activities declined by $492,000 primarily due to a planned
increase in inventory of $608,000,  mostly attributable to the purchase,  net of
usage, of $675,000 worth of end-of-life  parts used in our FaxPress  products in
an effort to guarantee a smooth  supply to our customers for the next two years,
and the timing of accounts  payable.  The increase in cash provided by operating
activities in 2003 as compared to 2002 was mainly due to higher earnings.

      In 2004, net cash provided by financing  activities was $394,000 primarily
from proceeds  from  issuance of common stock.  In the first quarter of 2003, we
repurchased  $48,000 of our stock from open  market  transactions.  We  acquired
additional property and equipment of $35,000, $164,000 and $34,000 in 2004, 2003
and 2002, respectively. Net cash used in financing activities of $2.0 million in
2002 was  largely  for the  repurchase  of our stock and the  professional  fees
associated with such repurchase.

      In the fourth quarter of 2002, our Board of Directors  authorized us, from
time to time, to repurchase at market prices,  up to $2.25 million shares of our
common  stock for cash in open market,  negotiated  or block  transactions.  The
timing of such  transactions has depended and will depend on market  conditions,
other  corporate  strategies  and has been and will be at the  discretion of our
management.  No time limit was set for the  completion  of this  program.  As of
December  31,  2003,  we  have  repurchased  from  open  market  and  negotiated
transactions a total of 1.67 million shares for $1.8 million,  at an average per
share price of $1.10. We performed no stock repurchases  during the rest of 2003
and 2004.  However,  we may  continue to execute our buyback  program as we deem
necessary.

      In  September,  2004,  we  entered  into  a  $4.0  million  collateralized
revolving  line of credit with a bank,  which is to expire in August  2005.  The
revolving  line  of  credit  provides  for  borrowings  of up to  $4.0  million.
Borrowings under this line of credit agreement are  collateralized by all of our
assets and bear  interest  at the bank's  prime rate plus  0.50%.  Under the new
facility  we are  required  to  maintain  certain  minimum  cash and  investment
balances  with the  bank  and meet  certain  other  financial  covenants.  As of
December  31,  2004,  we have not drawn  down on the line of credit  and were in
compliance with the terms of the agreement.

      We lease  certain of our  equipment  under  various  operating and capital
leases  that  expire  at  various  dates  through  2006.  The  lease  agreements
frequently  include renewal,  escalation  clauses and purchase  provisions,  and
require us to pay taxes,  insurance and  maintenance  costs.  As of December 31,
2004, we had $32,000 outstanding under a loan and security  agreement,  which is
subject to an interest rate of 12.8%.

      We lease our headquarters in Morgan Hill, California. We have extended our
building lease for a term of five years  commencing on June 1, 2004 and expiring
on May 31,  2009,  with one  conditional  three-year  renewal  option,  which if
exercised,  would  extend  the  lease to May 31,  2012  commencing  with rent at
ninety-five  percent of fair market  value.  As of  December  31,  2004,  future
minimum payments under the lease were $915,000.

      The  following  represents  combined  aggregate  maturities  for  all  our
financing and commitments as of December 31, 2004:


                                       28
<PAGE>

<TABLE>
<CAPTION>
                                                                   Payments Due by Period
                                            --------------------------------------------------------------------
   Contractual Obligations                                 Less Than                                 More than 5
                                              Total         1 Year      1 - 3 Years     3 - 5 Years      Years
                                            --------------------------------------------------------------------
<S>                                         <C>            <C>            <C>            <C>              <C>
  Capital (Finance) Lease Obligations       $     32       $     18       $     14             --         --
  Operating Lease Obligations               $    915       $    207       $    622       $     86         --
                                            --------------------------------------------------------------------
  Total contractual cash obligations        $    947       $    225       $    636       $     86         --
                                            ====================================================================
</TABLE>

      We believe that our existing cash  balances,  anticipated  cash flows from
operations  and  available  lines  of  credit  will be  sufficient  to meet  our
anticipated  capital  requirements for the next 12 months. If we have a need for
additional  capital  resources,  we may be required to sell additional equity or
debt securities,  secure  additional lines of credit or obtain other third party
financing.  The  timing  and  amount  of such  capital  requirements  cannot  be
determined at this time and will depend on a number of factors, including demand
for our existing and new  products,  if any,  and changes in  technology  in the
networking  industry.  There can be no assurance that such additional  financing
will be available on satisfactory terms when needed, if at all. Failure to raise
such additional financing, if needed, may result in our inability to achieve our
long-term business  objectives.  To the extent that additional capital is raised
through  the sale of  additional  equity or  convertible  debt  securities,  the
issuance  of  such  securities  would  result  in  additional  dilution  to  our
shareholders.

      In addition,  because of our dependency on a small number of  distributors
for a significant  portion of the sales of our products,  the loss of any of our
major distributors or their inability to satisfy their payment obligations to us
could have a significant  adverse effect on our business,  operating results and
financial condition.

                                  RISK FACTORS

      Shareholders  or investors  considering  the purchase of shares of the our
common stock should carefully  consider the following risk factors,  in addition
to other  information in this Annual Report on Form 10-K.  Additional  risks and
uncertainties  not presently  known to us or that we currently  deem  immaterial
also may impair our business operations.

Our revenue and operating  results have fluctuated in the past and are likely to
fluctuate significantly in the future, particularly on a quarterly basis.

      Our operating results may vary  significantly  from quarter to quarter due
to many  factors,  some of which are  outside  our  control.  For  example,  the
following conditions could all affect our results:

      o     changes in our product sales and customer mix;

      o     constraints in our manufacturing and assembling operations;

      o     shortages or increases in the prices of raw materials and
            components;

      o     changes in pricing policy by us or our competitors;

      o     a slowdown in the growth of the networking market;

      o     seasonality;

      o     timing of expenditures; and

      o     economic conditions in the United States, Europe and Asia.


                                       29
<PAGE>

      Our sales often reflect  orders  shipped in the same quarter in which they
are received.  In addition,  significant portions of our expenses are relatively
fixed  in  nature,  and  planned  expenditures  are  based  primarily  on  sales
forecasts.  Therefore,  if we inaccurately forecast demand for our products, the
impact on net  income  may be  magnified  by our  inability  to adjust  spending
quickly enough to compensate for the net sales shortfall.

      Other factors  contributing  to  fluctuations  in our quarterly  operating
results include:

      o     changes in the demand for our products;

      o     customer order deferrals in anticipation of new versions of our
            products;

      o     the introduction and acceptance of new products and product
            enhancements by us or our competitors;

      o     the effects of filling the distribution channels following
            introductions of new products and product enhancements;

      o     potential delays in the availability of announced or anticipated
            products;

      o     the mix of product and service revenue,

      o     the commencement or conclusion of significant development contracts;

      o     changes in foreign currency exchange rates; and

      o     the timing of significant marketing and sales promotions.

      Based on the foregoing,  we believe that quarterly  operating  results are
likely to vary significantly in the future and that period-to-period comparisons
of our results of operations  are not  necessarily  meaningful and should not be
viewed as indications of future performance.

We have a history of losses and may not be able to sustain profitability.

      We have experienced  significant  operating losses and, as of December 31,
2004, had an accumulated  deficit of $20 million.  Our development and marketing
of current and new products will continue to require  substantial  expenditures.
We  incurred  $591,000 of losses as recently as 2001 due to a slowdown in demand
for our products due in part to industry-wide  adverse economic  conditions.  We
were able to recover and have been  profitable  since the third quarter of 2001.
There  can be no  assurance  that  growth  in net  sales  will  be  achieved  or
profitability sustained in future years.

Our  common  stock is  listed on the  Nasdaq  SmallCap  Market,  and we have had
difficulty  satisfying the listing criteria to avoid the delisting of our common
stock

      Our common stock has been listed on the Nasdaq SmallCap Market since April
1999. In order to maintain our listing on the Nasdaq  SmallCap  Market,  we must
maintain  total assets,  capital and public float at specified  levels,  and our
common stock  generally must maintain a minimum bid price of $1.00 per share. If
we fail to maintain the standards  necessary to be quoted on the Nasdaq SmallCap
Market,  our common stock could  become  subject to  delisting.  There can be no
assurance that we will be able to maintain the $1.00 minimum bid price per share
of our common stock and thus maintain our listing on the Nasdaq SmallCap Market.

      If our common  stock is  delisted,  trading in our common  stock  could be
conducted on the OTC Bulletin Board or in the over-the-counter market in what is
commonly  referred to as the "pink sheets." If this occurs,  a shareholder  will
find it more  difficult  to dispose of our  common  stock or to obtain  accurate
quotations  as to the price of our  common  stock.  Lack of any  active  trading
market would have an adverse effect on a  shareholder's  ability to liquidate an
investment  in our common  stock easily and quickly at a  reasonable  price.  It
might also  contribute to volatility in the market price of our common stock and
could adversely affect our ability to raise additional  equity or debt financing
on acceptable terms or at all. Failure to obtain desired financing on acceptable
terms could adversely  affect our business,  financial  condition and results of
operations.


                                       30
<PAGE>

Substantially all of our revenue comes from the sale of fax server products, and
a decline  in demand  for those  products  would  harm our  business,  operating
results and financial condition.

      We derive  substantially  all of our  revenue  from the sale of fax server
products in 2004.  We expect that our current  products will continue to account
for most of our sales in the near future. A decline in demand for our fax server
products  as  a  result  of  competition,  technological  change,  shortages  of
components or other factors, or a delay in the development and market acceptance
of new  features  and  products,  would  have a material  adverse  effect on our
business, operating results and financial condition.

We  sell  our  products  through  a  limited  number  of  distributors,  and any
deterioration  in our  relationship  with  those  distributors  would  harm  our
business, operating results and financial condition.

      We  sell  our  products   primarily   through  a  two-tier   domestic  and
international  distribution network. Our distributors sell our products to VARs,
e-commerce  vendors and other resellers.  The distribution of personal computers
and  networking  products  has been  characterized  by rapid  change,  including
consolidations  due  to the  financial  difficulties  of  distributors  and  the
emergence  of  alternative   distribution  channels.  An  increasing  number  of
companies are competing for access to these channels. Our distributors typically
represent  other  products  that are  complementary  to, or  compete  with,  our
products.  Our distributors are not contractually  committed to future purchases
of our products and could discontinue  carrying our products at any time for any
reason. In addition,  because we are dependent on a small number of distributors
for a significant  portion of the sales of our products,  the loss of any of our
major distributors or their inability to satisfy their payment obligations to us
could have a significant  adverse effect on our business,  operating results and
financial  condition.  We have a  stock  rotation  policy  with  certain  of our
distributors that allows them to return marketable  inventory against offsetting
orders.  If we  reduce  our  prices,  we  credit  certain  distributors  for the
difference  between the purchase price of products  remaining in their inventory
and our reduced price for these products.  In addition,  inventory levels of our
products held by distributors could become excessive due to industry  conditions
or the  actions of  competitors,  resulting  in product  returns  and  inventory
write-downs.

The market for our products is affected by rapidly changing technology and if we
fail to  predict  and  respond  to  customers'  changing  needs,  our  business,
operating results and financial condition may suffer.

      The market for our  products is affected  by rapidly  changing  networking
technology,  evolving  industry  standards and the emergence of the Internet and
other new  communication  technologies.  We believe that our future success will
depend  upon our  ability to enhance  our  existing  products  and to  identify,
develop, manufacture and introduce new products which

      o     conform to or support emerging network telecommunications standards;

      o     are compatible with a growing array of computer and peripheral
            devices;

      o     support popular computer and network operating systems and
            applications;

      o     meet a wide range of evolving user needs; and

      o     achieve market acceptance.

There can be no assurance that we will be successful in these efforts.

      We have incurred,  and expect to continue to incur,  substantial  expenses
associated with the introduction and promotion of new products.  There can be no
assurance that the expenses  incurred will not exceed  research and  development
cost estimates or that new products will achieve market  acceptance and generate
sales sufficient to offset  development  costs. In order to develop new products
successfully,  we are  dependent  upon timely  access to  information  about new
technological developments and standards. There can be no assurance that we will
have such  access  or will be able to  develop  new


                                       31
<PAGE>

products  successfully and respond  effectively to  technological  change or new
product announcements by others.

      Complex  products  such as those  offered by us may contain  undetected or
unresolved hardware defects or software errors when they are first introduced or
as new versions are  released.  Changes in our or our  suppliers'  manufacturing
processes or the inadvertent use of defective  components could adversely affect
our ability to achieve acceptable  manufacturing yields and product reliability.
We have in the past discovered  hardware  defects and software errors in certain
of our new products and enhancements  after their  introduction.  Replacement of
discontinued  components  used in our products could lead to further defects and
errors.  There can be no assurance that despite testing by us and by third-party
test  sites,  errors and  defects  will not be found in future  releases  of our
products,  which would result in adverse product  reviews and negatively  affect
market acceptance of these products.

      The  introduction  of new or enhanced  products  requires us to manage the
transition from the older products to the new or enhanced  products or versions,
both internally and for customers.  We must manage new product  introductions so
as to minimize disruption in customer ordering patterns,  avoid excessive levels
of older product  inventories and ensure that adequate  supplies of new products
can be delivered to meet customer demands. We have from time to time experienced
delays in the shipment of new products.  There can be no assurance  that we will
successfully manage future product transitions.

Our success  depends upon the  continued  contributions  of our key  management,
marketing, product development and operational personnel.

      Our success will depend, to a large extent, upon our ability to retain and
continue to attract highly skilled personnel in management,  marketing,  product
development  and  operations.  Competition  for  employees  in the  computer and
electronics industries is intense, and there can be no assurance that we will be
able to attract and retain  enough  qualified  employees.  Volatility or lack of
positive performance in our stock price may also adversely affect our ability to
retain and  continue to attract key  employees,  many of whom have been  granted
stock  options.  Our inability to retain and attract key employees  could have a
material adverse effect on our product development,  business, operating results
and financial condition.  We do not carry key person life insurance with respect
to any of our personnel.

The  markets  for our  products  are  highly  competitive  and may  become  more
competitive in the future.

      The network enhancement  products and computer software markets are highly
competitive,  and we believe that competition will intensify in the future.  The
competition  is  characterized  by rapid change and  improvements  in technology
along with  constant  pressure to reduce the prices of  products.  We  currently
compete  principally  in the market for network  fax  servers and  fax-on-demand
software.  Both  direct and  indirect  competition  could  adversely  affect our
business and operating  results through pricing  pressure,  loss of market share
and other factors.  Any material  reduction in the average selling prices of our
products would adversely affect gross margins. There can be no assurance we will
be able to maintain the current  average  selling  prices of our products or the
related gross margins.

      The principal  competitive  factors  affecting the market for our products
include:

      o     product functionality;

      o     performance;

      o     quality;

      o     reliability;

      o     ease of use;

      o     quality of customer training and support;

      o     name recognition;

      o     price; and


                                       32
<PAGE>

      o     compatibility and conformance with industry standards and changing
            operating system environments.

      Several of our  existing  and  potential  competitors  have  substantially
greater financial,  engineering,  manufacturing and marketing resources than us.
We also experience  competition  from a number of other  software,  hardware and
service  companies.  In  addition  to  our  current  competitors,  we  may  face
substantial  competition from new entrants into the network  enhancement market,
including established and emerging computer, computer peripheral, communications
and software companies.  In the fax server market we compete with companies such
as Captaris Inc.,  Omtool,  Ltd. and Esker  Software.  There can be no assurance
that  competitors  will not introduce  products  incorporating  technology  more
advanced than the technology  used by us in our products.  In addition,  certain
competing  methods of  communications  such as the Internet or  electronic  mail
could  adversely  affect the market for fax products.  There can be no assurance
that we will be able to compete successfully or that competition will not have a
material  adverse  effect  on our  business,  operating  results  and  financial
condition.

We depend on sales in foreign  markets,  and  political  or economic  changes in
these  markets  could  affect our  business,  operating  results  and  financial
condition.

      Sales to  customers  located  outside  the  United  States  accounted  for
approximately  18%,  19%  and 21% of our net  sales  in  2004,  2003  and  2002,
respectively. We sell our products in approximately 40 foreign countries through
approximately 50 international distributors.  We expect that international sales
will  continue to represent a  significant  portion of our product  revenues and
that we will be subject  to the normal  risks of  international  sales,  such as
export laws, currency fluctuations,  longer payment cycles, greater difficulties
in accounts receivable  collections and the requirement of complying with a wide
variety of foreign laws.  There can be no assurance  that we will not experience
difficulties  resulting  from changes in foreign laws  relating to the export of
our products in the future.  In addition,  because we primarily  invoice foreign
sales in U.S.  dollars,  fluctuations  in exchange rates could affect demand for
our  products by causing  prices to be out of line with  products  priced in the
local  currency.  Additionally,  any such  difficulties  would  have a  material
adverse  effect on our  international  sales and a  resulting  material  adverse
effect on our  business,  operating  results  and  financial  condition.  We may
experience  fluctuations in European sales on a quarterly basis because European
sales may be weaker  during the third  quarter  than the second  quarter  due to
extended holiday shutdowns in July and August. There can be no assurance that we
will be able to maintain  the level of  international  sales in the future.  Any
fluctuations  in  international  sales will  significantly  affect our operating
results and financial condition.

The introduction of new products may reduce the demand for our existing products
and increase returns of existing products.

      From  time to  time,  we may  announce  new  products,  product  versions,
capabilities or  technologies  that have the potential to replace or shorten the
life  cycles of  existing  products.  The  release  of a new  product or product
version may result in the  write-down of products in inventory if this inventory
becomes  obsolete.  We have  in the  past  experienced  increased  returns  of a
particular  product version following the announcement of a planned release of a
new version of that product. There can be no assurance that product returns will
not exceed  our  allowance  for these  returns in the future and will not have a
material  adverse  effect  on our  business,  operating  results  and  financial
condition.

If we fail to obtain components of our products from third-party suppliers and
subcontractors, our business could suffer.

      Our products require components procured from third-party suppliers.  Some
of these  components  are  available  only from a single  source or from limited
sources. In addition,  we subcontract a substantial portion of our manufacturing
to third parties,  and there can be no assurance that these  subcontractors will
be able to support our manufacturing  requirements.  We purchase components on a
purchase  order  basis,  and  generally  have no long-term  contracts  for these
components.  If we are  unable


                                       33
<PAGE>

to  obtain a  sufficient  supply of  high-quality  components  from our  current
sources,  we could experience  delays or reductions in product  shipments.  From
time to time,  component  manufacturers  announce  the end of life of certain of
their products and may or may not have replacement products. If we are unable to
secure enough inventories of the end-of-life  components or their  replacements,
we  might  not be able to  deliver  our  products  to our  customers  and  could
adversely affect our revenue and net income. Furthermore, a significant increase
in the  price  of one or more of  these  components  or our  inability  to lower
component or  sub-assembly  prices in response to competitive  price  reductions
could adversely affect our gross margin.

Government  regulation  could increase our costs of doing business and adversely
affect our gross margin.

      Certain  aspects  of the  networking  industry  in  which we  compete  are
regulated  both in the United  States and in foreign  countries.  Imposition  of
public  carrier  tariffs,  taxation  of  telecommunications   services  and  the
necessity of incurring substantial costs and expenditure of managerial resources
to obtain regulatory approvals,  or the inability to obtain regulatory approvals
within a reasonable period of time, could have a material, adverse effect on our
business,  operating results and financial condition.  This is particularly true
in foreign countries where telecommunications standards differ from those in the
United States.  Our products must comply with a variety of equipment,  interface
and installation standards promulgated by communications  regulatory authorities
in  different  countries.  Changes  in  government  policies,   regulations  and
interface standards could require the redesign of products and result in product
shipment  delays which could have a material,  adverse  impact on our  business,
operating results and financial condition.

We depend on proprietary  technology,  and inability to develop and protect this
technology or license it from third parties could adversely affect our business,
operating results and financial condition.

      Our success depends to a certain extent upon our  technological  expertise
and proprietary software  technology.  We rely upon a combination of contractual
rights and  copyright,  trademark and trade secret laws to establish and protect
our  technologies.  Despite the precautions  taken by us, it may be possible for
unauthorized third parties to copy our products or to reverse engineer or obtain
and use information that we regard as proprietary. In addition, the laws of some
foreign  countries  either do not protect our  proprietary  rights or offer only
limited protection. Given the rapid evolution of technology and uncertainties in
intellectual property law in the United States and internationally, there can be
no  assurance  that our  current  or  future  products  will not be  subject  to
third-party claims of infringement.  Any litigation to determine the validity of
any  third-party  claims  could  result in  significant  expense  and divert the
efforts our technical and management personnel, whether or not any litigation is
determined in favor of us. In the event of an adverse result in  litigation,  we
could be  required to expend  significant  resources  to develop  non-infringing
technology or to obtain  licenses to the  technology  that is the subject of the
litigation.  There  can be no  assurance  that we  would be  successful  in this
development  or that  any  such  licenses  would be  available  on  commercially
reasonable terms. We also rely on technology licensed from third parties.  There
can be no assurance  that these  licenses  will  continue to be  available  upon
reasonable  terms, if at all. Any impairment or termination of our  relationship
with third-party licensors could have a material adverse effect on our business,
operating  results and financial  condition.  There can be no assurance that our
precautions  will be adequate to deter  misappropriation  or infringement of our
proprietary technologies.

      We have received, and may receive in the future,  communications asserting
that our products  infringe the  proprietary  rights of third parties or seeking
indemnification against the alleged infringement. There can be no assurance that
third  parties will not assert  infringement  claims  against us with respect to
current or future  products  or that any  assertion  may not require us to enter
into royalty  arrangements or result in costly litigation.  Any claims,  with or
without merit,  can be time  consuming and expensive to


                                       34
<PAGE>

defend. There can be no assurance that any intellectual property litigation will
not have a  material  adverse  effect on our  business,  operating  results  and
financial condition.

Our stock price has been  volatile,  and is likely to continue to be volatile in
the future.

      The price of our common stock has fluctuated  widely in the past. Sales of
substantial  amounts of our common  stock,  or the  perception  that sales could
occur, could adversely affect prevailing market prices for our common stock. Our
management  believes  past  fluctuations  may have been  caused  by the  factors
identified above, and that these factors may continue to affect the market price
of our common stock. Additionally,  stock markets have experienced extreme price
volatility in recent years. This volatility has had a substantial  effect on the
market  price of the  common  stock of us and other high  technology  companies,
often for reasons unrelated to operating performance.  We anticipate that prices
for our common stock may continue to be volatile.  Future stock price volatility
may result in the  initiation  of  securities  litigation  against us, which may
divert substantial management and financial resources and have an adverse effect
on our business, operating results and financial condition.

We may require  additional  capital in the  future,  and may be unable to obtain
this capital at all or on commercially reasonable terms.

      The development and marketing of products requires  significant amounts of
capital.  If we need additional  capital  resources,  we may be required to sell
additional  equity  or debt  securities,  secure  additional  lines of credit or
obtain  other  third  party  financing.  The timing  and amount of such  capital
requirements  cannot be  determined  at this time and will depend on a number of
factors,  including  demand for our  existing  and new  products  and changes in
technology in the networking industry. There can be no assurance that additional
financing  will be  available  on  satisfactory  terms when  needed,  if at all.
Failure  to raise  such  additional  financing,  if  needed,  may  result in our
inability to achieve our long-term business  objectives.  The issuance of equity
or  convertible  debt  securities  to raise  additional  capital would result in
additional dilution to our shareholders.

Recent  terrorist  activity  in the  United  States and the  military  action to
counter terrorism could adversely impact our business.

      Terrorist  acts or acts of war (wherever  located  around the world) could
significantly impact our revenue,  costs and expenses,  and financial condition.
The terrorist attacks that took place in the United States on September 11, 2001
have  created  many  economic  and  political  uncertainties,  some of which may
materially harm our business,  operating  results and financial  condition.  The
long-term  effects on our  business of the  September  11, 2001  attacks and the
ensuing war on terror are unknown.  The potential for future terrorist  attacks,
the national  and  international  responses  to  terrorist  attacks or perceived
threats to national security,  and other actual or potential conflicts,  acts of
war or hostility,  including the United States' activities in Iraq, have created
many  economic  and  political  uncertainties  that could  adversely  affect our
business,  operating  results  and  financial  condition  in  ways  that  cannot
presently be predicted.

The  costs of  compliance  with  recent  developments  in  corporate  governance
regulation may affect our business, operating results and financial condition in
ways that presently cannot be predicted  further.  In the event we are unable to
satisfy  regulatory  requirements  relating  to internal  controls,  or if these
internal controls over financial reporting are not effective, our business could
suffer.

      Beginning  with  the  enactment  of  the  Sarbanes-Oxley  Act of  2002,  a
significant number of new corporate governance requirements have been adopted or
proposed  through  legislation  and  regulation by the  Securities  and Exchange
Commission  and  Nasdaq  National  Stock  Market.  We may not be  successful  in
complying with these requirements at all times in the future.  Additionally,  we
expect these developments to increase our legal compliance and accounting costs,
and to make some activities more difficult,  such as stockholder approval of new
stock option plans. We have incurred and expect to


                                       35
<PAGE>

continue to incur  significant  costs in connection with compliance with Section
404 of that law regarding internal controls over financial reporting.  We expect
these developments to make it more difficult and more expensive for us to obtain
director  and  officer  liability  insurance,  and we may be  required to accept
reduced coverage or incur substantially  higher costs to obtain coverage.  These
developments could make it more difficult for us to attract and retain qualified
members of our board of  directors,  or  qualified  executive  officers.  We are
presently evaluating and monitoring regulatory  developments and cannot estimate
the timing or magnitude  of  additional  costs we may incur as a result,  or the
effect that these increased costs may have on our operating results.

      We  have  identified  and may  from  time to time  identify  a  number  of
deficiencies in our disclosure  controls and procedures.  In connection with the
audit of the consolidated  financial  statements for the year ended December 31,
2004, our independent  registered  public  accounting  firm, Grant Thornton LLP,
determined  that  we  had  internal  control  deficiencies  that  constituted  a
"material weakness."  Furthermore,  we cannot assure you that we will be able to
implement  enhancements  on a timely  basis in order to prevent a failure of our
internal controls or enable us to furnish future unqualified  certifications.  A
material  weakness or deficiency in internal  control over  financial  reporting
could materially  impact our reported  financial results and the market price of
our stock could significantly decline.  Additionally,  adverse publicity related
to the disclosure of a material weakness or deficiency in internal controls over
financial reporting could have a negative impact on our reputation, business and
stock price. Any internal control or procedure,  no matter how well designed and
operated,  can provide only  reasonable  assurance of achieving  desired control
objectives.

Voting control by officers, directors and affiliates may delay, defer or prevent
a change of control.

      At February 28, 2005,  our officers  and  directors  and their  affiliates
beneficially owned  approximately 25% of the outstanding shares of common stock.
Accordingly,  together  they had the  ability  to  significantly  influence  the
election of our  directors and other  corporate  actions  requiring  shareholder
approval.  Such  concentration  of  ownership  may have the effect of  delaying,
deferring or preventing a change in control.

Provisions  in our charter  documents  might deter a company from  acquiring us,
which could  inhibit  your  ability to receive an  acquisition  premium for your
shares.

      Our Board of Directors  has  authority to issue shares of preferred  stock
and to fix the rights,  including  voting  rights,  of these shares  without any
further  vote or action by the  shareholders.  The rights of the  holders of our
common stock will be subject to, and may be adversely affected by, the rights of
the  holders  of any  preferred  stock  that may be  issued in the  future.  The
issuance of preferred stock, while providing desirable flexibility in connection
with possible  acquisitions and other corporate purposes,  could have the effect
of making it more  difficult  for a third  party to  acquire a  majority  of our
outstanding voting stock, thereby delaying,  deferring or preventing a change in
control.  Furthermore,  such  preferred  stock may have other rights,  including
economic  rights,  senior to the common  stock,  and as a result,  the  issuance
thereof could have a material adverse effect on the market.

RECENT ACCOUNTING PRONOUNCEMENTS

      In December  2003,  the FASB issued a revised FASB  interpretation  No. 46
(FIN 46R),  "Consolidation for Variable Interest Entities, and interpretation of
ARB No. 51".  The FASB  published  the revision to clarify and amend some of the
original  provisions of FIN 46, which was issued in January 2003,  and to exempt
certain  entities from its  requirements.  A variable  interest  Entity  ("VIE")
refers to an entity subject to consolidation  according to the provisions of the
Interpretation.  FIN 46R applies to entities whose equity  investment at risk is
insufficient to finance that entity's  activities  without receiving  additional
subordinated  financial  support  provided  by  any  parties,  including  equity
holders,  or where  the  equity  investors  (if  any) do not have a  controlling
financial  interest.  FIN  46R  provides  that  if  an  entity  is  the  primary
beneficiary of a VIE, the assets, liabilities,  and results of operations of the
VIE should be consolidated in the entity's  financial  statements.  In addition,
FIN 46R requires  that both the primary


                                       36
<PAGE>

beneficiary and all other enterprises with a significant  variable interest in a
VIE provide additional disclosures. The provisions of FIN 46R were effective for
our fiscal 2004 first quarter. The adoption of FIN 46R did not have an impact on
our financial position or results of operations.

      In March  2004,  the FASB  issued  EITF  Issue No.  03-1,  The  Meaning of
Other-Than-Temporary  Impairment  and Its  Application  to Certain  Investments,
which provides new guidance for assessing  impairment  losses on debt and equity
investments.   Additionally,   EITF  Issue  No.  03-1  includes  new  disclosure
requirements  for  investments  that are deemed to be temporarily  impaired.  In
September  2004,  the FASB delayed the  accounting  provisions of EITF Issue No.
03-1; however,  the disclosure  requirements remain effective.  The Company does
not expect the adoption of EITF 03-1 to have a material  impact on our financial
position or results of operations.

      In December 2004, the FASB issued SFAS No. 123R,  "Share-Based Payment," a
revision  of  SFAS  No.  123,  "Accounting  for  Stock-Based  Compensation"  and
superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS
No. 123R requires the Company to expense  grants made under the Company's  stock
option  program.  That cost will be  recognized  over the vesting  period of the
plans.  SFAS No. 123R is effective for interim periods  beginning after June 15,
2005.  The Company is evaluating  the  alternatives  allowed under the standard,
which the Company is required to adopt effective for its third quarter of fiscal
2005.

      In  December  2004,  the  FASB  issued  Staff  Position  SFAS  No.  109-1,
Application  of FASB  Statement  No. 109,  Accounting  for Income Taxes (FSP No.
109-1) to the Tax Deduction on Qualified  Production  Activities Provided by the
American Jobs Creation Act of 2004 which was signed into law by the President of
the United States on October 22, 2004. Companies that qualify for the recent tax
law's  deduction  for domestic  production  activities  must account for it as a
special  deduction under SFAS No. 109 and reduce their tax expense in the period
or periods the amounts are deductible, according to FSP No. 109-1, effective for
the Company in its fiscal year 2005. The FASB's guidance is not expected to have
a material impact to the Company's financial results.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

      We had no holdings of  derivative  financial or commodity  instruments  at
December 31, 2004. However, we are exposed to financial market risks,  including
changes in interest rates and foreign currency exchange rates. While much of our
revenue is transacted in U.S. Dollars,  certain spending is transacted in Pounds
Sterling.  These amounts are not currently material to our financial statements;
therefore we believe that foreign currency  exchange rates should not materially
affect our overall financial position,  results of operations or cash flows. The
fair  value of our  money  market  accounts  and  related  income  would  not be
significantly impacted by increases or decreases in interest rates due mainly to
the highly  liquid  nature of these  investments.  However,  sharp  declines  in
interest rates could seriously harm interest earnings.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      In April 2005,  Castelle  completed a review of its  accounting  practices
with  respect to the  historical  classification  of cost of  service  revenues,
procedures for recognizing  revenue  associated with extended support  contracts
and procedures for  establishing the accrual for  paid-time-off,  and determined
that its historical  financial statements as of and for the years ended December
31, 2002 and 2003  contained  certain  errors in the  application  of  generally
accepted  accounting  principles.  The  outcome of this  review has  resulted in
adjustments to Castelle's previously filed financial  statements.  Consequently,
the historical financial statements and related financial  information contained
in Castelle's  Annual  Report on Form 10-K for the year ended  December 31, 2003
and each of Castelle's Forms 10-Q for the year ended December 31, 2004 should no
longer  be  relied  upon and are  superceded  by the  financial  statements  and
financial information in the Annual Report on Form 10-K.


                                       37
<PAGE>

      The consolidated  financial  statements and supplementary data required by
this Item are set forth at the pages indicated in Item 15 of this report.

ITEM  9.  CHANGES  IN AND  DISAGREEMENTS  WITH  ACCOUNTANTS  ON  ACCOUNTING  AND
          FINANCIAL DISCLOSURE

      On  September  24,  2004,  the Audit  Committee  of the Board of Directors
dismissed  PricewaterhouseCoopers LLP (PwC) as Castelle's independent registered
public accounting firm. On September 24, 2004, the Audit Committee engaged Grant
Thornton LLP as Castelle's new independent registered public accounting firm for
the fiscal year ended December 31, 2004.  The change in  independent  registered
public  accounting  firm was  reported  in a  Current  Report  on Form 8-K dated
September 30, 2004.

      PwC's reports on the consolidated financial statements of Castelle for the
fiscal years 2002 and 2003 contained no adverse opinion or disclaimer of opinion
and were not qualified or modified as to uncertainty,  audit scope or accounting
principle.  In connection with its audits of Castelle's  consolidated  financial
statements  as of and for the fiscal years ended  December 31, 2002 and 2003 and
through  September 24, 2004, there were no disagreements  with PwC on any matter
of accounting  principles  or  practices,  financial  statement  disclosure,  or
auditing  scope  or  procedure,  which  disagreements,  if not  resolved  to the
satisfaction  of PwC,  would have  caused PwC to make  reference  thereto in its
reports  on  the  consolidated  financial  statements  for  such  years.  During
Castelle's  fiscal years ended December 31, 2002 and 2003 and through  September
24,  2004,  there were no  "reportable  events," as that term is defined in Item
304(a)(1)(v) of Regulation S-K.

ITEM 9A. CONTROLS AND PROCEDURES

      Regulations  under the  Securities  Exchange  Act of 1934  require  public
companies,   including  our  company,  to  maintain   "disclosure  controls  and
procedures," which are defined to mean a company's controls and other procedures
that are  designed to ensure that  information  required to be  disclosed in the
reports that it files or submits  under the  Securities  Exchange Act of 1934 is
recorded, processed, summarized, and reported, within the time periods specified
in the Securities and Exchange Commission's rules and forms.

      Regulations  under the  Securities  Exchange  Act of 1934  require  public
companies,  including  our  company,  to  evaluate  any change in our  "internal
control  over  financial  reporting,"  which is  defined as a process to provide
reasonable  assurance  regarding  the  reliability  of financial  reporting  and
preparation  of financial  statements for external  purposes in accordance  with
accounting principles generally accepted in the United States.

      Our management  evaluated,  with the  participation of our Chief Executive
Officer and our Chief Financial  Officer,  the  effectiveness  of our disclosure
controls  and  procedures  as of the end of the period  covered  by this  Annual
Report on Form 10-K and as of the periods  affected by the restatement  referred
to elsewhere in this Form 10-K.  Based on this  evaluation,  our Chief Executive
Officer and our Chief  Financial  Officer  have  concluded  that our  disclosure
controls and  procedures  were not effective to ensure that  information  we are
required  to  disclose in 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 Securities and Exchange Commission rules and forms due
to the following:

      (1)   Through September 30, 2004, our historical classification of cost of
            service  revenues did not conform to generally  accepted  accounting
            principles as such costs were classified as a component of sales and
            marketing  expenses rather than as a component of cost of sales, due
            primarily to the fact that our internal  financial  reporting system
            did not track this  information  separately  from certain  sales and
            marketing expenses. This internal control deficiency that led to the
            errors in the historical  classification of cost of service revenues
            is deemed to  constitute  a


                                       38
<PAGE>

            "material  weakness"  as defined by the  Public  Company  Accounting
            Oversight Board's Auditing Standard No. 2.

      (2)   Through  September  30,  2004,  service  revenues   attributable  to
            extended  support   contracts  were  overstated  due  to  inadequate
            procedures in place to correctly recognize sales related to extended
            support  contracts.  The  Company's  independent  registered  public
            accounting firm, Grant Thornton LLP, has concluded that the internal
            control  deficiency  that led to the revenue  recognition  errors is
            also  a  "material  weakness"  as  defined  by  the  Public  Company
            Accounting Oversight Board's Auditing Standard No. 2.

      Effective  January 1,  2005,  the  Company  established  a cost  center to
separately capture the cost of service revenues as a component of cost of sales.
During the first quarter of fiscal 2005,  the Company also enhanced its internal
accounting  system and  related  controls  to ensure  that  revenue  relating to
extended support contracts is recognized over the actual contract term.

      In designing and evaluating our disclosure  controls and  procedures,  our
management  recognized  that any  controls  and  procedures,  no matter how well
designed and operated,  can provide only reasonable assurance of achieving their
objectives,  and our management  necessarily  applied its judgment in evaluating
the cost-benefit relationship of possible controls and procedures.

      ITEM 9B. OTHER INFORMATION

      None


                                       39
<PAGE>

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Identification of Directors

      The  information  required  by  this  Item  concerning  our  directors  is
incorporated by reference from the sections  captioned  "Proposal 1: Election of
Directors"  contained in our definitive Proxy Statement (the "Proxy Statement"),
related to our 2004 Annual  Meeting of  Shareholders  to be filed by us with the
Securities and Exchange  Commission ("SEC") no later than April 30, 2005 or will
be provided in an  amendment to this Form 10-K to be filed with the SEC no later
than April 30, 2005.

Identification of Executive Officers

      The information required by this Item concerning our executive officers is
set forth in Part I of this Report.

Section 16(a) Beneficial Ownership Reporting Compliance

      The information  concerning  compliance with Section 16(a) of the Exchange
Act required by this Item is incorporated by reference to the section  captioned
"Section 16(a) Beneficial Ownership Reporting Compliance" contained in the Proxy
Statement.

ITEM 11. EXECUTIVE COMPENSATION

      The information  required by this Item is incorporated by reference to the
section captioned "Executive Compensation" in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

      The information  required by this Item is incorporated by reference to the
section  captioned   "Security   Ownership  of  Certain  Beneficial  Owners  and
Management" contained in the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

      In October 2002, the Company  engaged W.R.  Hambrecht + Co. ("WRH + Co."),
an investment bank, to manage our stock buyback program approved by the Board of
Directors.  Mr. Robert Hambrecht,  a director of Castelle, is also a director of
W.R.  Hambrecht  + Co.  Through  March  31,  2003,  WRH + Co.  had  received  an
insignificant amount of compensation under this arrangement. There were no stock
buyback activities from March 2003 through March 10, 2005.

      Other information  required by this Item is incorporated by reference from
the sections  captioned  "Certain  Transactions"  and  "Executive  Compensation"
contained in the Proxy Statement.

ITEM 14. PRINCIPAL AUDITOR FEES AND SERVICES

      Information  regarding  principal  auditor  fees and  service is set forth
under  "Ratification  of  Selection  of  Independent   Auditors"  in  the  Proxy
Statement, which information is incorporated herein by reference.


                                       40
<PAGE>

                                     PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

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

            1)    Financial Statements

<TABLE>
<CAPTION>
                                                                                                  Page in
                                                                                                 Form 10-K
                                                                                                 ---------
<S>                                                                                                 <C>
                  Report of Grant Thornton LLP, Independent Registered
                  Public Accounting Firm........................................................    F-1
                  Report of Pricewaterhouse Coopers LLP, Independent Registered
                  Public Accounting Firm........................................................    F-2
                  Consolidated Balance Sheets as of December 31, 2004 and 2003..................    F-3
                  Consolidated Statements of Earnings for the years ended
                       December 31, 2004, 2003 and 2002.........................................    F-4
                  Consolidated Statements of Shareholders' Equity for the years ended
                       December 31, 2004, 2003 and 2002.........................................    F-5
                  Consolidated Statements of Cash Flows for the years ended
                       December 31, 2004, 2003 and 2002.........................................    F-6
                  Notes to Consolidated Financial Statements....................................    F-7
</TABLE>

            2)    Financial Statement Schedules

                  The following financial statement schedule of Castelle for the
                  years ended December 31, 2004,  2003 and 2002 is filed as part
                  of this Form 10-K and should be read in  conjunction  with the
                  Company's Financial Statements.

<TABLE>
<CAPTION>

                                                                                                   Page in
                                                                                                  Form 10-K
                                                                                                  ---------
<S>                                                                                                 <C>
                  Schedule II - Valuation and Qualifying Accounts...............................    F-29
</TABLE>

            3)    Additional Exhibits

                  In accordance with SEC Release No. 33-8212,  Exhibits 32.1 and
                  32.2 are to be treated as  "accompanying"  this report  rather
                  than "filed" as part of the report.

                  31.1  Certification  pursuant to 18 U.S.C.  Section  1350,  as
                        adopted  pursuant to Section  302 of the  Sarbanes-Oxley
                        Act of  2002,  executed  by  Scott  C.  McDonald,  Chief
                        Executive Officer and President of Castelle

                  31.2  Certification  pursuant to 18 U.S.C.  Section  1350,  as
                        adopted  pursuant to Section  302 of the  Sarbanes-Oxley
                        Act of 2002,  executed  by Paul Cheng,  Chief  Financial
                        Officer of Castelle

                  32.1  Certification  pursuant  to 18 U.S.C  Section  1350,  as
                        adopted  pursuant to Section  906 of the  Sarbanes-Oxley
                        Act of  2002,  executed  by  Scott  C.  McDonald,  Chief
                        Executive Officer of Castelle

                  32.2  Certification  pursuant  to 18 U.S.C  Section  1350,  as
                        adopted  pursuant to Section  906 of the  Sarbanes-Oxley
                        Act of 2002,  executed  by Paul Cheng,  Chief  Financial
                        Officer of Castelle


                                       41
<PAGE>

            Schedules  not listed above have been  omitted  because they are not
            applicable  or are not required or because the required  information
            is included in the Financial Statements or Notes thereto.

      (b)   Reports on Form 8-K

            During the  fourth  quarter  of 2004,  Castelle  filed a Form 8-K on
            October 27, 2004.  Furnished  under Item 12,  "Results of Operations
            and Financial  Condition",  Castelle filed a press release regarding
            its financial  results for its fiscal  quarter  ended  September 30,
            2004.

      (c)   Exhibits

<TABLE>
<CAPTION>
                                                                      Incorporated by Reference
                                                                      -------------------------
Exhibit                                                                                            Date of        Exhibit     Filed
Number                   Exhibit Description                    Form         File No.           First Filing       Number   Herewith
                                                                             --------           ------------       ------   --------
<S>         <C>                                                 <C>        <C>                   <C>                <C>         <C>
3.1         Registrant's Amended and Restated Articles of       SB-2/A     33-99628-LA-          12/8/1995          3.3
            Incorporation.

3.2         Registrant's Amended and Restated Bylaws.           10-K       000-22020             12/31/2000         3.2

4.1         Specimen Stock Certificate representing shares      SB-2/A     33-99628-LA-          12/14/1995         4.1
            of Registrant's Common Stock.

10.1*       1995 Non-Employee Directors' Stock Option Plan,     SB-2/A     111-22020             12/14/1995         10.2
            as amended, and form of Director Stock Option
            Agreement

10.2        Form of Indemnity Agreement between the             SB-2/A     33-99628-LA-          12/8/1995          10.4
            Registrant and each of its directors and
            executive officers.

10.3        OEM Purchase Agreement dated May 23, 1995, by       SB-2/A     33-99628-LA-          12/8/1995          10.7
            and between the Registrant and SerComm
            Corporation.

10.4        Distribution Agreement dated February 26, 1990,     SB-2/A     33-99628-LA-          12/8/1995          10.8
            by and between the Registrant and Ingram Micro D
            Inc.

10.5        Distributor Contract dated June 25, 1991, as        SB-2/A     33-99628-LA-          12/8/1995          10.9
            amended June 25, 1991, by and between the
            Registrant and Tech Data Corporation.

10.6        International Distributor Agreement dated           SB-2/A     33-99628-LA-          12/8/1995          10.12
            February 24, 1994, by and between the Registrant
            and Macnica.

10.7*       1988 Equity Incentive Plan, as amended, and form    S-8        333-75247             3/29/1999          99.1
            of option agreement

10.8        International Distributor Agreement dated April     10-K       000-22020             3/29/2002          10.11
            24, 2001 by and between the Registrant and AMS
            Limited.

10.9        Commercial Tenant Lease Agreement dated August      10-K       000-22020             3/29/2002          10.12
            16, 2000 by and among the Registrant and Kyung
            S. Lee and Ieesun Kim Lee.

10.10       First Amendment to Lease Agreement dated June 1,    10-Q       000-22020             8/11/2004          10.1
            2004 by and among the Registrant and by and
            between Kyung S. Lee and Ieesun Kim Lee.

10.11*      Summary of Severance Agreements with Named             -               -                     -              -       X
            Executive Officers.

10.12       Employment agreement dated April 22, 2002 by and    10-K       000-22020             3/28/2003          10.16
            between the Registrant and Scott McDonald.

10.13       Form of Executive Severance and Transition          10-K       000-22020             3/28/2003          10.16
            Benefits Agreement dated April 22, 2002 by and
            between the Registrant and Scott McDonald.

10.14*      2002 Equity Incentive Plan.                         10-K       000-22020             3/28/2003          10.16

10.15       Loan and Security Agreement dated March 18, 1999    10-K       000-22020             3/28/2003          10.17
            by and between the Registrant and Silicon Valley
            Bank.

10.16       Loan Modification Agreement dated March 16, 2003    10-K       000-22020             3/28/2003          10.18
            by and between the Registrant and Silicon Valley
            Bank.

10.17       Loan Modification Agreement dated March 15, 2004    10-K       000-22020             3/29/2004          10.16
            by and between the Registrant and Silicon Valley
            Bank.
</TABLE>


                                       42
<PAGE>

<TABLE>
<S>         <C>                                                 <C>        <C>                   <C>                <C>         <C>
10.18       Loan and Security Agreement dated August 2, 2004    10-Q       000-22020             8/11/2004          10.2
            by and between the Registrant and Silicon Valley
            Bank.

23.1        Consent of Grant Thornton LLP, Independent                                                                          X
            Registered Public Accounting Firm

23.2        Consent of PricewaterhouseCoopers LLP,                                                                              X
            Independent Registered Public Accounting Firm
</TABLE>

            *     Indicates management contracts or compensatory plans or
                  arrangements filed pursuant to Item 601(b)(10) of Regulation
                  S-K


                                       43
<PAGE>

                                   SIGNATURES

      Pursuant to the  requirements of Section 13 or 15(d) of the Securities Act
of 1934, as amended,  the  Registrant has duly caused this Annual Report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized on
the fifteenth day of April 2005.


                                       By: /S/ SCOTT C. MCDONALD
                                           -------------------------------------
                                           Scott C. McDonald
                                           President and Chief Executive Officer

      KNOW BY ALL PERSONS BY THESE  PRESENTS,  that each person whose  signature
appears below constitutes and appoints Scott C. McDonald, as his true and lawful
attorney-in-fact  and agent, with full power of substitution for him, and in his
name in any and all  capacities,  to sign any and all  amendments to this Annual
Report on Form  10-K,  and to file the same,  with  exhibits  thereto  and other
documents in connection therewith,  with the Securities and Exchange Commission,
granting unto said  attorney-in-fact  and agent,  full power and authority to do
and perform  each and every act and thing  requisite  and  necessary  to be done
therewith,  as  fully to all  intents  and  purposes  as he might or could do in
person,  hereby  ratifying and  confirming  all that said  attorney-in-fact  and
agent,  and any of them, or his  substitute or  substitutes,  may lawfully do or
cause to be done by virtue hereof.

      Pursuant to the requirements of the Securities  Exchange Act of 1934, this
Annual  Report on Form 10-K has been signed  below by the  following  persons on
behalf of the Registrant and in the capacities and on the dates indicated:

<TABLE>
<CAPTION>
Name                                          Title                              Date
----                                          -----                              ----
<S>                       <C>                                               <C>
/S/ SCOTT C. MCDONALD     President, Chief Executive Officer                April 15, 2005
-----------------------   (principal executive officer) and Director
Scott C. McDonald

/S/ PAUL CHENG            Vice President, Finance and Administration,       April 15, 2005
-----------------------   Chief Financial Officer (principal accounting
Paul Cheng                officer) and Secretary

/S/ DONALD L. RICH        Chairman of the Board                             April 15, 2005
-----------------------
Donald L. Rich

/S/ ROBERT H. HAMBRECHT   Director                                          April 15, 2005
-----------------------
Robert H. Hambrecht

/S/ ROBERT O. SMITH       Director                                          April 15, 2005
-----------------------
Robert O. Smith

/S/ PETER R. TIERNEY      Director                                          April 15, 2005
-----------------------
Peter R. Tierney
</TABLE>


                                       44
<PAGE>

             Report of Independent Registered Public Accounting Firm

To the Board of Directors and
Shareholders of Castelle

We have audited the  accompanying  balance sheet of Castelle and its  subsidiary
(the "Company") as of December 31, 2004 and the related  statements of earnings,
stockholders'  equity,  and cash flows for the year then ended.  These financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is to express an opinion on these financial  statements 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.  The Company is not  required to
have,  nor were we  engaged to perform  an audit of its  internal  control  over
financial reporting.  Our audit included  consideration of internal control over
financial  reporting  as  a  basis  for  designing  audit  procedures  that  are
appropriate  in the  circumstances,  but not for the  purpose of  expressing  an
opinion on the  effectiveness  of the Company's  internal control over financial
reporting.  Accordingly,  we express  no such  opinion.  An audit also  includes
examining,  on a test basis,  evidence supporting the amounts and disclosures in
the financial  statements.  An audit also  includes,  assessing  the  accounting
principles  used  and  significant  estimates  made  by  management,  as well as
evaluating the overall  financial  statement  presentation.  We believe that our
audit provides a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects,  the financial position of Castelle and its subsidiary as
of December  31, 2004 and the results of its  operations  and its cash flows for
the year then ended in conformity with accounting  principles generally accepted
in the United States of America.

We have also audited  Schedule II for the year ended  December 31, 2004.  In our
opinion,  this  schedule,  when  considered  in relation to the basic  financial
statements taken as a whole,  presents  fairly,  in all material  respects,  the
information therein.

Grant Thornton LLP
San Francisco, California
March 3, 2005, except
for Note 3, as to which the
date is March 31, 2005

<PAGE>

             Report of Independent Registered Public Accounting Firm

To the Board of Directors and
Shareholders of Castelle

In our  opinion,  the  consolidated  financial  statements  listed  in the index
appearing under Item 15(a)(1)  present  fairly,  in all material  respects,  the
financial  position of Castelle and its subsidiary at December 31, 2003, and the
results  of their  operations  and their cash flows for each of the two years in
the period ended  December 31, 2003 in  conformity  with  accounting  principles
generally accepted in the United States of America. In addition, in our opinion,
the  financial  statement  schedule  listed in the index  appearing  under  Item
15(a)(2)  presents fairly, in all material  respects,  the information set forth
therein  when  read in  conjunction  with  the  related  consolidated  financial
statements.  These financial statements and financial statement schedule are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial  statements and financial statement schedule based on
our audits.  We conducted our audits of these  statements 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,   assessing  the
accounting  principles  used and significant  estimates made by management,  and
evaluating the overall  financial  statement  presentation.  We believe that our
audits provide a reasonable basis for our opinion.

As described in Note 3, the Company has restated its  financial  statements  for
each of the two years in the period ended December 31, 2003

PricewaterhouseCoopers LLP
San Jose, California
March 29, 2004,
except for Note 3,
as to which the date is
April 13, 2005

<PAGE>

Castelle
Consolidated Balance Sheets
(in thousands)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                December 31,
                                                                      ------------------------------
                                                                          2004               2003
                                                                      -----------        -----------
Assets                                                                                    (Restated)
<S>                                                                   <C>                <C>
Current assets:
    Cash and cash equivalents                                         $     5,599        $     4,614
    Accounts receivable, net                                                  857                873
    Inventories                                                             1,785              1,177
    Prepaid expenses and other current assets                                 130                134
    Deferred taxes                                                            231                380
                                                                      -----------        -----------
           Total current assets                                             8,602              7,178

Property and equipment, net                                                   203                376
Other assets                                                                   50                103
Deferred taxes                                                              1,292                146
                                                                      -----------        -----------

             Total assets                                             $    10,147        $     7,803
                                                                      ===========        ===========

Liabilities and Shareholders' Equity
Current liabilities:
    Current portion of long-term debt                                 $        15        $        16
    Accounts payable                                                          511                314
    Accrued liabilities                                                     1,073              1,737
    Deferred revenue                                                        1,253                955
                                                                      -----------        -----------
           Total current liabilities                                        2,852              3,022

Long-term debt, net of current portion                                         14                 29
                                                                      -----------        -----------
           Total liabilities                                                2,866              3,051
                                                                      -----------        -----------

Commitments and contingencies (Note 5)

Shareholders' equity:
    Preferred stock, no par value:
      Authorized:  2,000 shares in 2004 and 2003
      Issued and outstanding:  none in 2004 and 2003                           --                 --
    Common stock, no par value:
      Authorized:  25,000 shares
      Issued and outstanding: 3,799 shares at December 31, 2004
           and 3,425 shares at December 31, 2003                           27,668             27,258
    Accumulated deficit                                                   (20,387)           (22,506)
                                                                      -----------        -----------
           Total shareholders' equity                                       7,281              4,752
                                                                      -----------        -----------

             Total liabilities and shareholders' equity               $    10,147        $     7,803
                                                                      ===========        ===========
</TABLE>


                                      F-3

   The accompanying notes are an integral part of these financial statements.

<PAGE>

Castelle
Consolidated Statements of Earnings
(in thousands, except per share data)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                  Year Ended December 31
                                                     -------------------------------------------------
                                                         2004               2003               2002
                                                     -----------        -----------        -----------
                                                                         (Restated)         (Restated)
<S>                                                  <C>                <C>                <C>
Net sales:
   Products                                          $     8,011        $     8,337        $     8,617
   Services                                                2,446              1,843              1,103
                                                     -----------        -----------        -----------
        Total net sales                                   10,457             10,180              9,720
                                                     -----------        -----------        -----------

Cost of sales:
   Products                                                2,556              2,485              2,833
   Services                                                  826                726                707
                                                     -----------        -----------        -----------
        Total cost of sales                                3,382              3,211              3,540
                                                     -----------        -----------        -----------
        Gross profit                                       7,075              6,969              6,180
                                                     -----------        -----------        -----------

Operating expenses:
    Research and development                               1,722              1,590              1,379
    Sales and marketing                                    2,486              2,398              2,301
    General and administrative                             1,801              1,902              1,943
    Restructuring recovery                                    --                 --                (40)
                                                     -----------        -----------        -----------
                                                           6,009              5,890              5,583
                                                     -----------        -----------        -----------

           Operating income                                1,066              1,079                597

Interest income, net                                          36                 16                 43
Other income (expense), net                                  (50)               (26)                 1
                                                     -----------        -----------        -----------

Income before provision for (benefit from)
    income taxes                                           1,052              1,069                641
Provision for (benefit from) income taxes                 (1,067)              (537)                 6
                                                     -----------        -----------        -----------

           Net income                                $     2,119        $     1,606        $       635
                                                     ===========        ===========        ===========

Net income per common share - basic                  $      0.59        $      0.49        $      0.14
                                                     ===========        ===========        ===========

Net income per common share - diluted                $      0.48        $      0.38        $      0.14
                                                     ===========        ===========        ===========

Shares used in per share calculation - basic               3,616              3,254              4,539
                                                     ===========        ===========        ===========

Shares used in per share calculation - diluted             4,417              4,186              4,586
                                                     ===========        ===========        ===========
</TABLE>


                                      F-4

   The accompanying notes are an integral part of these financial statements.

<PAGE>

Castelle
Consolidated Statements of Shareholders' Equity
Years Ended December 31, 2004, 2003 and 2002
(in thousands)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                            Common Stock
                                                   -----------------------------     Deferred        Accumulated
                                                      Shares            Amount     Compensation         Deficit           Total
                                                   -----------       -----------   ------------      -----------       -----------
<S>                                                      <C>         <C>            <C>              <C>               <C>
Balances, December 31, 2001, restated                    4,745       $    28,977    $        (1)     $   (24,747)      $     4,229

    Issuance of common stock through
      exercise of stock options                             61                38             --               --                38
    Repurchase and cancellation of common stock         (1,619)           (1,977)            --               --            (1,977)
    Amortization of deferred compensation                   --                --              1               --                 1
    Net income, as restated                                 --                --             --              635               635

                                                   -----------       -----------    -----------      -----------       -----------
Balances, December 31, 2002, restated                    3,187            27,038             --          (24,112)            2,926
                                                   ===========       ===========    ===========      ===========       ===========

    Issuance of common stock through
      exercise of stock options                            285               268             --               --               268
    Repurchase and cancellation of common stock            (47)              (48)            --               --               (48)
    Net income, as restated                                 --                --             --            1,606             1,606

                                                   -----------       -----------    -----------      -----------       -----------
Balances, December 31, 2003, restated                    3,425            27,258             --          (22,506)            4,752
                                                   ===========       ===========    ===========      ===========       ===========
    Issuance of common stock through
      exercise of stock options                            374               410             --               --               410
    Net income                                              --                --             --            2,119             2,119

                                                   -----------       -----------    -----------      -----------       -----------
Balances, December 31, 2004                              3,799       $    27,668    $        --      $   (20,387)      $     7,281
                                                   ===========       ===========    ===========      ===========       ===========
</TABLE>


                                      F-5

   The accompanying notes are an integral part of these financial statements.

<PAGE>

<PAGE>

Castelle
Consolidated Statements of Cash Flows
Years Ended December 31, 2004, 2003 and 2002
(in thousands)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                    Year Ended December 31,
                                                                      --------------------------------------------------
                                                                          2004                2003               2002
                                                                      ------------       ------------       ------------
Cash flows from operating activities:                                                     (Restated)         (Restated)
<S>                                                                   <C>                <C>                <C>
    Net income                                                        $      2,119       $      1,606       $        635
    Adjustments to reconcile net income to
      net cash provided by  operating activities:
        Depreciation and amortization                                          206                213                206
        Provision for doubtful accounts                                         (1)                 5                (21)
        Allowance for sales returns and stock rotation                         886                524                660
        Write-downs of excess and obsolete inventory                            72               (167)              (105)
        Deferred taxes                                                        (997)              (526)                --
        Compensation expense related to grant of stock options                  --                 --                  1
        Loss on disposal of fixed assets                                         2                 --                  1
        Changes in assets and liabilities:
           Accounts receivable                                                (869)              (958)              (403)
           Inventories                                                        (680)               100                (79)
           Prepaid expenses and other current assets                            57                (41)                42
           Accounts payable                                                    197                (45)                79
           Accrued liabilities                                                (663)                56               (321)
           Deferred revenue                                                    297                351                187
                                                                      ------------       ------------       ------------
             Net cash provided by operating activities                         626              1,118                882
                                                                      ------------       ------------       ------------

Cash flows from investing activities:
    Acquisition of property and equipment                                      (35)              (164)               (34)
                                                                      ------------       ------------       ------------
             Net cash used in investing activities                             (35)              (164)               (34)
                                                                      ------------       ------------       ------------

Cash flows from financing activities:
    Repayment of notes payable                                                 (16)               (20)               (17)
    Repurchase of common stock                                                  --                (48)            (1,977)
    Proceeds from issuance of common stock                                     410                268                 38
                                                                      ------------       ------------       ------------
             Net cash provided by (used in) financing activities               394                200             (1,956)
                                                                      ------------       ------------       ------------

Net increase (decrease) in cash and cash equivalents                           985              1,154             (1,108)

Cash and cash equivalents, beginning of period                               4,614              3,460              4,568
                                                                      ------------       ------------       ------------

Cash and cash equivalents, end of period                              $      5,599       $      4,614       $      3,460
                                                                      ============       ============       ============

Supplemental information:
    Cash paid during the period for:
      Interest                                                        $          5       $          9       $         10
</TABLE>


                                      F-6

   The accompanying notes are an integral part of these financial statements.

<PAGE>

<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

Throughout  these notes to the  financial  statements,  all  referenced  amounts
reflect the balances and amounts on a restated basis with respect to fiscal 2003
and 2002.

1.    Business and Organization of the Company

      Castelle  develops,  manufactures,  markets and supports office automation
      systems that allow  organizations  to easily  implement  faxing over local
      area networks and the Internet.  Castelle's  FaxPress and FaxPress Premier
      fax servers  provide simple ways to integrate fax with email,  desktop and
      back-end applications.

      The Company distributes its products primarily through a two-tier domestic
      and  international  distribution  network,  with its distributors  selling
      Castelle's   products  to  value-added   resellers,   system  integrators,
      e-commerce retailers and other resellers in the United States,  Europe and
      the Pacific Rim. The Company also has relationships with selected original
      equipment  manufacturers  and sells  software  enhancements  and  upgrades
      directly to end-users.

      The Company  believes that its existing cash balances and anticipated cash
      flows from operations  will be sufficient to meet its anticipated  capital
      requirements  for the  next  12  months.  If the  Company  has a need  for
      additional capital resources, it may be required to sell additional equity
      or debt  securities,  secure  additional  lines of credit or obtain  other
      third-party financing.  The timing and amount of such capital requirements
      cannot be  determined at this time and will depend on a number of factors,
      including demand for the Company's existing and new products,  if any, and
      changes  in  technology  in  the  networking  industry.  There  can  be no
      assurance that such additional financing will be available on satisfactory
      terms when needed, if at all. Failure to raise such additional  financing,
      if  needed,  may  result in the  Company  not being  able to  achieve  its
      long-term business objectives

      In  addition,  because  the  Company  is  dependent  on a small  number of
      distributors for a significant  portion of the sales of its products,  the
      loss of any of the  Company's  major  distributors  or their  inability to
      satisfy their payment  obligations to the Company could have a significant
      adverse effect on the Company's business,  operating results and financial
      condition. The Company's three largest distributors accounted for 51%, 57%
      and 56% of the  Company's  sales in 2004,  2003  and  2002,  respectively.
      Customers  accounting for more than 10% of net sales are presented in Note
      9, Major Customers and Geographic Information

2.    Summary of Significant Accounting Policies

      Use of estimates in preparation of financial statements

      The  preparation  of financial  statements in conformity  with  accounting
      principles  generally accepted in the United States 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 financial statements, and the reported amounts of revenues and
      expenses  during the reporting  period.  Actual  results could differ from
      those estimates.


                                      F-7
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      Principles of consolidation

      The consolidated financial statements include the accounts of Castelle and
      its wholly owned subsidiaries in the United States and the United Kingdom.
      All intercompany balances and transactions have been eliminated.

      Financial instruments

      Cash  equivalents  consist of highly liquid  investments  with original or
      remaining maturities of three months or less when purchased.

      Carrying  amounts of  financial  instruments  consisting  of cash and cash
      equivalents, accounts receivable, accounts payable and accrued liabilities
      included in the Company's financial statements  approximate fair value due
      to their short maturities.

      Concentrations of credit risk

      Financial   instruments   that   potentially   subject   the   Company  to
      concentrations of credit risk consist principally of trade receivables and
      cash equivalents.  With respect to trade receivables, the Company performs
      ongoing  credit  evaluations  of  its  customers'   financial   condition.
      Additionally,  the Company  establishes an allowance for doubtful accounts
      based upon  factors  surrounding  the credit risk of  specific  customers,
      historical  trends  and  other  available  information.   Three  customers
      accounted  for 60%,  69% and 68% of accounts  receivable  at December  31,
      2004, 2003 and 2002, respectively.  The same three customers accounted for
      51%,  57% and 56% of the  Company's  total  sales in 2004,  2003 and 2002,
      respectively. Although the Company does not require collateral on accounts
      receivable  arising from sales to large,  well-established  companies,  it
      does  require   prepayments  on  certain  sales  to  foreign  and  smaller
      companies.

      With respect to cash equivalents, the Company has cash investment policies
      that limit the amount of credit  exposure  to any one issuer and  restrict
      placement of these investments to issuers evaluated as creditworthy.

      Inventories and related write-downs for excess and obsolete inventory

      Inventories  are stated at the lower of standard cost (which  approximates
      cost on a first-in,  first-out basis) or market. We record write downs for
      excess and obsolete  inventory equal to the difference between the cost of
      inventory and the estimated fair value based on  assumptions  about future
      product  life-cycles,  product  demand  and market  conditions.  If actual
      product  life  cycles,  product  demand  and  market  conditions  are less
      favorable  than  those  projected  by  management,   additional  inventory
      write-downs may be required. At the point of the loss recognition,  a new,
      lower-cost basis for that inventory is established, and subsequent changes
      in facts and circumstances do not result in the restoration or increase in
      that newly established cost basis.

      We have purchased  approximately two years worth of end-of-life components
      to  ensure a smooth  supply of our  FaxPress  Products  to our  customers.
      Accordingly,  our management  reviews  periodically the usage,  supply and
      inventory levels of these parts to determine whether additional  purchases
      or excessive inventory provisions are necessary.  As of December 31, 2004,
      we have approximately $675,000 worth of end-of-life components on hand and
      we believe that most of these components will be utilized in the following
      two years,  resulting in insignificant amounts of excessive inventory,  or
      none at all.


                                      F-8
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      Property and equipment

      Property and  equipment are stated at cost less  accumulated  depreciation
      and amortization.  Depreciation is provided using the straight-line method
      over the estimated useful lives of the respective assets,  generally three
      to seven years.  Amortization  of leasehold  improvements is provided on a
      straight-line  basis over the life of the related asset or the lease term,
      if shorter.  Gains and losses upon asset  disposal are  recognized  in the
      year of disposition.  Expenditures  for  replacements  and betterments are
      capitalized,  while  expenditures  for maintenance and repairs are charged
      against earnings as incurred.

      Accounting for long-lived assets

      The Company reviews  long-lived  assets for impairment  whenever events or
      changes in circumstances indicate that the carrying amount of an asset may
      not be  recoverable.  Recoverability  is  measured  by  comparison  of the
      carrying  amount to  undiscounted  future  net cash  flows the  assets are
      expected to generate.  If such assets are  considered to be impaired,  the
      impairment  to be  recognized  is  measured  by the  amount  by which  the
      carrying amount of the asset exceeds its fair market value.

      Revenue recognition

      We recognize revenue based on the provisions of Staff Accounting  Bulletin
      No. 104 "Revenue  Recognition," AICPA Statement of Position No. 97-2 ("SOP
      97-2")   "Software   Revenue   Recognition,"   as  amended  by  SOP  98-9,
      "Modification of SOP 97-2,  Software  Revenue  Recognition with Respect to
      Certain  Transactions,"  and Statement of Financial  Accounting  Standards
      ("SFAS") No. 48 "Revenue Recognition When Right of Return Exits."

      The  Company  uses  the  residual  method  to  recognize  revenue  when an
      agreement  includes one or more elements to be delivered at a future date.
      If there is an  undelivered  element  under the  arrangement,  the Company
      defers  revenue based on  vendor-specific  objective  evidence of the fair
      value of the undelivered  element, as determined by the price charged when
      the element is sold separately.  If vendor-specific  objective evidence of
      fair value does not exist for all undelivered elements, the Company defers
      all revenue  until  sufficient  evidence  exists or all elements have been
      delivered.

      Product revenue is recognized when all of the following  criteria are met:
      persuasive evidence of an arrangement exists;  delivery has occurred;  the
      fee is fixed and determinable;  collection is probable; and returns can be
      reasonably estimated. If an acceptance period or other contingency exists,
      revenue is  recognized  upon  satisfaction  of the  contingency,  customer
      acceptance or  expiration of the  acceptance  period.  Shipment  generally
      occurs  and  title and risk of loss is  transferred  when the  product  is
      delivered to a common carrier.

      We enter into agreements with some of our distributors that permit limited
      stock rotation  rights.  These stock rotation rights allow the distributor
      to return  products  for credit but  require the  purchase  of  additional
      products of equal value.  Customers who purchase products directly from us
      also have  limited  return  rights,  which  expire  30 days  from  product
      shipment.  Revenues  subject to stock  rotation or other return rights are
      reduced by our estimates of anticipated exchanges and returns.

      Pursuant  to  our  agreements  with  distributors,  we  also  protect  our
      distributors'  exposure related to the impact of price reductions.  Future
      price  adjustments  are  estimated  and  accrued  at the time of sale as a
      reduction in revenue.


                                      F-9
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      We  generally  provide our  distributors  the  opportunity  to earn volume
      incentive  rebates  based on  sales  volume  achieved  during  the  fiscal
      quarter.  These incentive  rebates are accrued in the quarter incurred and
      recorded as a reduction in revenue.

      We also provide co-op and market  development  funds to our  distributors.
      These  incentives  are  accrued  at the time  revenue  is  recognized  and
      recorded as a reduction in revenue.

      We offer a standard  trade-in  discount to all of our  end-user  customers
      under  which the  customer,  upon  trade-in  of any  previously  purchased
      product,  is entitled to a discount from our  published  price list on any
      product  included  in  our  current  product  offerings.  We  require  our
      customers  to  physically  return the  previously  purchased  products  to
      qualify for the trade-in discount. We account for the trade-in discount as
      a  reduction  of  revenue  at the time the  product is traded in and a new
      product is purchased.

      Payment terms to our distributors and customers are generally thirty days,
      cash in advance, or by credit card.

      We evaluate  product  sales  through  our  distribution  channels  and the
      related reserve requirement to establish an estimate for our sales returns
      reserve by reviewing detailed point-of-sales and on-hand inventory reports
      provided  to us  by  our  channel  partners.  Based  on a  combination  of
      historical return  experience,  the sales activities to end-user customers
      by our  channel  partners  and the  level  of  inventories  on hand at the
      channel  partners,  we  determine  our returns  reserve at the end of each
      financial period, and increase or reduce the reserve balance accordingly.

      We provide  standard  support to our  customers  for an initial  period of
      sixty days,  which  includes  advance swap of the  defective  hardware and
      software,  bug fixes, software upgrades and technical support. In addition
      to standard  support,  we also offer our  customers the option to purchase
      extended  support at the time of product  purchase or anytime  thereafter.
      Extended support covers hardware and software for a period of one year. We
      have established  vendor-specific  objective  evidence with respect to the
      fair value of the standard support contracts based on standalone sales and
      renewals of our one-year extended support contracts. The fair value of our
      sixty day support  contracts  included with product sales is determined by
      pro-rating the related one-year extended support  contracts.  We recognize
      revenue from  extended  support  contracts  ratably over the period of the
      contract.

      Hardware is  warranted  for one year from the date of sale and is repaired
      free-of-charge.  Provisions  for estimated  warranty costs are recorded at
      the time  products  are  shipped  as a charge to cost of  sales.  While we
      engage in extensive  product quality programs and processes,  our warranty
      obligation  is  affected  by product  failure  rates,  material  usage and
      service  delivery costs incurred in correcting a product  failure.  Should
      product failure rates, material usage or service delivery cost differ from
      our  estimates,  revision to the  estimated  warranty  liability  would be
      required, which could affect the amount of gross profit reported.

      We do  not  sell  software,  which  is  incorporated  into  our  hardware,
      separately,  other than for our  customers  to  purchase  as an upgrade to
      their existing products when we announce a major release of the software.

      Shipping and handling

      Costs  related to shipping  and handling are included in cost of sales for
      all periods presented.


                                      F-10
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      Advertising costs

      Advertising costs, included in sales and marketing expenses,  are expensed
      as incurred and were  $219,000,  $345,000  and $193,000 in 2004,  2003 and
      2002, respectively.

      Research and development expenses

      Costs related to the  conceptual  formulation  and design of both hardware
      and software products are expensed as research and development while costs
      incurred subsequent to establishing  technological feasibility of software
      products are capitalized until general release of the product.  Generally,
      technological  feasibility  is  established  upon  completion of a working
      model. No significant  costs  subsequent to such point have been incurred,
      and all such costs have been expensed.

      Income taxes

      The Company  accounts for income taxes in  accordance  with the  liability
      method.  Under the liability  method,  deferred assets and liabilities are
      recognized based upon anticipated future tax consequences  attributable to
      differences  between  financial  statement  carrying amounts of assets and
      liabilities and their respective tax bases. The provision for income taxes
      is comprised of the current tax  liability  and the change in deferred tax
      assets and liabilities.  The Company  establishes a valuation allowance to
      the extent that all or some portion of the deferred tax assets more likely
      than not will not be recoverable against future taxable income.

      Foreign currency translation

      The functional  currency of the Company's  foreign  subsidiary is the U.S.
      dollar.  Accordingly,  all assets and liabilities are translated into U.S.
      dollars at the current  exchange rates as of the applicable  balance sheet
      date.  Revenues and expenses are translated at the average  exchange rates
      prevailing  during  the  period.  Cumulative  gains  and  losses  from the
      translation of the foreign  subsidiaries'  financial  statements  have not
      been material to date.  Foreign  exchange gains and losses  resulting from
      foreign  currency  transactions  were not  material  in any of the periods
      presented.

      Net income per share

      Basic net  income  per share is  computed  by  dividing  net income by the
      weighted  average  number of common  shares  outstanding  for that period.
      Diluted net income per share is  computed  giving  effect to all  dilutive
      potential common shares that were outstanding during the period.  Dilutive
      potential  shares  consist of  incremental  common  shares  issuable  upon
      exercise of stock options.

      Basic and  diluted  net income  per share are  calculated  as follows  (in
      thousands except per share amounts):


                                      F-11
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                              2004             2003             2002
                                                          -----------      -----------      -----------
      Basic:                                                                (Restated)       (Restated)
<S>                                                       <C>              <C>              <C>
         Weighted average shares                                3,616            3,254            4,539
                                                          ===========      ===========      ===========
         Net income                                       $     2,119      $     1,606      $       635
                                                          ===========      ===========      ===========
         Net income per share                             $      0.59      $      0.49      $      0.14
                                                          ===========      ===========      ===========

      Diluted:
         Weighted average shares                                3,616            3,254            4,539
         Common equivalent shares from stock options              801              932               47
                                                          -----------      -----------      -----------

         Shares used in per share calculation                   4,417            4,186            4,586
                                                          ===========      ===========      ===========

         Net income                                       $     2,119      $     1,606      $       635
                                                          ===========      ===========      ===========

         Net income per share                             $      0.48      $      0.38      $      0.14
                                                          ===========      ===========      ===========
</TABLE>

      The calculation of diluted shares outstanding  excludes 123,000,  120,000,
      and  1,153,000  shares of common  stock for the years ended  December  31,
      2004, 2003, and 2002 respectively, as their effect was antidilutive in the
      period.

      Stock-Based Compensation

      The Company  accounts  for its  stock-based  compensation  plans using the
      intrinsic value method  prescribed in Accounting  Principles Board Opinion
      No. 25, "Accounting for Stock Issued to Employees."  Compensation cost for
      stock  options,  if any, is  measured  by the excess of the quoted  market
      price of the  Company's  stock at the date of  grant  over the  amount  an
      employee  must pay to acquire  the stock.  SFAS No. 123,  "Accounting  for
      Stock-Based   Compensation,"   established   accounting   and   disclosure
      requirements using a fair-value based method of accounting for stock-based
      employee compensation plans.

      Had compensation  costs been determined  consistent with SFAS No. 123, the
      Company's  net income  would have been  changed to the  amounts  indicated
      below for the years  ended  December  31 (in  thousands,  except per share
      data):

<TABLE>
<CAPTION>
                                                                   2004              2003              2002
                                                               -----------       -----------       -----------
                                                                                  (Restated)        (Restated)
<S>                                                            <C>               <C>               <C>
             Net income - as reported                          $     2,119       $     1,606       $       635
             Fair value of stock-based compensation                   (520)             (433)             (176)
                                                               -----------       -----------       -----------
             Net income - pro forma                            $     1,599       $     1,173       $       459
                                                               ===========       ===========       ===========

             Net income per share - basic - as reported        $      0.59       $      0.49       $      0.14
             Net income per share - diluted - as reported      $      0.48       $      0.38       $      0.14
             Net income per share - basic - pro forma          $      0.44       $      0.36       $      0.10
             Net income per share - diluted - pro forma        $      0.36       $      0.28       $      0.10
</TABLE>


                                      F-12
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      The  Company  accounts  for  stock-based  compensation  arrangements  with
      non-employees  in  accordance  with  Emerging  Issues Task Force  ("EITF")
      Abstract No. 96-18,  Accounting for Equity  Instruments That Are Issued to
      Other Than Employees for Acquiring,  or in Conjunction with Selling, Goods
      or  Services.  Accordingly,  unvested  options held by  non-employees  are
      subject  to  revaluation  at each  balance  sheet  date  based on the then
      current fair market value.

      Comprehensive income

      Comprehensive  income is the change in equity from  transactions and other
      events and  circumstances  other than those resulting from  investments by
      owners and distributions to owners. There are no significant components of
      comprehensive income excluded from net income, and therefore,  no separate
      statement of comprehensive income has been presented.

      Segment information

      The Company  uses one  measurement  of  profitability  of its business for
      internal  purposes  and has  determined  that it operates in one  business
      segment:  server  appliances.  The Company's  sales by geographic area are
      included in Note 9.

      Recent accounting pronouncements

      In December  2003,  the FASB issued a revised FASB  interpretation  No. 46
      (FIN   46R),   "Consolidation   for   Variable   Interest   Entities,   an
      interpretation  of ARB No. 51" The FASB  published the revision to clarify
      and amend some of the original  provisions  of FIN 46, which was issued in
      January 2003,  and to exempt  certain  entities from its  requirements.  A
      variable  interest  Entity  refers to an entity  subject to  consolidation
      according  to the  provisions  of the  Interpretation.  FIN 46R applies to
      entities whose equity  investment at risk is  insufficient to finance that
      entity's activities without receiving  additional  subordinated  financial
      support provided by any parties,  including  equity holders,  or where the
      equity  investors (if any) do not have a controlling  financial  interest.
      FIN 46R provides  that if an entity is the primary  beneficiary  of a VIE,
      the assets,  liabilities,  and results of  operations of the VIE should be
      consolidated in the entity's financial  statements.  In addition,  FIN 46R
      requires that both the primary  beneficiary and all other enterprises with
      a significant  variable interest in a VIE provide additional  disclosures.
      The  provisions of FIN 46R were  effective  for the Company's  fiscal 2004
      first quarter.  The adoption of FIN 46R did not have a material  impact on
      the Company's financial position or results of operations.

      In March  2004,  the FASB  issued  EITF  Issue No.  03-1,  The  Meaning of
      Other-Than-Temporary   Impairment   and   Its   Application   to   Certain
      Investments,  which provides new guidance for assessing  impairment losses
      on debt and equity investments. Additionally, EITF Issue No. 03-1 includes
      new  disclosure  requirements  for  investments  that  are  deemed  to  be
      temporarily  impaired.  In September 2004, the FASB delayed the accounting
      provisions of EITF Issue No. 03-1;  however,  the disclosure  requirements
      remain effective. The Company does not expect the adoption of EITF 03-1 to
      have a material impact on our financial position or results of operations.

      In December 2004, the FASB issued SFAS No. 123R,  "Share-Based Payment," a
      revision of SFAS No. 123,  "Accounting for Stock-Based  Compensation"  and
      superseding   APB  Opinion  No.  25,   "Accounting  for  Stock  Issued  to
      Employees."  SFAS No. 123R  requires  the  Company to expense  grants made
      under the  Company's  stock option  program.  That cost will be recognized
      over the vesting  period of the grants.  SFAS No.  123R is  effective  for
      interim periods  beginning


                                      F-13
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      after June 15, 2005.. The Company is evaluating the  alternatives  allowed
      under the standard,  which the Company is required to adopt  effective for
      its third quarter of fiscal 2005.

      In  December  2004,  the  FASB  issued  Staff  Position  SFAS  No.  109-1,
      Application  of FASB  Statement No. 109,  Accounting for Income Taxes (FSP
      No.  109-1)  to the  Tax  Deduction  on  Qualified  Production  Activities
      Provided by the American  Jobs  Creation Act of 2004 which was signed into
      law by the President of the United  States on October 22, 2004.  Companies
      that qualify for the recent tax law's  deduction  for domestic  production
      activities  must account for it as a special  deduction under SFAS No. 109
      and reduce  their tax  expense in the period or periods  the  amounts  are
      deductible,  according  to FSP No.  109-1,  effective  for the  Company in
      fiscal year 2005.  The FASB's  guidance is not expected to have a material
      impact to the Company's financial results.

3.    Restatement of Previously Issued Financial Statements

      In March and April 2005, the Company  conducted a review of its accounting
      practices with respect to the historical classification of cost of service
      revenues,  procedures for  recognizing  revenue  associated  with extended
      support   contracts  and  procedures  for  establishing  the  accrual  for
      paid-time-off,  and determined that its historical financial statements as
      of and for the years ended  December 31, 2003 and 2002  contained  certain
      errors in the application of generally accepted  accounting  principles as
      described below:

      o     Classification of cost of service revenues

            The Company has concluded that its historical classification of cost
            of service revenues did not conform to generally accepted accounting
            principles.  Historically,  such costs were improperly included as a
            component  of  sales  and   marketing   expenses  on  the  Company's
            consolidated   statements  of  earnings;   however  under  generally
            accepted  accounting  principles,  such  costs  are  required  to be
            classified   as  cost  of   service   revenues.   Accordingly,   the
            accompanying consolidated statements of earnings for the years ended
            December 31, 2003 and 2002 reflect the  reclassification of $729,000
            and $711,000, respectively, out of sales and marketing and into cost
            of  service  revenues.   The  reclassifications  had  no  impact  on
            previously  reported sales,  net income,  earnings per share or cash
            flows   from   operations   for   the   respective   periods.    The
            misclassification,  however,  did  result  in  cost of  sales  being
            understated,   and  gross  profit  and  operating   expenses   being
            overstated by equal amounts.

      o     Revenue recognition related to extended support contracts

            The Company has determined  that service  revenues  attributable  to
            extended support contracts were overstated by approximately  $34,000
            and  $39,000  for the  years  ended  December  31,  2003  and  2002,
            respectively. These amounts should have been deferred and recognized
            as  service  revenues  in  subsequent  periods.   Accordingly,   the
            accompanying consolidated statements of earnings for the years ended
            December 31, 2003 and 2002 reflect reductions to previously reported
            service  revenues of $34,000 and  $39,000,  respectively.  The error
            that  led to these  revenue  overstatements  in 2003  and 2002  also
            affected  2001,  resulting  in revenue  being  understated  in 2001.
            Consequently,  opening retained  earnings as of January 1, 2002 have
            been  adjusted  to  reflect  the  impact of the error on 2001.  This
            adjustment  decreased  previously  reported  accumulated  deficit by
            $27,000 with a corresponding decrease to deferred revenue. The


                                      F-14
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

            accompanying  balance  sheets  reflect the  aggregate  impact of the
            restatement  adjustments  on  deferred  revenue  as of  the  periods
            presented.

      o     Accrual for paid-time off

            The Company has also determined  that its accrual for  paid-time-off
            was overstated as of December 31, 2003 and 2002. This error resulted
            in the overstatement of expenses by $7,000 and $15,000 for the years
            ended  December 31, 2003 and 2002,  respectively.  Accordingly,  the
            accompanying consolidated statements of earnings for the years ended
            December 31, 2003 and 2002 reflect reductions to previously reported
            operating  expenses  of  $7,000  and  $15,000,   respectively.   The
            accompanying  balance  sheets  reflect the  aggregate  impact of the
            restatement  adjustments  on accrued  liabilities  as of the periods
            presented.

      The following  tables set forth the  previously  reported  amounts and the
      restated amounts reflected in the accompanying financial statements:


                                      F-15
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                          Castelle
                                                          Reconciliation of Statements of Earnings
                                                        (amounts in thousands, except per share data)
                                  Year-ended                     Year-ended       Year-ended                     Year-ended
                                  ----------                     ----------       ----------                     ----------
                                  December 31,                                   December 31,
                                      2003                       December 31,        2002                       December 31,
                                 as previously                       2003       as previously                       2002
                                    reported      adjustments    as restated       reported      adjustments    as restated
                                 -------------    -----------    ------------   -------------    -----------    ------------
<S>                                 <C>              <C>          <C>              <C>             <C>            <C>
Sales:
    Products                        $  8,337             --       $  8,337         $  8,617              --       $  8,617
    Services                           1,877            (34)         1,843            1,142             (39)         1,103
                                    --------       --------       --------         --------        --------       --------
      Net sales                       10,214            (34)        10,180            9,759             (39)         9,720

Cost of sales:
    Products                           2,485             --          2,485            2,836              (3)         2,833
    Services                              --            726            726               --             707            707
                                    --------       --------       --------         --------        --------       --------
      Total cost of sales              2,485            726          3,211            2,836             704          3,540
                                    --------       --------       --------         --------        --------       --------
     Gross Profit                      7,729           (760)         6,969            6,923            (743)         6,180
                                    --------       --------       --------         --------        --------       --------
Operating expenses:
   Research and development            1,590             --          1,590            1,383              (4)         1,379
   Sales and marketing                 3,131           (733)         2,398            3,016            (715)         2,301
   General and administrative          1,902             --          1,902            1,943              --          1,943
   Restructuring charges                  --             --             --              (40)             --            (40)
                                    --------       --------       --------         --------        --------       --------
     Total operating expenses          6,623           (733)         5,890            6,302            (719)         5,583
                                    --------       --------       --------         --------        --------       --------
     Operating income                  1,106            (27)         1,079              621             (24)           597
                                    --------       --------       --------         --------        --------       --------

   Other income (expense), net           (10)            --            (10)              44              --             44
                                    --------       --------       --------         --------        --------       --------

Income before provision for
(benefit from) income taxes            1,096            (27)         1,069              665             (24)           641

   Provision for (benefit
   from) income taxes                   (537)            --           (537)               6              --              6
                                    --------       --------       --------         --------        --------       --------

     Net income                     $  1,633            (27)      $  1,606         $    659             (24)      $    635
                                    ========       ========       ========         ========        ========       ========
Net income per common
share:
     Basic                          $   0.50         ($0.01)      $   0.49         $   0.15          ($0.01)      $   0.14
                                    ========       ========       ========         ========        ========       ========
     Diluted                        $   0.39         ($0.01)      $   0.38         $   0.14        $   0.00       $   0.14
                                    ========       ========       ========         ========        ========       ========
</TABLE>


                                      F-16
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                          Castelle
                                                    Summary of Adjustments to Consolidated Balance Sheets
                                                                   (amounts in thousands)
                                     December 31,                                     December 31,
                                         2003                       December 31,         2002                        December 31,
                                    as previously   Restatement         2003         as previously   Restatement         2002
                                       reported     adjustments     as restated        reported      adjustments     as restated
                                    -------------   -----------     -----------      -------------   -----------    -------------
<S>                                   <C>                  <C>        <C>              <C>                  <C>        <C>
Balance sheet accounts:
Current liabilities:
     Accrued liabilities              $  1,759             ($22)      $  1,737         $  1,696             (15)       $  1,681
     Deferred revenue                      909               46            955              592              12             604
     Total current liabilities           2,998               24          3,022            2,668              (3)          2,665
Total liabilities                        3,027               24          3,051            2,712              (3)          2,709
                                      --------         --------       --------         --------        --------        --------
Accumulated deficit                    (22,482)             (24)       (22,506)         (24,115)              3         (24,112)
     Total shareholders' equity          4,776              (24)      $  4,752         $  2,923               3        $  2,926
Total liabilities and
shareholders' equity                  $  7,803               --       $  7,803         $  5,635              --        $  5,635
                                      ========         ========       ========         ========        ========        ========
</TABLE>

4.    Balance Sheet Detail (in thousands)

      Accounts Receivable, net:

                                                            December 31,
                                                    ---------------------------
                                                        2004           2003
                                                    -----------     -----------

         Accounts receivable                        $     1,295     $     1,354
         Less: allowance for sales returns                 (408)           (442)
         Less: allowance for doubtful accounts              (30)            (39)
                                                    -----------     -----------

            Total accounts receivable, net          $       857     $       873
                                                    ===========     ===========

      Inventories:

                                                            December 31,
                                                    ---------------------------
                                                        2004           2003
                                                    -----------     -----------

         Raw materials                              $     1,202     $       610
         Work in process                                    118              --
         Finished goods                                     465             567
                                                    -----------     -----------

            Total inventories                       $     1,785     $     1,177
                                                    ===========     ===========


                                      F-17
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      Property and equipment:

<TABLE>
<CAPTION>
                                                                       December 31,
                                                                ---------------------------
                                                                   2004             2003
                                                                ----------       ----------
<S>                                                             <C>              <C>
            Production, test and demonstration equipment        $      422       $      420
            Computer equipment                                       1,151            1,175
            Office equipment                                           105              100
            Leasehold improvements                                     446              442
                                                                ----------       ----------
                                                                     2,124            2,137
            Less accumulated depreciation and amortization          (1,921)          (1,761)
                                                                ----------       ----------

               Total property and equipment                     $      203       $      376
                                                                ==========       ==========
</TABLE>

            The  Company  recorded  depreciation  and  amortization  related  to
            property and  equipment of $206,000,  $213,000 and $206,000 in 2004,
            2003 and 2002, respectively.

            As of  December  31,  2004 and 2003,  the  Company  had  $75,000 and
            $100,000,   respectively,   of  equipment   under  capital   leases.
            Accumulated  amortization  associated  with these capital leases was
            $61,000 and $65,000 at December 31, 2004 and 2003, respectively.

      Accrued liabilities:

<TABLE>
<CAPTION>
                                                                       December 31,
                                                                ---------------------------
                                                                   2004             2003
                                                                ----------       ----------
<S>                                                             <C>              <C>
                                                                                 (Restated)
            Accrued compensation                                $      429       $      462
            Accrued sales and marketing                                123              378
            Accrued professional fees                                   73              136
            Other accruals                                             448              761
                                                                ----------       ----------

               Total accrued liabilities                        $    1,073       $    1,737
                                                                ==========       ==========
</TABLE>


                                      F-18
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

5.    Commitments and Contingencies

      Lease Commitments

      The Company has entered into a noncancelable  operating lease that expires
      in 2009 and other  capital  leases that expire at various  dates ending in
      2006,  and  is  responsible  for  certain  maintenance  costs,  taxes  and
      insurance  under  the  leases.  The  lease on the  Company's  headquarters
      facility was extended for a term of five years  commencing on June 1, 2004
      and  expiring on May 31, 2009,  with one  conditional  three-year  renewal
      option,  which if  exercised,  would  extend  the  lease  to May 31,  2012
      commencing with rent at ninety-five  percent of fair market value.  Future
      minimum payments under  noncancelable  operating leases are as follows (in
      thousands):

         Year Ending December 31,
              2005                                              $     207
              2006                                                    207
              2007                                                    207
              2008                                                    207
              2009                                                     87
                                                                ---------
                                                                $     915
                                                                =========

      Rent expense,  including  the facility  lease and  equipment  rental,  was
      $162,000 $288,000, and $298,000, for 2004, 2003 and 2002, respectively.

      The Company leases certain of its equipment  under various  capital leases
      that expire at various dates through 2006. The lease agreements frequently
      include renewal and escalation clauses and purchase provisions and require
      the Company to pay taxes,  insurance and maintenance costs. As of December
      31, 2004, the Company had a loan and security agreement of $32,000,  which
      is subject to an interest rate of 12.8%.  As of December 31, 2004,  future
      minimum lease payments are as follows (in thousands):

         Year Ending December 31,
              2005                                                     18
              2006                                                     14
                                                                ---------
            Total minimum lease payments                               32
         Less amount representing interest                             (3)
                                                                ---------
            Present value of capital lease obligations                 29
         Less current portion                                         (15)
                                                                ---------
            Long-term portion of capital lease obligations      $      14
                                                                =========

      Product Warranties and Guarantor Arrangements

      We offer  warranties  on certain  products and record a liability  for the
      estimated  future costs  associated with warranty  claims,  which is based
      upon historical  experience and our estimate of the level of future costs.
      Warranty  costs are  reflected  in the  Statement of Earnings as a Cost of
      Sales. If actual warranty costs are different from our estimated costs, or
      if the warranty claims were to be significantly higher than our historical
      experience,  then  revisions to the  estimated  warranty  liability may be
      required and the warranty  expense  could  change from current  levels.  A


                                      F-19
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      reconciliation of the changes in our warranty liability during the periods
      presented is as follows (in thousands):

<TABLE>
<CAPTION>
                                                             December 31,      December 31,
                                                                 2004              2003
<S>                                                          <C>               <C>
         Warranty accrual at the beginning of the year       $        24       $        34
         Accruals for warranties issued during the year                2                15
         Settlements made in kind during the year                    (13)              (25)
                                                             -----------------------------
         Warranty accrual at the end of the year             $        13       $        24
                                                             =============================
</TABLE>

      As permitted under California law, the Company has agreements  whereby the
      Company  indemnifies  its officers  and  directors  for certain  events or
      occurrences  while the  officer  or  director  is, or was,  serving at the
      Company's request in such capacity. The term of the indemnification period
      is for the officer's or director's lifetime.  The maximum potential amount
      of future  payments  the  Company  could be  required  to make under these
      indemnification  agreements  is  unlimited;  however,  the  Company  has a
      director and officer  insurance policy that limits the Company's  exposure
      and enables the Company to recover a portion of any future  amounts  paid.
      As a result  of the  Company's  insurance  policy  coverage,  the  Company
      believes the estimated fair value of these  indemnification  agreements is
      minimal.

      The  Company  enters  into  standard  indemnification  agreements  in  the
      ordinary  course of business.  Pursuant to these  agreements,  the Company
      indemnifies, holds harmless, and agrees to reimburse the indemnified party
      for losses  suffered or incurred by the indemnified  party,  generally the
      Company's  business  partners or customers,  in  connection  with any U.S.
      patent, or any copyright or other intellectual property infringement claim
      by any third party with  respect to the  Company's  products.  The term of
      these   indemnification   agreements  is  generally   perpetual  following
      execution  of the  agreement.  The  maximum  potential  amount  of  future
      payments the Company could be required to make under these indemnification
      agreements is unlimited;  however, the Company has never incurred costs to
      defend  lawsuits  or  settle  claims  related  to  these   indemnification
      agreements.

6.    Bank Borrowings

      On August 2, 2004,  we secured  from Silicon  Valley Bank a new  revolving
      line of credit to replace the previous credit facility.  The new revolving
      line of credit  provides  for  borrowings  of up to $4.0 million and has a
      one-year  term.  Borrowings  under  this  line  of  credit  agreement  are
      collateralized  by all of our assets and bear interest at the bank's prime
      rate plus  0.50%.  Under the new  facility  we are  required  to  maintain
      certain  minimum  cash  and  investment  balances  with  the bank and meet
      certain other  financial  covenants.  As of December 31, 2004, we have not
      drawn down on the line of credit and were in compliance  with the terms of
      the agreement.

7.    Common Stock

      Stock Repurchase Program

      In the fourth quarter of 2002, the Company's Board of Directors authorized
      the Company,  from time to time,  to repurchase  at market  prices,  up to
      $2.25  million of its common stock for cash in open market,  negotiated or
      block transactions.  The timing of such transactions will depend on market
      conditions,  other  corporate  strategies and will be at the discretion of
      the management of


                                      F-20
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      the Company.  No time limit was set for the completion of this program. At
      the time of the  approval  by the  Board of  Directors,  the  Company  had
      approximately 4.8 million shares of common stock  outstanding.  During the
      fourth  quarter of 2002,  the  Company  repurchased  from open  market and
      negotiated  transactions a total of approximately  1.62 million shares for
      approximately $1.8 million, at an average per share price of $1.10. During
      the first  quarter  of 2003,  the  Company  repurchased  from open  market
      transactions a total of 46,500 shares for $48,000, at an average per share
      price of $1.04.  The Company has not  repurchased  any of its common stock
      since then. The Company intends to continue to execute its buyback program
      as it deems necessary.

      2002 Equity Incentive Plan

      In December 2002, the shareholders of the Company approved the adoption of
      the 2002 Equity Incentive Plan ("2002 Plan"). A total of 850,000 shares of
      common stock have been reserved for issuance under the 2002 Plan. The 2002
      Plan  provides  for  awards  to  employees,  directors,   consultants  and
      independent  advisors.  The adoption of the 2002 Plan was  necessitated by
      the use or  expiration  of all but an  insignificant  amount of authorized
      shares under the prior option  plans,  (the 1995  Non-employee  Directors'
      Stock Option Plan  ("Directors  Plan") and the 1988  Incentive  Stock Plan
      ("1988  Plan")).  Under the 2002 Plan,  the Board of  Directors  may grant
      either the right to purchase  shares or options to purchase  shares of the
      Company's  common  stock at prices not less than the fair market  value at
      the date of grant for  incentive  stock options and 85% of the fair market
      value at the date of grant for non-qualified  options and purchase rights.
      Options  granted  under the 2002 Plan as well as those  granted  under the
      prior option plans generally become  exercisable,  and the Company's right
      to repurchase  shares issued and sold  pursuant to stock  purchase  rights
      generally  lapses,  at a rate of one-quarter of the shares under option or
      purchased  under  stock  purchase  rights at the end of the first year and
      thereafter  ratably over the next three years.  Awards under the 2002 Plan
      and the prior option plans  generally  expire seven years from the date of
      grant.  No  additional  option  grants will be made under any prior option
      plan. As of December 31, 2004, 400,205 options have been granted under the
      2002 Plan, while 903,000 options are outstanding under the prior plans.

      The following table  summarizes  option activity under the Company's stock
      option plans (in thousands):


                                      F-21
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                      Outstanding Options
                                                                             Weighted
                                                                              Average
                                           Available         Number          Exercise
                                           for Grant      Outstanding          Price
                                          ----------      -----------       ----------
<S>                                              <C>            <C>         <C>
         Balances, January 1, 2002               275            1,404       $     1.08
         Options granted                        (405)             405       $     0.71
         Options cancelled                       151             (175)      $     1.08
         Options expired                         (21)              --
         Options exercised                        --              (61)      $     0.63
                                          ----------       ----------       ----------

         Balances, December 31, 2002              --            1,573       $     1.00
         Additional shares reserved              850               --
         Options granted                        (305)             305       $     2.94
         Options cancelled                         1               (3)      $     2.05
         Options exercised                        --             (285)      $     0.94
                                          ----------       ----------       ----------

         Balances, December 31, 2003             546            1,590       $     1.38
         Options granted                         (96)              96       $     3.45
         Options cancelled                        10              (19)      $     1.92
         Options exercised                        --             (374)      $     1.10
                                          ----------       ----------       ----------

         Balances, December 31, 2004             460            1,293       $     1.61
                                          ==========       ==========       ==========
</TABLE>

      At December 31, 2004,  2003 and 2002,  993,000,  1,078,000,  and 1,087,000
      options,  respectively,  were  exercisable at a weighted  average exercise
      price of $1.34, $1.15 and, $1.10, respectively.


                                      F-22
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      Options to purchase common stock outstanding and currently  exercisable by
      exercise price at December 31, 2004, are as follows (in thousands,  except
      years and per share data):

<TABLE>
<CAPTION>
                         Options Outstanding                          Options Exercisable
      ----------------------------------------------------------   ------------------------
                                         Weighted
                                          Average       Weighted                    Weighted
       Range of                          Remaining       Average                    Average
       Exercise          Number         Contractual     Exercise       Number       Exercise
        Prices         Outstanding         Life           Price     Exercisable      Price
      -----------      -----------      -----------    ----------   -----------    ---------
<S>                      <C>                <C>           <C>           <C>          <C>
      $0.00-$0.50           10              4.3           $0.34          10          $0.34
      $0.51-$0.75          226              4.1           $0.70         164          $0.70
      $0.76-$1.00          436              3.2           $0.91         425          $0.91
      $1.01-$1.25           88              3.6           $1.12          88          $1.12
      $1.26-$1.50           67              2.0           $1.33          66          $1.33
      $1.51-$1.75           40              0.7           $1.60          40          $1.61
      $1.76-$2.00           30              5.2           $1.94          30          $1.94
      $2.00-$2.50           37              4.9           $2.38          20          $2.38
      $2.51-$3.00          172              5.8           $2.77         100          $2.78
      $3.01-$5.00          187              6.4           $3.45          50          $3.86
                       -------                                      -------
                         1,293              4.2           $1.61         993          $1.34
                       =======                                      =======
</TABLE>

      The fair  value of each  option  grant is  estimated  on the date of grant
      using the  Black-Scholes  model with the following  assumptions  for 2004,
      2003 and 2002:

<TABLE>
<CAPTION>
                                                2004                2003               2002
                                            -----------          -----------       -----------
<S>                                          <C>                 <C>                <C>
      Risk-free interest rate               3.68%-4.73%          3.32%-4.48%       3.86%-5.43%
      Expected life                          4.7 years           4.1 years          6.9 years
      Expected dividends                         -                   -                  -
      Volatility                                192%                201%               146%
</TABLE>

      The weighted  average fair value of options granted in 2004, 2003 and 2002
      was $3.45, $2.95, and $0.71 per share, respectively.

      Option Grants to Non-employees

      In  addition  to the  options  granted  under  the plans  detailed  above,
      Castelle has granted options to purchase common stock to consultants under
      special arrangements.

      There were no grants to  non-employees  in 2002, 2003, or 2004. Under EITF
      96-18,  the unvested  options are  revalued at each balance  sheet date to
      reflect  their  current fair value.  Compensation  expense is reflected in
      results of operations  over the vesting  period.  In  connection  with its
      grant of options to non-employees,  the Company recorded charges of $1,000
      in 2002 and nothing in 2003 or 2004.

      Options to purchase 27,000, 27,000, and 33,000 shares of common stock were
      held by non-employees  at December 31, 2004, 2003 and 2002,  respectively,
      of which 27,000,  27,000,  and


                                      F-23
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      33,000 were exercisable for aggregate total exercise  proceeds of $44,000,
      $44,000, and $50,000, respectively.

8.    Income Taxes

      The  provision  (benefit)  for  income  taxes is as  follows  (amounts  in
      thousands).

<TABLE>
<CAPTION>
                                                                      Year Ended December 31,
                                                            2004               2003              2002
                                                         -----------       -----------       -----------
<S>                                                      <C>               <C>               <C>
         Current
            Federal                                      $       (70)      $         5                --
            State                                                  1                 1                 6
                                                         -----------       -----------       -----------
            Total Current                                $       (69)      $         6       $         6
         Deferred
            Federal                                      $      (849)      $      (464)               --
            State                                               (149)              (79)               --
                                                         -----------       -----------       -----------
            Total Deferred                               $      (998)      $      (543)               --

                                                         -----------       -----------       -----------
         Total provision (benefit) for income taxes      $    (1,067)      $      (537)      $         6
                                                         ===========       ===========       ===========
</TABLE>

      The Company's tax provision  (benefit) differs from the provision computed
      using statutory income tax rates as follows (in thousands):

<TABLE>
<CAPTION>
                                                               2004              2003              2002
                                                           -----------       -----------       -----------
<S>                                                        <C>               <C>               <C>
         Federal tax provision at statutory rate           $       353       $       386       $       248
         Permanent difference due to
            non-deductible expenses                                 10                12                 7
         State tax provision, net of federal benefit                39                 1                 6
         Utilization of net operating loss carryovers              (33)             (187)             (122)
         Change in valuation allowance                          (1,436)             (689)              (65)
         General business credits                                   --               (60)              (68)
                                                           -----------       -----------       -----------
                                                           $    (1,067)      $      (537)      $         6
                                                           ===========       ===========       ===========
</TABLE>


                                      F-24
<PAGE>

Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

      The  components  of  the  net  deferred  tax  assets  are as  follows  (in
      thousands):

                                                             December 31,
                                                      ------------------------
                                                         2004          2003
                                                      ----------    ----------

            Inventory allowances and adjustments      $       72    $       77
            Accounts receivable allowances                    12            16
            Other liabilities and allowances                 369           526
            Net operating loss carryforwards               4,538         4,584
            Tax credit carryforwards                       1,633         1,615
            Depreciation and amortization                    478           396
            Valuation allowance                           (5,579)       (6,688)
                                                      ----------    ----------

               Total net deferred tax assets          $    1,523    $      526
                                                      ==========    ==========

      Significant  management  judgment is required in determining the provision
      for income taxes,  and in  particular,  any valuation  allowance  recorded
      against  the  Company's  deferred  tax assets.  During 2004 and 2003,  the
      Company  recorded tax benefits of $1,067,000  and $537,000,  respectively.
      This portion of the valuation  allowance was reversed  because the Company
      determined  that it was  more  likely  than not that  certain  future  tax
      benefits will be realized as a result of projected future income.

      At December 31, 2004, the Company had net operating loss  carryforwards of
      approximately  $12,955,000  and  $2,296,000  available  to  offset  future
      federal  and  California   taxable   income,   respectively.   These  loss
      carryforwards  will expire in varying  amounts  beginning  in 2005 through
      2021.  In  addition,  at December  31,  2004,  the Company had federal and
      California Research and Development credit  carryforwards of approximately
      $1,152,000   and  $728,000,   respectively.   The  federal   Research  and
      Development  credits  expire in varying  amounts  beginning  in 2007.  The
      California Research and Development credits carry-forward indefinitely.

      For federal and state income tax purposes,  the amount of benefit from the
      Company's net operating loss and credit  carryforwards  may be impaired or
      limited if the Company incurs a cumulative  ownership  change of more than
      50%, as defined, over a three year period.

      The  Company's  profit  before  provision for income taxes for all periods
      presented was derived substantially from domestic operations.

9.    Retirement Plan

      The  Company  has a  voluntary  401(k)  plan  covering  substantially  all
      employees.  The plan provides for employer contributions at the discretion
      of the Board of  Directors.  In 2004,  2003 and 2002,  the Company made no
      contributions to the plan.

10.   Major Customers and Geographic Information

      Revenues by geographic area are determined by the location of the customer
      and are summarized as follows (in thousands):


                                      F-25
<PAGE>

<TABLE>
<CAPTION>
                                                                        Year Ended December 31,
                                                             ---------------------------------------------
                                                                 2004             2003             2002
                                                             -----------      -----------      -----------
                                                                               (Restated)       (Restated)
<S>                                                          <C>              <C>              <C>
              United States                                  $     8,574      $     8,222      $     7,660
              Europe                                                 785              704              826
              Pacific Rim                                            804              883              887
              Rest of Americas, excluding United States              294              371              347
                                                             -----------      -----------      -----------

                 Total revenues                              $    10,457      $    10,180      $     9,720
                                                             ===========      ===========      ===========
</TABLE>

      Customers  that  individually  accounted for greater than 10% of net sales
      are as follows (in thousands):

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                       --------------------------------------------------------------------------------
                                2004                       2003                        2002
           Customer      Amount      Percentage     Amount      Percentage       Amount     Percentage
           --------    ---------     ----------    --------      ----------     --------     ----------
<S>                    <C>               <C>       <C>               <C>        <C>              <C>
              A        $  2,186          21%       $  2,200          22%        $  2,657         27%
              B        $  2,451          23%       $  2,899          28%        $  2,257         23%
</TABLE>

11.   Restructuring

      In the second quarter of 2002, a non-recurring  benefit of $40,000 arising
      from the reversal of a portion of the  previously  recorded  restructuring
      charge was included in the results of operations, following the completion
      of the  Company's  2001  restructuring  program  for less than  previously
      anticipated.

12.   Litigation

      From time to time and in the ordinary  course of business,  the Company is
      involved in various legal proceedings and third party assertions of patent
      or  trademark  infringement  claims  against  the  Company  in the form of
      letters and other  forms of  communication.  The Company is not  currently
      involved in any litigation  which, in management's  opinion,  would have a
      material adverse effect on its business,  operating results, cash flows or
      financial  condition;  however,  there can be no  assurance  that any such
      proceeding will not escalate or otherwise become material to the Company's
      business in the future.


                                      F-26
<PAGE>

Castelle
Supplemental Financial Information
--------------------------------------------------------------------------------

Supplemental Data (unaudited)

The  information  set forth below is not  necessarily  indicative  of results of
future  operations,  and  should  be  read  in  conjunction  with  "Management's
Discussion and Analysis of Financial  Condition and Results of  Operations"  and
the  Consolidated  Financial  Statements  and  related  Notes  thereto  included
elsewhere in this Annual Report on Form 10-K.

      Quarterly Results of Operations (unaudited)

      The following table sets forth certain  consolidated  quarterly  financial
      data for the eight quarters ended December 31, 2004.  This  information is
      unaudited,  but in our opinion, has been prepared on the same basis as the
      audited  consolidated  financial  statements  appearing  elsewhere in this
      report, and all necessary adjustments, consisting only of normal recurring
      adjustments,  have been  included in the amounts  stated  below to present
      fairly the unaudited  interim  results.  The results of operations for any
      quarter are not  necessarily  indicative of the results of operations  for
      any future period.

      The  consolidated  quarterly  financial data presented  below reflects the
      restatement  of the  periods  through  September  30,  2004 to reflect the
      adjustment  for  certain  errors  noted by the  Company  during the fourth
      quarter of fiscal 2004. For a description of the restatement items and the
      effect on  annual  periods  for  fiscal  2003 and 2002,  see Note 3 to the
      Company's consolidated financial statements.

<TABLE>
<CAPTION>
                                                        Year 2004, Quarter Ended
                                              ------------------------------------------
                                              Mar 31      Jun 30      Sep 30      Dec 31
                                              ------      ------      ------      ------
                                                  (in thousands, except per share data)
                                           (Restated)  (Restated)   (Restated)
<S>                                           <C>         <C>         <C>         <C>
       Net sales (1)                          $2,539      $2,691      $2,685      $2,542
       Gross profit (2)                        1,702       1,883       1,804       1,686
       Operating income (3)                      228         272         236         330
       Net income (4)                            129         146         130       1,714(5)
       Net income per share, basic (4)          0.04        0.04        0.04        0.46(5)
       Net income per share, diluted (4)        0.03        0.03        0.03        0.39(5)
</TABLE>

      (1)   Net sales in the 2004 quarters ended March 31, June 30 and September
            30 have been restated to reduce service revenues by $19,000, $26,000
            and $13,000,  respectively,  as compared to previously  reported net
            sales in relation to the extended support contract adjustments.

      (2)   Gross profit and operating expenses for the quarters ended March 31,
            June 30 and  September  30,  2004 have been  restated to reduce such
            balances  by equal  amounts  of  $198,000,  $216,000  and  $207,000,
            respectively,  as  compared to  previously  reported  amounts,  as a
            result of the  reclassification  of cost of  service  revenues  from
            operating expenses to cost of sales.


                                      F-27
<PAGE>

Castelle
Supplemental Financial Information
--------------------------------------------------------------------------------

      (3)   Operating  income  for the  quarters  ended  March 31,  June 30, and
            September  30, 2004 has been  increased by an  additional  $1,000 in
            each of the three  quarters,  as  compared  to  previously  reported
            amounts to correct the overstatement of the Company's  paid-time-off
            accrual.

      (4)   The  restatement  adjustments  referred to above reduced  previously
            reported net income by $18,000,  $25,000 and $12,000 in 2004 for the
            quarters  ended March 31, June 30 and  September  30,  respectively.
            Both basic and diluted net income per share as restated decreased by
            $0.01 for the  quarter  ended  June 30 as  compared  to the  amounts
            previously  reported.  Basic and  diluted  net  income  per share as
            restated did not change from the amounts previously reported in 2004
            for the quarters ended March 31 and September 30.

      (5)   Includes a non-cash tax benefit of $1.4 million,  or $0.37 per basic
            share, and $0.31 per diluted share,  resulting from the release of a
            portion of our tax valuation allowance.

<TABLE>
<CAPTION>
                                                              Year 2003, Quarter Ended
                                                 ----------------------------------------------
                                                 Mar 31       Jun 30      Sep 30         Dec 31
                                                 ------       ------      ------         ------
                                                    (in thousands, except per share data)
                                                (Restated)  (Restated) (Restated)      (Restated)
<S>                                               <C>         <C>         <C>            <C>
            Net sales(1)                          $2,495      $2,501      $2,561         $2,623
            Gross profit(2)                        1,626       1,752       1,814          1,777
            Operating income(3)                      252         232         238            357
            Net income(4)                            239         220         238            909(5)
            Net income per share, basic(4)          0.07        0.07        0.07           0.27(5)
            Net income per share, diluted(4)        0.06        0.05        0.05           0.21(5)
</TABLE>

      (1)   Net sales in the 2003 quarters ended March 31, June 30, September 30
            and  December  31 have been  restated to reflect  the  reduction  of
            service   revenues   by  $5,000,   $10,000,   $5,000  and   $14,000,
            respectively, as compared to previously reported amounts in relation
            to the extended support contract adjustments.

      (2)   Gross profit and operating expenses for the quarters ended March 31,
            June 30,  September 30 and  December 31, 2003 have been  restated to
            reduce  such  balances  by  equal  amounts  of  $172,000,  $177,000,
            $193,000  and  $187,000,  respectively,  as compared  to  previously
            reported  amounts,  as a result of the  reclassification  of cost of
            service revenues from operating expenses to cost of sales.

      (3)   Operating  income has been  increased by $1,000 in the quarter ended
            March 31, 2003 and $2,000 in each of the remaining quarters of 2003,
            as  compared  to  previously   reported  amounts,   to  correct  the
            overstatement of the Company's paid-time-off accrual.

      (4)   The  restatement  adjustments  referred to above reduced  previously
            reported  net income by $4,000,  $8,000,  $3,000 and $12,000 for the
            quarters  ended March 31, June 30,  September  30 and  December  31,
            respectively.  Basic net income per share as restated  decreased  by
            $0.01 for the  quarter  ended  March 31 and did not  change  for the
            quarters ended June 30,  September 30 or December 31, as compared to
            the  amounts  previously  reported.  Diluted net income per share as
            restated  decreased  by $0.01  for the  quarters  ended  June 30 and
            September 30 and did not change for the  quarters  ended March 31 or
            December 31, as compared to amounts previously reported.


                                      F-28
<PAGE>

Castelle
Supplemental Financial Information
--------------------------------------------------------------------------------

      (5)   Includes a non-cash  tax  benefit  of  $526,000,  or $0.16 per basic
            share, and $0.12 per diluted share,  resulting from the release of a
            portion of our tax valuation allowance.


                                      F-29
<PAGE>

Castelle                                                             Schedule II
Valuation and Qualifying Accounts
(in thousands)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                        Additions
                                                        Balance at      Charged to                        Balance at
                                                         Beginning       Costs and                          End of
                                                         of Period       Expenses        Deductions         Period
                                                        ----------      ----------       ----------       ----------
<S>                                                     <C>             <C>              <C>              <C>
Year Ended December 31, 2002:
Deducted from asset accounts:
    Allowance for doubtful accounts                     $       96      $      (21)      $       (5)      $       70
    Allowance for sales returns and stock rotation      $      630      $      660       $     (656)      $      634
    Valuation allowance for deferred tax asset          $    7,946      $       --       $     (257)      $    7,689

Year Ended December 31, 2003:
Deducted from asset accounts:
    Allowance for doubtful accounts                     $       70      $        5       $      (36)      $       39
    Allowance for sales returns and stock rotation      $      634      $      524       $     (716)      $      442
    Valuation allowance for deferred tax asset          $    7,689      $       --       $   (1,001)      $    6,688

Year Ended December 31, 2004:
Deducted from asset accounts:
    Allowance for doubtful accounts                     $       39      $       (1)      $       (8)      $       30
    Allowance for sales returns and stock rotation      $      442      $      886       $     (921)      $      407
    Valuation allowance for deferred tax asset          $    6,688      $       --       $   (1,109)      $    5,579
</TABLE>


                                      F-30
<PAGE>

Castelle
--------------------------------------------------------------------------------

 Exhibit
  Number      Description
---------     ------------------------------------------------------------------

  10.11       Summary of Severance Agreement with Named Executive Officers

  23.1        Consent of Independent Registered Public Accounting Firm - Grant
              Thornton LLP

  23.2        Consent of Independent Registered Public Accounting Firm -
              PricewaterhouseCoopers LLP

  31.1        Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
              2002 - Chief Executive Officer

  31.2        Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
              2002 - Chief Financial Officer

  32.1        Certification Pursuant to 8 U.S.C. Section 1350, as Adopted
              Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - Chief
              Executive Officer

  32.2        Certification Pursuant to 8 U.S.C. Section 1350, as Adopted
              Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - Chief
              Financial Officer


                                      F-31