##### Table of Contents



UNITED
    STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C.
    20549
      Form 10-K
      (Mark One)þ

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE FISCAL YEAR ENDED
    DECEMBER 31, 2006ORo

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE TRANSITION PERIOD
    FROM          TO   COMMISSION
    FILE NUMBER:
    000-24647
      TERAYON COMMUNICATION SYSTEMS, INC.
 (Exact Name of Registrant as
    Specified in Its Charter)
  Delaware(State or Other
    Jurisdiction of
    Incorporation or Organization)

77-0328533(IRS Employer
    Identification No.)   2450
    WALSH AVENUE
    SANTA CLARA, CALIFORNIA 95051(408) 235-5500 (Address,
    Including Zip Code, and Telephone Number,
    Including Area Code, of the Registrants Principal
    Executive Offices)
      SECURITIES
    REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
  Title of Each Class:

Name of Each Exchange on Which Registered:None

None   SECURITIES
    REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
    COMMON STOCK, par value $0.001 per share (Title
    of Class)
  o þ
  o þ
  þ o
  Regulation S-K Form 10-K Form 10-K. o
  Rule 12b-2
 o þ o
  Rule 12b-2).  Yes o þ
      DOCUMENTS
    INCORPORATED BY REFERENCE
  Form 10-K




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##### 



INDEX
    TERAYON COMMUNICATION SYSTEMS, INC.
  
  PageNo.PART IItem 1.

Business


3Item 1A.

Risk
    Factors


12Item 1B.

Unresolved Staff
    Comments


38Item 2.

Properties


38Item 3.

Legal
    Proceedings


38Item 4.

Submission of
    Matters to a Vote of Security Holders


42PART IIItem 5.

Market for
    Registrants Common Equity, Related Stockholder Matters and
    Issuer Purchases of Equity Securities


42Item 6.

Selected Financial
    Data


45Item 7.

Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations


46Item 7A.

Quantitative and
    Qualitative Disclosures About Market Risk


68Item 8.

Financial
    Statements and Supplementary Data


69Item 9.

Changes in and
    Disagreements with Accountants on Accounting and Financial
    Disclosure


103Item 9A.

Controls and
    Procedures


103Item 9B.

Other
    Information


110PART IIIItem 10.

Directors,
    Executive Officers and Corporate Governance


110Item 11.

Executive
    Compensation


110Item 12.

Security Ownership
    of Certain Beneficial Owners and Management and Related
    Stockholder Matters


110Item 13.

Certain
    Relationships and Related Transactions, and Director
    Independence


110Item 14.

Principal
    Accountant Fees and Services


110PART IVItem 15.

Exhibits, Financial
    Statement Schedules


110Signatures


114EXHIBIT 10.31EXHIBIT 21.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2   2




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PART I  Item 1.
    Business  Overview
  ® digital-to-analog line-ups,
  Form 10-K Form 10-K
  (408) 235-5500.
  History
    of the Company
  data-over-satellite
     3




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Industry
    Dynamics
    Migration
    of cable operators to all-digital networks
    Ability
    to leverage network infrastructures to offer multiple products
    and services
    ®
  Network
    operators and content aggregators must combat ad skipping
    technologies
    Continued
    network investment to support new product requirements in
    competitive and emerging markets
   4




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Consolidation
    of the cable industry
      The move
    towards localized and personalized content
      Business
  ® digital-to-analog line-ups,
 5




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and/or ® ®
  Business
    Strategy
    
    capitalize on the increasing demand for advanced digital video
    services, including HDTV and video on demand, by leveraging our
    strengths in bandwidth management, ad insertion, grooming
    applications and products;
    continue to develop video applications with enhanced
    capabilities that meet the localization on-demand and
    personalized advertising needs of network operators, and to
    address emerging markets, such as mobile video;
    increase the distribution opportunities for our digital video
    products through reseller channels by developing new
    relationships and expanding existing system integration
    partnerships with partners such as Harmonic, Alcatel-Lucent and
    Motorola; and
    improve margins through focused product cost-reduction efforts
    and by streamlining operational activities across our product
    lines.  IP-based
 6




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Products
  voice-over-cable Internet-over-satellite
  ® digital-to-analog ® line-ups, ®
  ®
  digital-to-analog IP-based
  ®
 7




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Product
    research and development
      Customers
      
    Comcast;
    Cox Communications Inc. (Cox);
    TWC;
    EchoStar Communications Corporation; and
    Harmonic.    Market
    Competition
  ®
    
    quality of product performance, features and reliability;
    customer technical support and service; 8




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
    price;
    size and financial stability of operations;
    breadth of product line;
    sales and distribution capabilities;
    relationships with network operators and content
    aggregators; and
    meeting current or prospective industry or customer standards
    applicable to our products.    
    larger and more established selling and marketing capabilities;
    greater economies of scale;
    significantly greater financial, technical, engineering,
    marketing, distribution, customer support and other resources;
    greater name recognition and a larger installed base of
    customers; and
    well-established relationships with our existing and potential
    customers.      Sales and
    Marketing
     9




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International
    Sales
        Customer
    Service and Technical Support
    Backlog
    Manufacturing
     10




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Intellectual
    Property
        and/or
   11




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Employees
    Access to
    Our Reports
  Form 10-K, Form 10-Q, Form 8-K, 1-800-SEC-0330.
  Item 1A.
    Risk
    Factors  The following is a summary description of some of the many
    risks we face in our business. You should carefully review the
    risks described below before making an investment decision. The
    risks and uncertainties described below are not the only ones
    facing us. Additional risks and uncertainties not presently
    known to us or that we currently deem immaterial also may impair
    our business operations. If any of the following risks actually
    occur, our business could be harmed. In such case, the trading
    price of our common stock could decline, and you may lose all or
    part of your investment. You should also consider the other
    information described in this report.
  Risks
    Related to the Restatement
  The
    restatement of our consolidated financial statements has had a
    material adverse impact on us, including increased costs, the
    delisting of our common stock from The NASDAQ Stock Market, the
    increased possibility of legal or administrative proceedings,
    and a default under our subordinated note
    agreement.
  Form 10-K Form 10-K),
  
    We have incurred substantial unanticipated costs for accounting
    and legal fees in 2005 and 2006 in connection with the
    restatement. Although the restatement is complete, we expect to
    incur additional costs as indicated below.
    We face an increased risk of being subject to legal or
    administrative proceedings. In December 2005, the Securities and
    Exchange Commission (Commission) issued a formal order of
    investigation in connection with our accounting review of
    certain customer transactions. This investigation has diverted
    and will continue to divert more of our managements time
    and attention and continue to cause us to 12




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incur substantial costs. Such investigations can also lead to
    fines or injunctions or orders with respect to future
    activities, as well as further substantial costs and diversion
    of managements time and attention.  
    On June 23, 2006, a securities litigation lawsuit based on
    the events concerning the restatement was filed against us and
    certain of our current and former executive officers. On
    November 8, 2006, a new lead plaintiff was appointed in the
    case, and on January 8, 2007, the new lead plaintiff filed
    an amended complaint. On March 9, 2007, Terayon and the
    individual defendants filed a motion to dismiss the amended
    complaint. That motion is scheduled to be heard on June 5,
    2007. The amended complaint was purportedly filed on behalf of
    all persons who purchased our common stock between June 28,
    2001 and March 1, 2006, and it added several current and
    former officers and directors and our former accounting firm to
    the defendants named in the original complaint. The amended
    complaint incorporates the prior allegations and includes new
    allegations relating to the restatement of our consolidated
    historical financial statements as reported in our 2005
    Form 10-K.
    In connection with this litigation and any further litigation
    that is pursued or other relief sought by persons asserting
    claims for damages allegedly resulting from or based on the
    restatement or events related thereto, we will incur defense
    costs that may include the amount of our deductible and defense
    costs exceeding our insurance coverage regardless of the
    outcome. Additionally, we may incur costs if the insurers of our
    directors and our liability insurers deny coverage for the costs
    and expenses related to any litigation.    
    We were de-listed from The NASDAQ Stock Market because we were
    unable to file our periodic reports with the Commission on a
    timely basis. This failure was attributable to our inability to
    complete the restatement of our consolidated financial
    statements for prior periods. As previously disclosed on our
    Current Reports on
    Form 8-K
    filed on November 22, 2005 and January 20, 2006,
    NASDAQ notified us of its intention to de-list our common stock
    based on our failure to timely file our Quarterly Report on
    Form 10-Q
    for the quarter ended September 30, 2005, and our failure
    to solicit proxies and hold an annual shareholders meeting
    during 2005. On March 31, 2006, The NASDAQ Listing and
    Qualifications Panel determined to de-list our securities from
    The NASDAQ Stock Market effective as of the opening of business
    on April 4, 2006, and our common stock currently trades on
    the Pink Sheets. See our risk factor entitled Our common
    stock has been de-listed from The NASDAQ Stock Market and trades
    on the Pink Sheets. We may be unable to relist on The
    NASDAQ Stock Market or any other exchange because we may not be
    able to meet the applicable initial listing requirements.
    Because we were unable to timely file our Quarterly Report on
    Form 10-Q
    for September 30, 2005, we defaulted on our
    $500 million of 5% convertible subordinated notes (Notes)
    due August 2007. On March 21, 2006, we paid off the entire
    principal amount of outstanding Notes, including all accrued and
    unpaid interest and related fees, for a total of
    $65.6 million. As a result, our repayment of the Notes
    reduced our unrestricted cash, decreased our liquidity and could
    materially impair our ability to operate our business especially
    if we are unable to generate positive cash flow from operations.
    The restatement may also result in other negative ramifications,
    including the potential loss of confidence by suppliers,
    customers, employees, investors, and security analysts, the loss
    of institutional investor interest, fewer business development
    opportunities and delays in future earnings announcements,
    regulatory filings with the Commission and listing with a
    securities exchange.  Material
    weaknesses or deficiencies in our internal control over
    financial reporting could harm stockholder and business
    confidence in our financial reporting, our ability to obtain
    financing and other aspects of our business.
  Form 10-K,
 13




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Form 10-K Form 10-K, Form 10-K.
    
    insufficient controls related to the identification, capture and
    timely communication of financially significant information
    between certain parts of the organization and the accounting and
    finance department to enable these departments to account for
    transactions in a complete and timely manner;
    lack of sufficient personnel with technical accounting
    experience in the accounting and finance department and
    inadequate review and approval procedures to prepare external
    financial statements in accordance with GAAP;
    the use of estimates, including monitoring and adjusting
    balances related to certain accruals, reserves, and fixed assets;
    ineffective controls over the documentation, authorization and
    review of manual journal entries and ineffective controls to
    ensure the accuracy and completeness of certain general ledger
    account analysis and reconciliations conducted in connection
    with period end financial reporting.  Form 10-K.
         14




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Our
    revenue recognition policy on digital video products has been
    corrected.
  Form 10-K, SOP 97-2,
  Our
    common stock has been de-listed from The NASDAQ Stock Market and
    trades on the Pink Sheets.
    If we
    are not able to remain current with our filings with the
    Commission, we will face several adverse
    consequences.
  Form S-3 Form S-8, Form S-8
 15




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Risks
    Related to Our Business
  We
    have a history of losses, may continue to incur losses in the
    future and may never achieve or maintain
    profitability.
      We
    depend on capital spending from the cable, satellite and
    telecommunications industries for our revenues, and any decrease
    or delay in capital spending in these industries would
    negatively impact our revenues, financial condition and cash
    flows.
    
    Cable and satellite operators and telecom providers access
    to financing;
    Annual budget cycles, and the typical reduction in upgrade
    projects during the winter months;
    Discretionary customer spending patterns;
    Impact of industry consolidation and financial restructuring;
    Federal, local and foreign government regulation of
    telecommunications and television broadcasting, and regulatory
    approvals that our customers need to obtain;
    Overall demand for communication services and acceptance of new
    video, voice and data services;
    Evolving industry standards and network architecture;
    Delays associated with the evaluation of new services, new
    standards, and system architectures by cable and satellite
    operators and telecom providers;
    An emphasis on generating revenue from existing customers by
    operators instead of new construction or network upgrades; 16




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
    The strategic focus of our customers and potential customers;
    Competitive pressures, including pricing pressures; and
    General economic conditions.    Due to
    the lengthy, complex and unpredictable sale cycle involved in
    the sale of our products, revenues forecasted for a particular
    period may not be realized, our financial results may vary and
    past results should not be relied on as an indication of future
    performance.
    
    A significant commitment of capital and other resources by
    service providers;
    Delays frequently associated with large capital expenditures and
    implementation procedures within an organization;
    Substantial time required to engineer the deployment of new
    technologies or new video, voice and data services;
    Significant technical evaluations, including customer trials, of
    our products as well as competing products prior to making a
    purchasing decision; and
    Significant test marketing of new services to subscribers.    period-to-period
  Our
    operating results are likely to fluctuate significantly and may
    fail to meet or exceed the expectations of securities analysts
    or investors or our guidance, causing our stock price to
    decline.
  Period-to-period
 17




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
    The sales cycle and timing of significant customer orders, which
    are dependent on the capital spending budgets of cable and
    satellite operators, telecom providers and other customers;
    Variations in the size of the orders by our customers and
    pricing concessions on volume sales;
    Competitive market conditions, including pricing actions by our
    competitors;
    New product introductions or the introduction of added features
    or functionality to products by competitors or by us;
    Delays in our introduction of new products, in our introduction
    of added features or functionality to our products, or our
    commercialization of products that are competitive in the
    marketplace;
    International conflicts, including the continuing conflict in
    Iraq, and acts of terrorism, and the impact of adverse economic,
    market and political conditions worldwide;
    The ability of our products to be qualified or certified as
    meeting industry standards
    and/or
    customer standards;
    Changes in market demand;
    Economic and financial conditions specific to the cable,
    satellite and telecom industries, and general economic
    conditions;
    Timing of revenue recognition on sales arrangements, which may
    include multiple deliverables;
    The amount and timing of sales to telecom companies, which are
    particularly difficult to predict;
    Changes in domestic and international regulatory environments;
    Market acceptance of new and existing products;
    The mix of our customer base, sales channels and our products
    sold;
    The level of international sales; and
    Delays in our receipt of, or cancellation of, orders forecasted
    by customers.    
    The sales mix of our products, the volume of products
    manufactured, and the average selling prices (ASPs) of our
    products;
    The costs of manufacturing our products;
    Delays in reducing the cost of our products and the
    effectiveness of our cost reduction measures;
    The type of distribution channel through which we sell our
    products; and
    Our ability to manage excess and obsolete inventory.   18




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Our
    expenses for any given quarter are based on expected sales and
    if sales are below expectations, our operating results may be
    adversely impacted by our inability to adjust spending to
    compensate for the shortfall in revenue.
    Because
    our customer base is highly concentrated among a limited number
    of large customers, the loss of or reduced demand from these
    customers could have a material adverse effect on our business,
    financial condition and results of operations.
       19




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Our
    continued growth will depend on our ability to diversify our
    customer base and deliver products that help enable telecom
    companies to provide video services. If the projected growth in
    demand for video services from telecom companies does not
    materialize or if these service providers find alternative
    methods of delivering video services, future sales of our
    digital video products will be adversely impacted.
      The
    reductions in workforce associated with any restructuring
    efforts could disrupt the operation of our business, distract
    our management from focusing on revenue-generating efforts,
    result in the erosion of employee morale, and impair our ability
    to respond rapidly to growth opportunities in the
    future.
    We are
    dependent on key personnel and we may face challenges in hiring
    and retaining qualified personnel due to the
    restatement.
   20




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Our
    future growth depends on developments in the digital video
    industry, on the adoption of new technologies and on several
    other industry trends.
  voice-over-IP, IP-based VC-1 and/or
    
    Convergence, or the desire of certain network operators to
    deliver a package of video, voice and data services to
    consumers, also known as the triple play;
    The use of digital video applications by businesses, governments
    and educators;
    The entry of telecom providers into the video business to allow
    them to offer the triple play purchase of services;
    Efforts by regulators and governments in the United States and
    abroad to encourage the adoption of broadband and digital
    technologies; and
    The extent and nature of regulatory attitudes towards such
    issues as competition between operators, access by third parties
    to networks of other operators, and local franchising
    requirements for telecom companies to offer video.    The
    markets in which we operate are characterized by rapidly
    changing technology, and we need to develop and introduce new
    and enhanced products in a timely manner to remain
    competitive.
   21




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
    Develop, in a timely manner, new products and applications that
    keep pace with developments in technology;
    Develop products that are cost effective;
    Meet evolving customer requirements;
    Enhance our current product and applications offerings; and
    Achieve market acceptance.      Average
    selling prices of our digital video products may decline, which
    would materially and adversely affect our financial
    performance.
   22




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period-to-period
  We
    must achieve cost reductions or increase revenues to attain
    profitability.
      Our
    repayment of our Notes could adversely affect our financial
    condition, and we may not be able to raise additional funds to
    continue operating our business.
    Form S-3.
 23




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Substantially
    all of our future revenue will be derived from the sale of our
    digital video products, and our operating results, financial
    conditions and cash flows will depend upon our ability to
    generate sufficient revenue from the sale of our digital video
    products.
    We may
    be unable to provide adequate customer support.
      The
    deployment process for our equipment may be lengthy and may
    delay the receipt of new orders and cause fluctuations in our
    revenues.
    We may
    have financial exposure to litigation.
  and/or
 24




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and/or
    The
    loss of existing reseller and system integrator relationships or
    the failure to establish new relationships or strategic
    partnerships could have a material adverse effect on our
    business, financial conditions and results of
    operations.
        We may
    fail to accurately forecast customer demand for our products,
    which could have a negative impact on our customer relationships
    and our revenues.
   25




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We may
    not be able to manage expenses and inventory risks associated
    with meeting the demand of our customers.
      We are
    dependent on a key third-party manufacturer and any failure of
    our manufacturer could materially adversely affect our financial
    condition and operating results.
       26




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We are
    dependent upon international sales and there are many risks
    associated with international operations, any of which could
    harm our financial condition and results of
    operations.
    
    Changes in foreign government regulations and communications
    standards;
    Import and export license requirements, tariffs and taxes, trade
    barriers and trade disputes;
    The uncertainty of laws and enforcement in certain countries
    relating to the protection of intellectual property;
    Difficulty in complying with environmental laws;
    Difficulty in collecting accounts receivable and longer payment
    cycles for international customers than those for customers in
    North America;
    Currency and exchange rate fluctuations;
    The burden of complying with a wide variety of foreign laws,
    treaties and technical standards;
    Difficulty in staffing and managing foreign operations;
    Specific social, political, labor and economic conditions, and
    political and economic changes in international markets; and
    Multiple and possibly overlapping tax structures and potentially
    adverse tax consequences.      We are
    subject to regulation by U.S. and foreign governments and
    qualification requirements by non-governmental agencies. If we
    are unable to obtain and maintain regulatory qualifications for
    our existing and future products, our financial results may be
    adversely affected.
   27




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The
    markets in which we operate are intensely competitive and many
    of our competitors are larger and more
    established.
      
    Product performance, features and reliability;
    Price;
    Size and stability of operations;
    Breadth of product line;
    Sales and distribution capabilities;
    Technical support and service;
    Relationships with network operators and content
    aggregators; and 28




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
    Compliance with industry standards.    
    Larger and more established selling and marketing capabilities;
    Greater economies of scale;
    Significantly greater financial, technical, engineering,
    marketing, distribution, customer support and other resources;
    Greater name recognition and a larger installed base of
    customers; and
    Well-established relationships with our existing and potential
    customers.        Our
    business is subject to the risks of warranty returns, product
    liability and product defects.
   29




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We may
    be unable to adequately protect or enforce our intellectual
    property rights.
          Our
    use of open source and third-party software could impose
    limitations on our ability to commercialize our
    products.
   30




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Third
    party claims of infringement or other claims against us could
    adversely affect our ability to market our products, require us
    to redesign our products or seek licenses from third parties,
    and seriously harm our operating results and disrupt our
    business.
      We are
    exposed to the credit risk of our customers and to credit
    exposures in weakened markets, which could result in material
    losses.
   31




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We
    have and we may seek to expand our business through acquisitions
    which could disrupt our business operations and harm our
    operating results.
    
    Difficulties in integrating the operations, technologies,
    products and personnel of an acquired company;
    Diversion of managements attention from normal daily
    operations of the business;
    Potential difficulties in completing projects associated with
    in-process research and development;
    Difficulties in entering markets in which we have no or limited
    direct prior experience and where competitors in such markets
    have stronger market positions;
    Initial dependence on unfamiliar supply chains or relatively
    small supply partners;
    Insufficient revenues to offset increased expenses associated
    with acquisitions; and
    The potential loss of key employees of the acquired companies.    
    Issue common stock that would dilute our current
    stockholders percentage ownership;
    Assume liabilities;
    Record goodwill and
    non-amortizable
    intangible assets that will be subject to impairment testing and
    potential periodic impairment charges;
    Incur amortization expenses related to certain intangible assets;
    Incur large and immediate write-offs; or
    Become subject to litigation.   32




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Our
    products are subject to safety approvals and
    certifications.
    Compliance
    with current and future environmental regulations may be costly
    which could impact our future earnings.
  .
  We are
    subject to import/export controls, and various import/export
    licensing requirements could materially and adversely affect our
    business or require us to significantly modify our current
    business practices.
     33




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Changes
    in telecommunications legislation and regulations could harm our
    prospects and future sales.
    Compliance
    with changing laws and regulations relating to corporate
    governance and public disclosure has resulted, and will continue
    to result, in the incurrence of additional
    expenses.
       34




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Recent
    and proposed regulations related to equity compensation could
    adversely affect earnings, our ability to raise capital and
    affect our ability to attract and retain key
    personnel.
    New
    privacy laws and regulations or changing interpretations of
    existing laws and regulations could harm our
    business.
    Our
    stock price has been and is likely to continue to be highly
    volatile.
      
    Actual or anticipated variations in quarterly operating results;
    Announcements of technological innovations;
    New products or services offered by us or our competitors;
    Changes in financial estimates by securities analysts;
    Conditions or trends in the broadband services and technologies
    industry;
    Changes in the economic performance
    and/or
    market valuations of technology, Internet, online service or
    broadband service industries;
    Announcement of significant acquisitions, strategic
    partnerships, joint ventures or capital commitments, by us or
    our current or potential competitors;
    Adoption of industry standards and the inclusion or
    compatibility of our technology with such standards;
    Adverse or unfavorable publicity regarding us or our products;
    Additions or departures of key personnel; 35




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
    Sales of common stock; and
    Other events or factors that may be beyond our control.    We
    have adopted a stockholder rights plan, which, together with
    provisions in our charter documents and Delaware law, may delay
    or prevent an acquisition of us, which could decrease the value
    of our stock.
      We
    rely on complex information technology systems and networks to
    operate our business. Any significant system or network
    disruption could have a material adverse impact on our
    operations, sales and financial performance.
    We,
    our sole manufacturer and our customers are vulnerable to
    earthquakes, disruptions to power supply, labor issues and other
    unexpected events.
    and/or
 36




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SPECIAL
    NOTE ON FORWARD-LOOKING STATEMENTS
  Form 10-K and/or
  
    Our belief that our current cash balances will be sufficient to
    satisfy our cash requirements for at least the next
    12 months;
    Our belief that we are well positioned to capitalize on the
    emerging digital video market because of the success our digital
    video products have had with the major U.S. cable operators
    and satellite providers, as well as our current success in
    digital ad insertion;
    Our belief that by focusing our business on higher margin
    digital video products, our margins may increase;
    Our belief that we are well positioned to capitalize on the
    growing demand for network operators to provide advanced video
    services to their subscribers;
    Our belief that the ongoing migration of network operators and
    content aggregators to all-digital networks represents a
    significant opportunity for companies similar to ours with
    products and technologies that enable our customers to maximize
    their bandwidth, to utilize important new transport methods and
    to deploy new services;
    Our belief that networks operators and content aggregators will
    increasingly rely on overlay to maintain or even increase their
    advertising revenues and that our digital video processing
    systems will enable them to do this more cost-effectively;
    Our belief that network operators will continue their
    investments in equipment to provide advanced services in a
    cost-effective manner to increase average revenues per unit from
    their subscribers;
    Our belief that there will be increasing competition to our
    digital video products, which may increase price competition and
    lead to decreased revenue and margins;
    Our expectation that research and development expenses will
    remain constant in 2007; and
    Our expectation that general and administrative expenses will
    decrease in 2007.  Forward-looking statements are not guarantees of future
    performance and involve risks and uncertainties, including those
    discussed in Item 1A of this Report. The forward-looking
    statements contained in this report are based on information
    that is currently available to us and expectations and
    assumptions that we deemed reasonable at the time the statements
    were made. We do not undertake any obligation to update any
    forward-looking statements in this report or in any of our other
    communications, except as required by law. All such
    forward-looking statements should be read as of the time the
    statements were made and with the recognition that these
    forward-looking statements may not be complete or accurate at a
    later date. The business risks discussed in Item 1A of this
    Report on
    Form 10-K,
    among other things, should be considered in evaluating our
    prospects and future financial performance.
 37




---



##### Table of Contents



Item 1B.
    Unresolved
    Staff Comments    Item 2.
    Properties  sub-sublease sub-sublease
  month-to-month
  Item 3.
    Legal
    Proceedings  In re Terayon Communication Systems,
    Inc. Securities Litigation.
  Bertram v. Terayon
    Communication Systems, Inc.
   38




---



##### Table of Contents



Campbell v. Rakib In re
    Terayon Communication Systems, Inc. Derivative Litigation
  Form 10-K
     39




---



##### Table of Contents



40




---



##### Table of Contents



and/or
         41




---



##### Table of Contents



Item 4.
    Submission
    of Matters to a Vote of Security Holders   PART II  Item 5.
    Market
    for the Registrants Common Equity, Related Stockholder
    Matters and Issuer Purchases of Equity Securities    High


LowYear Ended December 31, 2006First Quarter(1)

$
2.91


$
1.63Second Quarter(2)

$
2.24


$
1.18Third Quarter

$
1.38


$
0.74Fourth Quarter

$
2.25


$
0.94Year Ended December 31, 2005First Quarter(1)

$
3.73


$
1.99Second Quarter(1)

$
3.78


$
2.52Third Quarter(1)

$
4.10


$
2.91Fourth Quarter(1)

$
3.95


$
1.97     (1)
    
    Reflects trading on The NASDAQ Stock Market.(2)
    
    Reflects trading on The NASDAQ Stock Market from April 1,
    2006 to April 3, 2006.       42




---



##### Table of Contents



Common StockAvailable for FutureCommon Stock





Issuance Underto be Issued


Weighted Average


Equity CompensationUpon Exercise of


Exercise Price of


Plans (ExcludingOutstanding Options


Outstanding Options


Securities Reflectedand Rights


and Rights


in Column (a))Plan Category

(a)


(b)


(c)Equity compensation plans approved
    by Terayon stockholders(1)


9,664,399


$
4.25



7,529,114Equity compensation plans not
    approved by Terayon stockholders(2)


2,505,310


$
6.82



1,719,164Total


12,169,709


$
4.78



9,248,278     (1)
    
    Includes options to purchase common stock outstanding under the
    Terayon Communication Systems, Inc. 1995 Stock Option Plan, as
    amended (1995 Plan), the Terayon Communication Systems, Inc.
    1997 Equity Incentive Plan, as amended (1997 Plan), and the
    Terayon Communication Systems, Inc. 1998 Non-Employee Directors
    Stock Option Plan, as amended (1998 Plan). Does not include
    600,371 shares of our common stock that were available for
    issuance under the Terayon Communication Systems, Inc. 1998
    Employee Stock Purchase Plan, as amended, which was also
    approved by our stockholders, including the Terayon
    Communication Systems, Inc. 1998 Employee Stock Purchase Plan
    Offering for Foreign Employees. The 1997 Plan was amended on
    June 13, 2000 to, among other things, provide for an
    increase in the number of shares of our common stock on each
    January 1 beginning January 1, 2001 through January 1,
    2007, by the lesser of 5% of our common stock outstanding on
    such January 1 or 3,000,000 shares. In May 2003, the 1997
    Plan was amended to reduce the number of authorized shares in
    the 1997 Plan by 6,237,826 shares. In May 2005, the 1997
    Plan was amended to reduce the number of authorized shares in
    the 1997 Plan by 4,000,000 shares.(2)
    
    Includes options to purchase common stock outstanding under the
    Terayon Communication Systems, Inc. 1999 Non-Officer Equity
    Incentive Plan, as amended (1999 Plan), Mainsail Equity
    Incentive Plan, TrueChat Equity Incentive Plan, and options
    issued outside of any equity incentive plan. See Note 9,
    Stockholders Equity, to Consolidated Financial
    Statements for additional information regarding the provisions
    of the 1999 Plan. 43




---



##### Table of Contents



Stock
    Performance Graph
      Comparison
    of Five-Year Cumulative Return for Terayon, S&P 500 and
    NASDAQ Telecom
  
  2001


2002


2003


2004


2005


2006Terayon


$
100.00



$
24.79



$
54.41



$
32.77



$
27.93



$
26.96S&P 500



100.00




76.63




96.85




105.56




108.73




123.54NASDAQ Telecom



100.00




45.97




77.58




83.78




77.74




99.32  44




---



##### Table of Contents



Item 6.
    Selected
    Financial Data  Form 10-K.
  Year Ended December 31,2006


2005


2004


2003


2002(In thousands, except per share data)Consolidated statement of
    operations data:Revenues

$
76,430


$
90,664


$
136,484


$
130,187


$
130,730Cost of goods sold


30,848



55,635



101,887



103,835



101,808Gross profit


45,582



35,029



34,597



26,352



28,922Operating expenses 
    Research and development


17,377



17,650



33,199



42,634



58,696Sales and marketing


17,897



22,534



24,145



26,781



35,704General and administrative


24,944



20,356



12,039



11,934



15,639Restructuring charges, executive
    severance and asset write-offs(1)


199



2,257



12,336



2,803



8,922Total operating expenses


60,417



62,797



81,719



84,152



118,961Loss from operations


(14,835
)


(27,768
)


(47,122
)


(57,800
)


(90,039
)Interest income (expense) and
    other income (expense), net


1,200



966



(59
)


1,891



(618
)Gain on sale of assets(2)


9,984















Gain on early extinguishment of
    debt(3)


















50,983Income tax benefit (expense)


(180
)


(149
)


76



(316
)


(238
)Net loss

$
(3,831
)

$
(26,951
)

$
(47,105
)

$
(56,225
)

$
(39,912
)Basic and diluted net loss per
    share

$
(0.05
)

$
(0.35
)

$
(0.62
)

$
(0.76
)

$
(0.55
)Shares used in computing basic and
    diluted net loss per share(4)


77,637



77,154



75,751



74,074



72,718Consolidated Balance Sheet
    Data:Cash, cash equivalents and
    short-term investments

$
20,313


$
101,301


$
97,735


$
138,640


$
206,503Working capital


22,852



22,045



107,052



138,035



178,091Total assets


51,970



146,648



156,981



213,099



279,169Convertible debentures






65,367



65,588



65,809



66,030Long-term obligations (less
    current portion)


1,399



1,455



2,076



1,356



1,936Accumulated deficit


(1,066,269
)


(1,062,438
)


(1,035,487
)


(988,382
)


(932,157
)Total stockholders equity


19,822



20,657



44,943



90,563



142,191     (1)
    
    See Note 6, Restructuring Charges and Asset
    Write-Offs, to Consolidated Financial Statements for an
    explanation of restructuring charges and asset write-offs. 45




---



##### Table of Contents



(2)
    
    See Note 14, Sale of Certain Assets, to
    Consolidated Financial Statements for an explanation of the gain
    on the sale of certain assets.(3)
    
    See Note 7, Convertible Subordinated Notes, to
    Consolidated Financial Statements for an explanation of the
    repurchase of subordinated convertible notes and
    reclassification of related gains.(4)
    
    See Note 2, Summary of Significant Accounting
    Policies, to Consolidated Financial Statements for an
    explanation of the method employed to determine the number of
    shares used to compute per share data.  Item 7.
    Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations  Executive
    Overview
  ® digital-to-analog line-ups,
  data-over-satellite
     46




---



##### Table of Contents



Form 10-K.
  Changes
    to Previously Announced Fourth Quarter and Fiscal Year 2006
    Results
    Restatement
    of Consolidated Financial Statements
   47




---



##### Table of Contents



Results
    of Operations
  Comparison
    of Years Ended December 31, 2006 and 2005
  Revenues
      Revenues
    by Groups of Similar Products
    Year EndedDecember 31,


Variance in


Variance in2006


2005


Dollars


PercentRevenues by product:DVS

$
58,547


$
41,806


$
16,741



40.0
%HAS


13,569



41,061



(27,492
)


(67.0
)%CMTS


4,314



7,797



(3,483
)


(44.7
)%Total

$
76,430


$
90,664


$
(14,234
)


(15.7
)%      48




---



##### Table of Contents



Year EndedDecember 31,


Variance in


Variance in2006


2005


Dollars


PercentDVS product revenue invoiced and
    recognized in current period:Total invoiced in current period

$
45.5


$
53.9


$
(8.4
)


(15.6
)%Less: Invoiced in current period
    and recognized in future periods


4.0



27.4



(23.4
)


(85.4
)%Total invoiced and recognized in
    current period


41.5



26.5



15.0



56.6
%DVS product revenue invoiced in
    prior fiscal years and recognized in current period


17.0



15.3



1.7



11.1
%Total DVS product revenue
    recognized in current period

$
58.5


$
41.8


$
16.7



40.0
%     Revenues
    by Geographic Region
    Year EndedDecember 31,


Variance in


Variance in2006


2005


Dollars


PercentRevenues by geographic region:United States

$
54,387


$
52,838


$
1,549



2.9
%Americas, excluding United States


2,932



1,871



1,061



56.7
%Europe, Middle East and Africa
    (EMEA), excluding Israel


11,236



15,314



(4,078
)


(26.6
)%Israel


3,427



7,645



(4,218
)


(55.2
)%Asia, excluding Japan


3,078



11,544



(8,466
)


(73.3
)%Japan


1,370



1,452



(82
)


(5.6
)%Total

$
76,430


$
90,664


$
(14,234
)


(15.7
)%    49




---



##### Table of Contents



Significant
    Customers
      Cost of
    Goods Sold and Gross Profit
         50




---



##### Table of Contents



Year EndedDecember 31,


Variance in


Variance in2006


2005


Dollars


PercentCost of goods sold related to DVS
    product invoiced and recognized in current period:Total cost of goods sold related
    to DVS product invoiced in current period

$
9.7


$
13.4


$
(3.7
)


(27.6
)%Less: Cost of goods sold related
    to DVS product invoiced in current period and recognized in
    future periods


0.1



7.4



(7.3
)


(98.6
)%Total cost of goods sold related
    to DVS product invoiced and recognized in current period

$
9.6


$
6.0


$
3.6



60.0
%Cost of goods sold related to DVS
    product invoiced in prior fiscal years and recognized in current
    period


4.2



2.7



1.5



55.6
%Total cost of goods sold related
    to DVS product recognized in current period

$
13.8


$
8.7


$
5.1



58.6
%   97-2, (SOP 97-2),
     51




---



##### Table of Contents



Operating
    Expenses
    Year EndedDecember 31,


Variance in


Variance in2006


2005


Dollars


PercentResearch and development

$
17,377


$
17,650


$
(273
)


(1.5
)%Sales and marketing


17,897



22,534



(4,637
)


(20.6
)%General and administrative


24,944



20,356



4,588



22.5
%Restructuring charges, executive
    severance and asset write-offs


199



2,257



(2,058
)


(91.2
)%   Research
    and Development.
    Sales
    and Marketing.
    General
    and Administrative.
   52




---



##### Table of Contents



Restructuring
    Charges, Executive Severance and Asset Write-offs.
      Year EndedDecember 31,


Variance in


Variance in2006


2005


Dollars


PercentRestructuring charges

$



$
1,003


$
(1,003
)


(100.0
)%Executive severance






15



(15
)


(100.0
)%Long-lived assets written-off


962



85



877



1031.8
%Subtotal


962



1,103



(141
)


(12.8
)%Restructuring (recovery/change in
    estimate in prior year plans)


(763
)


1,154



(1,917
)


(166.1
)%Restructuring charges, executive
    severance and asset write-offs

$
199


$
2,257


$
(2,058
)


(91.2
)%     Non-operating
    Expenses
    Year EndedDecember 31,


Variance in


Variance in2006


2005


Dollars


PercentInterest income (expense), net

$
1,178


$
(189
)

$
1,367



(723.3
)%Other income, net


22



1,155



(1,133
)


(98.0
)%      53




---



##### Table of Contents



Income
    Tax (Expense) Benefit
    Stock-Based
    Compensation
        Comparison
    of Years Ended December 31, 2005 and 2004
  Revenues
     54




---



##### Table of Contents



Revenues
    by Groups of Similar Products
    Year EndedDecember 31,


Variance in


Variance in2005


2004


Dollars


PercentRevenues by product:DVS

$
41,806


$
24,102


$
17,704



73.5
%HAS


41,061



82,068



(41,007
)


(50.0
)%CMTS


7,797



30,210



(22,413
)


(74.2
)%Other






104



(104
)


(100.0
)%Total

$
90,664


$
136,484


$
(45,820
)


(33.6
)%   end-to-end
     55




---



##### Table of Contents



Year EndedDecember 31,


Variance in


Variance in2005


2004


Dollars


PercentDVS product revenue invoiced and
    recognized in current period:Total invoiced in current period

$
53.9


$
36.8


$
17.1



46.5
%Less: Invoiced in current period
    and recognized in future periods


27.4



15.0



12.4



82.7
%Total invoiced and recognized in
    current period

$
26.5


$
21.8


$
4.7



21.6
%DVS product revenue invoiced in
    prior fiscal years and recognized in current period


15.3



2.3



13.0



565.2
%Total DVS product revenue
    recognized in current period

$
41.8


$
24.1


$
17.7



73.4
%     Revenues
    by Geographic Region
    Year EndedDecember 31,


Variance in


Variance in2005


2004


Dollars


PercentRevenues by geographic areas:United States

$
52,838


$
72,838


$
(20,000
)


(27.5
)%Americas, excluding United States


1,871



4,930



(3,059
)


(62.0
)%Europe, Middle East and Africa
    (EMEA), excluding Israel


15,314



17,640



(2,326
)


(13.2
)%Israel


7,645



16,645



(9,000
)


(54.1
)%Asia, excluding Japan


11,544



15,259



(3,715
)


(24.3
)%Japan


1,452



9,172



(7,720
)


(84.2
)%Total

$
90,664


$
136,484


$
(45,820
)


(33.6
)%    56




---



##### Table of Contents



Significant
    Customers
    Cost of
    Goods Sold and Gross Profit
     57




---



##### Table of Contents



Year EndedDecember 31,


Variance in


Variance in2005


2004


Dollars


PercentCost of goods sold related to DVS
    product invoiced and recognized in current period:Total cost of goods sold related
    to DVS product invoiced in current period

$
13.4


$
7.8


$
5.6



71.8
%Less: Cost of goods sold related
    to DVS product invoiced in current period and recognized in
    future periods


7.4



2.7



4.7



174.1
%Total cost of goods sold related
    to DVS product invoiced and recognized in current period

$
6.0


$
5.1


$
0.9



17.6
%Cost of goods sold related to DVS
    product invoiced in prior fiscal years and recognized in current
    period


2.7



0.5



2.2



440.0
%Total cost of goods sold related
    to DVS product recognized in current period

$
8.7


$
5.6


$
3.1



55.4
%        58




---



##### Table of Contents



Operating
    Expenses
    Year EndedDecember 31,


Variance in


Variance in2005


2004


Dollars


PercentResearch and development

$
17,650


$
33,199


$
(15,549
)


(46.8
)%Sales and marketing


22,534



24,145



(1,611
)


(6.7
)%General and administrative


20,356



12,039



8,317



69.1
%Restructuring charges, executive
    severance and asset write-offs


2,257



12,336



(10,079
)


(81.7
)%   Research
    and Development
    Sales
    and Marketing
    General
    and Administrative
   59




---



##### Table of Contents



Restructuring
    Charges, Executive Severance and Asset Write-offs
    Year EndedDecember 31,


Variance in


Variance in2005


2004


Dollars


PercentRestructuring charges

$
1,003


$
6,784


$
(5,781
)


(85.2
)%Executive severance


15



3,451



(3,436
)


(99.6
)%Long-lived assets written-off


85



2,401



(2,316
)


(96.5
)%Subtotal


1,103



12,636



(11,533
)


(91.3
)%Restructuring (recovery/change in
    estimate in prior year plans)


1,154



(300
)


1,454



(484.7
)%Restructuring charges, executive
    severance and asset write-offs

$
2,257


$
12,336


$
(10,079
)


(81.7
)%   Restructuring
            Executive
    Severance
    Asset
    Write-offs
   60




---



##### Table of Contents



Non-operating
    Expenses
    Year EndedDecember 31,


Variance in


Variance in2005


2004


Dollars


PercentInterest expense, net

$
(189
)

$
(1,090
)

$
901



(82.7
)%Other income, net


1,155



1,031



124



12.0
%       Income
    Tax (Expense) Benefit
    Litigation
    Off-Balance
    Sheet Financings and Liabilities
    Liquidity
    and Capital Resources
    Form 10-Q Form 10-Q
 61




---



##### Table of Contents



62




---



##### Table of Contents



Contractual
    Obligations
    Payments Due by PeriodLess than


1 - 3


4 - 5


AfterTotal


1 Year


Years


Years


5 YearsUnconditional purchase obligations

$
6.4


$
6.4


$



$



$
Operating lease obligations


11.0



3.9



7.1







Total

$
17.4


$
10.3


$
7.1


$



$
     sub-sublease sub-sublease
    Amount of Commitment Expiration per PeriodLess than


1 - 3


4 - 5


AfterTotal


1 Year


Years


Years


5 YearsDeposits

$
7.5


$
7.5


$



$



$
Standby letters of credit


0.4







0.4







Total

$
7.9


$
7.5


$
0.4


$



$
    63




---



##### Table of Contents



Critical
    Accounting Policies
    Revenue
    Recognition
  free-on-board
  97-2, (SOP 97-2) SOP 81-1, (SOP 81-1).
    SOP 97-2,
   64




---



##### Table of Contents



SOP 97-2
  SOP 97-2.
  Deferred
    Revenue, Deferred Cost of Goods Sold
  SOP 97-2. SOP 97-2,
  Allowance
    for Doubtful Accounts
    Inventory
    Valuation
       65




---



##### Table of Contents



Warranty
    Reserves
    Restructuring
    and Other Related Charges
    Contingencies
   66




---



##### Table of Contents



Income
    Taxes
    Recently
    Issued Accounting Standards
       67




---



##### Table of Contents



Item 7A.
    Quantitative
    and Qualitative Disclosures About Market Risk  Interest Rate Risk. available-for-sale
  Foreign Currency Risk.
 68




---



##### Table of Contents



Item 8.
    Financial
    Statements and Supplementary Data  TERAYON
    COMMUNICATION SYSTEMS, INC.
  INDEX TO
    CONSOLIDATED FINANCIAL STATEMENTS
  PageReport of
    Stonefield Josephson, Inc., Independent Registered Public
    Accounting Firm


70Consolidated
    Balance Sheets


71Consolidated
    Statements of Operations


72Consolidated
    Statements of Stockholders Equity


73Consolidated
    Statements of Cash Flows


74Notes to
    Consolidated Financial Statements


75  69




---



##### Table of Contents



REPORT OF
    INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM             Internal Control  Integrated Framework
  
    70




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.



CONSOLIDATED
    BALANCE SHEETS  December 31,2006


2005(In thousands)ASSETSCurrent assets:Cash and cash equivalents

$
8,362


$
28,867Short-term investments


11,951



72,434Accounts receivable, net of
    allowance for doubtful accounts


10,914



9,879Other current receivables


1,296



1,606Inventory, net


2,324



10,915Deferred cost of goods sold


2,289



3,351Deposits


8,248



Other current assets


1,532



3,427Total current assets


46,916



130,479Property and equipment, net


3,309



3,915Restricted cash


395



332Long-term deferred cost of goods
    sold


1,338



4,351Other assets, net


12



7,571Total assets

$
51,970


$
146,648LIABILITIES AND
    STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

$
5,495


$
5,036Accrued payroll and related
    expenses


3,650



2,105Deferred revenues


9,329



13,952Deferred gain on asset sale






8,631Accrued warranty expenses


1,246



2,887Accrued restructuring and
    executive severance


149



1,305Accrued vendor cancellation charges


124



1,508Accrued other liabilities


4,071



6,287Interest payable






1,356Current portion of subordinated
    convertible notes






65,367Total current liabilities


24,064



108,434Long-term obligations


1,399



1,455Accrued restructuring and
    executive severance


193



1,381Long-term deferred revenue


6,492



14,721Total liabilities


32,148



125,991Commitments and contingencies
    (Notes 4 and 8)Stockholders equity:Preferred stock, $0.001 par
    value: 5,000,000 shares authorized; no shares issued and
    outstanding






Common stock: $0.001 par
    value, 200,000,000 shares authorized Issued 
    77,793,844 in 2006 and 77,794,186 in 2005
    Outstanding  77,637,177 in 2006 and 2005


78



78Additional paid-in capital


1,089,278



1,086,817Accumulated deficit


(1,066,269
)


(1,062,438
)Treasury stock, at cost;
    156,009 shares


(773
)


(773
)Accumulated other comprehensive
    loss


(2,492
)


(3,027
)Total stockholders equity


19,822



20,657Total liabilities and
    stockholders equity

$
51,970


$
146,648    71




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.



CONSOLIDATED
    STATEMENTS OF OPERATIONS  Year Ended December 31,2006


2005


2004(In thousands, except per share data)Revenues

$
76,430


$
90,664


$
136,484Cost of goods sold


30,848



55,635



101,887Gross profit


45,582



35,029



34,597Operating expenses:Research and development


17,377



17,650



33,199Sales and marketing


17,897



22,534



24,145General and administrative


24,944



20,356



12,039Restructuring charges, executive
    severance and asset write-offs


199



2,257



12,336Total operating expenses


60,417



62,797



81,719Loss from operations


(14,835
)


(27,768
)


(47,122
)Gain on sale of assets


9,984







Interest income (expense), net


1,178



(189
)


(1,090
)Other income, net


22



1,155



1,031Loss before income tax expense


(3,651
)


(26,802
)


(47,181
)Income tax benefit (expense)


(180
)


(149
)


76Net loss

$
(3,831
)

$
(26,951
)

$
(47,105
)Basic and diluted net loss per
    share

$
(0.05
)

$
(0.35
)

$
(0.62
)Shares used in computing basic and
    diluted net loss per share


77,637



77,154



75,751    72




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.



CONSOLIDATED
    STATEMENTS OF STOCKHOLDERS EQUITY  AccumulatedOther








TotalCommon Stock


Additional


Accumulated


Deferred


Comprehensive


Treasury Stock


StockholdersShares


Amount


Paid-in Capital


Deficit


Compensation


Income (loss)


Shares


Amount


Equity(In thousands, except share amounts)Balance at December 31,
    2003


74,874,001


$
75


$
1,082,034


$
(988,382
)

$
(22
)

$
(2,368
)


156,009


$
(773
)

$
90,563Exercise of option for cash to
    purchase common stock


225,645







494























494Re-valuation of options to
    non-employees










(5
)






5Amortization of deferred
    compensation


















17















17Issuance of common stock for
    Employee Stock Purchase Plan


1,197,419



1



1,186























1,187Comprehensive loss:Increase to unrealized gain on
    short term investments






















(520
)










(520
)Cumulative translation adjustment






















307











307Net loss














(47,105
)


















(47,105
)Comprehensive Loss


































(47,319
)Balance at December 31,
    2004


76,297,065



76



1,083,709



(1,035,487
)






(2,582
)


156,009



(773
)


44,943Exercise of option for cash to
    purchase common stock


1,340,112



2



3,056























3,058Accelerated Vesting of Options










52























52Comprehensive loss:Increase to unrealized gain on
    short term investments






















16











16Cumulative translation adjustment






















(461
)










(461
)Net loss














(26,951
)


















(26,951
)Comprehensive Loss


































(27,396
)Balance at December 31,
    2005


77,637,177



78



1,086,817



(1,062,438
)






(3,027
)


156,009



(773
)


20,657Stock based compensation expense










2,461























2,461Comprehensive loss:Increase to unrealized gain on
    short term investments






















425











425Cumulative translation adjustment






















110











110Net loss














(3,831
)


















(3,831
)Comprehensive Loss


































(2,746
)Balance at December 31,
    2006


77,637,177


$
78


$
1,089,278


$
(1,066,269
)

$



$
(2,492
)


156,009


$
(773
)

$
19,822    73




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.



CONSOLIDATED
    STATEMENTS OF CASH FLOWS  Year Ended December 31,2006


2005


2004Cash flows from operating
    activities:Net loss

$
(3,831
)

$
(26,951
)

$
(47,105
)Adjustments to reconcile net loss
    to net cash provided by (used in) operating activities:Depreciation and amortization


2,059



3,148



5,860Stock based compensation


2,461







Amortization of subordinated
    convertible notes premium


(286
)


(221
)


(221
)Amortization of deferred
    compensation










17Accretion of discounts on
    short-term investments


(126
)


(114
)


(107
)Realized gains on sales of
    short-term investments










(2
)Inventory provision


2,940



2,732



11,550Provision for doubtful accounts


(25
)


132



590Restructuring provision






2,068



6,513Write-off of fixed assets


1,092



602



3,045Warranty provision


673



(165
)


3,075Vendor cancellation provision


(1,040
)


1,143



387Recognition of deferred gain on
    asset sale


(8,631
)






Changes in operating assets and
    liabilities:Accounts receivable, net


(700
)


7,986



8,404Inventory


5,651



4,019



(11,939
)Other current assets


(5,291
)


(3,262
)


(311
)Long-term deferred cost of goods
    sold


3,013



(2,543
)


(1,458
)Other assets


7,496



2,896



2,172Accounts payable


459



(2,810
)


(17,440
)Accrued payroll and related expenses


1,545



(2,829
)


(1,984
)Deferred revenues


(12,852
)


12,624



11,852Deferred gain on asset sale


(2,314
)


8,631



Accrued warranty expenses


(2,344
)


(1,618
)


(3,634
)Accrued restructuring charges


(344
)


(4,507
)


(4,355
)Accrued vendor cancellation charges






(156
)


(2,735
)Other accrued liabilities


(3,628
)


1,793



(1,830
)Net cash provided by (used in)
    operating activities


(14,023
)


2,598



(39,656
)Cash flows from investing
    activities:Purchases of short-term investments






(44,707
)


(89,957
)Proceeds from sales and maturities
    of short-term investments


61,034



26,919



143,480Purchases of property and equipment


(2,545
)


(1,811
)


(2,700
)Net cash provided by (used in)
    investing activities


58,489



(19,599
)


50,823Cash flows from financing
    activities:Principal payments on capital leases










(126
)Debt extinguishment of convertible
    debt


(65,081
)






Proceeds from issuance of common
    stock






3,110



1,682Net cash provided by (used for)
    financing activities


(65,081
)


3,110



1,556Effect of foreign currency exchange
    rate changes


110



(460
)


307Net decrease in cash and cash
    equivalents


(20,505
)


(14,351
)


13,030Cash and cash equivalents at
    beginning of year


28,867



43,218



30,188Cash and cash equivalents at end of
    year

$
8,362


$
28,867


$
43,218Supplemental disclosures of cash
    flow information:Cash paid for income taxes

$
36


$
111


$
138Cash paid for interest

$
1,817


$
3,254


$
3,268Non-cash investing and financing
    activity:Deferred compensation relating to
    common stock issued to
    non-employee

$



$



$
17  74




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.



NOTES TO
    CONSOLIDATED FINANCIAL STATEMENTS



TERAYON
    COMMUNICATION SYSTEMS, INC.



NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)  Note 1.
    Organization  Description
    of Business
        Note 2.
    Summary
    of Significant Accounting Policies  Basis
    of Consolidation
    Use of
    Estimates
    Foreign
    Currency Translation
  end-of-period
  Treasury
    Stock
    Concentrations
    of Credit Risk, Customers, Suppliers and Products
   75




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
          Revenue
    Recognition
  free-on-board
  97-2, (SOP 97-2) SOP 81-1, (SOP 81-1).
   76




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    SOP 97-2,
    SOP 97-2
  SOP 97-2.
  Deferred
    Revenue, Deferred Cost of Goods Sold
  SOP 97-2. SOP 97-2,
  Accounts
    Receivable, Net of Allowance for Doubtful Accounts
   77




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Research
    and Development Expenses
  SOP 97-2, SOP 81-1.
  Shipping
    and Handling Costs
    Advertising
    Expenses
    Net
    Loss Per Share
    Year Ended December 31,2006


2005


2004Net loss

$
(3,831
)

$
(26,951
)

$
(47,105
)Basic and diluted net loss per
    share

$
(0.05
)

$
(0.35
)

$
(0.62
)Shares used in computing basic and
    diluted net loss per share


77,637



77,154



75,751     Cash,
    Cash Equivalents and Short-Term Investments
  available-for-sale
  other-than-temporarily
 78




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  03-01 Other-Than-Temporary other-than-temporarily
  available-for-sale other-than-temporary available-for-sale
  Other
    Current Receivables
    Inventory
  (first-in,
  Year Ended December 31,2006


2005Raw materials

$
203


$
58Work-in-process
    and Finished goods


2,121



10,857Total

$
2,324


$
10,915    79




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     Deposits
    Property
    and Equipment
      Year EndedDecember 31,2006


2005Software and computers

$
10,742


$
11,117Furniture and fixtures


436



357Office equipment


92



175Leasehold improvements


1,615



2,455Machinery and equipment


13,042



14,231Property and equipment


25,927



28,335Accumulated depreciation and
    amortization


(22,618
)


(24,420
)Property and equipment, net

$
3,309


$
3,915     Restricted
    Cash
    Other
    Assets, Net
   80




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   Warranty
    Obligations
    Stock-Based
    Compensation
    first-in,
       81




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Accumulated
    Other Comprehensive Loss
      Year Ended December 31,2006


2005Cumulative translation
    adjustments, net

$
(2,443
)

$
(2,554
)Unrealized loss on
    available-for-sale
    investments, net


(49
)


(473
)Total accumulated other
    comprehensive loss

$
(2,492
)

$
(3,027
)   Reclassifications
    Recently
    Issued Accounting Standards
       82




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
          Note 3.
    Fair
    Value of Financial Instruments   83




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     Gross


GrossAmortized


Unrealized


Unrealized


FairDecember 31, 2006

Cost


Gains


Losses


Value(In thousands)Investments maturing in less than
    1 year:Commercial paper

$



$



$



$
Government agency obligations














Subtotal














Investments maturing in
    1-2 years:Fixed income corporate securities














Government agency obligations


12,000







(49
)


11,951Subtotal


12,000







(49
)


11,951Total

$
12,000


$



$
(49
)

$
11,951   Gross


GrossAmortized


Unrealized


Unrealized


FairDecember 31, 2005

Cost


Gains


Losses


Value(In thousands)Investments maturing in less than
    1 year:Commercial paper

$
7,950


$



$
(3
)

$
7,947Government agency obligations


47,000







(325
)


46,675Subtotal


54,950







(328
)


54,622Investments maturing in
    1-2 years:Fixed income corporate securities


3,959







(9
)


3,950Government agency obligations


13,998







(136
)


13,862Subtotal


17,957







(145
)


17,812Total

$
72,907


$



$
(473
)

$
72,434     Note 4.
    Commitments  Leases
  sub-sublease sub-sublease sub-sublease
 84




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  month-to-month
  28-month
    OperatingLeases2007

$
3,9302008


3,8982009


3,1852010


Thereafter


Total minimum payments

$
11,013     Purchase
    Obligations
   85




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   Letters
    of Credit
    Note 5.
    Retention
    and Bonus Plans    Note 6.
    Restructuring
    Charges and Asset Write-offs    2004
    Restructurings
   86




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
       sub-subleased sub-sublease.
    Involuntary


Excess Leased


Aircraft LeaseTerminations


Facilities


Termination


TotalCharges

$
2,298


$
2,523


$
933


$
5,754Cash payments


(1,467
)


(850
)


(1,194
)


(3,511
)Changes in estimates


(239
)


324



954



1,039Balance at December 31, 2004


592



1,997



693



3,282Charges


1,037











1,037Cash payments


(1,534
)


(1,190
)


(344
)


(3,068
)Changes in estimates


(95
)


1,246



149



1,300Balance at December 31, 2005






2,053



498



2,551Charges














Cash payments






(1,109
)


(281
)


(1,390
)Changes in estimates






(601
)


(217
)


(818
)Balance at December 31, 2006

$



$
343


$



$
343   2001
    Restructuring
    Asset
    Write-offs
   87




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   Note 7.
    Convertible
    Subordinated Notes  Form 10-Q Form 10-Q
  Note 8.
    Contingencies  Litigation
  In re Terayon
    Communication Systems, Inc. Securities Litigation.
  Bertram v. Terayon Communication Systems, Inc.
 88




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Campbell v. Rakib In re Terayon Communication
    Systems, Inc. Derivative Litigation
  Form 10-K
   89




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
           90




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
          and/or
 91




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
              Note 9.
    Stockholders
    Equity  Stockholder
    Rights Plan
   92




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Common
    Stock Reserved
    December 31,2006Common stock options


21,395,432Employee stock purchase plan


600,371Total


21,995,803   Stock
    Option and Stock Purchase Plans
           93




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Options


Options OutstandingAvailable


Number of


Weighted-Averagefor Grant


Shares


Exercise PriceBalance at December 31, 2003


8,545,010



17,463,959


$
6.20Options authorized


3,000,000







Options granted


(4,738,944
)


4,738,944


$
1.96Options exercised






(225,645
)

$
2.19Options canceled


5,174,420



(5,174,420
)

$
5.19Balance at December 31, 2004


11,980,486



16,802,838


$
5.37Options authorized


(8,500,000
)






Options granted


(2,911,675
)


2,911,675


$
3.01Options exercised






(1,341,112
)

$
2.28Options canceled


5,341,415



(5,341,415
)

$
6.31Shares expired


(383,804
)






Balance at December 31, 2005


5,526,422



13,031,986


$
4.78Options authorized


3,000,000







Options granted


(577,000
)


577,000


$
2.05Options exercised










Options canceled


1,439,277



(1,439,277
)

$
3.66Shares expired










Balance at December 31, 2006


9,388,699



12,169,709


$
4.78     Options Outstanding


Options ExercisableWeighted Average


Weighted





WeightedShares


Remaining


Average


Exercisable


AverageRange of Exercise Prices

Outstanding


Contractual Life


Exercise Price


Options


Exercise Price$0.00 - $1.99


2,515,238



7.59


$
1.76



1,825,007


$
1.75$2.01 - $2.74


2,584,067



6.27



2.41



2,064,307



2.47$2.90 - $4.01


2,458,259



4.84



3.06



1,440,205



3.07$4.08 - $6.52


1,049,260



4.92



5.71



980,301



5.71$6.81 - $66.38


3,562,885



3.99



9.54



3,559,385



9.55Total


12,169,709



5.47


$
4.78



9,869,205


$
5.30     Employee
    Stock Purchase Plan
   94




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Valuation
    and Expense Information under SFAS 123(R)
    Year EndedDecember 31,2006Cost of goods sold

$
302Research and development


624Sales and marketing


792General and administrative


743Share-based compensation effect in
    income before taxes


2,461Income taxes


Net share-based compensation
    effect in net loss

$
2,461Impact on net loss per share

$
0.03Shares used in computing share
    amounts


77,637    95




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     Year Ended December 31,2005


2004Net loss, as reported

$
(26,951
)

$
(47,105
)Less: Total share-based employee
    compensation determined under the fair value method recognition
    provisions of SFAS 123 for all rewards, net of tax


4,144



13,947Pro forma net loss

$
(31,095
)

$
(61,052
)Reported basic and diluted net
    loss per share

$
(0.35
)

$
(0.62
)Pro forma basic and diluted income
    per share

$
(0.40
)

$
(0.81
)Shares used in computing pro forma
    basic and diluted net loss per share


77,154



75,751     Year EndedDecember 31,2006


2005Weighted average estimated fair
    value of grant

$
0.90


$
1.42Expected life (in years)


2.2



2.1Risk-free interest rate


4.75
%


3.93
%Volatility


71.1
%


58.0
%Dividend yield


0
%


0
%    96




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     WeightedAverageWeighted


Remaining


AggregateNumber of


Average


Contractual


IntrinsicShares


Exercise Price


Life


Value(1)(In years)Vested


9,869,205


$
5.30



5.4


$
884Expected to vest


2,025,490


$
2.54



5.9



341Total


11,894,695


$
4.83



5.5


$
1,225     (1)
    
    These amounts represent the differences between the exercise
    price and $2.23, the closing price of Terayon stock on
    December 29, 2006 as reported on the Pink Sheets for all
    in-the-money
    options outstanding.  Note 10.
    Income
    Taxes    Year Ended December 31,2006


2005


2004Current:Federal

$



$



$
State


(30
)






(40
)Foreign


(150
)


(149
)


116Total current


(180
)


(149
)


76Deferred:Federal










State










Foreign










Total deferred

$
(180
)

$
(149
)

$
76     Year Ended December 31,2006


2005


2004Tax benefit at U.S. statutory
    rate

$
1,085


$
9,418


$
16,513Loss for which no tax benefit is
    currently recognizable


(1,085
)


(9,418
)


(16,513
)Other, net


(180
)


(149
)


76$
(180
)

$
(149
)

$
76    97




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2006


2005Deferred tax assets:Net operating loss carryforwards

$
127,718


$
156,229Tax credit carryforwards


13,879



13,607Reserves and accruals


4,595



9,469Capitalized research and
    development


1,605



2,270Intangible asset amortization


24,534



24,929Deferred revenue


6,019



14,239Other, net


8,422



9,078Gross deferred tax assets


186,722



229,821Valuation allowance


(186,722
)


(229,821
)Net deferred tax assets

$



$
             Note 11.
    Defined
    Contribution Plan   98




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##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   Note 12.
    Segment
    Information        Note 13.
    Product
    Warranty   99




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##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2006


2005Balance at beginning of year

$
2,887


$
4,670Additions (reductions) charged to
    costs and expenses


673



(166
)Settlements


(2,314
)


(1,617
)Balance at end of year

$
1,246


$
2,887   Guarantees,
    Including Indirect Guarantees of Indebtedness of
    Others
    Note 14.
    Sale of
    Certain Assets   100




---



##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Note 15.
    Settlement
    of Litigation  In re Terayon
    Communication Systems, Inc. Derivative Litigation,
  In re Terayon Communication
    Systems, Inc. Securities Litigation No. C-00-1967-MHP,
      Note 16.
    Subsequent
    Events  Corporate
    Aircraft
   101




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##### Table of Contents



TERAYON
    COMMUNICATION SYSTEMS, INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  28-month
    RGB
    litigation Settlement
    Note 17.
    Unaudited
    Quarterly Financial Data    Quarter2006

1st


2nd


3rd


4thRevenues

$
21,490


$
20,425


$
16,828


$
17,687Gross profit


10,774



11,957



11,624



11,227Operating expenses


14,437



14,599



14,961



16,419Net (loss) income (1)


(3,944
)


8,344



(3,065
)


(5,166
)Net (loss) income per share:Basic

$
(0.05
)

$
0.11


$
(0.04
)

$
(0.07
)Diluted

$
(0.05
)

$
0.11


$
(0.04
)

$
(0.07
)   Quarter2005

1st


2nd


3rd


4thRevenues

$
17,813


$
18,925


$
23,440


$
30,486Gross profit


6,550



7,347



6,441



14,691Operating expenses


15,609



13,747



15,686



17,755Net loss


(9,233
)


(6,487
)


(8,120
)


(3,111
)Net loss:Basic

$
(0.12
)

$
(0.08
)

$
(0.11
)

$
(0.04
)Diluted

$
(0.12
)

$
(0.08
)

$
(0.11
)

$
(0.04
)     (1)
    
    This amount in the second quarter of 2006 includes
    $9.9 million from a gain on the sale of assets to ATI. See
    Note 14, Sale of Certain Assets, to
    Consolidated Financial Statements. 102




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##### Table of Contents



Item 9.
    Changes
    in and Disagreements with Accountants on Accounting and
    Financial Disclosure  Forms 8-K 8-K/A
 Item 9A.
    Controls and Procedures  a) Evaluation
    of Disclosure Controls and Procedures
    Form 10-K Form 10-K, Form 10-K.
  b) Managements
    Report on Internal Control over Financial Reporting
  Rules 13a-15(e)
   103




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##### Table of Contents



Form 10-K Form 10-Q
  Communication of Financial
    Information.
  Lack of Technical Accounting Expertise and Qualified
    Accounting Personnel
  The Use of Estimates.
  Inadequate
    Controls over Documentation and Record Keeping.
  
    The Company did not have sufficient controls in place to ensure
    the proper authorization and review of manual journal entries
    and the associated support documentation.
    The Company did not have sufficient controls to address the
    amendment of sales orders with its customers. Sales orders could
    be amended through the amendment of the sales orders, purchase
    orders and agreements. When sales were amended through sales or
    purchase orders, the person processing the amendments would
    exercise discretion in inputting the revised terms and
    conditions and there was no consistent policy requiring the
    accounting and finance department to approve such amendments or
    even informing the accounting and finance department of such
    amendments.
    The Company did not keep adequate documentation related to the
    analysis and reconciliation of certain general ledger accounts.
    The Company did not retain certain corporate records in
    connection with the sale of certain subsidiaries to third
    parties.      c) Remediation
    of Previously Disclosed Material Weakness
  Form 10-K Form 10-Q
 104




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##### Table of Contents



Revenue
    Recognition.
  SOP 97-2, 00-21, SOP 97-2, 00-21. SOP 97-2, 00-21.
    Remediation
    Steps:
  
    The Company engaged the services of experienced accounting
    consultants to review the Companys books and close
    procedures on a monthly basis to assist management in ensuring
    that the Companys financial statements are being recorded
    in accordance with GAAP.
    During the quarter ended September 30, 2006, the Company
    established a process where all significant accruals must be
    reviewed and approved by the Corporate Controller.
    During the first three quarters of 2006, the Companys
    accounting and finance department, with the assistance of
    outside consultants, implemented procedures to recognize sales
    of its video products under the software accounting rules under
    SOP 97-2
    in accordance with GAAP.
    In 2006, the Company established pricing guidelines and internal
    procedures to ensure consistent pricing to allow for the
    establishment of VSOE of fair value for sales made with multiple
    element arrangements.
    During the second and third quarters of 2005, the accounting and
    finance department established procedures surrounding the
    month-end close process to ensure that the information and
    estimates necessary for recognizing revenue in accordance with
    SOP 97-2
    were available.
    The Company provided its accounting staff with training on
    revenue recognition, including software accounting and project
    accounting, and GAAP, including attending seminars and
    conferences. Additional training will be provided on a regular
    and periodic basis and updated as considered necessary.
    During the quarter ended March 31, 2006, the Company hired
    an experienced revenue accountant to review all revenue
    transactions and to ensure that revenues, cost of goods sold,
    deferred revenue and deferred cost of goods sold are properly
    accounted for in accordance with GAAP and the Companys
    policies. 105




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##### Table of Contents



d) Remediation
    Steps to Address Continuing Material Weaknesses
    Communication
    of Financial Information.
  
    During the quarter ended June 30, 2005, the Company
    established procedures to document the review of press releases
    to account for transactions in a complete and timely manner.
    During the quarter ended June 30, 2005, the Company also
    improved the internal process of drafting and reviewing periodic
    reports by implementing additional management and external legal
    counsel review prior to their submission to the Companys
    independent registered public accounting firm.
    Continue to monitor the communication channels between the
    Companys senior management and the Companys
    accounting and finance department and take prompt action, as
    necessary, to further strengthen these communication channels;
    Implement training procedures for new employees and/or
    consultants in the accounting and finance department on the
    Companys disclosure procedures and controls, the Company
    and the Companys actions in previous reporting periods; and
    Take steps to ensure that the Company senior management has
    timely access to all material financial and non-financial
    information concerning our business.  Use of
    Estimates.
  
    The Company has engaged the services of experienced accounting
    consultants to review the Companys books and close
    procedures on a monthly basis to assist management in ensuring
    that the Companys financial statements are being recorded
    in accordance with GAAP.
    The Company continues to engage the services of an outside tax
    accounting firm to assist with the calculation of the
    Companys tax liabilities.
    During the quarter ended September 30, 2006, the Company
    established a process where all significant accruals must be
    reviewed and approved by the Corporate Controller.
    During the quarter ended June 30, 2006, the Company
    implemented a process to obtain and assess accruals for legal
    costs and expenses owed to third party vendors whereby the
    Companys legal department obtains monthly estimates from
    the third party vendors and reviews the amount reported by third
    party vendors for accuracy.  Lack
    of Technical Accounting Expertise and Qualified Accounting
    Personnel.
  
    During the quarter ended June 30, 2006, the Company engaged
    experienced accounting consultants to act as the VP Finance,
    Corporate Controller and Revenue Recognition Accountant.
    During the second, third and fourth quarters of 2006, the
    Company engaged expert accounting consultants to assist the
    Companys accounting and finance department with the
    management and implementation of controls surrounding revenue
    recognition, the administration of existing controls and
    procedures, the preparation of the Companys periodic
    reports and the documentation of complex accounting transactions. 106




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##### Table of Contents




    The Company is increasing staffing in the accounting and finance
    department, and re-allocating duties to persons within the
    accounting and finance organization to maximize their skills and
    experience.
    The Company continues to take steps to recruit additional
    qualified senior accounting personnel, including certified
    public accountants personnel with recent public accounting firm
    experience. The Company is looking to hire an accountant with
    SEC reporting experience.  Inadequate
    Controls over Documentation and Record Keeping.
  
    During the quarter ending March 31, 2007, the
    Companys employees involved in order entry will receive
    training regarding the controls and procedures surrounding the
    amendment of sales orders. Additional training will be provided
    on a regular and periodic basis and updated as necessary to
    reflect any changes in the Companys or its customers
    business practices or activities.
    The Company has established policies and procedures for the
    review and approvals of all manual journal entries.
    The Company has adopted a policy requiring it to retain a copy
    of all corporate records in connection with dispositions of
    assets to third parties.
    Improve the review process that occurs prior to providing the
    initial draft of the periodic report to our independent auditors
    for review.
    The Company has developed monthly close schedules which include
    the timeline for completion and approval of reconciliations by
    the Corporate Controller.
    During the quarter ended June 30, 2006, the Company entered
    into agreements with third parties that purchased assets from
    the Company in Israel. These agreements provide the Company with
    access to the corporate records and require the third parties to
    retain documents in accordance with Israeli law.  e) Subsequent
    Changes in Internal Control over Financial Reporting
   107




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##### Table of Contents



REPORT OF
    INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
    INTERNAL CONTROL OVER FINANCIAL REPORTING
  The Board
    of Directors and Shareholders of Terayon Communication Systems,
    Inc.
  Internal Control  Integrated Framework
          Communication of Financial
    Information.
  Lack of Technical Accounting Expertise and Qualified
    Accounting Personnel
 108




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##### Table of Contents



The Use of Estimates.
  Inadequate
    Controls over Documentation and Record Keeping.
  
    The Company did not have sufficient controls in place to ensure
    the proper authorization and review of manual journal entries
    and the associated support documentation.
    The Company did not have sufficient controls to address the
    amendment of sales orders with its customers. Sales orders could
    be amended through the amendment of the sales orders, purchase
    orders and agreements. When sales were amended through sales or
    purchase orders, the person processing the amendments would
    exercise discretion in inputting the revised terms and
    conditions and there was no consistent policy requiring the
    accounting and finance department to approve such amendments or
    even informing the accounting and finance department of such
    amendments.
    The Company did not keep adequate documentation related to the
    analysis and reconciliation of certain general ledger accounts.
    The Company did not retain certain corporate records in
    connection with the sale of certain subsidiaries to third
    parties.    in Internal Control-Integrated Framework in
    Internal Control-Integrated Framework
    
    109




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##### Table of Contents



Item 9B.
    Other
    Information   PART III  Item 10.
    Directors,
    Executive Officers and Corporate Governance    Item 11.
    Executive
    Compensation    Item 12.
    Security
    Ownership of Certain Beneficial Owners and Management and
    Related Stockholder Matters    Item 13.
    Certain
    Relationships and Related Transactions, and Director
    Independence    Item 14.
    Principal
    Accountant Fees and Services   PART IV  Item 15.
    Exhibits,
    Financial Statement Schedules  Form 10-K.
  Form 10-K.
     110




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##### Table of Contents



Form 10-K
  ExhibitNumber

Exhibit Description3
.1

Amended and Restated Certificate
    of Incorporation of Terayon Communication Systems, Inc.(11)3
.2

Bylaws of Terayon Communication
    Systems, Inc.(11)3
.3

Certificate of Amendment to
    Amended and Restated Certificate of Incorporation of Terayon
    Communication Systems, Inc.(11)3
.4

Certificate of Designation of
    Series A Junior Participating Preferred Stock.(4)4
.1

Specimen Common Stock
    Certificate.(2)4
.2

Amended and Restated Information
    and Registration Rights Agreement, dated April 6, 1998.(1)4
.3

Form of Security for Terayon
    Communication Systems, Inc.s 5% Convertible
    Subordinated Notes due August 1, 2007.(3)4
.4

Registration Rights Agreement,
    dated July 26, 2000, among Terayon Communication Systems,
    Inc. and Deutsche Bank Securities, Inc. and Lehman Brothers,
    Inc.(3)4
.5

Indenture, dated July 26,
    2000, between Terayon Communication Systems, Inc. and State
    Street Bank and Trust Company of California, N.A.(3)4
.6

Rights Agreement, dated
    February 6, 2001, between Terayon Communication Systems,
    Inc. and Fleet National Bank.(4)10
.1

Form of Indemnification Agreement
    between Terayon Communication Systems, Inc. and each of its
    directors and officers.(15)10
.2*

1995 Stock Option Plan, as
    amended.(1)10
.3*

1997 Equity Incentive Plan, as
    amended.(6)10
.4*

1998 Employee Stock Purchase Plan,
    as amended.(9)10
.5*

1998 Non-Employee Directors
    Stock Option Plan, as amended.(9)10
.6*

1998 Employee Stock Purchase Plan
    Offering for Foreign Employees.(5)10
.7*

1999 Non-Officer Equity Incentive
    Plan, as amended.(10)10
.8

Data Over Cable Service Interface
    Specifications License Agreement, dated December 21, 2001,
    between Terayon Communication Systems, Inc. and Cable Television
    Laboratories, Inc.(6)10
.9

Amendment to DOCSIS IPR Agreement
    to cover DOCSIS 2.0, dated December 21, 2002, between
    Terayon Communication Systems, Inc. and Cable Television
    Laboratories, Inc.(6)10
.10

Lease Agreement, dated
    September 18, 1996, between Sobrato Interests III and
    VeriFone.(7)10
.11

Triple Net Sublease, dated
    April 1, 2002, by and between Terayon Communication
    Systems, Inc. and Hewlett-Packard Company.(7)10
.12

Aircraft Lease Agreement, dated
    February 8, 2002, between Terayon Communication Systems,
    Inc. and General Electric Capital Corporation.(8)10
.13

First Amendment to Aircraft Lease
    Agreement and Security Deposit Pledge Agreement, dated
    December 31, 2003, between Terayon Communication Systems,
    Inc. and General Electric Capital Corporation.(13)10
.14

Notification Letter of Intent to
    Terminate or Sublease the Aircraft Lease Agreement, dated
    March 12, 2004.(13)10
.15*

Employment Agreement, dated
    July 22, 2005, between Terayon Communication Systems, Inc.
    and Jerry Chase.(16)10
.16

Proprietary Information and
    Inventions Agreement, dated July 22, 2004, between Terayon
    Communication Systems, Inc. and Jerry Chase.(12)10
.17

Aircraft Sublease Agreement, dated
    August 24, 2004, between Terayon Communication Systems,
    Inc. and United Furniture Equipment Rental, Inc.(12)10
.18*

Employment Agreement, dated
    July 22, 2005, between Terayon Communication Systems, Inc.
    and Mark Richman.(16)10
.19

Proprietary Information and
    Inventions Agreement, dated November 10, 2004, between
    Terayon Communication Systems, Inc. and Mark Richman.(15) 111




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##### Table of Contents



ExhibitNumber

Exhibit Description10
.20*

Form of Option Agreement for the
    Terayon Communication Systems, Inc. 1997 Equity Incentive
    Plan.(14)10
.21*

Form of Option Agreement for the
    Terayon Communication Systems, Inc. 1998 Non-Employee Directors
    Stock Option Plan.(15)10
.22

Lease, dated August 9, 2006
    between Sobrato Development Companies #871 and Terayon
    Communication Systems, Inc.(17)10
.23

Triple Net
    Sub-Sublease
    Agreement, effective as of August 9, 2006, as amended,
    between Terayon Communication Systems, Inc. and Citrix Systems,
    Inc.(17)10
.24*

Employment Agreement, dated
    July 27, 2005, between Terayon Communication Systems, Inc.
    and Matt Aden. (16)10
.25

Proprietary Information and
    Inventions Agreement, dated July 27, 2005, between Terayon
    Communication Systems, Inc. and Matthew J. Aden.(16)10
.26*

Amendment No. 1 to the
    Terayon Communication Systems, Inc. 1997 Equity Incentive
    Plan.(17)10
.27*

Non-Employee Director Equity
    Compensation Policy.(17)10
.28*

Non-Employee Director Equity
    Compensation Policy Nonstatutory Stock Option Agreement.(17)10
.29*

2006 Executive Sales Commission
    Plan.(17)10
.30*

2006 Section 16 Executive
    Officer Bonus Plan.(17)10
.31

Termination Agreement, effective
    as of March 22, 2007, between Terayon Communications
    Systems, Inc. and General Electric Capital Corporation14
.1

Code of Business Conduct.(17)21
.1

List of Subsidiaries.24
.1

Power of Attorney (see signatures
    of this
    Form 10-K).31
.1

Certification of the Chief
    Executive Officer pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.31
.2

Certification of the Chief
    Financial Officer pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.32
.1

Certification of the Chief
    Executive Officer pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002.32
.2

Certification of the Chief
    Financial Officer pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002.99
.1

Audit Committee Charter of Terayon
    Communication Systems, Inc.(17)99
.2

Compensation Committee Charter of
    Terayon Communication Systems, Inc.(17)99
.3

Nominating and Governance
    Committee Charter of Terayon Communication Systems, Inc. (17)     (1)
    
    Incorporated by reference to exhibits to our Registration
    Statement on
    Form S-1
    filed on June 16, 1998 (File
    No. 333-56911).(2)
    
    Incorporated by reference to exhibits to our Registration
    Statement on
    Form S-1/A
    filed on July 31, 1998 (File
    No. 333-56911).(3)
    
    Incorporated by reference to our Registration Statement on
    Form S-3
    filed on October 24, 2000 (File
    No. 333-48536).(4)
    
    Incorporated by reference to our Report on
    Form 8-K
    filed on February 9, 2001.(5)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on April 2, 2001.(6)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on April 1, 2002.(7)
    
    Incorporated by reference to our Report on
    Form 10-Q
    filed on May 15, 2002.(8)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on March 27, 2003.(9)
    
    Incorporated by reference to our Report on Registration
    Statement on
    Form S-8
    filed on August 30, 2002.(10)
    
    Incorporated by reference to our Report on
    Form 10-Q
    filed on August 14, 2003.(11)
    
    Incorporated by reference to our Report on
    Form 8-K
    filed on November 21, 2003. 112




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##### Table of Contents



(12)
    
    Incorporated by reference to our Report on
    Form 10-Q
    filed on November 9, 2004.(13)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on March 15, 2004.(14)
    
    Incorporated by reference to our Report on
    Form 8-K
    filed on September 14, 2004.(15)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on March 15, 2005.(16)
    
    Incorporated by reference to our Report on
    Form 10-Q
    filed on August 9, 2005.(17)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on December 29, 2006.*
    
    Management contract or compensatory plan or arrangement required
    to be filed as an exhibit pursuant to Item 15(b) of Form
    10-K.  (4)(d)
    Financial Statement Schedules
      Balance atBeginning of








Balance atPeriod


Charges


Deductions


End of PeriodDecember 31, 2006:Allowance for doubtful
    accounts  U.S.

$
2,809


$
(25
)

$
(2,540
)

$
244Reserve for inventory valuation


7,853



2,940



(5,198
)


5,595Valuation allowance on deferred
    tax assets (1)


229,821







(43,099
)


186,722December 31, 2005:Allowance for doubtful
    accounts  U.S.

$
2,254


$
132


$
423


$
2,809Reserve for inventory valuation


12,267



2,732



(7,146
)


7,853Valuation allowance on deferred
    tax assets (1)


226,560







3,261



229,821December 31, 2004:Allowance for doubtful
    accounts  U.S.

$
6,037


$
4,014


$
(7,797
)

$
2,254Allowance for doubtful
    accounts  International


473







(473
)


Total Allowance for doubtful
    accounts


6,510



4,014



(8,270
)


2,254Reserve for inventory valuation


12,291



11,550



(11,574
)


12,267Valuation allowance on deferred
    tax assets (1)


227,978







(1,418
)


226,560     (1)
    
    This deduction represents the change in a deferred tax asset. 113




---



##### Table of Contents



SIGNATURES      /s/  Jerry
    D. Chase   Chief Executive Officer
  attorney-in-fact Form 10-K, attorney-in- attorney-in-fact
    Signature

Title

Date/s/  Jerry
    D. ChaseJerry
    D. Chase

Chief Executive Officer and
    Director

March 30, 2007/s/  Mark
    A. RichmanMark
    A. Richman

Chief Financial Officer
    (Principal Financial Officer,
    Principal Accounting Officer)

March 30, 2007/s/  Zaki
    RakibDr.
    Zaki Rakib

Chairman of the Board of Directors

March 30, 2007/s/  Shlomo
    RakibShlomo
    Rakib

Director

March 30, 2007/s/  Lewis
    SolomonLewis
    Solomon

Director

March 30, 2007/s/  David
    WoodrowDavid
    Woodrow

Director

March 30, 2007/s/  Matthew
    MillerDr.
    Matthew Miller

Director

March 30, 2007/s/  Howard
    W.
    Speaks, Jr.Howard
    W. Speaks, Jr.

Director

March 30, 2007  114




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##### Table of Contents



Exhibit
    Index
 ExhibitNumber

Exhibit Description3
.1

Amended and Restated Certificate
    of Incorporation of Terayon Communication Systems, Inc.(11)3
.2

Bylaws of Terayon Communication
    Systems, Inc.(11)3
.3

Certificate of Amendment to
    Amended and Restated Certificate of Incorporation of Terayon
    Communication Systems, Inc.(11)3
.4

Certificate of Designation of
    Series A Junior Participating Preferred Stock.(4)4
.1

Specimen Common Stock
    Certificate.(2)4
.2

Amended and Restated Information
    and Registration Rights Agreement, dated April 6, 1998.(1)4
.3

Form of Security for Terayon
    Communication Systems, Inc.s 5% Convertible
    Subordinated Notes due August 1, 2007.(3)4
.4

Registration Rights Agreement,
    dated July 26, 2000, among Terayon Communication Systems,
    Inc. and Deutsche Bank Securities, Inc. and Lehman Brothers,
    Inc.(3)4
.5

Indenture, dated July 26,
    2000, between Terayon Communication Systems, Inc. and State
    Street Bank and Trust Company of California, N.A.(3)4
.6

Rights Agreement, dated
    February 6, 2001, between Terayon Communication Systems,
    Inc. and Fleet National Bank.(4)10
.1

Form of Indemnification Agreement
    between Terayon Communication Systems, Inc. and each of its
    directors and officers.(15)10
.2*

1995 Stock Option Plan, as
    amended.(1)10
.3*

1997 Equity Incentive Plan, as
    amended.(6)10
.4*

1998 Employee Stock Purchase Plan,
    as amended.(9)10
.5*

1998 Non-Employee Directors
    Stock Option Plan, as amended.(9)10
.6*

1998 Employee Stock Purchase Plan
    Offering for Foreign Employees.(5)10
.7*

1999 Non-Officer Equity Incentive
    Plan, as amended.(10)10
.8

Data Over Cable Service Interface
    Specifications License Agreement, dated December 21, 2001,
    between Terayon Communication Systems, Inc. and Cable Television
    Laboratories, Inc.(6)10
.9

Amendment to DOCSIS IPR Agreement
    to cover DOCSIS 2.0, dated December 21, 2002, between
    Terayon Communication Systems, Inc. and Cable Television
    Laboratories, Inc.(6)10
.10

Lease Agreement, dated
    September 18, 1996, between Sobrato Interests III and
    VeriFone.(7)10
.11

Triple Net Sublease, dated
    April 1, 2002, by and between Terayon Communication
    Systems, Inc. and Hewlett-Packard Company.(7)10
.12

Aircraft Lease Agreement, dated
    February 8, 2002, between Terayon Communication Systems,
    Inc. and General Electric Capital Corporation.(8)10
.13

First Amendment to Aircraft Lease
    Agreement and Security Deposit Pledge Agreement, dated
    December 31, 2003, between Terayon Communication Systems,
    Inc. and General Electric Capital Corporation.(13)10
.14

Notification Letter of Intent to
    Terminate or Sublease the Aircraft Lease Agreement, dated
    March 12, 2004.(13)10
.15*

Employment Agreement, dated
    July 22, 2005, between Terayon Communication Systems, Inc.
    and Jerry Chase.(16)10
.16

Proprietary Information and
    Inventions Agreement, dated July 22, 2004, between Terayon
    Communication Systems, Inc. and Jerry Chase.(12)10
.17

Aircraft Sublease Agreement, dated
    August 24, 2004, between Terayon Communication Systems,
    Inc. and United Furniture Equipment Rental, Inc.(12)10
.18*

Employment Agreement, dated
    July 22, 2005, between Terayon Communication Systems, Inc.
    and Mark Richman.(16)10
.19

Proprietary Information and
    Inventions Agreement, dated November 10, 2004, between
    Terayon Communication Systems, Inc. and Mark Richman.(15)10
.20*

Form of Option Agreement for the
    Terayon Communication Systems, Inc. 1997 Equity Incentive
    Plan.(14)10
.21*

Form of Option Agreement for the
    Terayon Communication Systems, Inc. 1998 Non-Employee Directors
    Stock Option Plan.(15)10
.22

Lease, dated August 9, 2006
    between Sobrato Development Companies #871 and Terayon
    Communication Systems, Inc.(17)




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##### Table of Contents



ExhibitNumber

Exhibit Description10
.23

Triple Net
    Sub-Sublease
    Agreement, effective as of August 9, 2006, as amended,
    between Terayon Communication Systems, Inc. and Citrix Systems,
    Inc.(17)10
.24*

Employment Agreement, dated
    July 27, 2005, between Terayon Communication Systems, Inc.
    and Matt Aden. (16)10
.25

Proprietary Information and
    Inventions Agreement, dated July 27, 2005, between Terayon
    Communication Systems, Inc. and Matthew J. Aden.(16)10
.26*

Amendment No. 1 to the
    Terayon Communication Systems, Inc. 1997 Equity Incentive
    Plan.(17)10
.27*

Non-Employee Director Equity
    Compensation Policy.(17)10
.28*

Non-Employee Director Equity
    Compensation Policy Nonstatutory Stock Option Agreement.(17)10
.29*

2006 Executive Sales Commission
    Plan.(17)10
.30*

2006 Section 16 Executive
    Officer Bonus Plan.(17)10
.31

Termination Agreement, effective
    as of March 22, 2007, between Terayon Communications
    Systems, Inc. and General Electric Capital Corporation14
.1

Code of Business Conduct.(17)21
.1

List of Subsidiaries.24
.1

Power of Attorney (see signatures
    of this
    Form 10-K).31
.1

Certification of the Chief
    Executive Officer pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.31
.2

Certification of the Chief
    Financial Officer pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.32
.1

Certification of the Chief
    Executive Officer pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002.32
.2

Certification of the Chief
    Financial Officer pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002.99
.1

Audit Committee Charter of Terayon
    Communication Systems, Inc.(17)99
.2

Compensation Committee Charter of
    Terayon Communication Systems, Inc.(17)99
.3

Nominating and Governance
    Committee Charter of Terayon Communication Systems, Inc. (17)     (1)
    
    Incorporated by reference to exhibits to our Registration
    Statement on
    Form S-1
    filed on June 16, 1998 (File
    No. 333-56911).(2)
    
    Incorporated by reference to exhibits to our Registration
    Statement on
    Form S-1/A
    filed on July 31, 1998 (File
    No. 333-56911).(3)
    
    Incorporated by reference to our Registration Statement on
    Form S-3
    filed on October 24, 2000 (File
    No. 333-48536).(4)
    
    Incorporated by reference to our Report on
    Form 8-K
    filed on February 9, 2001.(5)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on April 2, 2001.(6)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on April 1, 2002.(7)
    
    Incorporated by reference to our Report on
    Form 10-Q
    filed on May 15, 2002.(8)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on March 27, 2003.(9)
    
    Incorporated by reference to our Report on Registration
    Statement on
    Form S-8
    filed on August 30, 2002.(10)
    
    Incorporated by reference to our Report on
    Form 10-Q
    filed on August 14, 2003.(11)
    
    Incorporated by reference to our Report on
    Form 8-K
    filed on November 21, 2003.(12)
    
    Incorporated by reference to our Report on
    Form 10-Q
    filed on November 9, 2004.(13)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on March 15, 2004.(14)
    
    Incorporated by reference to our Report on
    Form 8-K
    filed on September 14, 2004.(15)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on March 15, 2005.(16)
    
    Incorporated by reference to our Report on
    Form 10-Q
    filed on August 9, 2005.(17)
    
    Incorporated by reference to our Report on
    Form 10-K
    filed on December 29, 2006.*
    
    Management contract or compensatory plan or arrangement required
    to be filed as an exhibit pursuant to Item 15(b) of Form
    10-K.