<PAGE>   1

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

                                    FORM 10-K

(MARK ONE)
  [X]     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
          EXCHANGE ACT OF 1934

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

                                       OR

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

    FOR THE TRANSITION PERIOD FROM                     TO
                                   -------------------      ---------------

                         COMMISSION FILE NUMBER 0-22202

                           PAIRGAIN TECHNOLOGIES, INC.
             (Exact name of registrant as specified in its charter)

              DELAWARE                                       33-0282809
   (State or other jurisdiction of                         (IRS Employer
    incorporation or organization)                       Identification No.)

                 14402 FRANKLIN AVENUE, TUSTIN, CALIFORNIA 92780
               (Address of principal executive offices) (Zip Code)

       Registrant's telephone number, including area code: (714) 832-9922

--------------------------------------------------------------------------------

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:  NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

                         COMMON STOCK, $.0005 PAR VALUE
                                (Title of Class)

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

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

        Based on the closing sale price on The Nasdaq Stock Market(SM) on
January 30, 1998, the aggregated market value of the voting stock held by non
affiliates of the registrant was $1,021,948,000. The number of shares
outstanding of the registrant's Common Stock, $.0005 par value, was 69,361,762
on January 30, 1998.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the Registrant's Proxy Statement for the Annual Meeting of
Stockholders currently expected to be held on June 10, 1998, as filed with the
Commission pursuant to Regulation 14A, are incorporated by reference in Part III
of this Report.


<PAGE>   2

                  GLOSSARY OF TERMS USED IN THIS ANNUAL REPORT

10BASE-T--The Institute of Electrical and Electronic Engineers (IEEE) 802.3
specification for Ethernet over unshielded twisted pair cable.

2B1Q--2 binary, one quarternary. A one-dimensional modulation for transmitting 2
bits per symbol. 2B1Q is a 4-level PAM (pulse amplitude modulation) system used
for HDSL, S-HDSL, and ISDN BRI.

ACCESS PROVIDER--Organization providing and maintaining network services for
subscribers.

ASYMMETRIC DIGITAL SUBSCRIBER LINE (ADSL)--A method of transmitting at speeds of
approximately 8 Mbps in one direction over a single copper telephone line, and
at speeds of approximately 1 Mbps in the other direction.

ANSI T1.403--The performance-monitoring, data-link, and network-interface
requirements for ESF CSUs as defined by the Exchange Carriers Standards
Association. T1.403 specifies automatic performance reports transmitted to the
network once per second via the data link. (In an E1 environment, Performance
Monitor is the equivalent of T1.403).

ANSI T1.413--The interface standard for DMT ADSL.

ASYNCHRONOUS TRANSFER MODE (ATM)--A key emerging technology that uses
fixed-length packets or cells to switch voice, data and video traffic over the
local- and wide-area network.

B CHANNEL--In ISDN, a full duplex, 64 kbps channel for sending data.

BACKBONE NETWORK--The main artery or link for a private or public network.
Typically the backbone carries a greater quantity of traffic (data, voice, video
or some combination), is capable of carrying significant bandwidth and is the
network to which small/remote networks/links are attached.

BANDWIDTH--A term now used to describe the capacity or amount of traffic (data,
voice or video) a certain communications line is capable of accommodating.
Bandwidth is often measured or stated in kilobits per second (kbps) or Megabits
per second (Mbps) for data transmission.

BASIC ENCODING RATE (BER)--Rule for encoding data units described in ANS.1.

BASIC RATE INTERFACE (BRI)--Reference ISDN.

BIT ERROR RATE (BER)--The ratio of received bits that are in error.

BITS PER SECOND (BPS)--The number of bits passing a point every second. The
transmission rate for digital information.

BRIDGE/ROUTER--A device that can provide the functions of a bridge, router or
both concurrently. Bridge/router can route one or more protocols, such as TCP/IP
and/or XNS, and bridge all other traffic.

BROADBAND--Data transmission at a high rate, generally greater than T1 speeds
(1.5 Mbps). This allows the transmission of voice, data and video signals over a
single medium.

CABLE MODEM--Modem designed for use on TV coaxial cable circuit.

CAMPUS AREA NETWORK--A network which encompasses interconnectivity between
floors of a building and/or buildings in a confined geographic area such as a
campus or industrial park. Such networks would not require public rights-of-way
and operate over fairly short distances.

CAP--Carrierless Amplitude Phase Modulation. A two-dimensional line code used in
ADSL.

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                                GLOSSARY OF TERMS
                                    CONTINUED

CENTRAL OFFICE (CO)--A local telephone company office which connects to the main
system where circuit switching of customer lines occurs.

COMPETITIVE ACCESS PROVIDER (CAP)--Alternative access provider to
Inter-Exchange Carriers (IXCs).

CIRCUIT SWITCHING--Switching system in which a dedicated physical circuit path
must exist between sender and receiver for the duration of the "call". Used
heavily in the phone company network, circuit switching often is contrasted with
contention and token passing as a channel-access method, and with message
switching and packet switching as a switching technique.

CLEC--A Competitive Local Exchange Carrier. Provides competitive local access
services to the Local Exchange Carrier (LEC) or Incumbent LEC (ILEC).

CONCENTRATOR--Device that serves as a wiring hub in star-topology network.
Sometimes refers to a device containing multiple modules of network equipment.

COPPEROPTICS--A PairGain trademark referring to the functionality of the
Company's xDSL technology. In essence, with PairGain xDSL products, users can
achieve fiber optic-quality signal transmission over copper cable.

CROSSTALK--Interference that can occur when wire pairs within the same bundles
are used for separate signal transmission. Especially evident with repeatered
T1/E1 transmission.

CUSTOMER PREMISES EQUIPMENT (CPE)--Terminating equipment, such as terminals,
phones, routers and modems, supplied by the phone company, installed at customer
sites, and connected to the phone company network.

D CHANNEL--Full duplex 16 kbps (basic rate) or 64 kbps (primary rate) ISDN
channel.

DEDICATED LINE--A transmission circuit installed between two sites of a private
network and "open," or available, at all times.

DIGITAL SIGNAL 0 (DS-0)--(1) North American Digital Hierarchy signaling standard
for transmission at 64 kbps. (2) Digital Signal Level 0 is the worldwide
standard transmission rate (64 kbps) for PCM digitized voice channels. 24 DS-0s
exist in each DS-1 (T1) signal.

DIGITAL SIGNAL 1 (DS-1)--North American Digital Hierarchy signaling standard for
transmissions at 1.544 Mbps. Supports 24 simultaneous DS-0 signals. Term often
used interchangeably with T-1, although DS-1 signals may be exchanged over other
transmission systems.

DIGITAL SUBSCRIBER LINE (DSL)--Another name for an ISDN BRI channel. Operated at
the Basic Rate Interface (with two 64 kbps circuit switched channels and one 16
kbps packet switched channel), the DSL can carry both voice and data signal at
the same time, in both directions, as well as the signaling data used for call
information and customer data. Also used to represent other DSL-based solutions,
including HDSL and ADSL.

DIGITAL SIGNAL PROCESSING (DSP)--The processing of signal transmission using
digital techniques.

DMT--Discrete Multitone. In DMT, a large number of low-rate carrier frequencies
are QAM-modulated at a low rate to transmit a single high-rate data stream. DMT
is used for ADSL and proposed for VDSL.

ECHO CANCELLATION--Process by which a transmitter/ receiver cancels out the
transmitted signal as to "hear" the received signal better.

E1--The term for a digital facility used for transmitting data over a telephone
network at 2.048 Mbps. The European equivalent of T1.

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                                GLOSSARY OF TERMS
                                    CONTINUED

ENTERPRISE NETWORK--A large typical corporate network under the auspices of one
organization.

ETHERNET--A baseband LAN specification invented by Xerox Corporation and
developed jointly by Xerox, Intel and Digital Equipment Corporation. Ethernet
networks typically operate at 10 Mbps or 100 Mbps over twisted pair, coaxial or
fiber optic cable. Ethernet transmission standards are produced by IEEE and are
referred to as IEEE 802.3.

FIBER OPTICS--A method for the transmission of information (sound, pictures,
data). Light is modulated and transmitted over high purity, hair-thin fibers of
glass. The potential bandwidth capacity of fiber optic cable is much greater
than that of conventional cable or copper wire.

FIBER OPTIC CABLE--A transmission medium that uses glass or plastic fibers,
rather than copper wire, to transport data or voice signals. The signal is
imposed on the fiber via pulses (modulation) of light from a laser or a
light-emitting diode (LED). Because of its high bandwidth and lack of
susceptibility to interference, fiber-optic cable is used in long-haul or other
applications where electromagnetic noise is problematic.

FRACTIONAL T1--A WAN communications service that provides the user with some
portion of a T1 circuit which has been divided into 24 separate 64 kbps
channels.

FRAME RELAY--A streamlined packet switching protocol designed to provide
high-speed frame or packet switching with minimal delay and efficient bandwidth
usage.

GIGABITS PER SECOND (GBPS)--1,000,000,000 (one billion) bits per second. A
measure of transmission speed.

HEADEND--The source end of a coaxial cable TV system. Often, the site for signal
processing equipment essential to proper functioning of a cable system.

HIGH-BIT-RATE DIGITAL SUBSCRIBER LINE (HDSL)--Designed to be a cost-effective
method of delivering T1/E1 line speeds over unconditioned copper cable, without
the use of repeaters.

INTEGRATED SERVICES DIGITAL NETWORK (ISDN)--a CCITT networking standard devised
to provide end-to-end, simultaneous handling of digitized voice and data traffic
on the same link.

INTEREXCHANGE CARRIER (IXC)--(1) A long-distance telephone company offering
circuit-switched, leased-line or packet-switched service or some combination.
(2) Any individual, partnership, association, joint-stock company, trust,
governmental entity or corporation engaged for hire in interstate or foreign
communication by wire or radio, between two or more exchanges.

ISP--Internet Service Provider

INTRANET--A private network that uses Internet software and standards.

KILOBITS PER SECOND (KBPS)--1,000 bits per second. A measure of transmission
speed.

LAST MILE--A reference to the local loop, the distance between a local telco
wire center and the subscriber, a distance about 0 to 3 miles (0 to 4
kilometers).

LEASED LINE--A transmission line reserved by a communications carrier for the
private use of a customer.

LIFELINE POTS--A minimal telephone service designed to extend "lifeline"
communications service to the subscriber in case of emergency, particularly when
electric power is lost.

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                                GLOSSARY OF TERMS
                                    CONTINUED

LINE CODE--Any method of converting digital information to analog form for
transmission on a telephone line. 2B1Q, DMT, and CAP are all line codes.

LOCAL AREA NETWORK (LAN)--The means by which a community of computer users
can share information and resources electronically. Many
communications protocols are used to accomplish this, the most prevalent of
which is Ethernet.

LOCAL LOOP--Refers to the physical copper pair or loop of wire from the
telephone company's wire center to the subscriber.

MODULATION--Process by which signal characteristics are transformed to represent
information. Types of modulation include frequency modulation (FM), where
signals of different frequencies represent different data values.

MULTIPLEXER (MUX)--A device that enables several data streams to be sent
over a single physical line.

NETWORK INTERFACE CARD (NIC)--The circuit board installed in a PC that provides
the interface between a communicating PC and the network.

NETWORK MANAGEMENT SYSTEM (NMS)--A system responsible for managing at least part
of a network. NMSs communicate with agents to help keep track of network
statistics and resources.

PAIR GAIN--The multiplexing of "x" phone conversations over a lesser number of
physical lines. "Pair gain" is the number of conversations obtained, divided by
the number of wire pairs used by the system.

PERMANENT VIRTUAL CIRCUIT (PVC)--A defined virtual link with fixed end-points
that are set-up by the network manager.

POTS--Plain old telephone service.

POSTAL, TELEGRAPH AND TELEPHONE COMPANY (PTT)--Generic term for a provider of
these services. A governmental agency in many countries.

QAM--Quadrature Amplitude Modulation. A two-dimensional modulation scheme used
for ADSL, cable modems and proposed for VDSL. CAP is a special case of QAM.

RADSL--Rate-Adaptive DSL. A simple extension of ADSL to encompass a wide
variety of data rates depending on the line's transmission capability. Rate
adaption can be achieved via CAP or DMT ADSL.

REGIONAL BELL OPERATING COMPANIES (RBOC) --The five LEC telephone companies
created after AT&T divestiture. Bell Atlantic, Bell South, Ameritech,
Southwestern Bell and US West.

REMOTE LAN ACCESS--A data communications such as a corporate or campus
environment in which the computer networks can be accessed remotely via public
telecommunications networks.

REPEATER--An electronic device used to regenerate digital signals and restore
signal quality across a certain distance of cable.

SDSL--Symmetric single-pair 2B1Q-based xDSL.



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                                GLOSSARY OF TERMS
                                    CONTINUED

S-HDSL--Single pair transmission using HDSL technology, normally 2B1Q.

SIMPLE NETWORK MANAGEMENT PROTOCOL (SNMP)--A network management standard
established to allow multi-vendor networks to be managed more easily using
common management tools.

SPANNING TREE--An algorithm, standardized by the IEEE to prevent bridge loops
and allow backup network paths.

SYMMETRIC TRANSMISSION--Transmission in which a channel sends and receives data
at the same rate.

SYNCHRONOUS OPTICAL NETWORK (SONET)--A networking standard that utilizes fiber
optics to create backbone networks, capable of transmitting at very high speeds
and accommodating gigabit-level bandwidth.

T1--Digital transmission facility operating with a nominal bandwidth of 1.544
Mbps. Also known as Digital Signal Level 1 (D1). Composed of 24 DS-0 channels in
many cases. T1 is the most common digital transmission technique in North
America.

TELECOMMUTER--Person who performs work at home while linked to the office by
means of a telecommunications-equipped computer system.

TRANSMISSION CONTROL PROTOCOL/INTERNET PROTOCOL (TCP/IP)--A reliable, full
duplex, connection-oriented end to end transport protocol running on top of IP.

TRANSPARENT LAN SERVICE--Service offered by a provider that is used to connect
LANs at geographically separated sites. "Transparent" means the connection is
invisible to the user.

TWISTED PAIR--Cable consisting of two 18 to 24 AWG (American Wire Gauge) solid
copper strands twisted around each other. The twisting provides a measure of
protection from electromagnetic and radio-frequency interference.

VLSI--Very large scale integration.

WIDE AREA NETWORK (WAN)--A network which encompasses interconnectivity between
devices over a wide geographic area.

XDSL--High-speed Digital Subscriber Line technology. A family of
technologies that provide high bandwidth over copper twisted pair.
Varieties of xDSL include HDSL, ADSL and RADSL.


                                      G-5
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                                     PART I


ITEM 1.  BUSINESS.
------------------

        PairGain Technologies, Inc. ("PairGain" or the "Company") is a leading
provider of telecommunications products based on xDSL technology. The Company
designs, manufactures, markets and supports products that allow
telecommunications carriers and private network owners to expand the
capabilities of copper cable and more efficiently provide high-speed digital
services to end users over the large existing infrastructure of unconditioned
copper wires. These services enable high-speed data transmission for
applications such as T1/E1, POTS, high-speed Internet access, telecommuting,
local and wide area networking and video conferencing.

RISK FACTORS

        Except for the historical information contained herein, the matters
discussed in this Annual Report are forward-looking statements which involve
risk and uncertainties, including but not limited to economic, competitive,
governmental and technological factors affecting the Company's operations,
markets, products, services and prices and other factors discussed in the
Company's filings with the Securities and Exchange Commission.

    Average Sales Price Reductions

        Commencing in mid-1993, the Company began reducing the average sales
prices of its HiGain(R) products in an effort to increase market demand for its
products and in anticipation of expected price competition. These reductions
have been significant, representing a reduction of as much as 30% during 1997,
17% during 1996 and 21% during 1995. The Company expects to continue to reduce
the average sales prices of its products, including its HiGain products, in
future periods. Accordingly, the Company's ability to maintain or increase
revenues will depend in part upon its ability to increase unit sales volumes of
HiGain products and to introduce and sell new products at rates sufficient to
compensate for the reduced revenue effect of such continuing reductions in the
average sales prices of the Company's HiGain products. Declining average sales
prices may also adversely affect gross margins on the Company's HiGain products
if the Company is unable to fully offset such reductions in average sales prices
by reductions in the Company's per unit costs. There can be no assurance that
the Company will be able to increase the unit sales volumes of its HiGain
products, introduce and sell new products, reduce its per unit costs or maintain
or increase revenues or margins attributable to such products. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations,"
"Business--Products" and "--Competition."

    Product Concentration

        Revenues from HiGain products represented approximately 67% of the
Company's total revenues in 1997 and 76% of the Company's total revenues in both
1996 and 1995. The Company expects that revenues from HiGain products will
continue to account for a majority of the Company's revenues for the foreseeable
future, although there can be no assurance that the Company will be able to
sustain recent levels of HiGain product sales. A decline in demand for HiGain
products, whether as a result of competition, deployment of fiber cable,
technological change or otherwise, could have a material adverse effect on the
Company's operating results. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations," "Business--Products."

    Future Operating Results Subject to Fluctuation; Lack of Backlog

       The Company's operating results may fluctuate in the future as a result
of a number of factors, including the timing of orders from, and shipments to,
major customers, the timing of new product announcements by the Company or its
competitors, variations in the Company's sales channels or the mix of products
it sells, changes in pricing policies by the Company's suppliers, the
availability and cost of key components, the timing of personnel hirings, the
market acceptance of new and enhanced versions of the Company's products and the
timing of final product approvals from any of the RBOCs.



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<PAGE>   8

       Because the Company generally ships products within a short period after
receipt of an order, the Company typically does not have a material backlog of
unfilled orders, and revenues in any quarter are substantially dependent on
orders booked in that quarter. Further, the Company's expense levels are based
in part on expectations of future revenues and are relatively fixed in the
short-term. The Company has been significantly increasing and intends to
continue to significantly increase operating expenditures and to increase
inventories as it expands its levels of operations. Therefore, the Company may
be unable to adjust spending in a timely manner to compensate for any unexpected
shortfall of orders. Accordingly, any significant shortfall of demand in
relation to the Company's expectations or any material delay of customer orders
in any quarter would have an almost immediate adverse impact on the Company's
business and results of operations for that quarter, and, potentially, on
results in future quarters.

    Competition

        Competition in the Company's markets is intense, and the Company expects
that competition will increase. Many of the Company's potential competitors have
substantially greater name recognition and technical, financial and marketing
resources than the Company. There can be no assurance that the Company will have
the financial resources, technical expertise or marketing, distribution and
support capabilities to compete successfully in the future. Competitive
pressures could reduce demand for the Company's products, cause the Company to
further reduce prices on its existing products, increase expenses or cause
delays or cancellations of customer orders, any one of which could adversely
affect the Company's business and results of operations.

        All manufacturers of products based on HDSL technology face competition
from fiber optic and conventional repeatered systems as alternate solutions for
the delivery of T1, E1 and other high-bandwidth services to end users. As
telephone companies continue to install fiber cable and conventional repeatered
T1 systems to provide high-bandwidth service in local subscriber loops, the
demand for HDSL products may decline. Further, the deployment of fiber to
replace existing HDSL installations will result in the availability of those
existing HDSL systems for installation elsewhere and may adversely affect future
demand for HDSL products.

        The Company is investing heavily in xDSL developments. The market for
xDSL-based products is emerging and will change dramatically over a very short
time. There can be no assurance that the products the Company develops will be
commercially successful. See "Business--Industry Background" and
"--Competition."

    Dependence on Suppliers and Subcontractors

        Certain components used in the Company's HDSL products are currently
purchased from a single source (including the Company's SPAROW II chip) and
others are available from a limited number of sources. In the past, the Company
has experienced delays in the receipt of certain of its key components, which
have resulted in delays in product deliveries. There can be no assurance that
delays in key component and product deliveries will not occur in the future. The
inability to obtain sufficient key components as required, or to develop
alternative sources if and as required in the future, could result in delays or
reductions in product shipments to the Company's customers. Any such delays or
reductions could have a material adverse effect on the Company's reputation and
customer relationships which could, in turn, have a material adverse effect on
the Company's business and results of operations. In addition, the Company uses
third-party subcontractors for the manufacture of its products. This reliance on
third-party subcontractors involves several risks, including the potential
absence of adequate capacity, the unavailability of or interruptions in access
to certain process technologies and reduced control over product quality,
delivery schedules, manufacturing yields and costs.

        Shortage of raw materials or production capacity constraints at the
Company's subcontractors could negatively affect the Company's ability to meet
its production obligations and result in increased prices for affected parts.
Any such reduction may result in delays in shipments of the Company's products
or increases in the price of components, either of which could have a material
adverse impact on the Company. See "Business--Manufacturing."




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    Customer Concentrations

        Aggregate sales to local telephone companies affiliated with the five
RBOCs accounted for approximately 57%, 62% and 65% of the Company's total
revenues for 1997, 1996 and 1995, respectively. As a result of the Company's
dependence on its largest customers, the Company's future success will
significantly depend upon the timeliness and size of future purchase orders, if
any, from its largest customers, the product requirements of such customers, the
financial and operational success of such customers, and in particular, the
success of such customers' services deployed using the Company's products. The
Company's sales to its largest customers have in the past fluctuated and may in
the future fluctuate significantly from quarter-to-quarter and year-to-year. The
loss of any such customer or the occurrence of any such sales fluctuations could
have a material adverse effect on the Company's business and results of
operations. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations," and "Business--Customers."

    Dependence on New Markets and Technologies

        The Company is evaluating new applications of high-speed copper
transmission technologies, is investing significant corporate resources in the
development of ADSL technology and expects to devote significant additional
resources to the development of other new technologies in the future. In
addition, the Company does not expect to generate significant revenues from ADSL
products until 1999, and there can be no assurance that the Company will ever
generate significant revenues from ADSL products. There can be no assurance that
such technologies will be viable or that markets for such technologies will
develop. Any failure in the development of new markets and technologies could
have a material adverse effect on the Company's business. "Business--Company
Strategy" and "--Product Development."

    Rapid Technological Change and Dependence on New Products

        The market for the Company's products is characterized by rapid
technological advances, evolving industry standards, changes in end user
requirements and frequent new product introductions and enhancements. The
introduction of xDSL products involving superior technologies or the emergence
of alternative technologies or new industry standards could render the Company's
existing products, as well as products currently under development, obsolete and
unmarketable. The Company believes its future success will depend in part upon
its ability to continue, on a cost-effective and timely basis, to enhance its
xDSL products, develop and introduce new products for the xDSL market and other
markets, meet changing customer needs and achieve broad market acceptance for
its products. There can be no assurance that the Company will be able to respond
effectively to technological changes or new product announcements, that the
Company will be able to successfully develop and market new products or product
enhancements or that such products or enhancement will achieve market
acceptance. Any failure by the Company to anticipate or respond on a cost
effective and timely basis to technological developments, changes in industry
standards or end user requirements, or any significant delays in product
development or introduction, could have a material adverse effect on the
Company's business. Further, there are physical limits to the speed at which
transmissions can travel over copper wire, and the Company's copper-based xDSL
products will not be a viable solution for customers requiring service at
performance levels beyond the limits of copper wire. See "Business--Company
Strategy" and "--Product Development."

    Need to Generate International Sales

        To date, sales of the Company's products outside of the United States
and Canada have been limited. The Company's ability to meet its objectives will
require it to generate significant international sales in 1998 and beyond.
International business is subject to risks in addition to those inherent in the
Company's North American business including substantially different regulatory
requirements in different jurisdictions, varying technical standards, tariffs
and trade barriers, political and economic instability, reduced protection for
intellectual property rights in certain countries, difficulties in staffing and
maintaining foreign operations, difficulties in managing distributors,
potentially adverse tax consequences, foreign currency exchange fluctuations,
the burden of complying with a wide variety of complex foreign laws and treaties
and the possibility of difficulties in collecting accounts receivable and
increased days sales outstanding. There can be no assurance that the Company
will be able to generate significant international sales, or establish new
strategic marketing relationships in the future. In addition, in the event the
Company is successful in doing business outside of North America, the Company
may also face


                                       3
<PAGE>   10

economic, political and foreign currency situations that are substantially more
volatile than those commonly experienced in the United States and other
international markets. There can be no assurance that any of these factors will
not have a material adverse effect on the Company's business and results of
operations.

    Proprietary Technology

        The Company's success and future revenue growth will depend, in part, on
its ability to protect trade secrets, obtain or license patents and operate
without infringing on the rights of others. Although the Company regards its
technology as proprietary, it has limited patents on such technology. The
Company relies on a combination of technical leadership, trade secrets,
copyright and trademark law and nondisclosure agreements to protect its
unpatented proprietary know-how. However, there can be no assurance that such
measures will provide meaningful protection for the Company's trade secrets or
other proprietary information. Moreover, in the absence of patent protection,
the Company's business may be adversely affected by competitors who
independently develop substantially equivalent technology. In addition, the laws
of some foreign countries do not protect the Company's proprietary rights to the
same extent as do the laws of the United States. The Company is also subject to
the risk of adverse claims and litigation alleging infringement of the
intellectual property rights of others. From time to time the Company has
received claims of infringement of other parties' proprietary rights, although
the Company is not party to any pending intellectual property litigation. There
can be no assurance that third parties will not assert infringement claims
against the Company in the future or that any such claims will not result in
costly litigation or require the Company to obtain a license to intellectual
property rights of such parties, regardless of the merit of such claims. No
assurance can be given that any necessary licenses will be available or that, if
available, such licenses can be obtained on commercially reasonable terms. See
"Business--Proprietary Rights."

    Dependence on Key Personnel

        The success of the Company is dependent in large part on two of its
founders, Howard S. Flagg and Benedict A. Itri, on its Chairman and Chief
Executive Officer, Charles S. Strauch, and on other key management and technical
personnel, the loss of one or more of whom could adversely affect the Company's
business. The Company does not have employment contracts with any of its
executive officers. In addition, the Company believes that its future success
will depend in large part upon its continued ability to attract, retain and
motivate highly skilled employees, who are in great demand. There can be no
assurance that the Company will be able to do so.

    Management of Expanding Operations

        The Company has experienced a period of significantly expanding
operations and headcount, which has placed, and will continue to place, a
significant strain on the Company's personnel and other resources. The Company's
ability to manage any future increases in the scope of its operations or
headcount, should they occur, will depend on significant expansion of its
manufacturing, research and development, marketing and sales, management and
financial and administrative capabilities. The failure of the Company's
management to effectively manage any expansion in its business could have a
material adverse effect on the Company's business and results of operations.

    Reliance on Primary Manufacturing Facilities

        The Company historically conducted virtually all final assembly and
final test functions at its manufacturing facility in Tustin, California. In
1996, the Company entered into an agreement to have its small subscriber
products manufactured, on a turnkey basis, by Jabil Circuits at Jabil's St.
Petersburg, Florida facility. Any extended interruption of operations at either
of these facilities could have a material adverse effect on the Company's
business and results of operations.

    Possible Volatility of Stock Price

        The market price of the Company's Common Stock has increased
significantly since the Company's initial public offering in September 1993, and
has experienced fluctuations during this period. The market price of the
Company's Common Stock has been volatile and may continue to be volatile in the
future. The trading price of the Company's Common Stock could be subject to wide
fluctuations in response to quarter-to-quarter variations in


                                       4
<PAGE>   11

operating results, changes in revenue and earnings estimates by analysts,
announcements of technological innovations or new products by the Company or its
competitors, developments in the Company's relationships with its suppliers or
customers, challenges associated with integration of businesses and other events
or factors. In addition, the stock market has from time to time experienced
extreme price and volume fluctuations which have particularly affected the
market price for many high technology companies, often without regard to the
operating performance of these companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock.

    Capital Requirements

        The Company's capital requirements will depend on many factors,
including the levels at which the Company maintains inventory, the continued
market acceptance of the Company's products, growth in unit sales volume of
HiGain products, the extent to which the Company invests in new technology and
improvements to its existing xDSL technology, the marketing expenditures
associated with launching new products and maintaining a competitive position in
the marketplace and the response of competitors to products based on the
Company's technology. To the extent that the Company's existing resources,
together with future earnings, are insufficient to fund the Company's future
activities, the Company may need to raise additional funds through public or
private financings. No assurance can be given that additional financing will be
available or that, if available, it can be obtained on terms favorable to the
Company and its stockholders.

INDUSTRY BACKGROUND

        In recent years, demands on the telephone infrastructure have prompted
telephone companies to improve the reliability and increase the speed of
transmission over telephone networks. Telephone networks have evolved from
systems based entirely on low speed analog communication over copper wires to
fiber optic backbones running throughout the interexchange carrier and local
exchange carrier networks. These fiber optic backbones permit digital
communication of much greater volumes of data with greatly enhanced reliability
and increased speed throughout the interexchange network and among the local
carriers. However, the "last mile," the local subscriber loop through which
telephone services are delivered from local carriers to end users, continues to
be predominantly characterized by low speed analog transmission over copper
wires.

        The quality of telephone service to end users is determined by the least
reliable and slowest link in the network, and the traditional analog
infrastructure was not designed to provide high-speed, high-data capacity
service to end users. However, end users are increasingly demanding higher speed
data transmission for applications such as Internet access, telecommuting,
remote LAN access, video conferencing and wide area networking, which includes
communications among computers and telephone systems. Telephone service carriers
are therefore facing increasing pressure to install digital telecommunications
services in the "last mile." Digital transmission has distinct advantages over
analog transmission, including increased speed, higher reliability, lower costs,
ease of installation and better quality. Installing digital service facilities
also provides telephone companies worldwide with the foundation to offer their
customers high-speed video and multimedia services. In addition, international
carriers, especially those in developing countries where the copper wire
infrastructure is less extensive, are facing a growing demand for digital
service and are deploying it to provide multiple voice circuits (telephone
lines) rather than the high-speed services requested in the United States.

        Competitive pressure from alternate carriers has further accelerated the
telephone companies' deployment of digital service in the "last mile." Unlike
public telephone companies, these alternate carriers are not required to provide
universal service and instead may choose to serve only those customers with high
demand for digital services, an important market targeted by the telephone
companies due to the higher rates and increased usage associated with these
services. By installing primarily fiber cable, these alternate carriers have
provided short delivery intervals and high quality service, which has enabled
them to compete effectively with the local telephone companies for these high
demand customers. In addition, telephone companies are facing competition from
cable companies that offer high-speed cable modem service. As a result of this
competitive pressure, the telephone companies face an increased need to provide
digital service approaching the quality of fiber optic cable quickly and
efficiently.



                                       5
<PAGE>   12

    T1/E1 Access

        The basic building blocks of today's high-speed digital
telecommunications networks in North America are T1 lines, which transmit data
at 1.544 Mbps, the equivalent of 24 voice circuits for simple telephone service.
E1 lines, the international functional equivalent of T1 lines, operate at 2.048
Mbps. Telephone companies are seeking cost effective methods of providing T1
service to meet customer demands for high-speed digital transmission. By
providing T1 service, telephone companies can provide the means for increased
customer usage which, in turn, expands the revenue base for these telephone
companies. One way that telephone companies have installed T1 service has been
to deploy fiber cable. However, deploying fiber cable in the "last mile" is
capital and labor intensive, so it is only cost efficient if a number of T1
lines are requested in the particular subscriber loop. A fiber system may be
capable of transporting from four to over one hundred T1 lines. The equipment
required at a customer's premises alone can cost a few thousand dollars for a T1
fiber optic system with four lines to tens of thousands of dollars for higher
capacity systems. In either case, significant additional costs are involved in
installing fiber cable in existing conduit or burying new cable. Installing
fiber cable in the "last mile" is also time consuming, often taking a carrier
weeks or months to complete, depending on the location to which the fiber is
deployed, the timeliness of the carrier's success in obtaining the necessary
rights of way and the extent to which the existing conduit is obstructed or
damaged.

        As an alternative to fiber deployment, telephone companies use
repeatered T1 lines, which require them to "condition" the existing copper wires
to meet T1 or E1 standards. Conditioning copper wires is accomplished through a
time consuming, capital and labor intensive installation process, which involves
the removal of bridged taps and the installation of repeaters. Repeaters are
devices required about every 3,000 to 5,000 feet to regenerate the signal as it
passes along the line. To condition existing copper wires, telephone company
engineers must (i) identify which copper wires are to be used (only three to
four pairs of wires in a single cable can be used due to "crosstalk," or
interference, from other pairs of wires in the same cable), (ii) define where
repeaters must be installed, (iii) allocate space in repeater housings and
manholes for the necessary equipment and (iv) locate bridged taps (wire leads
from previously disconnected lines) for removal. Technicians, following the
design of the engineers, must then go to each location to remove the bridged
taps, install the repeaters and add new repeater housings when needed. Next,
each repeater span must be measured by the engineers to ensure that the intent
of the design is achieved. The cost of installing a repeatered T1 line varies
widely depending on the amount of conditioning that the copper wires require,
including the number of repeaters that need to be installed. Generally, the cost
of installing a repeatered T1 line on up to 12,000 feet of unconditioned copper
wire can range from approximately $2,500 to $8,000. While often deployed as an
alternative to fiber, the transmission error rates on repeatered T1 lines are
significantly higher than fiber, which is particularly detrimental for certain
data and video transmissions.

        In the late 1980s, Bellcore, the research and development entity jointly
created and funded by the RBOCs for the development of new technologies,
developed the parameters for HDSL technology as a high quality, but lower cost
and more efficient method for installing T1 lines in the "last mile" on copper.
HDSL utilizes high-speed digital signal processing technology to create a
mathematical model of copper wire that allows the receiver to precisely
compensate for the predictable distortion that the wire imparts on the digital
signal sent from the distant end.

        A cost and performance comparison of a two-mile connection for the three
types of T1 deployment follows:

<TABLE>
<CAPTION>
                                          APPROXIMATE
TRANSMISSION TYPE     AVERAGE COST     INSTALLATION TIME      BANDWIDTH       QUALITY ACHIEVED
------------------- ------------------ ------------------ ------------------ -------------------
<S>                  <C>                <C>                <C>               <C>
Fiber                More than $20,000   2 to 4 Months      T1 (1.54 Mbps)   BER 10 to the minus 10
Repeatered T1        Less than $10,000   4 to 8 Weeks       T1 (1.54 Mbps)   BER 10 to the minus 7
HDSL                 Less than $1,500    Less than 1 Hour   T1 (1.54 Mbps)   BER 10 to the minus 10
</TABLE>

--------------------------
BER 10 to the minus 10 = one bit error every week in a constant transmission
versus BER 10 to the minus 7 which is one bit error every 6 to 7 seconds


                                       6
<PAGE>   13

        The following diagram depicts a comparison of a conventional repeatered
T1 line with an HDSL circuit:

                                    [DIAGRAM]

        The Company believes that HDSL technology offers a significant
opportunity to meet end user demand for high-speed digital telecommunications
services in the local subscriber loop. HDSL technology has a number of
advantages over both fiber cable and conventional repeatered T1 systems,
including lower installation costs and faster deployment time. Because HDSL
technology utilizes the existing copper wire infrastructure, it can be deployed
in one or two days instead of weeks or months. HDSL systems operate over copper
wire without the removal of bridged taps and can tolerate crosstalk, resulting
in reduced engineering design time and lower costs. HDSL systems also eliminate
the need for repeaters, thereby reducing a carrier's initial capital
expenditures and its subsequent maintenance costs for trouble shooting. HDSL
provides higher quality digital transmission than repeatered copper and
approaches the low error rate of fiber optic cable. There are, however, certain
situations in which HDSL technology is disadvantaged relative to these
alternative solutions. For example, if a number of T1 lines are requested at a
single location, fiber cable may be more cost effective to deploy.

    Subscriber Carrier Systems

        Subscriber carrier systems use HDSL technology allowing for rapid
deployment of new telephone service, cable capacity transmission and
full-featured services over existing copper lines. The systems increase the
channel capacity of copper lines in the local loop. Subscriber carrier systems
can be used to satisfy additional line demand from businesses, apartment
complexes, hotels, etc. In addition, some subscriber carrier systems can provide
access through a digital loop carrier.



                                       7
<PAGE>   14
        Megabit Access

        Various telecommuting, Internet access and remote LAN access
applications are driving the need for new higher-speed access technologies. T1
lines are not feasible for use by small businesses and residential customers.
Solutions for these customers have historically been limited to ISDN or
analog, voice grade circuits, which when equipped with 28.8 modems offer some
minimally useful capacities.

        Megabit access products go beyond modem and ISDN capabilities, offering
high-speed data services to business and residential customers. These services
include high-speed Internet and Intranet access, remote LAN access, advanced
services such as pay-per-view movies, telemedicine, distance learning,
interactive video games, educational video and many other on-demand services.
The following chart shows the relative efficiency of the various transmission
methodologies.


<TABLE>
<CAPTION>
                                                  MODEM       ISDN        XDSL       XDSL         XDSL        XDSL
   APPLICATION FILE TYPE            FILE SIZE   28.8 KBPS   128 KBPS    384 KBPS   768 KBPS    1,544 KBPS  6,144 KBPS
   ---------------------            ---------   ---------   --------    --------   --------    ----------  ----------
<S>                                 <C>          <C>         <C>        <C>         <C>         <C>         <C>
E-mail Users                        30 Kbytes    8.3 sec.    1.9 sec.   0.63 sec.   0.31 sec.   0.16 sec.   0.04 sec.
Consumer Digitized Photo           125 Kbytes   34.7 sec.    7.8 sec.   2.6 sec.    1.3 sec.    0.6 sec.    0.2 sec.
Business User Word Files           250 Kbytes   69.4 sec.   15.6 sec.   5.2 sec.    2.6 sec.    1.3 sec.    0.3 sec.
Telecommuter Videoconferencing     384 kbps        No           No         Yes        Yes         Yes         Yes
Telemedicine X-ray                   5 Mbytes   23.1 min.    5.2 min    1.7 min.   52.1 sec.   25.9 sec.    6.5 sec.
Remote LAN Access Bulk File         20 Mbytes    1.5 hr.    20.0 min.   6.9 min.    3.5 min.    1.7 min.   26.0 sec.
</TABLE>

Desired and acceptable response time is less than 3.0 seconds.

PAIRGAIN STRATEGY

        The Company pioneered the development of a VLSI implementation of HDSL
technology and is currently a leading provider of telecommunications products
based on xDSL technology. The Company's strategy for expanding the market for
its products consists of three primary elements:

   o    Maintain Technology Leadership. The Company believes that it is a leader
        in xDSL technology and systems. The Company intends to be able to offer
        clients whatever form of xDSL they desire. The Company's engineering
        organization includes a core development team focused on applying DSP
        techniques to telecommunications products. The Company leverages this
        core DSP expertise with an in-house VLSI design group that designs
        advanced VLSI components. The Company's in-house VLSI design group was
        the first to deliver an HDSL transceiver on a single chip (the SPAROW I
        chip). The Company believes that the close coordination between its VLSI
        design and product development teams enables it to reduce its time to
        market for new products. The engineering organization places the highest
        priority on maintaining the cost and feature competitiveness of the
        Company's HDSL product line through aggressive cost reduction and
        introduction of new products that provide high-speed transmission over
        copper wire. In addition to providing HDSL-based products, the Company
        plans to provide products that use ADSL technology. The Company has
        recently released its Falcon(TM) DMT ADSL chip, which will support DMT
        ADSL and "splitterless" ADSL, or G.lite. The Company believes that
        maintaining its leadership in technology for high-speed digital
        transmission over copper wire is critical to its ability to build and
        maintain strong relationships with the RBOCs and other customers and to
        achieve leadership in new markets.

   o    Leverage Core Technologies Into New Applications. The Company has
        developed its Campus product line and its PG-Plus(TM) and PG-Flex(TM)
        products based upon the same core HDSL technology utilized in the
        Company's HiGain products. The Company markets its Campus products to
        private network users such as universities, hospitals, military bases,
        corporate complexes and other campus environments. In addition,


                                       8
<PAGE>   15

        potential demand for the delivery of advanced communication services to
        residential and business customers, including high-speed Internet
        access, advanced video services such as pay-per-view movies, interactive
        video games, educational video and many other on-demand services, may
        present a significant new market opportunity for products incorporating
        the Company's DSP and copper transmission expertise by using ADSL
        technologies. See "-- Products" and "-- Product Development."

   o    Subscriber Carrier Systems. Due to a shortage in copper lines, the
        Company's subscriber carrier systems, PG-Flex and PG-Plus, represent an
        enormous potential market as carriers look to offer competitive local
        access and to provision second and third lines quickly and
        cost-effectively. The systems increase the channel capacity of copper
        cables in the local loop, allowing service providers to maximize the
        utility of the lines.

   o    Develop OEM Opportunities. The Company will continue to pursue
        opportunities to provide products and chipsets to manufacturers of
        telecommunications and data communications equipment. The Company
        believes that it can provide added value to third-party products through
        higher levels of integration with other elements of wide area networking
        infrastructures, such as bridges, routers and multiplexers. The Company
        also believes an opportunity exists to utilize its xDSL technology to
        connect local wireless communication systems to local central offices.

   o    Create Development Partnerships and Alliances. The Company has and will
        continue to establish partnerships with industry leaders in an effort to
        pursue new market opportunities. The Company is currently collaborating
        with leading telecommunications companies to develop a new standard for
        second generation HDSL technology, known as HDSL2. The purpose of
        setting a standard is to move the industry toward interoperability. In
        addition, the Company is a member of the Universal ADSL Working Group
        ("UAWG") aimed at accelerating the adoption and availability of
        high-speed Internet access for the mass market by creating an open
        interoperable International Telecommunication Union ("ITU") standard.

PRODUCTS

    Core Technology

        The core technology for the Company's HiGain, Campus, PG-Flex and
PG-Plus product lines is based on HDSL and was developed from the Company's dual
core competencies in digital signal processing and microelectronics. HDSL allows
the symmetric transmission and receipt of digital data at T1 rates (1.544 Mbps)
over two twisted pair of copper wires or at 768 kbps over a single twisted pair
of copper wire. HDSL permits the delivery of an outbound signal on the same pair
of wires on which the return signal is received. The transmitted signal is
canceled by the receiver by precisely predicting the amount of signal "echo" and
subtracting it from the overall input signal. HDSL-based products tolerate
crosstalk and operate not only on continuous unobstructed pairs of wires, but
also on cables with mixed wire gauges and bridged taps.

        The Company's unique implementation of HDSL technology stems from its
development of a special purpose digital signal processing integrated circuit.
This VLSI device, the SPAROW (Signal Processing Adaptive Receiver On Wire) chip,
operates at a speed of 250 million instructions per second, enabling it to
perform the extremely heavy numerical calculations required for the transmission
of signals at HDSL rates. The SPAROW chip has enabled the Company to
significantly reduce the physical size of its HDSL-based products. Two SPAROW
chips are used in each of the Company's HDSL-based products, one for each
twisted pair of copper wires entering the unit. The SPAROW I chip was replaced
by the Company's SPAROW II chip which provides all of the features of the
original SPAROW I chip, costs less to produce and consumes less power. Currently
under development is the Company's SPAROW III chip which will be specially
designed to handle pure data transport and include a built-in timing function to
enhance RADSL products and a new interface to use a lower cost analog chip. In
addition, the SPAROW III chip will use less power, cost less to produce and run
faster than the SPAROW II chip. The SPAROW III chip also conforms to the
requirements of the European Telecommunication Standards Institute ("ETSI").

        The Company's microelectronics team has design and development
capabilities that include silicon compilers which allow the Company to develop
chips that are at performance and complexity levels beyond what is


                                       9
<PAGE>   16

achievable on standard ASIC design systems. The Company has also leveraged its
microelectronics product capabilities into the HiGain and Campus product lines.
The Company is currently focusing its resources on further cost and performance
improvements in HDSL including an HDSL2 standard that will let service providers
deliver full T1 performance over a single twisted pair cable with the same
reach, robustness and spectral compatibility of today's two-pair HDSL.
Additionally, significant effort is being placed on new ADSL technology such as
the newly released Falcon chip, which is capable of transferring data, voice and
video at rates over 8 Mbps downstream and 1 Mbps upstream over a single copper
telephone line, and the RADSL product series, which allow for consumer and
business internet access, transparent LAN access and telecommuting applications.

        The Company is a supporter and contributor in the UAWG. The goal of the
UAWG is to accelerate the adoption and availability of high-speed digital
Internet access for the mass market by proposing a simplified version of ADSL
which will deliver to consumers high-speed modem communications over existing
phone lines based on an open, interoperable ITU standard. The UAWG is led by PC,
semiconductor and telecommunications industry leaders. The ADSL specification is
expected to be delivered to the ITU in 1998 for worldwide deployment.

        By utilizing its HDSL and ADSL technology in different forms, the
Company offers products for different markets and varied applications.

    T1/E1 Access

      HIGAIN SYSTEMS

        The Company's HiGain systems are used by telephone companies to (i)
provide a T1 or fractional T1 link between the central office and a carrier's
remote hub and (ii) provide T1 or fractional T1 service in the local subscriber
loop between the central office or remote hub and the customer. A HiGain system
consists of two units: a circuit plug-in unit that mounts in a shelf located in
the central office or in a shelf in a remote hub and a unit that mounts at or
near the customer's location. The circuit plug-in unit mounts in standard
telephone company shelves alongside conventional transmission equipment, making
it easily deployable in almost every central office and remote hub.

        HiGain systems are capable of providing T1 service over two twisted
pairs of copper wire of up to 12,000 feet in length over 24-gauge copper wire
and up to 9,000 feet over 26-gauge wire without the repeaters or complicated
engineering design required with repeatered T1 systems. According to Bellcore
and the RBOCs, approximately 85% of the business subscriber loops nationwide are
within these distances from the local central office. Each HiGain system
provides a single end user with the service of one T1 line, which is the
equivalent of 24 voice circuits for simple telephone service. An end user
requiring the capacity of multiple T1 lines will require an equivalent number of
HiGain systems.

        The Company also provides HiGain systems in different forms to address
variances in customer installation and configuration requirements. The Company's
doubler product regenerates the HDSL signal at the end of a wire to a HiGain
remote unit located a similar distance further on, allowing telephone companies
to increase the distance range of HDSL from 12,000 feet to 24,000 feet and
satisfy T1 demands by its more isolated customers. In addition, the Company has
also introduced a product which provides a T1 connection over shorter distances
requiring only one pair instead of two pairs of wire. The Company recently
introduced a comprehensive range of HDSL-based HiGain products designed
specifically to be deployed in digital loop carrier ("DLC") feeder environments
where multiple T1s are used to link remote DLC systems to telephone company
central offices.

        To ensure flexibility of installation, the Company's HiGain units are
available with a variety of shelf and mounting hardware, weather resistant
housings and connecting hardware. In addition, all HiGain remote units provide
self-diagnostic testing to detect failures and interface with the central office
alarm system. The Company first shipped units of its HiGain system to customers
in June 1992. As of December 31, 1997, the Company had shipped approximately
612,000 HiGain units.


                                       10
<PAGE>   17

                         ILLUSTRATION OF HIGAIN SYSTEM

                                 [ILLUSTRATION]


      ETSI HIGAIN SYSTEMS

        In order to provide digital E1 solutions to the Company's customers
outside of North America, including public carriers and private network
operators, the Company introduced the HiGain ETSI Global Access product line.
These products apply HDSL-based technology in compliance with ETSI requirements.
They allow service providers to rapidly establish E1 connections between central
offices and the customer. The equipment transfers data at rates of 2.048 kbps
over four-wire circuits. Its applications include LAN and PBX networking, WAN
connections, high-speed Internet access and videoconferencing. The Company's
ETSI HiGain systems were recently approved by the British Approvals Board for
Telecommunications for use with unconditioned, two-wire and four-wire circuits
from British Telecommunications. This will allow service providers to link their
private circuit networks into British Telecom's public network over
unconditioned copper telephone lines.

    Subscriber Carrier Systems

      PG-2

        PG-2 was the Company's first commercial product and was delivered to
customers beginning in 1989. The PG-2 system allows telephone companies to
establish two analog transmission lines over a single twisted pair of copper
wires, where traditional technology only allowed the establishment of one line
over a single twisted pair of copper wires. PG-2 systems are used by telephone
companies to provide emergency service and additional line service to residences
and small businesses. The Company's PG-2 system can also be used to convert a
degraded analog copper pair to high-speed digital transmission. In the
international marketplace, where the copper infrastructure is less extensive,
these digital subscriber systems allow PTTs to expand telephone service without
laying more copper lines.

        The Company's PG-2 products compete worldwide with products from a
number of telecommunications equipment manufacturers. The Company considers
itself to be at a competitive disadvantage in the international market for the
two channel digital subscriber carrier business served by its PG-2 system
because it lacks a local manufacturing presence, which results in price
disadvantages caused by import duties.

      PG-FLEX SYSTEMS

        PG-Flex is a small subscriber carrier product. PG-Flex employs HDSL
technology to provide a system for delivering up to 32 standard phone lines on
two pairs of wire over an operating range of up to 12,000 feet. The PG-Flex
system operates in the local loop at carrier service area distances. The remote
terminals are powered from the central office which enables virtually
uninterrupted service during local power outages. The Company markets the
PG-Flex product to both international and domestic telephone companies and
expects significant competition in


                                       11
<PAGE>   18

both markets. The Company began production shipments of PG-Flex systems in 1996.
PG-Flex has received numerous approvals from RBOCs and independent telcos.


                         ILLUSTRATION OF PG-FLEX SYSTEM

                                  [ILLUSTRATION]


      PG-PLUS

        In 1997, the Company introduced PG-Plus, a small subscriber carrier
system based on HDSL technology. The PG-Plus system can be configured to support
four or six channels for POTS or ISDN over one unconditioned copper telephone
line at distances up to 21,000 feet. PG-Plus can be deployed rapidly and is
intended to offer low cost solutions to business and residential users who
require additional voice, fax or data lines, or in emergency situations for
temporary voice communications. The PG-Plus system consists of central office
terminal and remote terminal equipment along with the alarm unit which is the
central point of communication within the PG-Plus system.

    Campus Systems

        The Company's Campus systems are xDSL transmission products designed by
the Company to meet the digital communications needs of organizations operating
their own private networks. Campus systems are reconfigured versions of the
HiGain product and provide high-speed digital connectivity over one or two
twisted pairs of copper wires between user premises in campus environments.
Examples of these environments include universities, hospitals, utility plants,
military bases, industrial parks and corporate complexes. The Campus systems
enable the interconnection of LANs, video conferencing, Internet and Intranet
access, PBX extensions and many other applications.

        A Campus system consists of two base units that operate at T1, E1, 768
kbps or 384 kbps speeds and are compatible with a number of standard data
communications interfaces. These interfaces allow Campus systems to connect
directly to LAN bridges, routers, T1 multiplexers, PBXs, video conferencing
systems and other high-speed networking devices. The Company first shipped
Campus systems to customers in June 1993.

      CAMPUS STAR(TM)

        The Company enhanced the Campus family of products in late 1994 with the
Campus-Star access platform. The Campus-Star is a rack mountable module that
incorporates power supplies and SNMP network management capabilities along with
slots for up to 14 Campus unit equivalents. The use of the Campus-Star platform
is driven by the needs of data communications managers to incorporate network
management capabilities into their network components. PairGain has further
enhanced the Campus-Star to provide Ethernet bridging interfaces and other high


                                       12
<PAGE>   19

bandwidth interfaces. The Campus-Star is being positioned to provide flexibility
in supporting a broad range of access interfaces and is designed to be a core
element of the networking strategy of Campus data communications managers.

      CAMPUS-REX(TM)

        The Company continued to enhance the Campus family of products with the
introduction of the Campus-REX(TM) (Remote Ethernet eXpress), a full bandwidth
Ethernet remote bridge, providing transparent connectivity between LANs without
repeaters at a distance of up to five miles. It provides a 10BASE-T port, one
serial port, an embedded SNMP agent and IEEE 802. 1d transparent MAC level
bridging with Spanning Tree protocol support.

                      PAIRGAIN CAMPUS PRODUCT APPLICATIONS
                             (Campus Area Network)

                               [NETWORK DIAGRAM]


    OEM Products

        The Company has formed an OEM sales group to establish relationships
with manufacturers to integrate PairGain's xDSL technologies into their own
products. Recent opportunities for relationships have centered around DLC
manufacturers. The Company currently has relationships with
DSC Communications and Advanced Fibre Communications.

    Megabit Access Products

        The Company's megabit access products offer high-speed solutions for a
wide range of consumer and business applications, including Internet and remote
LAN access. Megabit access products are designed for local exchange carriers,
ISPs and private network owners.



                                       13
<PAGE>   20

      MEGABIT MODEM(TM)

        The Company's Megabit Modem products provide high-speed access to the
Internet or corporate LANs at speeds up to 768 kbps in each direction. Megabit
Modems may also be installed at remote office sites to extend high-speed
services across wide area networks. It operates over a single copper telephone
line and outperforms ISDN, cable modems and dial-up modems.

      MEGABIT MODEM CRA(TM)

        The Megabit Modem CRA are RADSL modems that have been designed to
support a variety of applications in residential and business environments. The
modems automatically adjust transmission speeds to the highest rate possible
according to distance, traffic, line quality and other factors. The Megabit
Modem CRA transfers data at speeds up to 3.2 Mbps downstream (to the subscriber)
and 1 Mbps upstream to distances as far as 25,000 feet. With the addition of a
S1 NID ADSL Splitter, both digital and analog signals can be transmitted
simultaneously. The network management function for the RADSL products can be
integrated with other xDSL products, consolidating network management functions
for all network elements into one system. RADSL modems are easy to install and
require no end user configuration.

      ETHERPHONE(TM)

        The Company's EtherPhone products provide both an Ethernet network
connection and an analog POTS voice connection over a single telephone line. The
unit mounts on the outside of a residence or small office, and does not require
any end user configuration. The EtherPhone provides a 64 kbps voice channel and
transmits data at speeds up to 704 kbps in each direction. EtherPhone products
facilitate telecommuting applications and allow high-speed Internet access.

      ADSL CHIPS

        The Company recently introduced its Falcon DMT ADSL chip which is the
industry's first single-chip DMT ADSL processor. The Falcon chip will support
DMT ADSL and "splitterless ADSL," or G.lite, a standard currently under
development by the ITU to simplify modem deployment by eliminating customer
premises splitter installation for simultaneous data and analog voice
connections. Although telephone companies have focused on deploying fiber and
hybrid fiber and coaxial cable networks for delivering these advanced services,
the Company believes the high cost and long implementation periods that will be
involved in setting up these networks will provide a window of opportunity for
equipment that can deliver similar capabilities on ordinary telephone wires.


                                       14
<PAGE>   21

                              CONSUMER APPLICATIONS

                                    [GRAPHIC]


PRODUCTS UNDER DEVELOPMENT

    HDSL2

        The Company is currently collaborating with leading telecommunications
companies to develop a new standard for second generation HDSL technology, known
as HDSL2. The purpose of setting a standard is to move the industry toward
interoperability. HDSL2 is being developed to deliver full T1 performance over a
single twisted pair cable, with the same reach, robustness and spectral
compatibility of current two-pair HDSL technology.

    ADSL Modules

        The Company is developing products that will use the Falcon chip to
support DMT ADSL and "splitterless ADSL," or G.lite.

    DSLAM

        The Company is also providing resources to develop ATM-based Digital
Subscriber Line Access Multiplexer ("DSLAM") products at its Tustin, California
and Wallingford, Connecticut facilities.

CUSTOMERS

        The Company sells its HiGain, PG-2, PG-Flex, PG-Plus and megabit access
products primarily into the public network market and its Campus products
primarily into the private network market. The Company uses its direct sales
force to market its products to the public network market in the United States
and Canada. The Company markets its domestic Campus products and all
international products through both direct sales and distributors.

    Public Networks

        The public network market consists of the five RBOCs and their local
telephone company affiliates, as well as independent telephone companies, CLECs,
ISPs and international carriers.

        RBOCs. Prior to selling products in volume to a local telephone company
affiliated with an RBOC, a vendor must first receive approval of its product
from the RBOC. Although the approval process for a new product varies somewhat
among the five RBOCs, the process generally consists of the following three
phases:



                                       15
<PAGE>   22

    o  Laboratory Evaluation. The product's functions and performance are tested
       against all relevant industry standards. This process can take from two
       weeks to three months, or longer, depending on a variety of factors.

    o  Field Trial. A number of actual telephone lines are equipped with the
       product for live operation in a field trial lasting from three weeks to
       three months, or longer. These field trials are for evaluating
       performance, assessing the ease of installation and establishing
       troubleshooting procedures. The RBOCs grant conditional approval upon
       successful completion of a new product's field trial, enabling field
       personnel to order limited quantities of the product under one-time
       approvals.

    o  Final Approval and Contract. Prior to final approval, which may take from
       one to four months, or longer, the RBOC develops and implements a variety
       of procedures that cover ordering, stocking, installation, maintenance,
       returns and all other activities associated with use of the product.


        All five U.S. RBOCs and Bell Canada have approved the Company's HiGain
products. In addition, several carriers have approved the Company's small
subscriber carrier systems: two RBOCs and Bell Canada have approved the
Company's PG-2 system, four RBOCs have approved the PG-Flex system and one RBOC
has approved the PG-Plus system. Sales in the aggregate to local telephone
companies affiliated with the five RBOCs accounted for approximately 57% of the
Company's total revenues in 1997. See Note 3 of Notes to Consolidated Financial
Statements contained in a separate section of this Annual Report on Form 10-K
commencing on page F-1.

        Independent Telephone Companies. There are approximately 1,500 telephone
companies in the United States that are unaffiliated with any of the RBOCs. The
Company has targeted approximately 50 of the largest independent telephone
companies as potential customers for its carrier products. Although the
independent telephone company market does not present as large an opportunity as
the RBOC market, the Company's experience has been that the independent
telephone companies are often more receptive to new technology. As a result, the
approval process for new technology is often less time consuming. Several of the
large and small independent telephone companies have approved and deployed the
Company's HiGain system. One large independent telephone company has approved
the Company's PG-Flex and PG-2 small subscriber carrier systems.

        CLECs and ISPs. There are numerous competitive local exchange carriers
and Internet service providers throughout North America. These providers supply
Internet access, T1, long distance and other residential services to consumers
or businesses. In many cases, CLECs will lease unbundled network elements from
the local exchange carrier to deliver digital services using their own
transmission equipment. Most CLECs are focused on new types of data or voice
services and are potential customers for the Company's products. The CLEC
market is relatively new (since the 1996 Telecom Act), and it is unknown at
this point how CLECs will evolve.

        International Carriers. In most international markets there is one
telephone company per country; there are no alternate carriers and no
independents. Typically these PTTs are highly regulated, government-owned
agencies that have an even more rigorous approval process for new technology
than the RBOCs. While the international carrier network systems are
architecturally similar to the domestic public networks, E1 service is not
deployed as extensively in local subscriber loops internationally as T1 service
is in local loops domestically. The demand for E1 service has grown, however,
and international carriers are deploying it primarily to provide multiple voice
circuits rather than the high-speed service requested in the United States. The
Company's products have been successfully deployed in over 95 countries, and in
1997, sales outside of North America comprised approximately 9% of total
revenues.

    Private Networks

        Customers for the Company's Campus products, first introduced in 1993,
include universities, hospitals, military bases and other government
installations, corporate complexes and other campus-like environments with
private network systems.

SALES, MARKETING AND CUSTOMER SUPPORT

    Sales and Marketing

        The Company's direct sales force markets its products to the RBOCs and
their local telephone company affiliates and to the larger independent telephone
companies by working closely with the planning, switching and


                                       16
<PAGE>   23

transmission departments of such customers. The Company sells to other
independent carriers, CLECs and owners of private networks through direct sales,
telesales and distributors.

        The Company's North American sales personnel are located in the
following areas: California, Florida, Georgia, Utah, Texas, Washington, New
Hampshire, Illinois, New Jersey, New York, North Carolina, Oregon,
Massachusetts, Maryland, Missouri, Kansas, Colorado, Pennsylvania, Virginia,
Washington, DC, and in the provinces of Alberta and Quebec. The Company sells
its products outside of North America through its own sales force based in the
United States, Switzerland, Brazil, Hong Kong and China, and a network of
international data communications equipment distributors.

        In addition to the specific sales efforts directed at its public and
private network customers, the Company's marketing activities include
participation in industry trade shows and conferences, distribution of sales and
product literature, media relations, advertising in trade journals, direct mail
and ongoing communications with its customers and industry analysts.

    Customer Support

        Service, repair and technical support of the Company's products are
performed primarily in-house, however, the Company also uses an independent
third party repair service. The Company's field service personnel are located in
California, New York, Maryland, Georgia, Florida, Illinois, Texas, Missouri,
Colorado, Virginia, Massachusetts, and Ontario, Canada, Sao Paulo, Brazil,
Mexico City, Mexico, Dubai, U.A.E. and Guangzhou, China. The Company offers
technical support to its customers on a 24-hours-a-day, 7-days-a-week basis via
an 800 hotline and through paging systems for all support personnel. The
Company's products are sold with a five year warranty.

PRODUCT DEVELOPMENT

        The Company believes that its future success depends on its ability to
maintain its technological leadership through enhancements of its existing
products and development of new products that meet a wide range of customer
needs. Accordingly, the Company intends to continue to make substantial
investments in product development.

        The Company's engineering efforts consist of microelectronics, software
development and hardware development. Within the microelectronics group, a
substantial majority of the Company's efforts are devoted to the development of
ADSL, the enhancement of microelectronics used in the Company's HiGain and
Campus product lines and the development of microelectronics products based on
the Company's existing products. Within the software development group, the
Company's efforts are devoted to the development and enhancement of network
management software and protocol compliance for its products and the development
of firmware for products such as PG-Flex, PG-Plus and ETSI.

        The remainder of the Company's research and development is devoted to
the development, improvement and enhancement of new and existing hardware
products and is directed at the following:

    o  Cost Reduction. The Company continuously reviews the design and
       manufacturing process of its products to determine areas of product cost
       savings or enhanced product quality. This review includes, among other
       things, an examination of the product design to determine if further
       improvements can be made in the VLSI components.

    o  Product Line Extensions. The Company seeks to extend its existing product
       lines through product modifications and enhancements in order to meet the
       needs of its different customers and their applications. Products
       resulting from the Company's product line extension efforts include the
       PairGain Management System for management of HiGain products, long range
       384 kbps Campus systems, single pair T1 systems and the HiGain doubler
       product.

    o  New Technology. The Company explores new transmission technologies to
       determine whether they represent an opportunity for products
       incorporating the Company's DSP and copper transmission expertise.


                                       17
<PAGE>   24

        During 1997, 1996 and 1995, research and development expenses were
approximately $32.0 million, $19.5 million and $10.7 million, respectively. All
of the Company's research and development expenses were charged to operations as
incurred.

MANUFACTURING

        The Company's manufacturing operations consist primarily of final
assembly, burn-in, full system test, packaging and shipping. The Company uses
domestic independent third-party contract assembly companies on a consignment
basis for circuit board assembly, including in-circuit and functional testing,
for many of its products. The Company conducts final assembly and final test
functions for those products at its facility in Tustin, California. In addition,
the Company performs extensive burn-in, testing and inspection of all of its
products prior to shipping them to customers. Product quality and reliability
are the Company's prime concerns in all phases of the manufacturing process.
Quality control is maintained through incoming inspection of components and
subassemblies, auditing of consignment and turnkey contractors, in-house final
assembly and test functions, plus a final shipping inspection of all products.
During 1996, the Company entered into an agreement to have its PG-2 and PG-Plus
products manufactured, on a turnkey basis, by Jabil Circuits at Jabil's St.
Petersburg, Florida facility. Under the terms of this agreement, Jabil
manufactures, tests, packages and ships these products directly to the Company's
customers.

        In April 1996 the Company achieved ISO 9001 certification for its
manufacturing operations located in Tustin, California. ISO 9000 Quality
Standards were developed by the International Organization for Standardization.
It is a quality system standard for ensuring a total quality management system
in engineering and manufacturing and is becoming an accepted prerequisite for
international trade. ISO 9001 is the most comprehensive standard, covering
design and development as well as production, installation and service.

        The Company currently procures all of its components from outside
suppliers, either directly from manufacturers or distributors or through its
consignment and turnkey contractors. The Company generally purchases and stores
the more expensive components at its location and allows its assembly and test
subcontractors to purchase and store other necessary components. In procuring
components, the Company and its subcontractors rely upon a number of suppliers
that are the sole source for certain of the components. One such sole supplier
part is the SPAROW II chip. Although the Company has utilized its VLSI expertise
to design its SPAROW II chip in a manner that will facilitate transition to
multiple sources of supply, such a transition could result in delays or
reductions in product shipments which, in turn, could have a material adverse
effect on the Company's customer relationships and operating results.

        The Company's backlog at December 31, 1997 was approximately $10.4
million. The Company includes in backlog all firm purchase orders for products
regardless of their ship date. Because of the quick turnaround that the
Company's customers expect on their orders, and because of the possibility of
customer changes in delivery schedules or cancellation of orders, the Company's
backlog as of any particular date may not be indicative of actual revenues
expected for any future period.

        The Company's products are subject to FCC regulations regarding emission
of electromagnetic energy, which may interfere with other equipment. All of the
Company's currently commercially available products have been tested and comply
with the relevant FCC regulations. The Company's commercially available products
that are sold for use at the end user's premises, such as the HiGain remote unit
and the Campus products, also comply with all required UL safety specifications.

COMPETITION

        Competition in the Company's markets is intense, and the Company expects
that competition will increase. Many of the Company's potential competitors have
substantially greater name recognition and technical, financial and marketing
resources than the Company. There can be no assurance that the Company will have
the financial resources, technical expertise or marketing, distribution and
support capabilities to compete successfully in the future. Competitive
pressures could reduce demand for the Company's products, cause the Company to
further reduce prices on its existing products, increase expenses or cause
delays or cancellations of customer orders, any one of which could adversely
affect the Company's business and results of operations.


                                       18
<PAGE>   25

        Some companies that offer competitive products in PairGain's primary
revenue segments are listed below:

<TABLE>
<CAPTION>

                                                    SUBSCRIBER      CAMPUS/
                                        T1/E1        CARRIER        PRIVATE
              COMPETITOR               ACCESS        SYSTEMS       NETWORKS
<S>                                      <C>            <C>           <C>
    ---------------------------------------------------------------------------
    ADC Telecommunications                X                            X
    ---------------------------------------------------------------------------
    Adtran, Inc.                          X                            X
    ---------------------------------------------------------------------------
    Alcatel Network Systems, Inc.         X
    ---------------------------------------------------------------------------
    DSC Communications Corporation                      X
    ---------------------------------------------------------------------------
    ECI Telecom                           X             X
    ---------------------------------------------------------------------------
    E/O Networks                                        X
    ---------------------------------------------------------------------------
    GoDigital Telecommunications, Inc.                  X
    ---------------------------------------------------------------------------
    Orckit Communications Ltd.            X
    ---------------------------------------------------------------------------
    Paradyne                                                           X
    ---------------------------------------------------------------------------
    Raychem Corporation                                 X
    ---------------------------------------------------------------------------
    Siemens                               X
    ---------------------------------------------------------------------------
    Tut Systems                                                        X
    ---------------------------------------------------------------------------
    Wescom Communications, Inc.                         X
    ---------------------------------------------------------------------------
    Westell, Inc.                                                      X
    ---------------------------------------------------------------------------
</TABLE>

        All manufacturers of products based on HDSL technology face competition
from fiber optic and conventional repeatered systems as alternate solutions for
the delivery of T1, E1 and other high-bandwidth services to end users. As
telephone companies continue to install fiber cable and conventional repeatered
T1 systems to provide high-bandwidth service in local subscriber loops, the
demand for HDSL products may decline. Further, the deployment of fiber to
replace existing HDSL installations will result in the availability of those
existing HDSL systems for installation elsewhere and may adversely affect future
demand for HDSL products.

        The Company is investing heavily in xDSL developments. The market for
xDSL-based products is emerging and will change dramatically over a very short
time. There can be no assurance that the products the Company develops will be
commercially successful.

PROPRIETARY RIGHTS

        The Company relies on a combination of technical leadership, trade
secret, patent, copyright and trademark law and nondisclosure agreements to
establish and protect its proprietary rights in its products. Currently, the
Company holds two United States patents and has an application pending for one
additional patent. The Company also has certain registered and other trademarks.
The Company believes that, because of the rapid pace of technological change in
the networking industry, patent and copyright protection are less significant to
the Company's competitive position than factors such as the knowledge, ability
and experience of the Company's personnel, new product development, market
recognition and ongoing product maintenance and support.

EMPLOYEES

        As of December 31, 1997, the Company employed 640 persons, including 227
in manufacturing, 99 in sales and marketing, 20 in customer service, 241 in
engineering and 53 in finance and administration. The Company also employs a
number of temporary and contract employees. During the last quarter of fiscal
1997, the Company employed between 94 and 100 temporary employees, mostly in
manufacturing. None of the Company's employees is represented by a labor union
and the Company has experienced no work stoppages. The Company does not have any
employment contracts with any of its executive officers.


                                       19
<PAGE>   26

ITEM 2.  PROPERTIES.
--------------------

        The Company has several property leases, as detailed below:

<TABLE>
<CAPTION>
                                                                Approx.       Lease
                       Use / Location                         Square Feet   Expiration
                       --------------                         -----------   ----------
<S>                                                              <C>        <C>
         Principal administrative, engineering, manufacturing,
         sales and marketing facilities
               Tustin, California                                75,000      02/29/00
               Tustin, California                                66,000      12/31/04
               Tustin, California                                15,000      07/31/99

         Research and development facilities
               Raleigh, North Carolina                           20,000      08/31/01
               Wallingford, Connecticut                          14,000      09/30/99

         Sales offices
               Landover, Maryland                                 1,000      10/31/99
               Miami, Florida                                     2,000      03/31/01
               Baden-Daettwil, Switzerland                        2,000      06/30/98
               Wanchai, Hong Kong                                 2,000      07/31/99
</TABLE>

ITEM 3.  LEGAL PROCEEDINGS.
---------------------------

        In January 1996, the Company received a copy of a complaint, filed
derivatively by a Company stockholder on behalf of the Company, naming as
defendants the Company's directors and certain officers, as well as Mr. S. Jay
Goldinger and Capital Insight, Inc., a third party investment advisor. This suit
arose out of losses incurred by the Company in 1995 of approximately $15.8
million in connection with unauthorized trading of investments made by Mr.
Goldinger and Capital Insight on the Company's behalf. The derivative complaint
alleged causes of action for breach of fiduciary duty, abuse of control,
constructive fraud, gross mismanagement and waste of corporate assets. The
complaint sought in excess of $15.8 million in damages and legal fees and
expenses in connection with the loss by the Company of the funds it provided to
Mr. Goldinger and Capital Insight. The suit was filed in Superior Court of the
State of California, County of Orange. Additionally, the same stockholder filed
a separate, related complaint, brought derivatively on behalf of the Company, in
the Orange County Superior Court, against a brokerage firm involved in the
Capital Insight matter.

        In September 1996, the Company and other parties to the derivative suits
described above executed definitive settlement agreements to settle and dismiss
the derivative suits. The Court approved the settlement on November 19, 1996.
Under the terms of the settlement, the Company received $2.5 million from a
brokerage firm involved in processing the investments for Capital Insight, and
paid plaintiff's attorneys fees of $450,000. The impact of the settlement was
recorded in the Company's financial statements for the year ended December 31,
1996.

        In January 1996, the Company filed suit in Los Angeles federal court
against Mr. S. Jay Goldinger and Capital Insight, Inc. charging unauthorized
trading, fraudulent misrepresentation, violation of federal securities laws and
breach of fiduciary duties. The suit seeks $15.8 million in damages by reason of
the losses incurred by the Company, as well as punitive damages and legal fees.

                                       20
<PAGE>   27

        As previously reported, the U.S. Attorney's office and the Securities
and Exchange Commission have been investigating S. Jay Goldinger and Capital
Insight, Inc. in connection with their loss of nearly $100 million of their
clients' funds, including $15.8 million of PairGain's funds. The U.S. Attorney
and the SEC are also investigating whether PairGain and some of its past and
present officers and employees engaged in any wrongdoing with respect to
PairGain's investment of its excess cash with Capital Insight, the disclosure of
such investments and the disclosure of losses incurred.

        See Notes 15 and 16 of Notes to Consolidated Financial Statements
contained in a separate section of this Annual Report on Form 10-K commencing on
page F-1.

        The Company does not maintain Directors and Officers liability
insurance. However, under the terms of its certificate of incorporation, the
Company indemnifies its directors and officers for damages and legal fees
arising from litigation matters.


ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
------------------------------------------------------------

        None.

                                       21
<PAGE>   28

                                    PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
-------------------------------------------------------------------------------

        The Company's Common Stock is traded on The Nasdaq Stock Market(SM)
under the symbol PAIR. As of January 30, 1998, there were 69,361,762 shares of
the Company's Common Stock issued and outstanding. The number of stockholders of
record at that date was 637. This number does not account for Common Stock
registered in street name. Accordingly, the actual number of holders of record
of the Company's Common Stock may be significantly greater than the number
indicated above. The following table sets forth, for the fiscal periods
indicated, the high and low sale prices for the Common Stock as reported on the
Nasdaq Stock Market(SM). The market quotations set forth below reflect
inter-dealer prices, without retail markup, markdown or commissions, and may not
necessarily represent actual transactions. The Company has never paid cash
dividends and has no present intention of declaring a cash dividend for the
foreseeable future.

<TABLE>
<CAPTION>
                                                      QUARTERLY  QUARTERLY
                                                        HIGH*       LOW*
                                                      ---------  ---------
<S>                                                   <C>         <C>
                   YEAR ENDED DECEMBER 31, 1997
                       Fourth Quarter                 $ 31.25     $ 17.38
                       Third Quarter                    30.00       15.50
                       Second Quarter                   32.75       14.63
                       First Quarter                    43.25       22.38

                   YEAR ENDED DECEMBER 31, 1996
                       Fourth Quarter                 $ 41.88     $ 28.69
                       Third Quarter                    41.50       19.50
                       Second Quarter                   31.13       16.41
                       First Quarter                    17.50        9.75
</TABLE>

        On January 30, 1998, the last reported sales price for the Company's
stock was $18.38.

*  1996 share prices have been adjusted for the June 18, 1996 and December 18,
   1996 two-for-one stock splits.


    USE OF PROCEEDS FROM REGISTERED SECURITIES

        The effective date of the Company's first registration statement (the
"Registration Statement") filed on Form S-1 (Registration No. 33-66680) under
the Securities Act of 1993, as amended, was September 13, 1993. The class of
securities registered was Common Stock. The offering commenced on September 15,
1993 and all securities were sold in the offering. The managing underwriters for
the offering were Lehman Brothers, Inc. and Hambrecht & Quist, Inc.

        Pursuant to the Registration Statement, the Company sold 4,140,000
shares of its Common Stock for an aggregate offering price of $58.0 million, and
certain selling shareholders sold 632,500 shares of the Common Stock of the
Company for an aggregate offering price of $8.9 million.

        The Company incurred expenses of $4.7 million of which $4.1 million
represented underwriting discounts and commissions and $573,000 represented
other expenses. All such expenses were direct or indirect payments to others.
The net offering proceeds to the Company after total expenses was $53.3 million.

        Of the net proceeds from the offering, $5.3 million was used to pay off
indebtedness in 1993 and $48.0 million has been invested in short-term
investments. In 1995, the Company realized a $15.8 million unauthorized trading
loss. See Notes 15 and 16 of Notes to Consolidated Financial Statements
contained in a separate section of this Annual Report on Form 10-K commencing on
page F-1.

        The use of the proceeds from the offering does not represent a material
change in the use of the proceeds described in the prospectus which is part of
the Registration Statement.

                                       22
<PAGE>   29

ITEM 6.  SELECTED FINANCIAL DATA.
---------------------------------

                      SELECTED CONSOLIDATED FINANCIAL DATA

        The selected consolidated financial data of the Company as of December
31, 1997 and 1996 and for the years ended December 31, 1997, 1996 and 1995 is
derived from audited consolidated financial statements of the Company included
elsewhere in this Annual Report. The selected consolidated financial data of the
Company as of December 31, 1995, 1994 and 1993 and for the years ended December
31, 1994 and 1993 are derived from audited consolidated financial statements of
the Company not included in this Annual Report. The following information should
be read in conjunction with the Consolidated Financial Statements of the Company
and the related notes thereto and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" included in separate sections of
this Annual Report.


<TABLE>
<CAPTION>
                                                       YEAR ENDED DECEMBER 31,
                                       ---------------------------------------------------
                                         1997       1996(1)    1995       1994      1993
                                       --------   --------   --------    -------   -------
                                               (IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
<S>                                    <C>        <C>        <C>         <C>       <C>
STATEMENT OF OPERATIONS DATA:
 Revenues                              $282,325  $205,505    $107,224    $59,518   $36,307
 Income from operations                 71,739     51,526      23,532     10,513     8,614
 Unusual loss due to unauthorized
  trading of investments by third
  parties                                   --         --     (15,827)        --        --
 Settlement income related to
  unauthorized trading of
  investments by third parties              --      2,500          --         --        --
 Net income                             47,637     34,908       1,056      8,567     7,612
 Earnings per common share(2)
   Basic                               $  0.70    $  0.54     $  0.02    $  0.17   $  0.21
   Diluted                             $  0.63    $  0.47     $  0.02    $  0.14   $  0.15
 Average shares outstanding(2)
   Basic                                67,991     64,247      58,225     50,131    36,773
   Diluted                              75,225     73,768      67,280     61,612    49,940
</TABLE>


<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                       --------------------------------------------------------
                                          1997       1996(1)      1995        1994       1993
                                       ---------   ---------   ---------   ---------  ---------
                                                            (IN THOUSANDS)
<S>                                    <C>         <C>         <C>         <C>        <C>
BALANCE SHEET DATA:
  Working capital                      $ 214,724   $ 140,681   $  84,766   $  71,368  $  62,941
  Total assets                           282,419     195,004     105,326      86,625     68,303
  Long-term debt                              --          --          --          --         --
  Total stockholders' equity             235,517     157,596      93,931      74,846     65,236
</TABLE>

    The Company paid no dividends on its Common Stock during any of the periods
presented.

(1)   Financial data for 1996 reflect the February 27, 1997 business combination
      between PairGain and Avidia Systems, Inc. accounted for on a
      pooling-of-interests basis. Avidia was formed in December 1995 and had no
      significant transactions prior to January 1, 1996. See Notes 1 and 2 of
      Notes to the Consolidated Financial Statements contained in a separate
      section of this Annual Report on Form 10-K commencing on page F-1.

(2)   All share and per share amounts have been adjusted for the June 18, 1996
      and December 18, 1996 two-for-one stock splits and have been restated to
      reflect the adoption of SFAS No. 128, "Earnings Per Share" ("SFAS
      No. 128").

                                       23
<PAGE>   30

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


        The following discussion should be read in conjunction with the
        consolidated financial statements and related notes included elsewhere
        herein as well as the section entitled "Risk Factors" in Item 1 of this
        Annual Report. The Company's future operating results may be affected by
        various trends and factors which are beyond the Company's control. These
        include, among other factors, economic, competitive, governmental and
        technological factors affecting the Company's operations, markets,
        products, services and prices. Accordingly, past results and trends
        should not be used by investors to anticipate future results or trends.

        Except for the historical information contained herein, the matters
        discussed in this Annual Report are forward-looking statements which
        involve risk and uncertainties. A number of important factors including
        those contained in the section entitled "Risk Factors," as well as
        factors discussed elsewhere in this report and in the Company's other
        reports filed with the Securities and Exchange Commission, could affect
        the Company's actual results and cause actual results to differ
        materially from those in the forward-looking statements.

OVERVIEW

        PairGain Technologies, Inc. ("PairGain" or the "Company") is a leading
provider of telecommunications products based on high-speed Digital Subscriber
Line ("xDSL") technology. The Company designs, manufactures, markets and
supports products that allow telecommunications carriers and private network
owners to expand the capabilities of copper cable and more efficiently provide
high-speed digital services to end users over the large existing infrastructure
of unconditioned copper wires. These services enable high-speed data
transmission for applications such as T1/E1, high-speed Internet access,
telecommuting, local and wide area networking and video conferencing.

        The Company's first product was PG-2, a two-channel digital subscriber
carrier system, which was initially shipped in late 1989. In 1991, the Company
undertook the development of its HiGain products, which were first shipped in
June 1992. In June 1993, the Company introduced its Campus line of products, and
in 1996, began shipping its PG-Flex product, a small subscriber carrier system
for delivering up to 32 voice channels over two pair of copper wires. In the
first quarter of 1997, the Company commenced shipments of its PG-Plus and ETSI
products. Revenues from HiGain products represented approximately 67% the
Company's total revenues in 1997 and 76% of the Company's total revenues in both
1996 and 1995. Although revenues from sales of the Company's HiGain products
have historically represented a substantial majority of the Company's total
revenues and are expected to continue to account for a majority of its revenues
for the foreseeable future, the Company believes that revenues from sales of its
Campus, PG-Flex, PG-Plus and other products will continue to increase as a
percentage of total revenues in the future.

        Commencing in mid-1993, the Company began reducing the average sales
prices of its HiGain products in an effort to increase market demand for its
products and in anticipation of expected price competition. These reductions
have been significant, representing reductions of then current prices of as much
as 16% in 1997, 14% in 1996 and 23% in 1995. Although future effects of price
competition and other competitive pressures inherent in the Company's business
are uncertain, the Company expects to continue to reduce the average sales
prices of its HiGain and other products. Accordingly, the Company's ability to
maintain or increase revenues will depend in part upon its ability to increase
unit sales volumes of existing products and to introduce and sell new products
at rates sufficient to compensate for the reduced revenue effect of such
continuing reductions in the average sales prices of the Company's existing
products. Declining average sales prices may also adversely affect gross margins
on the Company's existing products if the Company is unable to fully offset such
reductions in average sales prices by reductions in the Company's per unit
costs. During 1997, 1996 and 1995 the Company's continuing effort toward cost
reduction through engineering design changes, reduced prices for components,
increased manufacturing efficiencies and increases in volume resulted in gross
margins of 49% in 1997 and 48% in 1996 and 1995. However, there can be no
assurance that the Company will be able to continue to increase unit sales
volumes, introduce and sell new products or further reduce its per unit costs in
the future.



                                       24
<PAGE>   31

RESULTS OF OPERATIONS

        The results of operations discussed below are comprised of two sections.
The first section compares 1997 to 1996 for all items noted on the Consolidated
Statements of Income contained in a separate section of this Annual Report on
Form 10-K commencing on page F-1. The second section compares 1996 to 1995
for the same items.

        All share and per share amounts have been adjusted to reflect the
two-for-one stock splits effective June 18, 1996 and December 18, 1996 and have
been restated to reflect the adoption of SFAS No. 128, for all periods
presented.

        The following table sets forth, for the periods indicated, certain
operating data as a percentage of total revenues.

<TABLE>
<CAPTION>
                                                      YEAR ENDED DECEMBER 31,
                                                   ------------------------------
                                                    1997        1996       1995
                                                   ------      -------    -------
<S>                                                 <C>         <C>         <C>
     Revenues:
      Product sales                                 100 %       100 %       99 %
      Royalty income                                 --          --          1
                                                   ------      -------    -------
     Total revenues                                 100         100        100
     Cost of revenues                                51          52         52
                                                   ------      -------    -------
     Gross profit                                    49          48         48
     Operating expenses:
      Research and development                       11           9         10
      Selling and marketing                           8           9          9
      General and administrative                      4           5          6
      Merger expenses                                 1          --         --
                                                   ------      -------    -------
     Total operating expenses                        24          23         25
                                                   ------      -------    -------
     Income from operations                          25          25         23
     Other income, (loss):
      Interest income, net                            3           2          2
      Gain on sales of investments                   --          --         --
      Loss on long-term investment                   --          --         --
      Unusual loss due to unauthorized
        trading of investments by third
        parties                                      --          --        (15)
      Settlement income related to unauthorized
        trading of investments by third parties      --           1          --
                                                   ------      -------    -------
     Income before income taxes                      28          28         10
     Provision for income taxes                      11          11          9
                                                   =======     =======    =======
     Net income                                      17 %        17 %        1 %
                                                   =======     =======    =======
</TABLE>


    1997 Compared to 1996

      REVENUES

        Revenues increased 37% to $282.3 million in 1997 compared with $205.5
million in 1996. This increase was primarily due to a 39% increase in unit sales
volume of the Company's HiGain products and, to a lesser extent, a 57% and 41%
increase in unit sales volume of the Company's Campus and PG-2 products,
respectively. These increases were partially offset by declines in the average
sales prices of HiGain and Campus products of 16% and 13%, respectively. In
addition, revenues from the Company's PG-Flex, PG-Plus and megabit access
products increased to 7% of total revenues in 1997 compared to 2% in 1996.
Revenue per average employee increased to $432,000 in 1997, compared to $399,000
in 1996.

        Aggregate sales to local telephone companies affiliated with the five
RBOCs accounted for approximately 57% and 62% of the Company's total revenues
for 1997 and 1996, respectively.

                                       25
<PAGE>   32

      GROSS PROFIT

        Gross profit represents total revenues for a period, including royalty
income, less the cost of revenues for such period. Cost of revenues represents
primarily product costs, together with associated overhead expenditures and
provisions for inventory and warranty reserves. In 1997, the Company's gross
profit as a percentage of total revenues increased to 49% from 48% in 1996
despite decreases in average sales prices and increases in overhead spending and
provisions for inventory and warranty reserves. The Company's continuing effort
toward cost reduction through engineering design changes, reduced prices for
components, increased manufacturing efficiencies and increases in volume was
the primary reason for the Company's ability to increase gross margin to 49% of
revenues in 1997.

      OPERATING EXPENSES

        Operating expenses, excluding merger expenses, increased 38% to $65.4
million in 1997 from $47.5 million in 1996. As a percentage of revenue,
operating expenses, excluding merger expenses in 1997, were 23% for 1997 and
1996. The majority of the increase in absolute operating expense levels was in
the area of research and development with the remainder of the increase coming
from selling and marketing expenses. The Company plans to increase its relative
spending in engineering and field sales support in an effort to continue to
develop and market new products and technologies such as the small subscriber
and megabit access product lines and the newly released Falcon(TM) DMT ADSL
chip.

        Research and development expense increased 64% to $32.0 million in 1997
from $19.5 million in 1996. Research and development expense was 11% of total
revenues in 1997 compared to 9% in 1996. The increase in expenses was primarily
due to the addition of personnel for the development of new products,
specifically, development programs for PG-Flex, PG-Plus, Falcon chip technology
and megabit access products, and sustaining, enhancement and cost reduction
programs for HiGain and Campus products. Costs for prototype expenditures as new
products were tested in the lab and payments to consultants where specific
resources were needed in the development process also increased in 1997 over the
prior year. The Company anticipates that research and development expenses will
continue to increase as new products are further developed and other xDSL
technologies and applications are pursued.

        Selling and marketing expense increased 30% to $22.8 million in 1997
from $17.6 million in 1996. Selling and marketing expense as a percentage of
total revenues was 8% in 1997 and 9% in 1996. The increase in absolute expense
levels was primarily due to the addition of personnel and the associated
increase in salaries, benefits and travel expenses, and additional advertising
and trade show expenditures designed to market the Company's new products and
technology. In addition, costs related to the expansion of the Company's
presence in the international market more than doubled over the prior year. The
Company anticipates higher selling and marketing spending levels in the future
in order to maintain its leadership position in the xDSL market and to secure
market share in the small subscriber and megabit access markets.

        General and administrative expense increased to $10.6 million in 1997
from $10.4 million in 1996. Increases in personnel-associated costs and
expenditures for computer equipment, software maintenance and consulting fees
related to upgrading the Company's information system capabilities were offset
by decreases in legal fees and provisions for bad debts. General and
administrative expense as a percentage of total revenues was 4% in 1997 compared
to 5% in 1996.

      MERGER EXPENSES

        Expenses related to the acquisition of Avidia Systems, Inc. aggregating
approximately $2.6 million were charged against the operations of the Company in
the quarter ended March 31, 1997. These expenses consisted of $1.8 million in
investment banking fees, $588,000 in legal fees, $120,000 in accounting fees and
$121,000 in other expenses.



                                       26
<PAGE>   33

      INTEREST INCOME, NET

        Net interest income was $6.9 million in 1997 and $3.7 million in 1996.
The increase in interest income was the result of increased average cash
balances.

      GAINS ON SALES OF SHORT-TERM INVESTMENTS

        Realized gains on sales of short-term investments were $23,000 in 1997.
There were no realized gains on sales of short-term investments in 1996 and
there were no realized losses on sales of short-term investments in 1997 or
1996.

      LOSS ON NOTE RECEIVABLE AND LONG-TERM INVESTMENT

        In July 1995, the Company entered into certain agreements with Sourcecom
Corporation of Westlake, California ("Sourcecom"). The agreements provided for
the incorporation of Sourcecom's networking technology into the Company's
current and future transmission products. Under the terms of the agreements, the
Company loaned Sourcecom $2.7 million and had rights to purchase a minority
ownership position. The note bore interest at the prime rate less one percent,
payable monthly, with the principal balance due July 1999.

        In April 1996, the Company purchased approximately 150,000 shares of
Sourcecom's Series A Preferred Stock for an aggregate of $273,000. In September
1996, the Company purchased approximately 321,000 shares of Sourcecom's Common
Stock for an aggregate of $271,000. Shares purchased have been adjusted to
reflect Sourcecom's two-for-one stock split, effective September 24, 1996.

        In the third quarter of 1997, Sourcecom filed for protection from
creditors under the U.S. Bankruptcy Act. Accordingly, the Company recorded a
valuation adjustment of $544,000 during the third quarter of 1997 to reflect an
impairment in its investment in Sourcecom. In December 1997, Sourcecom and the
Company reached an agreement for a mutual release of all claims. Under the terms
of the release, Sourcecom paid $2.6 million to the Company to settle the loan
made under the original agreements. In the fourth quarter of 1997, the Company
wrote-off the balance of the note and associated legal fees aggregating
$200,000.

      SETTLEMENT INCOME RELATED TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD
      PARTIES

        As described in Notes 15 and 16 of Notes to the Consolidated Financial
Statements, the Company incurred a loss of $15.8 million from unauthorized and
inappropriate trading of investments by third parties in 1995.

        In January 1996, the Company received copies of complaints filed
derivatively by a Company stockholder on behalf of the Company, naming as
defendants the Company's directors and certain officers, as well as Capital
Insight and Mr. S. Jay Goldinger, its president, and a brokerage firm used in
executing and clearing transactions authorized by Mr. Goldinger. The derivative
complaint stated causes of action for breach of fiduciary duty, abuse of
control, constructive fraud, gross mismanagement and waste of corporate assets.
The suit sought an award in the amount of all damages sustained by the Company
including the losses of $15.8 million and legal fees and expenses.

        In September 1996, the Company and other parties to the derivative suits
described above executed definitive settlement agreements to settle and dismiss
the derivative suits. The Court approved the settlement on November 19, 1996.
Under the terms of the settlement, the Company received $2.5 million from a
brokerage firm involved in processing the investments for Capital Insight, and
the Company paid plaintiff's attorneys fees of $450,000. The impact of the
settlement was recorded in the Company's financial statements for the year ended
December 31, 1996.

      PROVISION FOR INCOME TAXES

        The Company's provision for income taxes increased to $30.3 million in
1997, compared to $22.8 million in 1996. The effective tax rate during 1997 was
39%. The effective tax rate during 1996 was 40%.



                                       27
<PAGE>   34

        Excluding non-deductible merger expenses, the 1997 effective tax rate
was 38%. The primary reason for the reduction in the Company's effective tax
rate was due to additional research and development tax credits.

      NET INCOME AND EARNINGS PER SHARE

        Net income for the year ended December 31, 1997 was $47.6 million or
$0.70 per share, compared to $34.9 million or $0.54 per share, for the year
ended December 31, 1996. The weighted average number of common shares
outstanding were 68.0 million and 64.2 million for the years ended December 31,
1997 and 1996, respectively. This increase in common shares was attributable to
the exercise of stock options and warrants and the issuance of shares under the
Employee Stock Purchase Plan.

        Earnings per share, taking into account the dilutive effects of common
stock options and warrants, were $0.63 per share and $0.47 per share for the
year ended December 31, 1997 and 1996, respectively. The weighted average number
of common and common equivalent shares outstanding were 75.2 million in 1997 and
73.8 million in 1996.


    1996 Compared to 1995

      REVENUES

        Revenues increased 92% to $205.5 million in 1996 compared with $107.2
million in 1995. This increase was primarily due to a 106% increase in unit
sales volume of the Company's HiGain products and, to a lesser extent, a 90% and
64% increase in unit sales volume of the Company's Campus and PG-2 products,
respectively. These increases were somewhat offset by declines in the average
sales prices of HiGain and Campus products of 14% and 7%. Revenue per average
employee increased 46% to $399,000 in 1996, compared to $274,000 in 1995.

        Aggregate sales to local telephone companies affiliated with the five
RBOCs accounted for approximately 62% and 65% of the Company's total revenues
for 1996 and 1995, respectively. In addition, included in revenues for 1995 was
royalty income totaling $1.1 million. These royalties were paid to the Company
primarily in connection with technology licensing agreements entered into with
Alcatel and ADC Telecommunications, Inc. In 1995, the agreement between the
Company and Alcatel was renegotiated. As a result, royalty income from these
licensing agreements will be minimal in future periods.

      GROSS PROFIT

        In 1996, the Company's gross profit as a percentage of total revenues
continued at the 1995 rate of 48% in spite of decreases in average sales prices,
a decline in royalty income and increases in overhead spending and provisions
for inventory and warranty reserves. The Company's continuing effort toward cost
reduction through engineering design changes, reduced prices for components,
increased manufacturing efficiencies and increases in volume, was the primary
reason for the Company's ability to maintain gross margin at 48% of revenues.

      OPERATING EXPENSES

        Research and development expense increased to $19.5 million in 1996 from
$10.7 million in 1995. Research and development expense was 9% of total revenues
in 1996 compared to 10% in 1995. The increase in absolute expense levels was
primarily due to the addition of personnel for the development of new products,
specifically, development programs for PG-Flex, PG-Plus, Falcon chip technology
and megabit access products, and sustaining, enhancement and cost reduction
programs for HiGain and Campus products. Costs for prototype expenditures as new
products were tested in the lab and payments to consultants where specific
resources were needed in the development process also increased in 1996 over the
prior year. In addition, the Company's research and development facility in
Raleigh, North Carolina, which was established in the second half of 1995, and
its research facility in Wallingford, Connecticut, which was established in
December 1995, were expanded significantly during 1996.



                                       28
<PAGE>   35

        Selling and marketing expense increased to $17.6 million in 1996 from
$9.9 million in 1995. This increase in expense levels was primarily due to the
addition of personnel and the associated increase in salaries, commission and
travel expenses, and additional advertising and trade show expenditures. Selling
and marketing expense as a percentage of total revenues was 9% in both 1996 and
1995.

        General and administrative expense increased to $10.4 million in 1996
from $6.8 million in 1995. This increase was primarily due to the addition of
personnel, payments to outside consultants related to the implementation of an
information systems upgrade, legal and accounting fees related to the unusual
trading losses and subsequent settlement and an overall increase in spending
commensurate with the Company's increase in headcount and operating activities.
General and administrative expense as a percentage of total revenues was 5% in
1996 compared to 6% in 1995.

      INTEREST INCOME, NET

        Net interest income was $3.7 million in 1996 and $2.1 million in 1995.
The increase in interest income was the result of increased average cash
balances.

      GAINS ON SALES OF SHORT-TERM INVESTMENTS

        There were no realized gains or losses on sales of investments in 1996.
Realized gains on sales of short-term investments were $415,000 in 1995.

      UNUSUAL LOSS / SETTLEMENT INCOME RELATED TO UNAUTHORIZED TRADING OF
      INVESTMENTS BY THIRD PARTIES

        As described in Notes 15 and 16 of Notes to the Consolidated Financial
Statements, the Company incurred a loss of $15.8 million from unauthorized and
inappropriate trading of investments by third parties in 1995.

        In January 1996, the Company received copies of complaints filed
derivatively by a Company stockholder on behalf of the Company, naming as
defendants the Company's directors and certain officers, as well as Capital
Insight and Mr. S. Jay Goldinger, its president, and a brokerage firm used in
executing and clearing transactions authorized by Mr. Goldinger. The derivative
complaint stated causes of action for breach of fiduciary duty, abuse of
control, constructive fraud, gross mismanagement and waste of corporate assets.
The suit sought an award in the amount of all damages sustained by the Company
including the losses of $15.8 million and legal fees and expenses.

        In September 1996, the Company and other parties to the derivative suits
described above executed definitive settlement agreements to settle and dismiss
the derivative suits. The Court approved the settlement on November 19, 1996.
Under the terms of the settlement, the Company received $2.5 million from a
brokerage firm involved in processing the investments for Capital Insight, and
the Company paid plaintiff's attorneys fees of $450,000. The impact of the
settlement was recorded in the Company's financial statements for the year ended
December 31, 1996.

      PROVISION FOR INCOME TAXES

        The Company's provision for income taxes increased to $22.8 million in
1996, compared to $9.2 million in 1995. The effective tax rate during 1996 was
40%. The effective tax rate during 1995 was 90%, since the Company did not
record any tax benefit on the unusual trading losses in that year.

        Excluding the $15.8 million unusual loss, the Company's effective tax
rate in 1995 was 37%. The increased effective tax rate in 1996 over 1995 was
principally attributed to tax-free interest income representing a smaller
proportion of total pre-tax income as a result of the earnings growth.
Additionally, the Company did not record any tax benefit related to Avidia
Systems net operating losses and research and development tax credits for
pre-acquisition periods due to the uncertainty of their realization as a result
of separate return limitation year rules.

                                       29
<PAGE>   36

      NET INCOME AND EARNINGS PER SHARE

        Net income for the year ended December 31, 1996 was $34.9 million or
$0.54 per share, compared to $1.1 million or $0.02 per share, for the year ended
December 31, 1995. Excluding the impact of the unauthorized trading loss, 1995
net income was $16.5 million or $0.28 per share. The weighted average number of
common shares outstanding were 64.2 million and 58.2 million for the years ended
December 31, 1996 and 1995, respectively. This increase in common shares was
attributable to the exercise of stock options, the issuance of stock under the
Employee Stock Purchase Plan and the issuance of Common Stock by Avidia prior to
its acquisition by the Company.

        Earnings per share, taking into account the dilutive effects of common
stock options and warrants, were $0.47 per share and $0.02 per share for the
year ended December 31, 1996 and 1995, respectively. Excluding the impact of the
unauthorized trading loss, 1995 diluted earnings per share were $0.24. The
weighted average number of common and common equivalent shares outstanding were
73.8 million in 1996 and 67.2 million in 1995.

LIQUIDITY AND CAPITAL RESOURCES

        As of December 31, 1997, the Company had $176.6 million in cash, cash
equivalents and short-term investments and $214.7 million in working capital,
compared to $114.2 million in cash, cash equivalents and short-term investments
and $140.7 million in working capital in 1996. These figures represent an
increase of $62.4 million in cash, cash equivalents and short-term investments
and $74.0 million in working capital over December 31, 1996. These increases
were primarily attributable to cash generated from operations of $66.3 million
and $8.1 million in cash generated from the issuance of Common Stock resulting
from exercises of options and warrants and Common Stock sold under the Employee
Stock Purchase Plan, offset by capital expenditures of $13.5 million. In 1996,
the Company had cash flow from operations of $60.2 million. In addition, $10.4
million in cash was generated from the issuance of stock, including $7.4 million
resulting from the exercises of common stock options and Common Stock sold under
the Employee Stock Purchase Plan and $3.0 million from the issuance of stock by
Avidia prior to its acquisition by the Company.

        Accounts receivable increased to $35.4 million at December 31, 1997,
compared to $23.9 million at December 31, 1996. Gross inventories increased $9.8
million to $50.6 million at December 31, 1997 compared to $40.8 million at
December 31, 1996, due to increased stocking levels to support future shipments.
Reserves for inventory obsolescence, excess quantities, cost reductions and test
and evaluation inventories increased to $20.1 million at December 31, 1997
compared to $14.7 million at December 31, 1996. The primary reasons for the
increase in these reserves were: (a) an increase in components, materials and
sub-assemblies to support production builds; (b) an increase in excess and
obsolete inventories; (c) valuation reductions due to product cost reduction
programs; and (d) an increase in test and evaluation inventories of new products
on trial with customers. The Company's net inventory turns increased to 4.7
times in 1997 from 4.1 times in 1996.

        Capital expenditures were $13.5 million, $7.6 million and $5.9 million
for the years ended December 31, 1997, 1996 and 1995, respectively. Included in
these amounts were approximately $3.5 million, $450,000 and $750,000 in 1997,
1996 and 1995, respectively, of software and equipment purchased to upgrade the
Company's information system capabilities. Additional expenditures in 1997
included $1.2 million for a manufacturing and material handling system, $1.8
million in improvements to the Company's new engineering and production facility
adjacent to its main Tustin facility and $4.8 million for test equipment
primarily related to new products. Expenditures in 1996 also included $251,000
in leasehold improvements at two of the Company's Tustin facilities and $158,000
in leasehold improvements at the Company's Raleigh, North Carolina research and
development center. Included in the 1995 additions is $1.0 million in leasehold
improvements at the Company's Tustin, California manufacturing, engineering and
administrative headquarters.

        During 1996, the Company made investments in Sourcecom and E/O Networks
("E/O") of $544,000 and $3.0 million, respectively. Both investments were made
with internally generated funds. In the third quarter of 1997, Sourcecom filed
for protection from creditors under the U.S. Bankruptcy Act. The Company
recorded a valuation adjustment to its investment of $544,000 during the third
quarter of 1997 to reflect an impairment in its investment in Sourcecom. A
mutual release of all claims between Sourcecom and the Company was reached in


                                       30
<PAGE>   37

December 1997. Under the terms of the release, Sourcecom paid $2.6 million to
the Company to offset the $2.7 million loan made to Sourcecom in 1995.
Accordingly, in the fourth quarter of 1997, the Company wrote off the balance of
the loan and associated legal fees aggregating $200,000.

        The Company maintains an unsecured line of credit with a bank. The line
allows maximum borrowings of $5,000,000, including the issuance of letters of
credit and foreign exchange contracts. The line bears interest at the prime rate
(8.5% at December 31, 1997). At December 31, 1997, the Company had no
outstanding borrowings under this line of credit. The debt agreement specifies
certain financial and other covenants. The Company was in compliance with the
financial and other covenants at December 31, 1997. The agreement expires May 1,
1998. The Company typically renews the line upon expiration.

        The Company has no other material near-term commitments for its funds.
The Company believes that the current cash and short-term investment balances
and internally generated cash flow will be sufficient to meet its working
capital and capital expenditure requirements through 1998. To the extent that
the Company's existing resources, together with future earnings, are
insufficient to fund the Company's future activities, the Company may need to
raise additional funds through public or private financings.

YEAR 2000 ISSUE

        Many of the world's computer systems currently record years in a
two-digit format. Such computer systems will be unable to properly interpret
dates beyond the year 1999, which could lead to business disruptions in the U.S.
and internationally (the "Year 2000" issue). The potential costs and
uncertainties associated with the Year 2000 issue will depend on a number of
factors, including software, hardware and the nature of the industry in which a
company operates. Additionally, companies must coordinate with other entities
with which they electronically interact, such as customers, creditors and
borrowers.

        In 1997, the Company began a review of its computer systems to assess
the potential costs and scope of the Year 2000 issue. In January 1998, the
Company began a project to upgrade its core business applications which support
sales and customer service, manufacturing, distribution and finance and
accounting, with an implementation target of October 1998. Additional areas that
require conversion are expected to be identified by the end of the first quarter
of 1998, with a goal of completing all relevant internal software remediation
and testing by the end of 1998. Year 2000 compliance efforts and testing will
continue through 1999.

        The Company will utilize both internal and external resources to
reprogram, or replace, and test its software for Year 2000 modifications. The
total cost to the Company of these Year 2000 issue activities has not been and
is not anticipated to be material to its financial position or results of
operations in any given year. Purchased hardware and software will be
capitalized in accordance with normal policy. Personnel and all other costs
related to the project are being expensed as incurred. Costs incurred related to
the Year 2000 issue are being funded through operating cash flows.

        An assessment of the readiness of external entities with which the
Company interfaces, such as vendors, counterparties, customers, payment systems
and others, is ongoing. The Company has initiated formal communications with all
of its significant suppliers and large customers to determine the extent to
which the Company's interface systems are vulnerable to those third parties'
failure to remedy their own Year 2000 issue. There can be no guarantee that the
systems of other companies on which the Company's systems rely will be timely
converted and would not have an adverse effect on the Company's systems.

        The above was based upon management's best estimates, which were derived
utilizing numerous assumptions of future events, including the continued
availability of certain resources, third party modification plans and other
factors. However, there can be no guarantee that these estimates will be
achieved and actual results could differ materially from those anticipated.
Specific factors that might cause such material differences include, but are not
limited to, the availability and cost of personnel trained in this area, the
ability to locate and correct all relevant computer codes, the nature and amount
of programming required to upgrade or replace each of the affected programs, the
rate and magnitude of related labor and consulting costs and the success of the
Company's external customers and suppliers in addressing the Year 2000 issue.

                                       31
<PAGE>   38

NEW ACCOUNTING PRONOUNCEMENTS

        In June 1997, the Financial Accounting Standards Board (the "FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income" ("SFAS No. 130"). SFAS No. 130 discusses how to report and
display comprehensive income and its components in a full set of general-purpose
financial statements. Also in June 1997, the FASB issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information" ("SFAS No.
131"). SFAS No. 131 establishes standards for the way that public business
enterprises report information about operating segments in annual financial
statements and requires those enterprises to report selected information about
operating segments in interim financial reports issued to shareholders. SFAS No.
130 and SFAS No. 131 must be implemented by PairGain in 1998. The Company has
not completed its evaluation of these statements, but does not anticipate a
material impact on the consolidated financial statements from the adoption of
the additional disclosure requirements of these accounting standards.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
---------------------------------------------------------------------

        At December 31, 1997, the Company had an investment portfolio of fixed
income securities, including those classified as cash equivalents, of $155.6
million. These securities are subject to interest rate fluctuations. An increase
in interest rates could adversely affect the market value of the Company's fixed
income securities.

        A sensitivity analysis was performed on the Company's investment
portfolio as of December 31, 1997. This sensitivity analysis is based on a
modeling technique that measures the hypothetical market value changes that
would result from a parallel shift in the yield curve of plus 50, plus 100 or
plus 150 basis points over a 12-month time horizon. The market value changes for
a 50, 100 or 150 basis point increase in short-term treasury security yields
were not material due to the overall short-term maturity of the Company's
portfolio. As of December 31, 1997, the weighted average maturity of the
Company's portfolio is 187 days.

        The Company limits its exposure to interest rate and credit risk by
establishing and strictly monitoring clear policies and guidelines for its fixed
income portfolios. At the present time, the maximum average maturity of the
Company's overall investment portfolio is limited by policy to 36 months. The
guidelines also establish credit quality standards, limits on exposure to one
issue, issuer, as well as the type of instrument. Due to the limited duration
and credit risk criteria established in the Company's guidelines, the exposure
to market and credit risk is not expected to be material. The Company does not
use derivative financial instruments in its investment portfolio to manage
interest rate risk.

                                       32
<PAGE>   39

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
-----------------------------------------------------

        The Company's consolidated financial statements and schedule appear in a
separate section of this Annual Report on Form 10-K beginning on page F-1 and
S-1, respectively.

     SUPPLEMENTARY FINANCIAL DATA
     ----------------------------

<TABLE>
<CAPTION>
                                                  SELECTED QUARTERLY FINANCIAL DATA
                                                             (UNAUDITED)

                                                      FOR THE THREE MONTHS ENDED
                                     -------------------------------------------------------------
                                       MARCH 31,       JUNE 30,     SEPTEMBER 30,   DECEMBER 31,
                                     ------------------------------ -------------- ---------------
                                                (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                   <C>            <C>            <C>             <C>
1997
 Revenues                             $  70,749      $  66,369      $  70,697       $  74,510
 Gross profit                            34,969         32,786         34,925          37,074
 Income  from operations                 18,936         16,841         17,585          18,377
 Net income                              11,374         11,720         11,797          12,746

 Earnings per common share(1)
   Basic                              $    0.17      $    0.17      $    0.17       $    0.19
   Diluted                            $    0.15      $    0.16      $    0.16       $    0.17
 Average shares outstanding(1)
   Basic                                 66,865         67,838         68,387          68,874
   Diluted                               75,539         74,736         75,165          75,458
</TABLE>

<TABLE>
<CAPTION>
                                                      FOR THE THREE MONTHS ENDED
                                     -------------------------------------------------------------
                                     MARCH 31,(2)   JUNE 30,(2)  SEPTEMBER 30,(2)  DECEMBER 31,(2)
                                     ------------- ------------ ------------------ ---------------
                                                (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                   <C>            <C>            <C>             <C>
1996
 Revenues                             $  40,511      $  47,241      $  54,618       $  63,135
 Gross profit                            19,039         22,667         26,149          31,132
 Income  from operations                  9,332         11,169         13,255          17,770
 Settlement income related to
   unauthorized trading of
   investments by third parties              --             --             --           2,500
 Net income                               6,222          7,324          8,468          12,894

 Earnings per common share(1)
   Basic                              $    0.10      $    0.11      $    0.13       $    0.20
   Diluted                            $    0.09      $    0.10      $    0.11       $    0.17
 Average shares outstanding(1)
   Basic                                 62,680         63,778         64,581          65,940
   Diluted                               71,772         73,552         74,347          75,390
</TABLE>

--------------------------
(1)   All share and per share amounts have been adjusted for the June 18, 1996
      and December 18, 1996 two-for-one stock splits and have been restated to
      reflect the adoption of SFAS No. 128.

(2)   Financial data for 1996 reflect the February 27, 1997 business combination
      between PairGain and Avidia Systems, Inc. accounted for on a
      pooling-of-interests basis. Avidia was formed in December 1995 and had no
      significant transactions prior to January 1, 1996. See Notes 1 and 2 of
      Notes to the Consolidated Financial Statements contained in a separate
      section of this Annual Report on Form 10-K commencing on page F-1.


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

        None.


                                       33
<PAGE>   40

                                    PART III


ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
-------------------------------------------------------------

        The sections tilted "Directors and Nominees" and "Compliance with
Section 16(a) of the Exchange Act" appearing in the Company's Proxy Statement
for the 1998 Annual Meeting of Stockholders is incorporated herein by reference.

               DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

        The following table sets forth certain information concerning the
Executive Officers and Directors of the Company.

<TABLE>
<CAPTION>
          NAME                 AGE                             POSITION
--------------------------  ----------- --------------------------------------------------------------
<S>                            <C>      <C>
Charles S. Strauch             62       Chairman of the Board and Chief Executive Officer
Howard S. Flagg                43       President and Director
Benedict A. Itri               44       Executive Vice President, Chief Technical Officer and Director
Charles W. McBrayer            49       Senior Vice President, Chief Financial Officer and Secretary
Dennis Young                   55       Senior Vice President, Operations and Product Line Management
Bruce Kimble                   48       Vice President, T1 Access
Thomas Reynolds                46       Senior Vice President, Sales, Service and Field Marketing
Robert C. Hawk(1)              58       Director
Robert A. Hoff(1,2)            45       Director
B. Allen Lay(1,2)              63       Director
Howard G. Bubb                 43       Director
</TABLE>

--------------------------
(1)  Member of the Audit Committee
(2)  Member of the Compensation Committee

        Mr. Strauch became a director of the Company in October 1991, Chairman
of the Board of Directors of the Company in November 1991 and Chief Executive
Officer of the Company in April 1992. Prior to his employment with the Company,
Mr. Strauch held executive management positions and directorships with various
publicly traded companies including Chief Executive Officer of MSI Data
Corporation, a manufacturer of hand-held data collection devices (AMEX); Chief
Executive Officer of Magnuson Computer Systems, a manufacturer of main frame
computers (Nasdaq); and President/Chief Operating Officer of Memorex, a
manufacturer of computer peripherals (NYSE). Mr. Strauch has also held several
directorships including Symbol Technologies, EECO Inc. and BMC Industries.

        Mr. Flagg, a founder of the Company, has been President and a director
of the Company since November 1991. He served as Chief Executive Officer from
November 1991 to April 1992 and as Vice President, Research and Development from
February 1988 to November 1991. Prior to founding the Company, Mr. Flagg founded
and served as a principal of Advanced Telecommunications, Inc., an aerospace
telecommunications consulting firm.

        Mr. Itri, a founder of the Company, was named Chief Technical Officer in
April 1996. Previously, Mr. Itri was Vice President, Engineering of the Company
since its inception in February 1988 and has been a director of the Company
since November 1991. Prior to founding the Company, Mr. Itri founded and served
as a principal of Advanced Telecommunications, Inc.

        Mr. McBrayer was named Senior Vice President and Chief Financial Officer
in February 1998. Mr. McBrayer joined the Company in March 1995 as Vice
President, Finance and Administration and Chief Financial Officer. Mr. McBrayer
served as Vice President, Finance and Chief Financial Officer for Triconex
Corporation, a publicly held corporation (Nasdaq), from 1986 to March 1995 and
was named to the Board of Directors of Triconex in January 1994.

                                       34
<PAGE>   41
 Mr. Young was named Senior Vice President, Operations and Product Line
Management in February 1998. Mr. Young joined the Company in September 1993 as
Director, European Operations and assumed the position of Vice President,
Operations in December 1994. From 1985 to 1993, Mr. Young served as Managing
Director of Talley (UK) Ltd. and EECO (UK) Ltd. These companies designed,
manufactured and marketed both consumer and industrial products throughout the
United Kingdom, Europe and certain world markets.

        Mr. Kimble was named Vice President, T1 Access in February 1998. Mr.
Kimble joined the Company in September 1993 as Project Manager and later assumed
the position of Director of Engineering. He was named Vice President,
Engineering in April 1996. From 1991 to 1993, Mr. Kimble was a Product Line
Manager at Cable and Computer Technology, Inc., a military computer systems
manufacturer. From 1985 to 1991, Mr. Kimble was President and owner of Semaphore
Corporation, a telemetry equipment and DSP consulting firm.

        Mr. Reynolds joined the Company in October 1996 as Senior Vice
President, Sales, Customer Service and Field Marketing. Mr. Reynolds was
employed by Motorola Information Systems Group from 1990 to 1996 where he served
in various senior management positions in sales and marketing. From 1983 to
1990, Mr. Reynolds held field sales management positions at Hewlett-Packard and
Harris Corporation, manufacturers of workstation and data communications
products.

        Mr. Hawk became a director of the Company in November 1992. Mr. Hawk is
President of Hawk Communications and recently retired as President and CEO of U
S WEST Multimedia Communications, Inc. From 1988 until 1996, Mr. Hawk served as
President of the Carrier Division of U S WEST Communications, Inc. Prior to that
time, Mr. Hawk served as Vice President, Marketing and Strategic Planning for
CXC Corporation and as Director, Advanced Systems Development for AT&T/American
Bell. Mr. Hawk also serves as a director of Premisys Communications (Nasdaq),
Xylan Corporation (Nasdaq), Concord Communications (Nasdaq) and privately-held
Radcom.

        Mr. Hoff became a director of the Company in February 1989. Mr. Hoff has
been a general partner of Crosspoint Venture Partners, a private venture capital
investment company, since September 1983. Mr. Hoff also serves as a director of
privately-held Com21 Incorporated, Efficient Networks, Sonoma Systems and
Accredited Home Lenders and publicly-held Onyx Acceptance Corporation (Nasdaq)
and US Web Corporation (Nasdaq).

        Mr. Lay became a director of the Company in February 1989. Mr. Lay has
been a general partner of Southern California Ventures, a private venture
capital investment partnership, since May 1983. Mr. Lay serves as a director of
privately-held Physical Optics Corporation and Waveband, Inc. and of
publicly-held ViaSat, Inc. (Nasdaq), Kofax Imaging Corporation (Nasdaq) and
Helisys, Inc. (Nasdaq).

        Mr. Bubb became a director of the Company in December 1997. Mr. Bubb has
been President and CEO of Dialogic Corporation since June 1993. From July 1991
through June 1993, Mr. Bubb was an Executive Vice President of Dialogic. Mr.
Bubb has served as director for Dialogic since 1994. Mr. Bubb joined Dialogic
from Lexar's Telenova subsidiary where he was senior vice president and general
manager. Mr. Bubb also held senior management positions at United Technologies,
Memorex and Telex corporations.

                                       35
<PAGE>   42

ITEM 11.  EXECUTIVE COMPENSATION.
---------------------------------

        The section titled "Executive Compensation and Related Information"
appearing in the Company's Proxy Statement for the 1998 Annual Meeting of
Stockholders is incorporated herein by reference.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
-------------------------------------------------------------------------

        The section titled "Principal Stockholders" appearing in the Company's
Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated
herein by reference.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
---------------------------------------------------------

        The section titled "Certain Transactions" appearing in the Company's
Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated
herein by reference.

                                       36
<PAGE>   43

                                     PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
---------------------------------------------------------------------------

    (A)(1)  FINANCIAL STATEMENTS:

        The following financial statements are included in a separate section of
this Annual Report on Form 10-K commencing on page F-1:

   Independent Auditors' Report
   Consolidated Balance Sheets
   Consolidated Statements of Income
   Consolidated Statements of Stockholders' Equity
   Consolidated Statements of Cash Flows
   Notes to Consolidated Financial Statements

       (2)  FINANCIAL STATEMENT SCHEDULE:

        The following financial schedule for the years 1997, 1996 and 1995 is
included in a separate section of this Annual Report on Form 10-K commencing on
page S-1:

   Schedule II - Valuation and Qualifying Accounts.

        All other schedules are omitted because they are not applicable or the
required information is shown in the financial statements or notes thereto.

       (3)  EXHIBITS:

<TABLE>
<C>       <S>
(a)  3.4  Certificate of Incorporation of Registrant, a Delaware corporation

(a)  3.5  Form of Agreement and Plan of Merger of Registrant, a Delaware corporation, and
          Registrant, a California corporation

(a)  3.6  Bylaws of Registrant, a Delaware corporation

(a) 10.1  PairGain Technologies, Inc. 1990 Stock Option Plan (the "1990 Plan")

(a) 10.2  Form of Incentive Stock Option Agreement pertaining to the 1990 Plan

(a) 10.3  Form of Supplemental Incentive Stock Option Agreement pertaining to the 1990 Plan

(a) 10.4  Form of Nonstatutory Stock Option Agreement pertaining to the 1990 Plan

(a) 10.5  PairGain Technologies, Inc. 1993 Option/Stock Issuance Plan (the "1993 Plan")

(a) 10.6  Form of Stock Option Agreement pertaining to the 1993 Plan

(a) 10.7  Form of Stock Issuance Agreement pertaining to the 1993 Plan

(a) 10.8  Contract No. BA07617 dated as of October 27, 1990, between the Registrant and Bell
          Atlantic Network Services, Inc., as amended

(a) 10.9  Stock Option Agreement dated June 23, 1992 between the Registrant and Charles S. Strauch

(a) 10.10 Stock Option Agreement dated June 23, 1992 between the Registrant and Howard S. Flagg
</TABLE>

                                       37
<PAGE>   44

<TABLE>
<C>       <S>
(a) 10.11 Stock Option Agreement dated June 23, 1992 between the Registrant and Benedict A. Itri

(a) 10.12 Agreement dated April 26, 1991 between the Registrant and Brooktree Corporation

(a) 10.13 Loan and Security Agreement dated as of July 31, 1991, between the Registrant and
          Silicon Valley Bank, as amended

(a) 10.14 Standard Sublease dated as of October 29, 1991, between the Registrant and Kirkwood
          Dynaelectric Company

(a) 10.15 Series B Preferred Stock Purchase Agreement dated as of January 17, 1992, among the
          Registrant and the investors listed therein

(a) 10.16 Industrial Lease dated as of March 17, 1992, between the Registrant and Alondra
          Shoemaker Associates

(a) 10.17 Warrant to Purchase Stock dated June 22, 1992, issued to Silicon Valley Bank

(a) 10.18 Development and license Agreement and Remote HDSL OEM Agreement both dated June 30, 1992,
          between the Registrant and ADC Telecommunications, Inc.

(a) 10.19 Agreement No. PR-6727-A dated September 11, 1992, between the Registrant and Bell South
          Telecommunications, Inc., as amended

(a) 10.20 Series B Preferred Stock Purchase Agreement dated as of September 30, 1992, among the
          Registrant and the investors listed therein

(a) 10.21 Registration Rights Agreement dated as of September 30, 1992, among the Registrant,
          Alcatel Network Systems, Inc., and the investors listed therein

(a) 10.22 License and Distribution Agreement dated September 30, 1992, between the Registrant and
          Alcatel Network Systems, Inc.

(a) 10.23 PairGain Technologies, Inc. Series D Preferred Stock Purchase Warrant dated September 30,
          1992, issued to Alcatel Network Systems, Inc.

(a) 10.24 Subordinated Demand Promissory Note, principal amount $3,000,000, dated September 30, 1992,
          issued to Alcatel Network Systems, Inc.

(a) 10.25 PairGain Technologies, Inc. Common Stock Purchase Warrant dated March 25, 1993, issued to
          Ventana Leasing, Inc.

(a) 10.26 PairGain Technologies, Inc. Common Stock Purchase Warrant dated March 25, 1993, issued to
          Praktikerfinans A.B.

(a) 10.27 Form of Indemnification Agreement

(b) 10.28 Sublease Agreement dated as of August 1, 1994, between the Registrant and LH Research

(b) 10.29 Lease Agreement dated January 30, 1995 between the Registrant and Mr. Niles Gates

(c) 10.30 Senior Note and Warrant Purchase Agreement dated July 24, 1995 between PairGain Technologies,
          Inc. and Sourcecom Corporation

(c) 10.31 Warrant Agreement dated July 24, 1995 between PairGain Technologies, Inc. Sourcecom Corporation
</TABLE>

                                       38
<PAGE>   45

<TABLE>
<C>       <S>
(c) 10.32 Investor Right Agreement dated July 24, 1995 between PairGain Technologies, Inc.
          Sourcecom Corporation

(c) 10.33 Stock Purchase Agreement dated July 24, 1995 between PairGain Technologies, Inc.
          Sourcecom Corporation

(d) 10.34 PairGain Technologies, Inc. Common Stock Purchase Warrant dated May 10, 1995, issued to
          Brobeck, Phleger & Harrison

(d) 10.35 PairGain Technologies, Inc. Common Stock Purchase Warrant dated August 3, 1995, issued to
          Nexus Applied Research, Inc.

(d) 10.36 Amendment to Loan and Security Agreement dated May 3, 1995, between the Registrant and
          Silicon Valley Bank

(e) 10.37 Lease Agreement dated May 30, 1996 between the Registrant and Parker-Raleigh Development
          XXIII, Limited Partnership

(f) 10.38 PairGain Technologies, Inc. 1996 Non-Employee Directors Stock Option Plan

(g) 10.39 Amendment to Certificate of Incorporation of PairGain Technologies, Inc.

(i) 10.40 Amendment to Certificate of Incorporation of PairGain Technologies, Inc.

(j) 10.41 Lease Agreement dated December 25, 1996 between the Registrant and the Cheek Family Trust "D"

(j) 10.42 Lease Agreement dated January 7, 1997 between the Registrant and Catellus Development Corporation

(k) 10.43 Avidia Systems, Inc. 1996 Stock Plan (the "Avidia Plan")

(k) 10.44 Form of Incentive Stock Option Agreement pertaining to the Avidia Plan

(k) 10.45 Form of Non-Qualified Stock Option Agreement pertaining to the Avidia Plan

(k) 10.46 Form of Stock Option Assumption Agreement pertaining to the Avidia Plan

(l) 10.47 PairGain Technologies, Inc. 1993 Option/Stock Issuance Plan as amended (the "1993 Plan")

(h) 20.1  Notice to Company Shareholders of Hearing on Proposed Settlement of derivative Action,
          Case No. 758117.

(b) 21    Subsidiaries of the Registrant

    21.1  Subsidiaries of the Registrant

    23.1  Consent of Deloitte & Touche LLP, Independent Auditors

    27.1  Financial Data Schedule

    27.2  Restated Financial Data Schedule

    27.3  Restated Financial Data Schedule
</TABLE>

                                       39
<PAGE>   46

<TABLE>
<C>       <S>
    27.4  Restated Financial Data Schedule

    27.5  Restated Financial Data Schedule

    27.6  Restated Financial Data Schedule

    27.7  Restated Financial Data Schedule

    27.8  Restated Financial Data Schedule

    27.9  Restated Financial Data Schedule
</TABLE>

--------------------
(a)     Incorporated herein by reference to the same Exhibit number to the
        Company's Registration Statement on Form S-1 (Registration No. 33-66680)
        declared effective by the Commission on September 14, 1993, as amended.

(b)     Incorporated herein by reference to the same Exhibit number to the
        Company's Annual Report on Form 10-K for the fiscal year ended December
        31, 1994, as filed with the Commission on February 22, 1995.

(c)     Incorporated herein by reference to the same Exhibit number to the
        Company's Quarterly Report on Form 10-Q for the second quarter ended
        June 30, 1995, as filed with the Commission on August 10, 1995.

(d)     Incorporated herein by reference to the same Exhibit number to the
        Company's Quarterly Report on Form 10-Q for the third quarter ended
        September 30, 1995, as filed with the Commission on November 6, 1995.

(e)     Incorporated herein by reference to the same Exhibit number to the
        Company's Quarterly Report on Form 10-Q for the second quarter ended
        June 30, 1996, as filed with the Commission on August 13, 1996.

(f)     Incorporated herein by reference to Exhibit number 99-1 of Form S-8
        Registration Statement as filed with the Commission on July 23, 1996.

(g)     Incorporated herein by reference to Appendix A of Proxy Statement for
        the Annual Meeting of Stockholders to be held June 12, 1996 as filed
        with the Commission on May 9, 1996.

(h)     Incorporated herein by reference to the same Exhibit number to the
        Company's Quarterly Report on Form 10-Q for the third quarter ended
        September 30, 1996, as filed with the Commission on November 8, 1996.

(i)     Incorporated herein by reference to Appendix A of Proxy Statement for
        the Special Meeting of Stockholders to be held December 10, 1996 as
        filed with the Commission on November 12, 1996.

(j)     Incorporated herein by reference to the same Exhibit number to the
        Company's Annual Report on Form 10-K for the fiscal year ended December
        31, 1996, as filed with the Commission on March 19, 1997.

(k)     Incorporated herein by reference to Exhibit number 99.1 to the Company's
        Registration Statement on Form S-8, as filed with the Commission on May
        7, 1997.

(l)     Incorporated herein by reference to Exhibit number 99.1 to the Company's
        Registration Statement on Form S-8, as filed with the Commission on
        August 15, 1997.

    (B)  REPORTS ON FORM 8-K:

        None.

                                       40
<PAGE>   47

                                          SIGNATURES

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

<TABLE>
                                                          PAIRGAIN TECHNOLOGIES, INC.
<S>                                         <C>

      Date:    March 30, 1998               By:             /S/ CHARLES S. STRAUCH
                                                 ---------------------------------------------
                                                              Charles S. Strauch
                                                                 (Registrant)
                                                     Chairman and Chief Executive Officer
                                                         (Principal Executive Officer)


      Date:    March 30, 1998               By:             /S/ CHARLES W. MCBRAYER
                                                 ---------------------------------------------
                                                              Charles W. McBrayer
                                                            Senior Vice President,
                                                     Chief Financial Officer and Secretary
                                                         (Principal Financial Officer)


      Date:    March 30, 1998               By:               /S/ ROBERT R. PRICE
                                                 ---------------------------------------------
                                                                Robert R. Price
                                                    Vice President and Corporate Controller
                                                        (Principal Accounting Officer)
</TABLE>


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

<TABLE>
<CAPTION>
                Signature                           Title                     Date
                -------                             -----                     ----
<S>                                    <C>                              <C>

     /S/ CHARLES S. STRAUCH            Chairman, Chief Executive        March 30, 1998
     ------------------------------    Officer and Director
     Charles S. Strauch


     /S/ HOWARD S. FLAGG               President and Director           March 30, 1998
     ------------------------------
     Howard S. Flagg


     /S/ BENEDICT A. ITRI              Executive Vice President,        March 30, 1998
     ------------------------------    Chief Technical Officer and
     Benedict A. Itri                  Director


     /S/ ROBERT C. HAWK                Director                         March 30, 1998
     ------------------------------
     Robert C. Hawk


     /S/ ROBERT A. HOFF                Director                         March 30, 1998
     ------------------------------
     Robert A. Hoff


     /S/ B. ALLEN LAY                  Director                         March 30, 1998
     ------------------------------
     B. Allen Lay


     /S/ HOWARD G. BUBB                Director                         March 30, 1998
     ------------------------------
     Howard G. Bubb
</TABLE>

                                       41
<PAGE>   48

                           PAIRGAIN TECHNOLOGIES, INC.

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995


                                    CONTENTS


<TABLE>
<CAPTION>
                                                                                       PAGE
                                                                                       ----
<S>                                                                                    <C>
     Independent Auditors' Report                                                      F-2

     Consolidated Financial Statements:
     Consolidated Balance Sheets                                                       F-3
     Consolidated Statements of Income                                                 F-4
     Consolidated Statements of Stockholders' Equity                                   F-5
     Consolidated Statements of Cash Flows                                             F-6
     Notes to Consolidated Financial Statements                                        F-7
</TABLE>


                                      F-1
<PAGE>   49

                          INDEPENDENT AUDITORS' REPORT


To the Board of Directors and Stockholders
PairGain Technologies, Inc.
Tustin, California

We have audited the accompanying consolidated balance sheets of PairGain
Technologies, Inc. and subsidiaries (the "Company") as of December 31, 1997 and
1996, and the related consolidated statements of income, stockholders' equity,
and cash flows for each of the three years in the period ended December 31,
1997. Our audits also included the financial statement schedule listed in the
index at Item 14 (a)(2). These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.

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

In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of PairGain Technologies, Inc. and
subsidiaries as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.


DELOITTE & TOUCHE LLP

Costa Mesa, California
January 29, 1998

                                      F-2

<PAGE>   50

                           PAIRGAIN TECHNOLOGIES, INC.

                           CONSOLIDATED BALANCE SHEETS

                                     ASSETS

<TABLE>
<CAPTION>
                                                                              DECEMBER 31,
                                                                     ---------------------------
                                                                         1997          1996
                                                                     ------------  -------------
                                                                       (DOLLARS IN THOUSANDS)
<S>                                                                  <C>            <C>
Current assets:
  Cash and cash equivalents                                          $ 111,602      $  48,416
  Short-term investments (Note 4)                                       64,983         65,779
  Accounts receivable, less allowance for doubtful accounts of
    $955 and $935 at December 31, 1997 and 1996, respectively           35,429         23,888
  Inventories (Note 5)                                                  30,538         26,149
  Deferred tax assets (Note 10)                                         15,419         11,074
  Other current assets                                                   3,655          2,783
                                                                     ------------  -------------
TOTAL CURRENT ASSETS                                                   261,626        178,089
Property and equipment, net (Note 6)                                    17,423         10,390
Note receivable and long-term investments   (Note 7)                     3,000          6,252
Other assets                                                               370            273
                                                                     ------------  -------------
TOTAL ASSETS                                                         $ 282,419      $ 195,004
                                                                     ============  =============

                              LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Trade accounts payable                                             $   8,527      $   6,339
  Accrued expenses (Note 9)                                             21,702         15,243
  Accrued income taxes (Note 10)                                        16,673         15,826
                                                                     ------------  -------------
TOTAL CURRENT LIABILITIES                                               46,902         37,408
                                                                     ------------  -------------

COMMITMENTS AND CONTINGENCIES  (NOTE 11)

Stockholders' equity (Notes 12 and 13):
  Preferred stock, $.001 par value:
    Authorized shares -- 2,000,000
    Issued and outstanding shares -- None                                   --             --
  Common stock, $.0005 par value:
    Authorized shares -- 175,000,000
    Issued and outstanding shares-- 69,023,713 and 66,278,293
      at December 31, 1997 and 1996, respectively                           34             33
  Additional paid-in-capital                                           146,277        116,081
  Deferred compensation                                                   (161)          (237)
  Unrealized gain on short-term investments (Note 4)                        82             71
  Retained earnings                                                     89,285         41,648
                                                                     ------------  -------------
TOTAL STOCKHOLDERS' EQUITY                                             235,517        157,596
                                                                     ------------  -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                           $ 282,419      $ 195,004
                                                                     ============  =============
</TABLE>


                        See notes to consolidated financial statements.

                                      F-3

<PAGE>   51

                           PAIRGAIN TECHNOLOGIES, INC.

                        CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
                                                                  YEAR ENDED DECEMBER 31,
                                                         ---------------------------------------
                                                            1997          1996          1995
                                                         ------------  -----------   -----------
                                                      (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                      <C>           <C>           <C>
Revenues (Note 3):
  Product sales                                          $  282,117    $  205,408    $  106,173
  Royalty income                                                208            97         1,051
                                                         ------------  -----------  ------------

TOTAL REVENUES                                              282,325       205,505       107,224

Cost of revenues                                            142,571       106,518        56,223
                                                         ------------  -----------  ------------

Gross profit                                                139,754        98,987        51,001
                                                         ------------  -----------  ------------

Operating expenses:
  Research and development                                   31,982        19,512        10,728
  Selling and marketing                                      22,808        17,585         9,944
  General and administrative                                 10,583        10,364         6,797
  Merger expenses (Note 2)                                    2,642            --            --
                                                         ------------  -----------  ------------

Total operating expenses                                     68,015        47,461        27,469
                                                         ------------  -----------  ------------

INCOME FROM OPERATIONS                                       71,739        51,526        23,532

Other income (loss):
  Interest income, net                                        6,925         3,698         2,118
  Gain on sales of short-term investments                        23            --           415
  Loss on note receivable and long-term investment
    (Note 7)                                                   (744)           --            --
  Unusual loss due to unauthorized trading of
    investments by third parties  (Note 15)                      --            --       (15,827)
  Settlement income related to unauthorized
    trading of investments by third parties
    (Note 16)                                                    --         2,500            --
                                                         ------------  -----------  ------------

Income before income taxes                                   77,943        57,724        10,238

Provision for income taxes  (Note 10)                        30,306        22,816         9,182
                                                         ------------  -----------  ------------

NET INCOME                                               $   47,637    $   34,908    $    1,056
                                                         ============  ===========  ============

Per Share Data (Note 1):
  Earnings per common share
    Basic                                                $     0.70    $     0.54    $     0.02
                                                         ============  ===========   ===========
    Diluted                                              $     0.63    $     0.47    $     0.02
                                                         ============  ===========   ===========
  Average shares outstanding
    Basic                                                67,991,000    64,247,000    58,225,000
                                                         ============  ===========   ===========
    Diluted                                              75,225,000    73,768,000    67,280,000
                                                         ============  ===========   ===========
</TABLE>

                       See notes to consolidated financial statements.

                                      F-4

<PAGE>   52

                           PAIRGAIN TECHNOLOGIES, INC.

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

                             (DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                             UNREALIZED
                                 COMMON STOCK    ADDITIONAL                GAIN (LOSS) ON              TOTAL
                               -----------------  PAID-IN      DEFERRED      SHORT-TERM   RETAINED  STOCKHOLDERS'
                                 SHARES   AMOUNT  CAPITAL    COMPENSATION    INVESTMENTS  EARNINGS     EQUITY
                               ---------- ------ ---------   --------------  -----------  --------  -------------
<S>                            <C>         <C>   <C>         <C>             <C>         <C>         <C>
BALANCE AT JANUARY 1, 1995     50,834,544  $13   $ 69,513    $   (170)       $   (210)   $  5,700    $  74,846
  Issuance of common stock
   for cash, net of offering
   costs of $842                2,000,000    1     10,969         --              --          --        10,970
  Exercise of warrants          5,771,124    1      2,726         --              --          --         2,727
  Exercise of common stock
   options                      2,024,380   --      1,440         --              --          --         1,440
  Issuance of common stock
   under Employee Stock
   Purchase Plan                   79,020   --        386         --              --          --           386
  Tax benefits from
   exercise of common stock
   options                            --    --      2,141         --              --          --         2,141
  Amortization of deferred
   compensation                       --    --        --           88             --          --            88
  Unrealized gain on
   short-term investments,
   net of tax of $181                 --    --        --          --              277         --           277
  Net income                          --    --        --          --              --        1,056        1,056
                               ----------  ---   --------    --------        --------    --------    ---------
BALANCE AT DECEMBER 31, 1995   60,709,068   15     87,175         (82)             67       6,756       93,931
  Exercise of common stock
   options                      3,258,320    1      6,252         --              --          --         6,253
  Issuance of common stock      2,235,697    1      3,014         --              --          --         3,015
  Issuance of common stock
   under Employee Stock
   Purchase Plan                   75,208   --      1,110         --              --          --         1,110
  Tax benefits from
   exercise of common
   stock options                      --    --     18,245         --              --          --        18,245
  Deferred compensation
   related to stock options           --    --        285        (285)            --          --           --
  Amortization of deferred
   compensation                       --    --        --          130             --          --           130
  Unrealized gain on
   short-term investments,
   net of tax of $1                   --    --        --          --                4         --             4
  Stock split effected
   as a stock dividend                --    16        --          --              --          (16)         --
  Net income                          --    --        --          --              --       34,908       34,908
                               ----------  ---   --------    --------        --------    --------    ---------
BALANCE AT DECEMBER 31, 1996   66,278,293   33    116,081        (237)             71      41,648      157,596
  Exercise of common stock
   options                      2,556,330    1      6,528         --              --          --         6,529
  Exercise of common stock
   warrants                       131,168   --        495         --              --          --           495
  Issuance of common stock
   under Employee Stock
   Purchase Plan                   57,922   --      1,059         --              --          --         1,059
  Tax benefits from
   exercise of common
   stock options                      --    --     22,114         --              --          --        22,114
  Amortization of deferred
   compensation                       --    --        --           76             --          --            76
  Unrealized gain on
   short-term investments,
   net of tax of $6                   --    --        --          --               11         --            11
  Net income                          --    --        --          --              --       47,637       47,637
                               ----------  ---   --------    --------        --------    --------    ---------
BALANCE AT DECEMBER 31, 1997   69,023,713  $34   $146,277    $   (161)       $     82    $ 89,285    $ 235,517
                               ==========  ===   ========    ========        ========    ========    =========
</TABLE>

                 See notes to consolidated financial statements.

                                      F-5

<PAGE>   53

                           PAIRGAIN TECHNOLOGIES, INC.

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                  YEAR ENDED DECEMBER 31,
                                                            ------------------------------------
                                                               1997         1996        1995
                                                            ----------- ------------ -----------
                                                                  (DOLLARS IN THOUSANDS)
<S>                                                         <C>         <C>          <C>
Cash flows from operating activities:
Net income                                                  $  47,637   $   34,908   $   1,056
Adjustments to reconcile net income to net cash
 provided by operating activities:
   Depreciation and amortization                                7,677        4,749       4,048
   Gains on sales of investments                                  (23)          --        (415)
   Unusual loss due to unauthorized trading of
      investments by third parties                                 --           --      15,827
   Provision for deferred taxes                                (5,663)      (7,721)     (1,400)
   Loss on note receivable and long-term investment               652           --          --
   Change in operating assets and liabilities:
      Accounts receivable                                     (11,541)     (10,844)     (2,876)
      Inventories                                              (4,389)      (3,627)     (6,048)
      Other current assets                                       (872)      (1,667)       (421)
      Other assets                                                (97)        (229)         (8)
      Trade accounts payable                                    2,188          (63)       (268)
      Accrued expenses                                          6,459       10,213       2,893
      Income taxes (Note 1)                                    24,273       34,472         132
                                                            ----------- ------------ -----------
NET CASH PROVIDED BY OPERATING ACTIVITIES                      66,301       60,191      12,520
                                                            ----------- ------------ -----------
Cash flows from investing activities:
Purchases of short-term investments                           (81,034)     (68,620)    (43,272)
Proceeds from sales of short-term investments                  80,724       33,025      48,711
Purchase of property and equipment                            (13,488)      (7,590)     (5,909)
Repayment (issuance) of note receivable                         2,600           --      (2,708)
Purchases of long-term investments                                 --       (3,544)         --
                                                            ----------- ------------ -----------
NET CASH USED IN INVESTING ACTIVITIES                         (11,198)     (46,729)     (3,178)
                                                            ----------- ------------ -----------
Cash flows from financing activities:
Payments on bank line of credit                                    --           --      (1,000)
Proceeds from issuance of common stock                          8,083       10,378      15,523
                                                            ----------- ------------ -----------
NET CASH PROVIDED BY FINANCING ACTIVITIES                       8,083       10,378      14,523
                                                            ----------- ------------ -----------
Increase in cash and cash equivalents                          63,186       23,840      23,865
Cash and cash equivalents at beginning of year                 48,416       24,576         711
                                                            ----------- ------------ -----------
CASH AND CASH EQUIVALENTS AT END OF YEAR                    $ 111,602    $  48,416   $  24,576
                                                            =========== ============ ===========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Income taxes paid                                           $  12,719    $   4,335   $  10,887
                                                            =========== ============ ===========
Income tax refunds received                                 $   1,055    $   8,342   $      --
                                                            =========== ============ ===========
</TABLE>


                       See notes to consolidated financial statements.

                                      F-6
<PAGE>   54

                           PAIRGAIN TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  THE COMPANY AND SIGNIFICANT ACCOUNTING POLICIES

        PairGain Technologies, Inc. ("PairGain" or the "Company") designs,
manufactures, markets and supports a comprehensive line of digital
telecommunications products that allow telecommunications carriers and private
network owners to more efficiently provide high-speed digital services to end
users over the large infrastructure of unconditioned copper wires. These
services enable high-speed data transmission for applications such as T1/E1,
high-speed Internet access, telecommuting, wide area networking and video
conferencing.

        The accompanying consolidated financial statements reflect the February
27, 1997 business combination between PairGain and Avidia Systems, Inc.
("Avidia") accounted for on a pooling-of-interests basis. Avidia was formed in
December 1995 and had no significant transactions prior to January 1, 1996. (See
Note 2)

PRINCIPLES OF CONSOLIDATION

        The consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All significant intercompany balances
and transactions have been eliminated in consolidation.

TRANSLATION OF FOREIGN CURRENCIES

        Foreign subsidiary financial statements are translated into U.S. dollars
in accordance with Statement of Financial Accounting Standards ("SFAS") No. 52,
"Foreign Currency Translations." The functional currency of the Company's
Canadian and Swiss subsidiaries is the U.S. dollar; therefore, translation gains
and losses are included in results of operations. Transaction and translation
gains and losses were not significant in 1997, 1996 or 1995.

USE OF ESTIMATES

        The preparation of financial statements in conformity with generally
accepted accounting principles 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 periods. Actual results could differ from those estimates.

RECLASSIFICATIONS

        Certain prior year amounts have been reclassified to conform with the
current year presentation.

FAIR VALUE OF FINANCIAL INSTRUMENTS

        Pursuant to SFAS No. 107, "Disclosures about Fair Value of Financial
Instruments," the Company is required to estimate the fair value of all
financial instruments included on its balance sheets at December 31, 1997 and
December 31, 1996. The Company considers the carrying value of such amounts in
the financial statements to approximate their fair value due to the relatively
short period of time between origination of the instruments and their expected
realization or the overall immateriality of the amounts.

CASH AND CASH EQUIVALENTS

        The Company considers all highly liquid investments with maturities at
the date of purchase of less than three months to be cash equivalents.

                                      F-7
<PAGE>   55

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

SHORT-TERM INVESTMENTS

        Short-term investments are accounted for in accordance with SFAS No.
115, "Accounting for Certain Investments in Debt and Equity Securities."
Management determines the appropriate classification of such securities at the
time of purchase and reevaluates such classification as of each balance sheet
date. Based on its intent, the Company's investments are classified as
available-for-sale and are carried at fair value, with unrealized gains and
losses, net of tax, reported as a separate component of stockholders' equity.
The investments are adjusted for amortization of premiums and discounts to
maturity and such amortization is included in interest income. Realized gains
and losses and declines in value judged to be other than temporary are
determined based on the specific identification method and are reported in the
consolidated statements of income.

INVENTORIES

        Inventories are stated at lower of cost (determined on a first-in,
first-out basis) or market. The Company maintains allowances for estimated
obsolete and excess inventories based upon projected sales levels.

PROPERTY AND EQUIPMENT

        Property and equipment are carried at cost. The Company provides for
depreciation and amortization using the straight-line method. Equipment is
depreciated over an estimated useful life of three years. Leasehold improvements
are amortized over the lesser of five years or the life of the lease.

WARRANTY RESERVE

        The Company accrues warranty reserves, which are charged against cost of
goods sold, based upon historical rates and estimated future costs.

REVENUE RECOGNITION

        Revenue from product sales is recognized at the time of shipment.
Provision is made currently for estimated product returns which historically
have been insignificant. Royalty income is recognized when earned.

RESEARCH AND DEVELOPMENT COSTS

        Research and development costs are expensed as incurred.

PER SHARE INFORMATION

        In February 1997, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 128, "Earnings Per Share," ("SFAS No. 128"). This statement is
effective for periods ending after December 15, 1997 and requires restatement of
all prior periods. The Statement redefines earnings per share ("EPS") under
generally accepted accounting principles, making EPS comparable to international
standards. SFAS No. 128 requires dual presentation of "Basic" and "Diluted" EPS,
by entities with complex capital structures, replacing "Primary" and "Fully
diluted" EPS under Accounting Principles Board ("APB") Opinion No. 15.

        Basic EPS excludes dilution from common stock equivalents and is
computed by dividing income available to common stockholders by the weighted
average number of common shares outstanding for the period. Diluted EPS reflects
the potential dilution from common stock equivalents, similar to fully diluted
EPS, but uses only the average stock price during the period as part of the
computation.

        The Company has adopted the provisions of SFAS No. 128 in the
accompanying 1997 consolidated financial statements and has restated prior
periods to reflect the adoption of SFAS No. 128.

                                      F-8
<PAGE>   56

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

        The following table reconciles the weighted average shares outstanding
for basic and diluted earnings per share for the periods presented.

<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                       --------------------------------------
                                                          1997         1996         1995
                                                       ------------ ------------ ------------
                                                          (IN THOUSANDS EXCEPT PER SHARE
                                                                     AMOUNTS)
<S>                                                    <C>          <C>          <C>
      Net income                                       $ 47,637     $ 34,908     $  1,056
                                                       ============ ============ ============
      Basic earnings per common share:

        Weighted average of common shares outstanding    67,991       64,247       58,225
                                                       ============ ============ ============
        Basic earnings per common share                $   0.70     $   0.54     $   0.02
                                                       ============ ============ ============
      Diluted earnings per common share:

        Weighted average of common shares outstanding    67,991       64,247       58,225
        Weighted average of common share equivalents:
           Weighted average warrants outstanding             62          119        1,292
           Weighted average options outstanding          11,853       13,111       12,069
           Anti-dilutive options                         (1,256)          --           --
           Shares assumed to be repurchased using
             the treasury stock method                   (2,265)      (2,385)      (3,253)
           Shares assumed to be repurchased to
             reflect the effects of tax benefits         (1,160)      (1,324)      (1,053)
                                                       ------------ ------------ ------------
        Weighted average number of common and common
          equivalent shares                              75,225       73,768       67,280
                                                       ============ ============ ============
        Diluted earnings per common share              $   0.63     $   0.47     $   0.02
                                                       ============ ============ ============
</TABLE>

RECENTLY ISSUED ACCOUNTING STANDARDS

        In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income," ("SFAS No. 130"). This statement establishes standards for the
reporting of comprehensive income and its components in a financial statement
that is displayed with the same prominence as other financial statements.
Comprehensive income, as defined, includes all changes in equity (net assets)
during a period from non-owner sources. Examples of items to be included in
comprehensive income, which are excluded from net income, include foreign
currency translation adjustments and unrealized gain/loss on available-for-sale
securities. The disclosures prescribed by SFAS No. 130 are effective beginning
with the first quarter of calendar 1998.

        In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments
of an Enterprise and Related Information," ("SFAS No. 131"). This statement
establishes standards for the way companies report information about operating
segments in annual financial statements. It also establishes standards for
related disclosure about products and services, geographic areas and major
customer. The Company has not yet determined the impact, if any, of adopting
this new standard. The disclosures prescribed by SFAS No. 131 are effective for
fiscal years beginning after December 15, 1997.

                                      F-9
<PAGE>   57

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

STOCK SPLITS

        All share and per share amounts have been adjusted to reflect the
two-for-one stock splits, effective June 18, 1996 and December 18, 1996, for all
periods presented. (See Note 12)

ACCOUNTING FOR STOCK-BASED COMPENSATION

        The Company accounts for stock-based awards to employees using the
intrinsic value method in accordance with APB Opinion No. 25, "Accounting for
Stock Issued to Employees." (See Note 13)

STATEMENT OF CASH FLOWS

        Significant noncash transactions in 1997, 1996 and 1995 affecting the
Company's accounts consisted of tax benefits from exercises of common stock
options of $22.1 million, $18.2 million and $2.1 million, respectively, and
$285,000 in deferred compensation related to stock options issued in 1996.

2.  ACQUISITION OF AVIDIA

        On February 27, 1997, the Company acquired Avidia pursuant to an
Agreement and Plan of Reorganization (the "Merger Agreement") among Avidia and
others, with Avidia surviving as a wholly-owned subsidiary of the Company (the
"Acquisition") in a transaction accounted for as a pooling-of-interests.
Pursuant to the Merger Agreement, the Company issued 2,235,697 shares of
PairGain Common Stock to Avidia stockholders in exchange for all outstanding
Avidia Common Stock, Preferred Stock and vested warrants to purchase Avidia
Common Stock. In addition, outstanding options and unvested warrants to purchase
Avidia Common Stock were exchanged for options and warrants to purchase 232,521
and 131,168 shares, respectively, of the Company's Common Stock. Merger expenses
of $2.6 million, which consisted of investment banking, legal, accounting and
other costs, were charged to expense upon the closing of the Acquisition. The
Company's historical consolidated financial statements have been restated to
reflect the financial position and results of operations of Avidia.

3.  CONCENTRATION OF CREDIT RISK, MAJOR CUSTOMERS, PRODUCTS AND MARKET DATA

        The Company markets its products principally to telephone companies in
the United States and Canada. Credit is extended based on an evaluation of the
customer's financial condition and collateral is not required. Credit losses are
provided for in the financial statements and consistently have been minimal.
Sales to major customers as a percentage of total product revenue were as
follows:

<TABLE>
<CAPTION>
                                      1997        1996        1995
                                   ----------- ----------- -----------
<S>                                    <C>         <C>         <C>
           Customer A                  13%         15%         15%
           Customer B                  13%         13%         17%
           Customer C                  10%         10%         11%
           Customer D                   9%         12%         12%
</TABLE>

        A decision by a significant customer to substantially decrease or delay
purchases from the Company or the Company's inability to collect receivables
from these customers could have a material adverse effect on the Company's
financial condition and results of operations.

                                      F-10
<PAGE>   58

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

        Revenues from HiGain products represented approximately 67% of the
Company's total revenues in 1997 and 76% of the Company's total revenues in both
1996 and 1995. A significant decline in demand or average sales price for HiGain
products, whether as a result of competition, deployment of fiber cable,
technological change or otherwise, could have a material adverse effect on the
Company's financial condition and results of operations.

        Export sales represented 17%, 13% and 9% of product revenue during 1997,
1996 and 1995, respectively. Product sales by geographical region is summarized
as follows:

<TABLE>
<CAPTION>
                                                   1997          1996          1995
                                               ------------- ------------- -------------
                                                            (IN THOUSANDS)
<S>                                              <C>           <C>           <C>
           United States                         $ 234,138     $ 178,135     $  96,849
           Canada                                   21,467        16,418         5,670
           Other international                      26,512        10,855         3,654
                                               ------------- ------------- -------------
           Total product sales                   $ 282,117     $ 205,408     $ 106,173
                                               ============= ============= =============
</TABLE>

4.  SHORT-TERM INVESTMENTS

        Short-term investments as of December 31, 1997 and 1996 are summarized
as follows:

<TABLE>
<CAPTION>
                                                          GROSS         GROSS
                                                        UNREALIZED   UNREALIZED       FAIR
                                             COST         GAINS        LOSSES        VALUE
                                         ------------- ------------- ------------ -------------
                                                            (IN THOUSANDS)
<S>                                        <C>           <C>         <C>            <C>
 1997
    Municipal bonds                        $  62,695     $     140   $      --      $  62,835
    Other short-term investments               2,160            --         (12)         2,148
                                         ------------- ------------- ------------ -------------
                                           $  64,855     $     140   $     (12)     $  64,983
                                         ============= ============= ============ =============
 1996
    Municipal bonds                        $  59,686      $     41   $      --      $  59,727
    Other short-term investments               5,982            70          --          6,052
                                         ------------- ------------- ------------ -------------
                                           $  65,668     $     111   $      --      $  65,779
                                         ============= ============= ============ =============
</TABLE>

        For the year ended December 31, 1997 there was a realized gain of
$23,000. There were no realized gains or losses for the year ended December 31,
1996. Unrealized gains on short-term investments, net of tax, included as a
separate component of stockholders' equity were $82,000 and $71,000 in 1997 and
1996, respectively.

        The amortized cost and estimated fair value of investments at December
31, 1997 by contractual maturity are shown below. Actual maturities may differ
from contractual maturities because the issuer of the securities may have the
right to repurchase such securities. The Company classifies short-term
investments as current assets as all such investments are available for current
operations.

<TABLE>
<CAPTION>
                                                            COST           FAIR VALUE
                                                       ---------------   ---------------
                                                                (IN THOUSANDS)
<S>                                                     <C>               <C>
         Due in one year or less                        $   35,565        $   35,597
         Due after one year through three years             29,290            29,386
                                                       ---------------   ---------------
                                                        $   64,855        $   64,983
                                                       ===============   ===============
</TABLE>

                                      F-11
<PAGE>   59

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5.  INVENTORIES

        Inventories consist of:

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                      ----------------------------------
                                                           1997               1996
                                                      ----------------   ---------------
                                                               (IN THOUSANDS)
<S>                                                     <C>               <C>
          Finished goods                                $   14,119        $   10,603
          Work in process                                    6,982             9,745
          Purchased parts                                    9,437             5,801
                                                      ----------------   ---------------
                                                        $   30,538        $   26,149
                                                      ================   ===============
</TABLE>

6.  PROPERTY AND EQUIPMENT

        Property and equipment consist of:

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                      ----------------------------------
                                                           1997               1996
                                                      ----------------   ---------------
                                                               (IN THOUSANDS)
<S>                                                     <C>               <C>
          Machinery and equipment                       $  28,555         $  16,991
          Leasehold improvements                            3,444             1,520
                                                      ----------------   ---------------
                                                           31,999            18,511
          Less accumulated depreciation and
          amortization                                    (14,576)           (8,121)
                                                      ----------------   ---------------
                                                        $  17,423         $  10,390
                                                      ================   ===============
</TABLE>

7.  NOTE RECEIVABLE AND LONG-TERM INVESTMENTS

        In July 1995, the Company entered into certain agreements with Sourcecom
Corporation of Westlake, California ("Sourcecom"). The agreements provided for
the incorporation of Sourcecom's networking technology into the Company's
current and future transmission products. Under the terms of the agreements, the
Company loaned Sourcecom $2.7 million and had rights to purchase a minority
ownership position. The note bore interest at the prime rate less one percent,
payable monthly, with the principal balance due July 1999.

        In April 1996, the Company purchased approximately 150,000 shares of
Sourcecom's Series A Preferred Stock for an aggregate of $273,000. In September
1996, the Company purchased approximately 321,000 shares of Sourcecom's Common
Stock for an aggregate of $271,000. Shares purchased have been adjusted to
reflect Sourcecom's two-for-one stock split, effective September 24, 1996.

        In the third quarter of 1997, Sourcecom filed for protection from
creditors under the U.S. Bankruptcy Act. In addition, Sourcecom sold all of its
assets to an unrelated third party for $8.0 million. Based upon the information
available, the Company recorded a valuation adjustment of $544,000 during the
third quarter of 1997 to reflect an impairment in its investment in Sourcecom. A
mutual release of all claims between Sourcecom and the Company was reached in
December 1997. Under the terms of the release, Sourcecom paid $2.6 million to
the Company to offset the loan made under the original agreements. In the fourth
quarter of 1997, the Company wrote off the balance of the note and associated
legal fees aggregating $200,000.

                                      F-12
<PAGE>   60

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

        In June 1996, the Company made a minority investment in E/O Networks of
Hayward, California ("E/O"). E/O supplies low-density fiber optic access
equipment to public carriers both domestically and internationally. The Company
purchased approximately 545,000 shares of E/O's Series D Preferred Stock for an
aggregate of $3.0 million.

        The Company accounts for long-term investments using the cost method.
However, when it is determined that an investment is permanently impaired, the
Company records a valuation adjustment.

8.  BANK LINE OF CREDIT

        The Company maintains an unsecured line of credit with a bank. The line
allows maximum borrowings of $5,000,000, including the issuance of letters of
credit and foreign exchange contracts. The line bears interest at the prime rate
(8.5% at December 31, 1997). At December 31, 1997, the Company had no
outstanding borrowings under this line of credit. The debt agreement specifies
certain financial and other covenants. The Company was in compliance with the
financial and other covenants at December 31, 1997. The agreement expires May 1,
1998.

9.  ACCRUED EXPENSES

        Accrued expenses consist of:

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                      ----------------------------------
                                                           1997               1996
                                                      ----------------   ---------------
                                                               (IN THOUSANDS)
<S>                                                     <C>               <C>
          Accrued compensation and related expenses     $    8,836        $    5,772
          Accrued warranty                                   9,161             3,868
          Other accrued expenses                             3,705             5,603
                                                      ----------------   ---------------
                                                        $   21,702        $   15,243
                                                      ================   ===============
</TABLE>

10.  INCOME TAXES

        The components of the provision for income taxes are as follows:

<TABLE>
<CAPTION>
                                                           1997       1996       1995
                                                         ---------- ---------- ----------
                                                                 (IN THOUSANDS)
<S>                                                      <C>        <C>        <C>
         Current:
           Federal                                       $28,822    $25,179    $ 8,150
           State                                           5,859      4,358      2,380
           Foreign                                         1,288      1,000         52
                                                         ---------- ---------- ----------
         Total current                                    35,969     30,537     10,582
                                                         ---------- ---------- ----------
         Deferred:
           Federal                                        (5,129)    (7,047)    (1,207)
           State                                          (1,031)    (1,371)      (193)
           Foreign                                            --         --         --
                                                         ---------- ---------- ----------
         Total deferred                                   (6,160)    (8,418)    (1,400)
         Valuation allowance                                 497        697         --
                                                         ---------- ---------- ----------
         Total provision                                 $30,306    $22,816    $ 9,182
                                                         ========== ========== ==========
</TABLE>

                                      F-13
<PAGE>   61

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

        The provision for income taxes for the years ended December 31, 1997,
1996, and 1995 differs from the U.S. federal statutory tax expense for the years
as follows:

<TABLE>
<CAPTION>
                                                                    1997      1996      1995
                                                                  --------- --------- ----------
                                                                         (IN THOUSANDS)
<S>                                                               <C>       <C>       <C>
     U.S. federal statutory tax expense                           $27,280   $20,204   $ 3,583
     State taxes, net of federal tax benefit                       3,179     1,942      1,422
     Research and development credit                              (2,387)     (737)      (216)
     Non-taxable interest income                                    (838)     (623)      (527)
     Merger expenses                                                 925        --         --
     Unusual loss due to unauthorized trading of investments by
         third parties                                                --        --      4,980
     Increase in valuation allowance for deferred tax assets         497       697         --
     Other items, net                                              1,650     1,333        (60)
                                                                  --------- --------- ----------
     Total provision                                              $30,306   $22,816   $ 9,182
                                                                  ========= ========= ==========
</TABLE>

        Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. Significant
components of the Company's deferred tax assets are as follows:

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                      ----------------------------------
                                                           1997               1996
                                                      ----------------   ---------------
                                                               (IN THOUSANDS)
<S>                                                       <C>               <C>
          Deferred tax assets:
            Inventory and related reserves                $  9,739          $  6,867
            Warranty reserve                                 3,893             1,538
            Other reserves and accruals                      1,645             1,450
            Other                                              299             1,219
            Capital loss carryforwards                         312                --
            Net operating loss and
               research and development
               credit carryforwards                            725               697
                                                      ----------------   ---------------
          Gross deferred tax assets                         16,613            11,771
          Valuation allowance                               (1,194)             (697)
                                                      ----------------   ---------------
          Net deferred tax assets                         $ 15,419          $ 11,074
                                                      ================   ===============
</TABLE>

        At December 31, 1997, the Company had federal and state capital loss
carryforwards for income tax purposes of approximately $721,000 which will begin
expiring in 2002. The Company also had net operating loss carryforwards and
research and development credit carryforwards of $1.6 million and $36,000,
respectively, which will expire beginning in 2011 and 2012. The net operating
loss and tax credit carryforwards are subject to separate return limitation year
("SRLY") rules related to the Company's acquisition of Avidia. The Company has
established a valuation allowance of $1,037,000 related to these carryforwards
and $157,000 related to non-California state deferred tax assets since the
realization of the benefit from these items is not reasonably assured at the end
of 1997.

                                      F-14
<PAGE>   62

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

11.  COMMITMENTS

        The Company has entered into several operating leases for its facilities
with varying terms and escalation clauses. Future annual minimum lease payments
under non-cancelable operating leases are as follows:

<TABLE>
<CAPTION>
                       YEARS ENDING DECEMBER 31,      (IN THOUSANDS)
                       ---------------------------    --------------
<S>                                                     <C>
                         1998                           $  1,355
                         1999                              1,238
                         2000                                670
                         2001                                601
                         2002                                484
                         Thereafter                        1,038
                                                      --------------
                                                        $  5,386
                                                      ==============
</TABLE>

        Rent expense for the years ended December 31, 1997, 1996 and 1995
aggregated $1.3 million, $747,000 and $424,000, respectively.

12.  STOCKHOLDERS' EQUITY

STOCK SPLITS

        In June 1996, the Company's stockholders approved an amendment to the
Company's Certificate of Incorporation (the "Amendment") to increase the
authorized Common Stock of the Company from 30 million shares, par value $.001,
to 60 million shares, par value $.0005, and to effect a two-for-one stock split
(the "Stock Split").

        In December 1996, the Company's stockholders approved an amendment to
the Company's Amended and Restated Certificate of Incorporation (the "Second
Amendment") to increase the authorized Common Stock of the Company from 60
million shares, par value $.0005, to 175 million shares, par value $.0005. The
Second Amendment was proposed to facilitate a two-for-one stock split (the
"Second Stock Split") which was effected in the form of a 100% stock dividend.

        All references in the accompanying consolidated financial statements
related to Common Stock, common stock options, common stock warrants and
earnings per share have been adjusted to reflect both stock splits.

STOCK OFFERINGS

        In a series of private placements during 1996, Avidia sold common and
preferred shares which converted in the Merger into 2,235,697 of the Company's
shares. The net proceeds raised were approximately $3,015,000.

        In March 1995, the Company completed a secondary public offering and
sold 2,000,000 shares of its Common Stock at a price of $5.91 per share. The net
proceeds raised by the Company were approximately $10,970,000. In connection
with the offering, certain outstanding warrants were exercised to purchase
5,750,620 shares of Common Stock at an aggregate exercise price of $2,717,000.

WARRANTS

        In 1996, Avidia granted warrants to certain stockholders which converted
in the Merger into the right to purchase 131,168 shares of the Company's Common
Stock at an aggregate exercise price of $495,000. Such warrants were exercised
in February 1997.

                                      F-15
<PAGE>   63

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

        In 1995, the Company granted warrants for the purchase of 40,000 shares
of its Common Stock at exercise prices of $5.00 to $6.25 per share in exchange
for services. Such warrants were outstanding at December 31, 1997 and expire
beginning in May 1998 through September 1999.

13.  STOCK OPTION PLANS

1993 EMPLOYEE STOCK OPTION PLAN

        Under the Company's 1993 Stock Option/Stock Issuance Plan ("the Plan"),
which is the successor plan to its 1990 Stock Option Plan ("the 1990 Plan"), a
Committee consisting of non-employee members of its Board of Directors, is
authorized to grant stock options or issue Common Stock to officers, key
employees, members of the Board of Directors and certain consultants or other
independent contractors of the Company. In addition, the Plan also provides for
the purchase of the Company's Common Stock by eligible individuals at a price
per share not less than 85% of the fair market value at the time of issuance. No
shares have been issued under the purchase provisions. Incentive options are
granted at a price equal to 100% of the fair market value at the date of grant
(at least 85% of the fair market value for non-qualified options) and vested
options are exercisable for a period determined by the Committee that is not to
exceed ten years from the date of grant. Options issued under the 1990 Plan are
exercisable immediately upon grant and shares issued related to options
exercised but not vested are subject to repurchase by the Company at the
exercise price of such options. At the discretion of the Committee, the Plan
provides option holders stock appreciation rights which allow the holder to
exercise such options in exchange for the payment of the difference between the
fair market value and option price of the underlying shares in the form of cash
or shares of Common Stock. Under certain circumstances in the event of a merger,
sale or other significant transaction involving the Company, the options and
stock issued may become fully vested and exercisable.

        In January 1995, the Company's Board of Directors approved an increase
in the number of common shares reserved and available for issuance under the
Plan from 14,800,000 shares to 18,800,000 shares. In January 1997, the Company's
Board of Directors approved an increase in the number of common shares reserved
and available for issuance under the Plan from 18,800,000 shares to 21,800,000
shares.

1996 NON-EMPLOYEE DIRECTORS STOCK OPTION PLAN

        In June 1996, the Company's stockholders approved the 1996 Non-Employee
Directors Stock Option Plan (the "Directors Plan"). Under the terms of the
Directors Plan, 400,000 shares of Common Stock have been reserved for issuance
to non-employee members of the Board. Following the 1996 Annual Meeting, initial
options to purchase 40,000 shares of the Company's Common Stock were granted to
each non-employee director who had not previously received any stock option
grants from the Company. On an annual basis beginning with the 1997 Annual
Meeting, an option to purchase an additional 20,000 shares of Common Stock will
be granted to each individual who is to continue to serve as a non-employee
Board member. There is no limit to the number of such annual 20,000-share option
grants any one non-employee Board member may receive over his or her period of
continued Board service during the term of the Directors Plan. Each option will
have an exercise price per share equal to 100% of the fair market value per
share of Common Stock on the option grant date and a maximum term of ten years
measured from the option grant date. Each option will be immediately exercisable
for all the option shares, but any purchased shares will be subject to
repurchase by the Company, at the exercise price paid per share, upon the
optionee's cessation of Board service. Each initial option grant will vest (and
the Company's repurchase rights will lapse) in four successive equal annual
installments over the optionee's period of Board service, with the first such
installment to vest upon the completion of one year of Board service measured
from the option grant date. Additional option grants will vest (and the
Company's repurchase rights will lapse) upon the completion of one year of Board
service measured from the option grant date. The term of the Directors Plan is
ten years.

                                      F-16
<PAGE>   64

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

AVIDIA STOCK OPTION AND INCENTIVE AWARD PLAN

        In 1996, Avidia established the 1996 Stock Option and Incentive Award
Plan (the "Avidia Plan") which provides for the grant of any or all of the
following types of awards: (1) stock options, including incentive stock options
and non-qualified stock options, and (2) performance share awards. Under the
terms of the Avidia Plan, 232,521 shares of Common Stock have been reserved for
issuance to directors, employees, consultants, advisors and vendors of Avidia
and any related corporations. The majority of the stock options vest over a
four-year period, with 25% of the shares becoming exercisable on each of the
first four anniversaries of the grant date. The Board of Directors at its
discretion may grant accelerated vesting. The options expire ten years from the
date of the grant. During 1996, all of the options under the Avidia Plan were
granted at less than market value, which resulted in total compensation of
$285,000. This compensation is being amortized over a period of four years, and
has resulted in charges to earnings of $76,000 and $48,000 in 1997 and 1996,
respectively.

        Option activity under the plans is as follows:

<TABLE>
<CAPTION>
                                                                                      WEIGHTED
                                                                       NUMBER OF      AVERAGE
                                                                        SHARES     EXERCISE PRICE
                                                                      ------------ --------------
<S>                                                                   <C>             <C>
Outstanding, January 1, 1995
    (4,649,244 exercisable at a weighted average price of $0.34)      10,681,172      $ 0.90

Granted (weighted average fair value of $2.96)                         4,956,400      $ 5.14
Exercised                                                             (2,024,380)     $ 0.71
Canceled                                                               (286,700)      $ 3.39
                                                                      ------------
Outstanding, December 31, 1995
    (5,692,132 exercisable at a weighted average price of $0.66)      13,326,492      $ 2.48

Granted (weighted average fair value of $13.47)                        3,025,386      $19.70
Exercised                                                             (3,258,320)     $ 1.92
Canceled                                                               (228,611)      $ 6.87
                                                                      ------------

Outstanding, December 31, 1996
    (6,094,404 exercisable at a weighted average price of $2.15)      12,864,947      $ 6.59

Granted (weighted average fair value of $12.26)                        1,634,135      $19.72
Exercised                                                             (2,556,330)     $ 2.80
Canceled                                                               (441,417)      $19.62
                                                                      ------------

Outstanding, December 31, 1997                                        11,501,335      $ 8.89
                                                                      ============
</TABLE>

                                      F-17
<PAGE>   65

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

        The outstanding stock options primarily vest ratably over a four year
period. Stock options outstanding at December 31, 1997 are summarized as
follows:

<TABLE>
<CAPTION>
                                OPTIONS OUTSTANDING                   OPTIONS EXERCISABLE
                    -------------------------------------------- -------------------------------
                                        WEIGHTED
                         NUMBER         AVERAGE      WEIGHTED         NUMBER         WEIGHTED
                     OUTSTANDING AT    REMAINING     AVERAGE      EXERCISABLE AT     AVERAGE
     RANGE OF         DECEMBER 31,    CONTRACTUAL    EXERCISE      DECEMBER 31,      EXERCISE
 EXERCISE PRICES          1997            LIFE        PRICE            1997           PRICE
------------------- ----------------- -------------------------- ----------------- -------------
<S>                    <C>                <C>         <C>           <C>               <C>
  $0.04 - $0.07        2,758,696          4.3         $ 0.07        2,697,249         $ 0.07
  $0.83 - $3.44        2,322,090          6.5         $ 2.58        1,657,088         $ 2.43
  $4.00 - $7.63        2,489,062          7.5         $ 5.96        1,167,554         $ 5.97
 $10.31 - $15.88       1,254,934          8.9         $13.67          268,347         $12.53
 $17.31 - $20.88       1,060,352          8.7         $18.20          308,908         $17.73
 $26.06 - $30.00       1,616,201          8.8         $27.33          509,327         $27.49
                    -----------------                            -----------------
  $0.04 - $30.00      11,501,335          7.0         $ 8.89        6,608,473         $ 5.16
                    =================                            =================
</TABLE>

        At December 31, 1997, 2,898,853 and 260,000 shares were available for
future grants under the 1993 Employee Stock Option Plan and 1996 Non-Employee
Directors Stock Option Plan, respectively.

EMPLOYEE STOCK PURCHASE PLAN

        Under the Company's Employee Stock Purchase Plan, (the "Purchase Plan"),
eligible employees are permitted to have salary withholdings to purchase shares
of Common Stock at a price equal to 85% of the lower of the market value of the
stock at the beginning or end of each six-month offer period, subject to an
annual limitation. Activity under the Purchase Plan is summarized as follows:

<TABLE>
<CAPTION>
                                                WEIGHTED AVERAGE     WEIGHTED AVERAGE
               YEAR          SHARES ISSUED       PRICE PER SHARE    FAIR VALUE PER SHARE
          ------------------------------------ -------------------- --------------------
<S>                             <C>                  <C>                  <C>
               1997             57,922               $18.28               $21.50
               1996             75,208               $14.77               $17.38
               1995             79,020               $ 4.89               $ 5.75
</TABLE>

        At December 31, 1997, 787,850 shares were reserved for future issuances
under the Purchase Plan.

ADDITIONAL STOCK PLAN INFORMATION (SFAS NO. 123)

        As discussed in Note 1, the Company accounts for its stock-based awards
using the intrinsic value method in accordance with APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and its related interpretations.

        SFAS No. 123, "Accounting for Stock-Based Compensation," requires the
disclosure of pro forma net income and earnings per share had the Company
adopted the fair value method as of the beginning of fiscal 1995. Under SFAS No.
123, the fair value of stock-based awards to employees is calculated through the
use of option pricing models, even though such models were developed to estimate
the fair value of freely tradable, fully transferable options without vesting
restrictions, which significantly differ from the Company's stock option awards.
These models also require subjective assumptions, including future stock price
volatility and expected time to exercise, which greatly affect the calculated
values.

                                      F-18
<PAGE>   66

                                  PAIRGAIN TECHNOLOGIES, INC.
                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

        The Company's calculations were made using the Black-Scholes option
pricing model with the following weighted average assumptions:

<TABLE>
<CAPTION>
                                                       FOR OPTIONS GRANTED DURING:
                                                  --------------------------------------
                       ASSUMPTIONS                   1997         1996         1995
          --------------------------------------- ------------ ------------ ------------
<S>                                               <C>           <C>          <C>
           Expected life, following vesting       nine months   six months   six months
           Stock volatility                           71%           65%          65%
           Risk free interest rate                   6.22%         6.26%        6.11%
           Dividends during expected term            none          none         none
</TABLE>

        The Company's calculations are based on a single option valuation
approach and forfeitures are recognized as they occur. The computed fair values
for options awards are $19.4 million, $34.4 million and $14.7 million in 1997,
1996 and 1995, respectively. If the fair values of the awards had been amortized
to expense over the vesting period of the awards, results would have been as
follows:

<TABLE>
<CAPTION>
                                                     1997         1996         1995
                                                  ------------ ------------ ------------
                                                 (IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
<S>                                               <C>          <C>          <C>
              Net income as reported              $  47,637    $  34,908    $   1,056
              Pro forma net income (loss)         $  38,361    $  31,294    $    (258)
              Pro forma earnings per share:
                  Basic                             $  0.56      $  0.49      $  0.00
                  Diluted                           $  0.51      $  0.42      $  0.00
</TABLE>

        The impact of stock options granted prior to 1995 has been excluded from
the pro forma calculation; accordingly, the 1997, 1996 and 1995 pro forma
adjustments may not be indicative of future period pro forma adjustments, when
the calculation will be applicable to all stock options.

14.  EMPLOYEE BENEFIT PLANS

401 (K) MATCHING CONTRIBUTION

        The Company sponsors a defined contribution 401(K) Savings and
Investment Plan, which was established in 1993, covering substantially all of
the Company's employees subject to certain eligibility requirements. At its
discretion, the Company may make contributions to the plan. In April 1996, the
Board approved a resolution to match employee contributions provided that a
threshold earnings per share level was reached. Employee deferrals during 1997
and from April 28, 1996 through December 31, 1996 were eligible for a matching
contribution equal to fifty percent (50%) of the employee's salary deferral, not
to exceed $500 per employee. Matching contributions vest over a period of four
years of service. The aggregate expense related to the contributions was
$221,000 in 1997 and $145,000 in 1996.

                                      F-19
<PAGE>   67

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

PROFIT SHARING

        In October 1996, the Company established a company-wide Profit Sharing
Plan for fiscal years beginning after December 31, 1996. Under the terms of the
Profit Sharing Plan, a pool equal to 2.5% of pre-tax income was established for
payments to be made on a pro rata basis, based on the amount of each
participant's base compensation. Plan participants include all employees in the
Company except those on an incentive compensation or sales commission plan who
are employed as of the date of the Profit Sharing payment. Payment is subject to
achieving a predetermined threshold earnings per share level as established by
the Board of Directors and is to take place approximately one month after the
end of the year for which the Profit Sharing applies. The aggregate accrual for
the Profit Sharing pool included in the accompanying consolidated balance sheet
as of December 31, 1997 was $2.0 million.

MANAGEMENT DEFERRED COMPENSATION PLAN

        The Company established a Management Deferred Compensation Plan in 1996.
The purpose of the plan is to provide a tax deferred capital accumulation
opportunity to senior management. Employees whose annual base salary is $85,000
or greater are eligible to participate. The minimum deferral is $5,000 per Plan
year (January 1 to December 31) and can be satisfied from salary, commission
and/or incentive compensation payments. Deferrals may be increased, decreased or
terminated for any subsequent years by filing an election by December 1 of the
prior year. The Company may make discretionary Company contributions at any time
as approved by the Compensation Committee of the Board of Directors. To date, no
Company contributions have been made to the Deferred Compensation Plan.

15.  UNUSUAL LOSS DUE TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD PARTIES

        In 1993 and 1994, the Company invested a portion of its excess cash with
Capital Insight, Inc. ("Capital Insight"), a financial advisor and broker based
in Beverly Hills, California. The Company had no funds invested with Capital
Insight at either December 31, 1993 or December 31, 1994, as all such invested
funds were returned to the Company prior to the end of each of those years.

        In early 1995, the Company again invested a portion of its excess cash
with Capital Insight, with instructions that the funds be invested solely in
U.S. Treasury securities with maturities of one year or less. These instructions
were consistent with the investment guidelines which had been approved by the
Company's Board of Directors in October 1994. However, these instructions were
violated and the funds were used to engage in unauthorized trading in options
and futures. In November 1995, the Company confirmed that it had incurred
non-recurring losses of $15.8 million resulting from these inappropriate and
unauthorized trading activities.

        The Company's outside directors retained independent legal counsel and
forensic accountants to determine the facts and circumstances surrounding this
matter. This investigation revealed no improper involvement by any Company
director, officer or employee in the unauthorized trading. Additionally, the
investigation found that the Company was provided with fictitious statements by
Capital Insight, and the Company had actually incurred substantial losses in the
second quarter of 1995. During the third and fourth quarters of 1995, the
unauthorized trading generated significant gains resulting in net trading losses
of $15.8 million for the year. Furthermore, it was determined that the 1994
statements provided by this advisor and relied upon by the Company for its
quarterly reporting were also incorrect. Although total financial results for
1994 were not impacted by these false statements, previously reported 1994
quarterly financial statements did not reflect the proper periods in which the
trading gains and losses occurred. Based on the results of the investigation,
the Company amended its quarterly statements for both 1994 and 1995 to reflect
the proper reporting of the trading gains and losses.

                                      F-20
<PAGE>   68

                           PAIRGAIN TECHNOLOGIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

        In January 1996, the Company filed suit in Los Angeles federal court
against Mr. S. Jay Goldinger and Capital Insight, Inc. charging unauthorized
trading, fraudulent misrepresentation, violation of federal securities laws and
breach of fiduciary duties. The suit seeks $15.8 million in damages by reason of
the losses incurred by the Company, as well as punitive damages and legal fees.

16. SETTLEMENT INCOME RELATED TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD
    PARTIES

        In January 1996, the Company received a copy of a complaint, filed
derivatively by a Company stockholder on behalf of the Company, naming as
defendants the Company's directors and certain officers, as well as Capital
Insight and Mr. S. Jay Goldinger, its president. The derivative complaint stated
causes of action for breach of fiduciary duty, abuse of control, constructive
fraud, gross mismanagement and waste of corporate assets by reason of unusual
losses incurred by the Company as a result unauthorized trading of investment by
third parties (See Note 15). The suit sought an award in the amount of all
damages sustained by the Company including the losses of $15.8 million and legal
fees and expenses.

        In September 1996, the Company and other parties to the derivative suits
described above executed definitive settlement agreements to settle and dismiss
the derivative suits. The Court approved the settlement in November 1996. Under
the terms of the settlement, the Company received $2.5 million from a brokerage
firm involved in processing the investments for Capital Insight, and paid
plaintiff's attorneys fees of $450,000. The impact of the settlement has been
recorded in the Company's financial statements for the year ended December 31,
1996.

                                      F-21
<PAGE>   69

                           PAIRGAIN TECHNOLOGIES, INC.

                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS


<TABLE>
<CAPTION>
                                                     ADDITIONS
                                             -------------------------
                                 BALANCE AT   CHARGED TO  CHARGED TO
                                 BEGINNING    COSTS AND      OTHER                   BALANCE AT
         DESCRIPTION             OF PERIOD     EXPENSES    ACCOUNTS     DEDUCTIONS  END OF PERIOD
------------------------------- ------------ ------------ ------------ ------------ -------------
                                                        (IN THOUSANDS)
<S>                              <C>          <C>          <C>          <C>          <C>
 Year ended December 31, 1997:
 Allowance for doubtful
  accounts receivable            $    935     $     20     $     --     $     --     $     955
 Inventory reserves                14,656        7,929           --        2,479        20,106
                                ------------ ------------ ------------ ------------ -------------
 Total                           $ 15,591     $  7,949     $     --     $  2,479     $  21,061
                                ============ ============ ============ ============ =============
 Year ended December 31, 1996:
 Allowance for doubtful
  accounts receivable            $    469     $    463     $      3     $     --     $     935
 Inventory reserves                 4,235       13,877           --        3,456        14,656
                                ------------ ------------ ------------ ------------ -------------
 Total                           $  4,704     $ 14,340     $      3     $  3,456     $  15,591
                                ============ ============ ============ ============ =============
 Year ended December 31, 1995:
 Allowance for doubtful
  accounts receivable            $    298     $    159     $     91     $     79     $     469
 Inventory reserves                 1,882        3,353           --        1,000         4,235
                                ------------ ------------ ------------ ------------ -------------
 Total                           $  2,180     $  3,512     $     91     $  1,079     $   4,704
                                ============ ============ ============ ============ =============
</TABLE>

                                      S-1