##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-K



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|           |   |                                                                    |                                                                                           
|---------- | - | ------------------------------------------------------------------ | ------------------------------------------------------------------------------------------
|(Mark one)
|          
|           | þ |                                                                    | ANNUAL REPORT PURSUANT TO SECTION 13 OR
	15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934    
|           |   | For the fiscal year ended December 31,
	2001                      
|or        
|           | o |                                                                    | TRANSITION REPORT PURSUANT TO SECTION 13 OR
	15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934
|           |   | For the transition period
	from                to                .

Commission File Number: 000-24647



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Terayon Communication Systems, Inc.

(Exact name of registrant as specified in its
charter)


|                                                               |  |                                   
|-------------------------------------------------------------- |  | ----------------------------------
|Delaware                                                       |  | 77-0328533                        
|(State or other jurisdiction of
	incorporation or organization |  | (IRS Employer
	Identification No.)

2952 Bunker Hill Lane

Santa Clara, California 95054


(408) 727-4400


(Address, including zip code, and telephone
number, including area code, of the registrants principal
executive offices)




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

|                     |  |                      
|-------------------- |  | ---------------------
|                     |  | Name of each exchange
|Title of Each Class: |  | 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)


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

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

The aggregate market value of the voting stock
held by non-affiliates of the registrant, based upon the closing
sale price of the Common Stock on March 28, 2002 as reported on
the Nasdaq National Market, was approximately $471,647,933.
Shares of Common Stock held by each officer and director and by
each person known to the Company who owns 5% or more of the
outstanding Common Stock have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliate
status is not necessarily a conclusive determination for other
purposes.

As of March 28, 2002, registrant had
outstanding 72,701,056 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement to be
filed with the Securities and Exchange Commission in May 2002,
pursuant to Section 14 of the Securities Exchange Act of
1934, in connection with the 2001 Annual Meeting of Stockholders
of Terayon Communication Systems, incorporated: Part III.



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TABLE OF CONTENTS



|              |                                                                                               |  |  |  |  |  |  | 
|------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I       
|              | Item 1. Business                                                                             
|              | Item 2. Properties                                                                           
|              | Item 3. Legal Proceedings                                                                    
|              | Item 4. Submission of Matters to a Vote of Security Holders                                  
|PART II      
|              | Item 5. Market for the Registrants Common Equity and Related Stockholder Matters            
|              | Item 6. Selected Financial Data                                                              
|              | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|              | Item 7a. Market Risk Disclosure Information                                                  
|              | Item 8. Financial Statements and Supplementary Data                                          
|              | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
|PART III     
|              | Item 10. Directors and Officers of the Registrant                                            
|              | Item 11. Executive Compensation                                                              
|              | Item 12. Security Ownership of Certain Beneficial Owners and Management                      
|              | Item 13. Certain Relationship and Related Transactions                                       
|PART IV      
|              | Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K                    
|SIGNATURES   
|EXHIBIT INDEX
|EXHIBIT 10.3 
|EXHIBIT 10.14
|EXHIBIT 10.15
|EXHIBIT 10.16
|EXHIBIT 10.17
|EXHIBIT 10.18
|EXHBIIT 21.1 
|EXHIBIT 23.1 



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Special Note on Forward-Looking
Statements

This report on Form 10-K contains
forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934 which
are subject to the safe harbor created by those
sections. These forward-looking statements include, but are not
limited to: statements related to industry trends and future
growth in the markets for cable modem systems; our strategies
for reducing the cost of our products; our product development
efforts; the effect of GAAP accounting pronouncements on our
recognition of revenues; our future research and development;
the timing of our introduction of new products; the timing and
extent of deployment of our products by our customers; and
future profitability. We usually use words such as
may, will, should,
expect, plan, anticipate,
believe, estimate, predict,
future, intend, or certain
or the negative of these terms or similar expressions to
identify forward-looking statements. Discussions containing such
forward-looking statements may be found throughout the document.
These forward-looking statements involve certain risks and
uncertainties that could cause actual results to differ
materially from those in such forward-looking statements. We
disclaim any obligation to update these forward-looking
statements as a result of subsequent events. The business risks
discussed in Item 7 of this Report on Form 10-K, among
other things, should be considered in evaluating our prospects
and future financial performance.




PART I




Item
1.     Business

Overview

We develop, market and sell equipment to cable
television operators, telecom carriers and satellite network
operators, who use our products to deliver broadband voice,
video and data services to residential and business subscribers.

Driving the demand in our market (broadband
equipment) is the proliferation of broadband services delivered
by cable television operators, telecommunication carriers and
satellite network operators. As operators and carriers add new
residential and business subscribers for broadband services,
they must deploy Customer Premise Equipment (CPE) such as
cable and Digital Subscriber Line (DSL) modems and install
corresponding equipment such as Cable Modem Termination Systems
(CMTS), DSL Access Multiplexers (DSLAM) and video headends
in their networks to operate the CPE.

Worldwide demand for broadband services is
growing rapidly. This demand has been driven by residential and
commercial users who are accessing networks for a variety of
data, video and voice applications, including high-speed
Internet access, electronic commerce, online gaming, file
sharing, telecommuting, interactive television and telephone
services. Research firm Kinetic Strategies estimates that in
North America alone, residential broadband Internet subscribers
more than doubled in 2001 to 13.3 million. DellOro
Group estimates that worldwide cable modem and DSL subscribers
will increase from 31 million at the end of 2001 to
178 million in 2006.

Corresponding with the anticipated growth of
subscribers for broadband services is an increased need for
modems at the subscribers premise, and CMTSs, DSLAMs and
video headends by operators and carriers. DellOro
estimates that the worldwide market for broadband cable
equipment will reach $2.8 billion in 2006, up from
$1.4 billion in 2001. Furthermore, DellOro estimates
that the worldwide market for broadband DSL equipment will reach
$8 billion in 2006, up from $5.4 billion in 2001.

Business

We are an experienced and focused partner for
broadband service providers. Our mission is to deliver the most
innovative broadband data, video and voice solutions that enable
service providers to accelerate the deployment of
revenue-generating services today and tomorrow.

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We are structured around the following operating
segments: Cable Broadband Access Systems (Cable) and Telecom
Carrier Systems (Telecom). Currently, 88% of our revenues are
derived from Cable and 12% from Telecom. We believe Cable will
continue to generate the vast majority of our revenues in the
foreseeable future. See Note 11 in our Notes to Consolidated
Financial Statements contained in Item 8 for financial
information on Cable and Telecom.

In 2001, we experienced significant changes in
our company structure. As a result of our decision to suspend
certain product lines and product development efforts during
2001, intangible assets totaling $572.8 million relating to
certain acquisitions were written-off. In addition, we incurred
restructuring and other charges in the amount of
$14.3 million relating to employment termination costs and
consolidation of facilities. In order to reduce our
indebtedness, we repurchased approximately $325.9 million
of Convertible Subordinated Notes issued in July 2000, resulting
in an extraordinary gain of approximately $185.3 million
net of unamortized issuance costs.

We were incorporated in California in 1993,
reincorporated in Delaware in 1998 and have been a publicly
traded company since 1998.

Business Strategy

Our business strategy emphasizes the development
and deployment of broadband access technologies that will
improve service providers return on investment by
leveraging their existing infrastructure to deliver new
broadband services with less expense. This strategy may result
in benefits to our customers that could include faster recovery
of subscriber acquisition costs, a reduction of customer
turnover, a competitive edge in winning new customers, increased
revenues and reduced operational and capital expenditures.

We expect that Cable will continue to dominate
our strategy as we transition from our Synchronous Code Division
Multiple Access (S-CDMA) proprietary-based products to new
products based on the Data Over Cable Service Interface
Specification (DOCSIS) 2.0 specification from the CableLabs
research and development consortium (CableLabs). DOCSIS 2.0
is the latest version of the DOCSIS specification for cable data
systems, which combines two advanced modulation techniques,
S-CDMA technology and advanced Time Division Multiple Access
(A-TDMA). We are developing DOCSIS 2.0-based cable modems
and CMTSs that we believe may have a time-to-market advantage
over our competition because of our development and history of
developing and bringing to market products incorporating S-CDMA
technology.

DOCSIS 2.0 builds on the capabilities of and
is compatible with previous DOCSIS 1.0 and DOCSIS 1.1
specifications. Through its S-CDMA and A-TDMA advanced physical
layer technologies, DOCSIS 2.0 triples the upstream
throughput of cable networks, compared to DOCSIS 1.1. This
greater upstream throughput is expected to enable operators to
create new services for residential and business markets, such
as but not limited to, video conferencing, telephone service,
peer-to-peer computing and increases robustness for additional
functionality and support for lifeline services. Additionally,
DOCSIS 2.0 protects against noise interference.

To maximize the return in our investment in
DOCSIS 2.0 technology, we established Imedia Semiconductor
Corporation (Imedia SemiconductorTM), a wholly-owned
subsidiary, in October 2001. Imedia Semiconductor consists of
our former semiconductor division and will design, manufacture
and sell advanced broadband silicon and software solutions to
broadband equipment manufacturers.

Cable

Cable includes products for delivering broadband
data, video and voice services. Within Cable, most of our
revenue comes from sales of our data products. In particular,
our TeraComm cable data system, which is based on our
proprietary S-CDMA technology, generates the majority of our
revenue. We also sell our family of DOCSIS 1.0 and
Euro-DOCSIS 1.0 CMTSs and DOCSIS 1.0,
Euro-DOCSIS 1.0 and DOCSIS 1.1 and 2.0 based cable
modems. Our other Cable products include the CherryPicker
digital video management system and the Multigate telephony and
data access system. We market and sell our Cable products to

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Multiple Systems Operators (MSO) within the
worldwide cable industry. The Cable segment contributed
approximately 88% of our revenue in 2001.


To capitalize on our potential time-to-market
advantage in DOCSIS 2.0, we are developing our new
DOCSIS 2.0 based BW 3000 family of CMTSs and TJ 600
line of modems.

Products



| |                                                   
| | --------------------------------------------------
| | Terayon TeraComm® S-CDMA Cable Data
	Access System

Our TeraComm cable data system, which is based on
our S-CDMA technology, enables cable operators to offer
high-speed Internet access across a broad range of cable network
architectures and conditions. This end-to-end system consists of
a TeraLink® 1000 Master Controller and TeraLink Gateway
located at a cable operators headend and TeraPro®
cable modems installed at subscribers homes. Our S-CDMA
cable modem system is widely deployed by leading cable operators
outside the United States.



| |                                       
| | --------------------------------------
| | Terayon BE 2000 Family of DOCSIS
	CMTS

Our BE 2000 product combines the functionality of
a CMTS, which controls subscribers cable modems, with a
high-performance Internet Protocol (IP) switch/router. The
BE 2000 has been qualified as meeting the DOCSIS 1.0
specification and the Euro-DOCSIS 1.0 specification. This
qualification ensures that the BE 2000 is interoperable
with other DOCSIS and Euro-DOCSIS equipment, including our
TJ line of DOCSIS and Euro-DOCSIS modems.



| |                                                        
| | -------------------------------------------------------
| | Terayon TJ Line of DOCSIS and Euro-DOCSIS
	Cable Modems

We offer a line of high-performance cable modems
certified to meet the DOCSIS 1.0 and Euro-DOCSIS 1.0
cable modem standards. These fully certified modems can
interoperate with other DOCSIS and Euro-DOCSIS equipment. We are
producing a next generation of TJ cable modems that are based on
the DOCSIS 2.0 specification.



| |                                                  
| | -------------------------------------------------
| | Terayon BW 3000 Family of DOCSIS 2.0-based
	CMTSs

Our BW 3000 family of DOCSIS 2.0-based CMTSs is
composed of our BW 3500, a scalable, carrier-class solution
for operators most demanding broadband applications, and
our BW 3200, a compact solution ideal for smaller or
segmented cable networks. Designed from the outset to support
voice and other advanced broadband services, both models are
built on an advanced hardware-centric architecture that enables
intense per-flow authentication, classification and filtering,
meeting the most stringent Quality of Service (QoS) requirements
necessary for reliable service delivery.



| |                                                       
| | ------------------------------------------------------
| | Terayon
	CherryPickerTMDigital Video Management System

Our CherryPicker digital video management system
offers cable, satellite and telecom network operators
unprecedented choice, control and flexibility in managing their
digital video content. For example, operators can use
CherryPicker to create custom channel line-ups by cherry
picking from a variety of content sources such as
satellite broadcast and local servers to better serve their
subscribers. In addition, CherryPicker can support most digital
video applications, such as Near Video-on-Demand (NVOD) and
seamlessly insert digital advertising into digital programming.



| |                                          
| | -----------------------------------------
| | Terayon Multigate Cable Telephony
	System

Our Multigate system enables cable operators to
deploy toll-quality voice services over their networks. Based on
proven circuit-switch telephony technology, Multigate is unique
for utilizing our S-CDMA technology. This enables cable
operators to deploy Multigate without upgrading their networks
as extensively as competing products require. The complete
Multigate system is composed of a central unit, installed at the
headend of a cable operators network, and CPE located in
subscribers homes.

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Customers

We market and sell our Cable products to MSOs
that provide broadband services to both residential and business
subscribers. Our target market consists of the largest MSOs in
each major geographic area, including North America, Europe and
Asia.

Our principal customers include the following:



| |                                                 
| | ------------------------------------------------
| | Shaw Communications                             
| | Jupiter Telecommunications (Cross Beam Networks)
| | Rogers Communications                           
| | Hong Kong Cable (i-CABLE Communications)        

One of our principal customers, Rogers
Communications, is a related party. Two customers, Shaw
Communications and Jupiter Telecommunications, each accounted
for more than 10% of our revenues for the year ended
December 31, 2001. We believe that the loss of either or
both of Shaw Communications and Jupiter Telecommunications could
have a material adverse affect on our business. Additionally, we
also believe that a substantial majority of our revenues will
continue to be derived from sales to a relatively small number
of customers for the foreseeable future.

Market
Competition

The market for broadband equipment is extremely
competitive and is characterized by rapid technological change,
and more recently, market consolidation. In the past, most cable
data systems were based on proprietary technology, meaning that
modems only worked with CMTSs from the same vendor. Therefore,
customers had to purchase CMTSs and modems from the same vendor.
With the advent of DOCSIS certified and qualified products,
customers can purchase interoperable CMTSs and modems from a
variety of equipment manufacturers.

The market leader in CMTSs is Cisco Systems, with
greater than 50% market share in 2001, based on transmit ports
shipped, according to the DellOro Group. Cisco Systems
sells DOCSIS based CMTSs, as does ADC, Arris, Juniper Networks
and Motorola. We are the number two supplier of CMTSs, according
to DellOro, based on the number of transmit ports shipped.
The vast majority of our CMTS shipments in 2001 were based on
our proprietary S-CMDA technology. In 2001, competitors selling
proprietary CMTSs include Motorola and Com21.

The worldwide market leader in modems is
Motorola, ranking first in the market with over 30% market
share, based on both manufacturers revenue and units
shipped, according to the DellOro Group. Also according to
the DellOro Group, we ranked second in the market with
over 15% market share based on manufacturers revenue and
ranked third in the market with over 12% market share based on
units shipped. The vast majority of our modem shipments in 2001
were based on our proprietary S-CMDA technology. The other two
market leaders in modems were Toshiba and Thomson based on both
manufacturers revenue and units shipped, according to the
DellOro Group. The majority of modems sold into the market
in 2001 were DOCSIS based.

In the market for video grooming and
remultiplexing, we believe we are the market leader with our
CherryPicker digital video management system. Although several
companies are attempting to penetrate this market, we do not
believe that they have yet achieved significant market
penetration levels. Competitors include Cisco Systems, Harmonic
and a privately held company named BigBand.

We sell our Multigate product into the market for
cable telephony systems. We believe that the market for cable
telephony products is just now emerging. As a result, we have
few customers and limited sales of our Multigate product.
Competitors in the market include ADC, Alcatel, Arris, Nortel
and Tellabs.

Telecom

In Telecom, we develop, market and sell DSL
systems and access concentrators. We offer three product lines,
the Mainsail multi-service, multi-function access platform, the
Miniplex digital subscriber line

4



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multiplexer system and the Internet Protocol To
The Loop (IPTL) Symmetric DSL (SDSL) system. Most of
Telecoms revenue in 2001 came from the Miniplex products.
Telecom contributed approximately 12% of our revenues in 2001.


Products



| |                                                                              
| | -----------------------------------------------------------------------------
| | Terayon
	MainSailTM8000 Multi-Service, Multi-Function Access Platform
	(MMAP)

Our MainSail 8000 MMAP provides a bridge between
Metropolitan Area Networks (MAN) and local access
communication systems that enables telecom carriers to deliver a
wide range of optical and copper-based broadband access services
with the fewest network devices. The Mainsail 8000 sets a new
precedent for integration by aggregating simultaneous voice and
data facilities, transport protocols and services, plus the
functions of an optical multiplexer, cross connect, gateway and
switch, in a single platform. As a result, telecom carriers can
offer new broadband services to subscribers, simply and
cost-effectively.



| |                                                      
| | -----------------------------------------------------
| | Terayon MainSail Family of Integrated Access
	Devices

Terayons MainSail family of integrated
access devices (IAD) enables telecom carriers to provide small
to medium-sized businesses with converged voice and data
services. Telecom carriers install the MainSail IADs at
their customers sites in either a stand-alone mode or in
conjunction with Terayons MainSail 8000 MMAP. MainSail
IADs can also be connected to other standards-based devices such
as cross connects, voice switches, concentrators or multiplexors.



| |                                                              
| | -------------------------------------------------------------
| | Terayon MiniPlex® Digital Subscriber Line
	Multiplexer System

Our MiniPlex digital subscriber-line multiplexer
system enables telecom carriers to offer up to four telephone
lines over a single copper pair. Having the ability to offer
multiple telephone lines over a single copper pair is extremely
important for carriers who are experiencing increased demand for
phone lines but have a limited number of copper pairs.



| |                                                                
| | ---------------------------------------------------------------
| | Terayon IPTL Digital Subscriber Line Access
	Multiplexer System

Our IPTL system is an innovative access system
that enables international telecom carriers to provide small and
medium-size businesses with integrated voice and high-speed data
services. The IPTL system consists of an IAD (Integrated Access
Device) located at the subscribers office and a DSLAM
installed at a telecom carriers central office. The IPTL
system uses SDSL, which enables high performance two-way
communication.

Customers

We market and sell our products to telecom
carriers including Incumbent Local Exchange Carriers (ILECs),
Competitive Local Exchange Carriers (CLECs) and Interexchange
Carriers (IXCs) that offer telecommunications services such as
T1, T3, xDSL, Ethernet and OC-3C to residential and business
subscribers. The MainSail 8000 MMAP has successfully penetrated
some of the larger US independent local carriers, received
formal product certification from a major IXC and has
significant ongoing deployment with a financially sound CLEC
customer. The MainSail 8000 MMAP has between 175 and 200 nodes
installed supporting thousands of subscribers today. MiniPlex
boasts 1.5 million lines currently in service, and counts
three of the largest ILECs as customers. To date, sales of our
IPTL systems have been limited and concentrated outside of the
United States.

5



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Our principal customers include the following:

Quest
Communications

Verizon
Communications

NuVox
Communications

BellSouth
Corporation

SBC
Communications

None of our customers accounted for more than 10%
of our revenues for the year ended December 31, 2001.

Market
Competition

The competitive landscape for the Integrated
Multi-Access Platform (IMAP) has been affected by significant
volatility of service providers, as the edge/access market was
the first to suffer in the communications equipment fallout. As
a result, several established vendors either abandoned or
lessened their commitment to the market. Leading vendors in this
market include Alcatel with over 33% share of the access
concentrator market based on manufacturers revenue in
2001, Lucent with over 11% market share and Siemens with over
10% market share, according the DellOro Group. Other
vendors in this market are ADC, Accelerated Networks, Efficient
Networks, Integral Access, Marconi, Nortel and Zhone. We are a
new entrant into this market with limited sales.

The MiniPlex product line competes with product
offerings from companies such as GoDigital and ECI.
Additionally, the product segment is facing competition from
other technologies that minimize the need for multiple
residential phone lines such as ADSL and wireless technologies.

Research and Development

We believe that our future success depends on our
ability to enhance our existing products and to develop and
introduce new products to meet the evolving needs of broadband
service providers and their customers. In addition, to address
competitive and pricing pressures, we believe that we must
reduce the cost of manufacturing our products.

We have designed and developed a DOCSIS 2.0 based
system that includes cable modems and accompanying CMTSs. We are
moving forward with commercialization of these products and
believe they will be commercially available in the third quarter
of 2002. Our current research and development efforts include
development of multimedia platforms for the convergence of data,
voice and video over existing broadband infrastructures. Total
research and development costs were $79.9 million,
$68.2 million, and $17.6 million for the years ended
December 31, 2001, 2000, and 1999, respectively.

Sales and Marketing

We market and sell our products directly to
broadband service providers through our direct sales forces in
North America, South America, Europe and Asia. We also market
and sell our products through distributors, resellers and system
integrators throughout these regions.

We support our sales activities through marketing
vehicles, such as industry press, trade shows, advertising and
the web. Through our marketing efforts, we strive to educate
broadband services providers on the technological and business
benefits of our products, as well as our ability to provide
quality support and service. We participate in the major trade
shows and industry events for the broadband access industry in
the United States and throughout the world. Industry referrals
and reference accounts are significant marketing tools we
develop and utilize.

6



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International Sales

We have established international sales offices
in five countries, including Belgium, United Kingdom, Brazil,
Hong Kong and Israel. In fiscal 2001, 2000, and 1999,
approximately 82%, 75% and 84%, respectively of the
Companys net revenues were to customers outside of the
U.S. Sales to Canada were approximately 41%, 35% and 42% of our
net revenues in fiscal 2001, 2000, and 1999. Sales to Japan were
13%, 11% and 14%. No other foreign country accounted for more
than 10% of net revenues in any period. See Note 11 in our Notes
to Consolidated Financial Statements contained in Item 8
for financial information on operating results and assets by
geographic area.

Almost all of our international sales are
currently invoiced in U.S. dollars. However, we do enter into
certain transactions originating in Brazil, Belgium, United
Kingdom, Hong Kong, Canada, and Israel that may be denominated
in currencies other than the U.S. dollar. In the near
future, we expect that most of our business in Europe will be
invoiced in euros or British pounds. Invoicing in other
currencies will subject us to the risk associated with foreign
exchange rate fluctuations. We will be considering the need for
hedging or other strategies to minimize these risks.

Our international operations are subject to
certain risks common to foreign operations in general, such as
governmental regulations and import restrictions. In addition,
there are social, political, labor and economic conditions in
specific countries or regions as well as difficulties in
staffing and managing foreign operations, and potential adverse
foreign tax consequences, among other factors that could also
have an impact on our business and results of operations outside
of the United States.

Customer Service and Technical
Support

We believe that our ability to provide
consistently high quality service and support will be a key
factor in attracting and retaining customers. Our technical
services and support organization, with personnel in North
America, Europe, South America and Asia, offers support 24 hours
a day, seven days per week. Prior to deployment of our products,
each customers needs are assessed and proactive solutions
are implemented, including various levels of training, periodic
management and coordination meetings and problem escalation
procedures. We place a strong emphasis on technical training for
our customers. Training is offered at our headquarters in Santa
Clara and on our customers premises.

Backlog

Most of our revenues are generated from orders
booked and shipped within the current quarter. Assuming product
availability, our practice is to ship our products promptly upon
the receipt of purchase orders from our customers. Therefore, we
believe that backlog information is not material to an
understanding of our business.

Manufacturing

Most of our finished goods are produced by
subcontract manufacturers. During 2001, we produced modems
primarily in Thailand. Currently, our modems are sole sourced
from our manufacturer in Thailand. Our data and video headend
equipment and our North American telecom equipment is produced
in Fremont, California. Our voice systems and international
telecom equipment are produced in Israel.

Our manufacturing operations employ a wide
variety of semiconductors, electromechanical components and
assemblies and raw materials such as plastic resins and sheet
metal. Although that we believe that the materials and supplies
necessary for our manufacturing operations are presently
available in the quantities required, we sometimes experience a
short supply of certain component parts as a result of strong
demand in the industry for those parts. See Note 3 in our
Notes to Consolidated Financial Statements contained in
Item 8 for financial information on purchase obligations.

Our subcontractors purchase materials, supplies
and product subassemblies from a substantial number of vendors.
For many of our products, there are existing alternate sources
of supply. However, for certain components contained in our
products, we rely on sole sources.

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As noted above, we sole source our modems from
one subcontract manufacturer in Thailand and sole source certain
components in our products from sole source vendors. While this
has not resulted in material disruptions in the past, should any
change in these relationships or disruptions to our
vendors operations occur, our business and results of
operations could be adversely affected.

Intellectual Property

We rely on a combination of patent, trade secret,
copyright and trademark laws and contractual restrictions to
establish and protect proprietary rights in our products. Even
though we seek to establish and protect proprietary rights in
our products, there are risks. Our pending patent applications
may not be granted. Even if they are granted, the claims covered
by the patent may be reduced from those included in our
applications. Any patent might be subject to challenge in court
and, whether or not challenged, might not be broad enough to
prevent third parties from developing equivalent technologies or
products without a license from us.

We have entered into confidentiality and
invention assignment agreements with our employees, and we enter
into non-disclosure agreements with many of our suppliers,
distributors and appropriate customers so as to limit access to
and disclosure of our proprietary information. These contractual
arrangements, as well as statutory protections, may not prove
sufficient to prevent misappropriation of our technology or
deter independent third-party development of similar
technologies. In addition, the laws of some foreign countries
may not protect our intellectual property rights to the same
extent as do the laws of the United States.

CableLabs DOCSIS 2.0 specification includes
two modulation techniques, S-CDMA and A-TDMA. In connection with
the development of the DOCSIS 2.0 specification by
CableLabs, we entered into an agreement with CableLabs whereby
we licensed to CableLabs any of our intellectual property rights
to the extent that such rights may be asserted against a party
desiring to design, manufacture or sell DOCSIS based products,
including DOCSIS 2.0 based products. This license agreement
grants to CableLabs the right to sublicense our intellectual
property, including our intellectual property rights in our
S-CDMA patents, to manufacturers that compete with us in the
marketplace for DOCSIS based products.

We have received three letters claiming that our
technology infringes the intellectual property rights of others.
We have reviewed the allegations made and, after consulting with
patent counsel, we have determined that the claims alleging
infringement are without merit. If these allegations are
submitted to a court, the court could find that our products
infringe these intellectual property rights. If we are found to
have infringed these rights, we could be subject to substantial
damages and/or an injunction preventing us from conducting our
business. In addition, other third parties may assert
infringement claims against us in the future. A claim of
infringement, whether meritorious or not, could be
time-consuming, result in costly litigation, cause product
shipment delays or require us to enter into royalty or licensing
arrangements. These royalty or licensing arrangements may not be
available on terms acceptable to us or at all. Litigation also
may be necessary to enforce our intellectual property rights.

We pursue the registration of our trademarks in
the United States and have applications pending to register
several of our trademarks throughout the world. However, the
laws of certain foreign countries might not protect our products
or intellectual property rights to the same extent as the laws
of the United States. Effective trademark, copyright, trade
secret and patent protection may not be available in every
country in which our products may be manufactured, marketed or
sold.

Employees

As of December 31, 2001, we had 618
employees, of which 390 were located in the United States, 172
in Israel and 56 in Canada, Europe, South America and Asia. 329
of our employees were in research and development, 130 were in
marketing, sales and customer support, 68 were in operations and
91 were in general and administrative functions. None of our
employees are represented by collective bargaining agreements.
We believe that our relations with our employees are good.

8



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##### Table of Contents






Item
2.Properties

The lease for our Santa Clara, California
headquarters expired in March 2002. We are negotiating a seven
year lease for a new headquarters in Santa Clara, California
consisting of approximately 150,000 square feet. Pending our
move to our new headquarters, we will continue to rent the
current facility on a month to month basis. In the United
States, we also have facilities in Menlo Park and Fremont,
California, where Telecom is concentrated, and development
centers in Costa Mesa, California and Denver Colorado.

In addition, we lease properties worldwide. We
have a facility in Tel Aviv, Israel consisting of approximately
82,000 square feet which expires in 2005. We have sales offices
in Sao Paulo, Brazil; Hong Kong; Leeds, England and Brussels,
Belgium and development centers in Prague, Czech Republic and
Ontario, Canada. We believe that our existing facilities are
adequate to meet our needs for the immediate future.




Item 3.Legal
Proceedings

In September 1999, a group of prospective
investors in Imedia Corporation (Imedia), now our subsidiary,
named Imedia as a defendant in an action alleging that Imedia
breached its term sheet with the plaintiffs when Imedia
negotiated its acquisition by us and, as a result, did not
permit plaintiffs to invest in Imedia. The plaintiffs sought
damages in excess of $12.0 million. The terms of the Imedia
Agreement and Plan of Merger and Reorganization provided that
shares of our common stock that were to be issued to the former
shareholders of Imedia were placed in escrow to indemnify us for
any damages that are directly or indirectly suffered by us as a
result of plaintiffs claims. The value of the escrowed
shares was approximately $10.0 million based on the market
value of our common stock on or about the closing date of the
acquisition.

On or about September 5, 2000, the Company
received an amended complaint (Complaint) in a matter captioned
Evergreen Canada Israel Management, Ltd. v. Imedia
Corporation, Case no. 306185, pending in the Superior Court
of the State of California for the City and County of San
Francisco. The Complaint alleged both (i) intentional
interference with contractual relations and
(ii) intentional interference with prospective economic
advantage against us, claiming that we formed and operated a
conspiracy to deprive plaintiffs of the opportunity to invest in
Imedia. Plaintiffs argued that, prior to our purchase of the
Imedia shares, we knew of an alleged, pre-existing financing
agreement between plaintiffs and Imedia that contained a
no shop clause, prohibiting Imedia from seeking or
obtaining financing from any other sources, including
(apparently, in plaintiffs view) a prohibition against
Imedia selling its own stock or engaging in related transactions
that preceded the acquisition. We were subsequently served with
the Complaint and filed a demurrer challenging the legal
sufficiency of the two causes of action. Other defendants
demurred also. The demurrer hearing was held on January 16,
2001. Prior to the Court issuing a final ruling at that hearing,
Plaintiffs agreed to amend their complaint. Plaintiffs filed a
second amended complaint and, in response, we (and all other
defendants) filed demurrers challenging all the causes of
action. Our demurrer was heard on May 22, 2001, and the
Court ruled (by subsequent written decision) that three contract
claims and the tortuous interference with the prospective
economic advantage claims should be dismissed. The Court also
dismissed the two fraud claims with leave to amend.

The Plaintiffs then filed a third amended
complaint, and the defendants each filed demurrers and motions
to strike challenging that pleading. The demurrers and motions
to strike were argued on November 8, 2001.

Prior to a ruling on the demurrers and motions to
strike, the parties entered into a settlement agreement in which
plantiffs dismissed all claims with prejudice. The parties
agreed that the settlement agreement would not be construed to
be an admission of any liability on our part or the part of any
of the other defendants. The lawsuit was dismissed with
prejudice on March 6, 2002.

Beginning in April 2000, several plaintiffs filed
lawsuits against us and certain of our officers and directors in
federal court. The plaintiff in the first of these lawsuits
purported to represent a class whose members purchased our
securities between February 2, 2000 and April 11,
2000. The complaint alleged that the defendants had violated the
federal securities laws by issuing materially false and
misleading statements and failing to disclose material
information regarding our technology. The allegations in the
other lawsuits were

9



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##### Table of Contents



substantially the same and, on August 24,
2000, all of these lawsuits were consolidated in the United
States District Court, Northern District of California. The
consolidated lawsuit is named In re Terayon Communication
Systems, Inc. Securities Litigation, Case
No. C 00-1967-MHP. The court hearing the consolidated
action has appointed lead plaintiffs and lead plaintiffs
counsel pursuant to the Private Securities Litigation Reform Act.


On September 21, 2000, the lead plaintiffs
filed a consolidated class action complaint containing factual
allegations nearly identical to those in the original lawsuits.
The consolidated class action complaint, however, alleged claims
on behalf of a class whose members purchased or otherwise
acquired our securities between November 15, 1999 and
April 11, 2000. On October 30, 2000, defendants moved
to dismiss the consolidated class action complaint. On
March 14, 2001, after defendants motion had been fully
briefed and argued, the court issued an order granting in part
defendants motion and giving plaintiffs leave to file an
amended complaint. On April 13, 2001, plaintiffs filed
their first amended consolidated class action complaint. On
June 15, 2001, defendants moved to dismiss this new
complaint and oral argument on the motion occurred on
December 17, 2001. As of March 28, 2002, we have not
received an order from the court regarding the motion to dismiss
argued on December 17, 2001.

The lawsuit seeks an unspecified amount of
damages, in addition to other forms of relief. We consider the
lawsuits to be without merit and we intend to defend vigorously
against these allegations. However, the litigation could prove
to be costly and time consuming to defend, and there can be no
assurances about the eventual outcome.

On October 16, 2000, a lawsuit was filed
against the Company and the individual defendants (Zaki Rakib,
Selim Rakib, and Raymond Fritz) in the superior court of San
Luis Obispo County, California. This lawsuit is titled
Bertram v. Terayon Communications Systems, Inc., Case
No. CV 000900 (Bertram). The Bertram complaint
contains factual allegations similar to those alleged in the
federal securities class action lawsuit. The complaint asserts
causes of action under California Business & Professions
Code Sections 17200 et seq. and 17500 et seq. for unlawful
business practices, unfair and fraudulent business practices,
and false and misleading advertising. Plaintiffs purport to
bring the action on behalf of themselves and as representatives
of all persons or entities in the State of California and
such other persons or entities outside California that have been
and are adversely affected by defendants activity, and as
the Court shall determine is not inconsistent with the exercise
of the Courts jurisdiction. Plaintiffs seek
equitable and injunctive relief. Defendants removed the Bertram
case to the United States District Court, Central District of
California and, on January 19, 2001, filed a motion to
dismiss the complaint. A hearing on defendants motion was
held March 26, 2001 and the court granted Defendants
motion to dismiss the action and denied Plaintiffs motion
requesting remand. On April 5, 2001, Defendants moved for
an order requiring further proceedings, if any to take place in
the Northern District of California. Plaintiffs did not oppose
this motion and eventually entered into a stipulation to go
forward in the Northern District. On July 9, 2001, a status
conference was held in this case before Judge Patel. Plaintiffs
did not appear for the conference, and the court requested that
defendants submit an order dismissing the Bertram action with
prejudice, which the defendants have submitted to the court. We
believe that these allegations, as with the allegations in the
federal securities case, are without merit and intends to
contest the matter vigorously.




Item
4.Submission of Matters to a
Vote of Security Holders

There were no matters submitted to a vote of
security holders in the fourth quarter of 2001.




PART II






|        |                                                                           
|------- | --------------------------------------------------------------------------
|Item 5. | Market for the Registrants Common
	Equity and Related Stockholder Matters

Our common stock is traded on the Nasdaq National
Market under the symbol TERN. Public trading of our
common stock commenced on August 18, 1998. Prior to that,
there was no public market for our common stock. The following
table sets forth, for the periods indicated, the high and low
per share sale prices

10



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##### Table of Contents



of our common stock, as reported by the Nasdaq
National Market after giving effect to the two-for-one split on
May 5, 2000.


|      |                |      |   |         |  |  |   |        | 
|----- | -------------- | ---- | - | ------- |  |  | - | ------ | 
|      |                | High |   | Low    
|      |                |      |   |        
|2000  |                |      |   |         |  |  |   |       
|      | First Quarter  |      | $ | 142.625 |  |  | $ | 27.250 | 
|      | Second Quarter |      | $ | 139.937 |  |  | $ | 28.000 | 
|      | Third Quarter  |      | $ | 81.937  |  |  | $ | 30.250 | 
|      | Fourth Quarter |      | $ | 41.937  |  |  | $ | 3.516  | 
|2001: |                |      |   |         |  |  |   |       
|      | First Quarter  |      | $ | 9.125   |  |  | $ | 3.500  | 
|      | Second Quarter |      | $ | 7.600   |  |  | $ | 2.360  | 
|      | Third Quarter  |      | $ | 7.550   |  |  | $ | 3.980  | 
|      | Fourth Quarter |      | $ | 14.750  |  |  | $ | 6.750  | 




Item
6.     Selected Financial
Data

|                                              |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |         |  
|--------------------------------------------- | ------------------------------------------------ | ------------------------------------- | -------- | -------- | - | ---- | -------- | -------- | - | ---- | ------- | ------- | - | - | ------- | ------- | - | - | ------- | ------- | -
|                                              |                                                  |                                      
|                                              |                                                  | Years Ended December 31,             
|                                              |                                                  |                                      
|                                              |                                                  | 2001                                  |          | 2000     |   | 1999 |          | 1998     |   | 1997
|                                              |                                                  |                                       |          |          |   |      |          |          |   |     
|                                              |                                                  |                                      
|                                              |                                                  | (In thousands, except per share data)
|Consolidated Statement of Operations Data:    |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        
|Revenues                                      |                                                  | $                                     | 279,481  |          |   | $    | 339,549  |          |   | $    | 97,009  |         |   | $ | 31,696  |         |   | $ | 2,118   |        
|Cost of goods sold                            |                                                  |                                       | 229,611  |          |   |      | 270,531  |          |   |      | 72,044  |         |   |   | 34,518  |         |   |   | 6,462   |        
|Special charges                               |                                                  |                                       | 33,506   |          |   |      | 19,000   |          |   |      |        |         |   |   |        |         |   |   |        |        
|                                              |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        
|Gross profit (loss)                           |                                                  |                                       | 16,364   |          |   |      | 50,018   |          |   |      | 24,965  |         |   |   | (2,822  | )       |   |   | (4,344  | )      
|                                              |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        
|Operating expenses:                           |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        
|                                              | Research and development                         |                                       |          | 79,927   |   |      |          | 68,270   |   |      |         | 17,579  |   |   |         | 10,685  |   |   |         | 11,319  |  
|                                              | Cost of product development assistance agreement |                                       |          |         |   |      |          | 9,563    |   |      |         | 35,147  |   |   |         |        |   |   |         |        |  
|                                              | In-process research and development(2)           |                                       |          |         |   |      |          | 30,535   |   |      |         | 14,600  |   |   |         |        |   |   |         |        |  
|                                              | Sales and marketing                              |                                       |          | 55,701   |   |      |          | 45,261   |   |      |         | 15,727  |   |   |         | 6,947   |   |   |         | 4,468   |  
|                                              | General and administration                       |                                       |          | 31,309   |   |      |          | 24,809   |   |      |         | 7,476   |   |   |         | 3,223   |   |   |         | 2,546   |  
|                                              | Goodwill and administrative                      |                                       |          | 25,410   |   |      |          | 59,057   |   |      |         | 3,524   |   |   |         |        |   |   |         |        |  
|                                              | Restructuring and asset write-offs(3)            |                                       |          | 587,149  |   |      |          |         |   |      |         |        |   |   |         |        |   |   |         |        |  
|                                              |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        
|                                              | Total operating expenses                         |                                       |          | 779,496  |   |      |          | 237,495  |   |      |         | 94,053  |   |   |         | 20,855  |   |   |         | 18,333  |  
|                                              |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        
|Loss from operations                          |                                                  |                                       | (763,132 | )        |   |      | (187,477 | )        |   |      | (69,088 | )       |   |   | (23,677 | )       |   |   | (22,677 | )      
|Interest income, net                          |                                                  |                                       | 44       |          |   |      | 6,710    |          |   |      | 5,008   |         |   |   | 449     |         |   |   | 128     |        
|Income tax benefit                            |                                                  |                                       | (13,915  | )        |   |      |         |          |   |      |        |         |   |   |        |         |   |   |        |        
|Extraordinary gain(4)                         |                                                  |                                       | 185,327  |          |   |      |         |          |   |      |        |         |   |   |        |         |   |   |        |        
|                                              |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        
|                                              | Net loss                                         |                                       |          | (563,846 | ) |      |          | (180,767 | ) |      |         | (64,080 | ) |   |         | (23,228 | ) |   |         | (22,549 | )
|Series F convertible preferred stock dividend |                                                  |                                       |         |          |   |      |         |          |   |      |        |         |   |   | 23,910  |         |   |   |        |        
|                                              |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        
|Net loss applicable to common stockholders    |                                                  | $                                     | (563,846 | )        |   | $    | (180,767 | )        |   | $    | (64,080 | )       |   | $ | (47,138 | )       |   | $ | (22,549 | )      
|                                              |                                                  |                                       |          |          |   |      |          |          |   |      |         |         |   |   |         |         |   |   |         |        

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|                                                                                                               |  |                                       |        |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |       |  
|-------------------------------------------------------------------------------------------------------------- |  | ------------------------------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | - |  | - | ----- | -
|                                                                                                               |  |                                      
|                                                                                                               |  | Years Ended December 31,             
|                                                                                                               |  |                                      
|                                                                                                               |  | 2001                                  |        | 2000 |  | 1999 |        | 1998 |  | 1997
|                                                                                                               |  |                                       |        |      |  |      |        |      |  |     
|                                                                                                               |  |                                      
|                                                                                                               |  | (In thousands, except per share data)
|Historical and basic diluted net loss per share
	applicable to common stockholders before extraordinary gain   |  | $                                     | (10.96 | )    |  | $    | (2.95  | )    |  | $    | (1.55  | ) |  | $ | (2.62  | ) |  | $ | (2.63 | )
|Extraordinary gain on early retirement of debt                                                                 |  | $                                     | 2.71   |      |  |      |       |      |  |      |       |   |  |   |       |   |  |   |      |  
|                                                                                                               |  |                                       |        |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |       |  
|Basic and diluted net loss per share                                                                           |  | $                                     | (8.25  | )    |  | $    | (2.95  | )    |  | $    | (1.55  | ) |  | $ | (2.62  | ) |  | $ | (2.63 | )
|                                                                                                               |  |                                       |        |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |       |  
|Shares used in computing historical basic and
	diluted net loss per share applicable to common stockholders(1) |  |                                       | 68,331 |      |  |      | 61,349 |      |  |      | 41,260 |   |  |   | 17,972 |   |  |   | 8,578 |  
|                                                                                                               |  |                                       |        |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |       |  

|                                                     |  |                |          |      |  |      |           |      |  |      |          |   |  |   |         |   |  |    |         |  
|---------------------------------------------------- |  | -------------- | -------- | ---- |  | ---- | --------- | ---- |  | ---- | -------- | - |  | - | ------- | - |  | -- | ------- | -
|                                                     |  |               
|                                                     |  | December 31,  
|                                                     |  |               
|                                                     |  | 2001           |          | 2000 |  | 1999 |           | 1998 |  | 1997
|                                                     |  |                |          |      |  |      |           |      |  |     
|                                                     |  |               
|                                                     |  | (In thousands)
|Consolidated Balance Sheet Data:                     |  |                |          |      |  |      |           |      |  |      |          |   |  |   |         |   |  |    |         |  
|Cash, cash equivalents and short-term investments    |  | $              | 333,888  |      |  | $    | 562,457   |      |  | $    | 112,992  |   |  | $ | 28,880  |   |  | $  | 1,987   |  
|Working capital (deficit)                            |  |                | 316,175  |      |  |      | 547,938   |      |  |      | 112,374  |   |  |   | 24,422  |   |  |    | (4,847  | )
|Total assets                                         |  |                | 466,646  |      |  |      | 1,426,727 |      |  |      | 301,236  |   |  |   | 42,146  |   |  |    | 8,778   |  
|Long-term debt (less current portion)(4)             |  |                | 178,641  |      |  |      | 500,477   |      |  |      | 37       |   |  |   | 10      |   |  |    | 44      |  
|Accumulated deficit                                  |  |                | (892,994 | )    |  |      | (329,148  | )    |  |      | (148,381 | ) |  |   | (84,301 | ) |  |    | (37,163 | )
|Total stockholders equity (net capital
	deficiency) |  | $              | 180,304  |      |  | $    | 702,681   |      |  | $    | 258,655  |   |  | $ | 28,103  |   |  | ($ | 1,174   | )



---



|    |                                                                                                                                                                           
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 1 of Notes to Consolidated
	Financial Statements for an explanation of the method employed
	to determine the number of shares used to compute per share
	amounts.
|   
|(2) | See Note 14 of Notes to Consolidated
	Financial Statements for an explanation regarding business
	acquisitions.                                                           
|   
|(3) | See Note 6 of Notes to Consolidated
	Financial Statements for an explanation for restructuring and
	asset write-offs.                                                     
|   
|(4) | See Note 7 of Notes to Consolidated
	Financial Statements for an explanation of the repurchase of
	subordinated convertible notes.                                        






|        |                                                                                       
|------- | --------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
	of Financial Condition and Results of Operations

The following discussion and analysis should be
read in conjunction with our consolidated financial statements
and notes thereto.

Overview

We develop, market and sell equipment to cable
television operators, telecom carriers and satellite network
operators, who use our products to deliver broadband voice,
video and data services to residential and business subscribers.
We strive to deliver the most innovative broadband data, video
and voice solutions that enable service providers to accelerate
the deployment of revenue-generating services today and tomorrow.

We sell our products to cable operators and other
providers of broadband services through direct sales forces in
North America, South America, Europe and Asia. We also
distribute our products through resellers and system
integrators. We are structured around and our sales are derived
from the following operating

12



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##### Table of Contents



segments: Cable Broadband Access Systems (Cable)
and Telecom Carrier Systems (Telecom). The products sold in
Cable consists of our proprietary S-CDMA products, our
CherryPicker digital video management system and the Multigate
telephony and data access system, which are sold primarily to
cable operators for the deployment of data, video and voice
services over the existing cable infrastructure. The products
sold in Telecom consists of our MiniPlex DSL multiplexer system,
the IPTL DSLAM, MainSail MMAP and MainSail IAD, which are sold
to broadband service providers for the deployment of voice and
data services over the existing copper wire infrastructure.
Currently, 88% of our revenues are derived from Cable and 12%
from Telecom.


During 2000 and 1999, we acquired 10 companies in
order to expand our portfolio of broadband products to support
high-speed delivery of voice, data and video services over
cable, DSL and wireless. For more information relating to the
acquisitions, see Note 14 of the accompanying Notes to
Consolidated Financial Statements.

We sustained a net loss of $563.8 million in
the year ended December 31, 2001 and $180.8 million in
2000. We had an accumulated deficit of $893.0 million as of
December 31, 2001. A significant portion of the current
year loss was due to the write-off of intangible assets and
restructuring charges, but was partially offset by extraordinary
gains resulting from our buy back of a majority of our
convertible debt. Our operating expenses are based in part on
our expectations of future sales, and we expect that a
significant portion of our expenses will be committed in advance
of sales. We expect to continue to increase our expenditures in
technical development and sales and marketing as we engage in
activities related to product enhancement and increasing market
penetration. Additionally, we expect to increase our capital
expenditures and other operating expenses in order to support
our operations. We anticipate that we will spend approximately
$12 million to $15 million on capital expenditures and
approximately $70 million to $80 million on research
and development during the year ending December 31, 2002.
Anticipated capital expenditures consist of purchases of
additional test equipment to support higher levels of production
and computer hardware, furniture and leasehold improvements for
our facilities, expanded geographical implementation of an
enterprise resource planning system and software and equipment
for newly hired employees. As a result of these anticipated
increased operating expenses, we expect to continue to incur
losses for the foreseeable future.

Critical Accounting Policies

We consider certain accounting policies related
to revenue recognition, bad debt reserves, inventory reserves,
impairment of long-lived assets, warranty returns and
contingencies to be critical policies due to the estimation
processes involved in each.

Use of Estimates.The preparation of consolidated
financial statements in conformity with generally accepted
accounting principles requires that we make estimates and
assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ
from those estimates.

Revenue Recognition.We recognize revenue in accordance
with SEC Staff Accounting Bulletin No. 101, Revenue
Recognition in Financial Statements(SAB 101), as amended by
SAB 101A and 101B. SAB 101 requires that four basic criteria
must be met before revenue can be recognized:
(1) persuasive evidence of an arrangement exists;
(2) delivery has occurred or services rendered;
(3) the selling price is fixed and determinable; and
(4) collectibility is reasonably assured. Determination of
criteria (4) is based on managements judgments
regarding the collectibility of the selling price. Should
changes in conditions cause management to determine these
criteria are not met for certain future transactions, revenue
recognized for any reporting period could be adversely affected.

Bad Debt Reserves.We evaluate our trade receivables based upon a combination of
factors. When we become aware of a customers inability to
pay, such as in the case of bankruptcy or a decline in the
customers operating results or financial position, we
record a specific reserve for bad debt to reduce the related
receivable to an amount we reasonably believe is collectible. We
also record reserves for bad debt for customers based upon other
factors including the length of time the receivables are past
due and historical experience. If circumstances related to a
specific customer change, our estimates of the recoverability of
receivables could be further reduced.

13



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##### Table of Contents



Inventory Reserves.We perform a detailed assessment of
inventory at each balance sheet date which includes a review of,
among other factors, demand requirements, product lifecycle and
product development plans. Based on this analysis, we record
adjustments, when appropriate, to reflect inventory at net
realizable value.

We have adjusted our reserves significantly in
recent periods due to changes in strategic direction, such as
discontinuances of product lines as well as fluctuations in
market conditions due to changes in demand requirements. If
future demand is less favorable than we have projected,
additional inventory write-downs may be required.

Impairment of Long-lived Assets.Our long-lived assets include
long-term investments, goodwill and other intangible assets. At
December 31, 2001, we had $4.5 million of long-term
investments and $3.8 million of goodwill and other
intangible assets. Our estimate of the fair value of the
long-term investments is dependent on the performance of the
companies in which we have invested, as well as the volatility
inherent in the external markets for these investments. If the
forecasts are not met, we may have to record additional
impairment charges. During the year ended December 31,
2001, we recognized approximately $2.5 million of
impairment losses related to our long-term investments.

In assessing the recoverability of our goodwill
and other intangible assets, we must make assumptions regarding
estimated future cash flows and other factors to determine the
fair value of the respective assets. If these estimates or their
related assumptions change in the future, we may be required to
record additional impairment charges for these assets. During
the year ended December 31, 2001, we recorded impairment
charges of $572.8 million. On January 1, 2002, we
adopted Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets(SFAS 142) and will be required to analyze our
remaining indefinite lived assets, including goodwill for
impairment during the first six months of 2002, and on a
periodic basis thereafter.

Warranty Reserves.We provide a standard warranty for
most of our products, generally lasting one year from the date
of purchase. We provide for the estimated cost of product
warranties at the time revenue is recognized. Our warranty
obligations are affected by product failure rates, material
usage and service delivery costs incurred in correcting a
product failure. Our estimate of costs to service our warranty
obligations is based on historical experience and expectation of
future conditions. Should actual product failure rates, material
usage or service delivery costs differ from our estimates,
revisions to the estimated warranty liability would be required,
resulting in decreased gross profits.

Contingencies.We
are subject to proceedings, lawsuits and other claims related to
labor, acquisition and other matters. We are required to assess
the likelihood of any adverse judgments or outcomes to these
matters as well as potential ranges of probable losses. A
determination of the amount of reserves required, if any, for
these contingencies are made after careful analysis of each
individual issue. The required reserves may change in the future
due to new developments in each matter or changes in approach
such as a change in settlement strategy in dealing with these
matters, resulting in higher net loss.

Results of Operations

Years Ended
December 31, 2001 and 2000

Revenues.We sell
our products directly to broadband service providers, and to a
lesser extent, resellers and system integrators. Revenues
related to product sales are generally recognized when:
(1) persuasive evidence an arrangement exists,
(2) delivery has occurred or services rendered,
(3) the selling price is fixed or determinable, and
(4) collectibility is reasonably assured. Our existing
agreements typically do not contain price protection provisions
and generally do not grant return rights beyond those provided
by our standard warranty.

Revenues consist primarily of sales of products
to new and existing customers providing broadband services. The
global economic downturn contributed significantly to the
decline in both North America and international revenues in
2001. Our revenues decreased 17.7% to $279.5 million for
the year ended December 31, 2001 from $339.5 million
in 2000. Revenues in North America, which includes the United

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States and Canada decreased 19.2% to
$163.6 million in 2001, down from $202.5 million in
2000. Revenues from international locations decreased 15.5% to
$115.9 million in 2001 down from $137.0 million in
2000.


Revenues from Cable amounted to
$245.8 million for the year ended December 31, 2001,
down 19.0% from $303.5 million in 2000. Although we shipped
slightly more modems in 2001 than in 2000, average selling
prices (ASPs) declined year over year as ongoing competitive
pricing pressures affected revenue performance in several of our
product offerings.

Revenues from Telecom were $33.7 million,
down 6.4% from $36.0 million in 2000. We have a relatively
small customer base, and revenues were impacted by declines in
telecom industry spending.

The intensely competitive nature of the market
for broadband products has resulted in significant price erosion
over time. We have experienced and expect to continue to
experience downward pressure on our unit ASPs. A key component
of our strategy is to decrease the cost of manufacturing our
products to offset the decline in ASP. We intend to continue to
implement cost reduction efforts, including design changes and
manufacturing efficiencies.

Cost of Goods Sold.Cost of goods sold consists of direct product costs as well as
the cost of our manufacturing operations group. The cost of the
manufacturing operations group includes assembly, test and
quality assurance for products, warranty costs and associated
costs of personnel and equipment. In the year ended
December 31, 2001, cost of goods sold decreased 9.1% to
$263.1 million from $289.5 million in 2000. For the
years ended December 31, 2001 and 2000, we incurred special
charges of $33.5 million and $19.0 million,
respectively, relating to vendor cancellation charges and
inventory reserves. Cost of goods sold for the year ended
December 31, 2001 also included approximately
$13.9 million of amortization of acquired intangible assets
compared to $36.3 million in 2000. Excluding special
charges and amortization of intangible assets, cost of goods
sold decreased $18.5 million or 7.9% due primarily to lower
sales, largely offset by the usage, in the first three quarters
of 2001, of higher priced inventories purchased in the fourth
quarter of 2000.

Gross Profit.We
achieved a gross profit of $16.4 million or 5.9% of sales
in the year ended December 31, 2001 compared to
$50.0 million or 14.7% in 2000. The decrease in our gross
profit was largely the result of lower ASPs due to competitive
pricing pressures, a shift in our sales to lower margin CPE,
utilization of higher priced inventory primarily purchased in
2000, and special charges described above. During 2002, we
anticipate further decreases in our ASPs and continued pressure
on our margins, and we expect to continue to see decreasing
margins in 2002 unless and until we can produce lower cost
products. These ASP decreases, without a corresponding decrease
in our product costs, will likely have an adverse impact on our
operating results in 2002.

Research and
Development.Research and development
expenses consist primarily of personnel costs, internally
designed prototype material expenditures, equipment and supplies
required to develop and enhance our products. Research and
development expenses increased to $79.9 million or 28.6% of
sales in the year ended December 31, 2001 from
$68.3 million or 20.1% of sales in 2000. Increases in
research and development spending are attributable to the
development of our new line of standards-based products, which
we believe will be commercially available for shipments in the
third quarter of 2002. Also included in research and development
costs is the amortization of intangible assets of approximately
$5.7 million in 2001 compared to $4.6 million in 2000.
We believe it is critical to continue to make significant
investments in research and development to create innovative
technologies and products that meet the current and future
requirements of our customers. Accordingly, we expect in future
years to continue to devote substantial resources to research
and development programs.

In-Process Research and Development.There were no charges for in-process
research and development in the year ending December 31,
2001. We incurred charges of $30.5 million in the year
ended December 31, 2000, related to research and
development projects in process at companies that we acquired,
in chronological order, Telegate Ltd. (Telegate), Access Network
Electronics division of Tyco Electronics Corporation (ANE),
Combox Ltd. (Combox), certain assets of Internet Telecom Ltd.
(Internet Telecom), Ultracom Communications Holding 1995 Ltd.
(Ultracom), Digital Transmission Equipment (Digitrans) and
MainSail Networks, Inc. (MainSail) at the time of the
acquisitions. At the date of each acquisition, the projects

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identified as in-process research and development
required additional efforts in order to establish technological
feasibility.


In-process technology acquired relating to the
acquisition of Mainsail in 2000, was valued at approximately
$5.0 million and consisted primarily of additions to
Mainsails core technology, which was related to
Mainsails planned development of new features. The
resultant technology provides a high capacity CPE and a low cost
gateway. This development was completed in 2001.

In-process technology acquired relating to the
acquisitions of Telegate, Combox, Internet Telecom, ANE,
Ultracomm and Digitrans, all in 2000, was valued at
approximately $7.5 million, $8.0 million,
$2.6 million, $0.7 million, $1.8 million and
$4.9 million, respectively. During 2001, we decided not to
pursue any further development efforts on these projects.

Sales and Marketing.Sales and marketing expenses consist primarily of salaries and
commissions for sales personnel, marketing and support
personnel, and costs related to trade shows, consulting and
travel. Sales and marketing expenses increased to
$55.7 million or 19.9% of sales in the year ended
December 31, 2001 from $45.3 million or 13.3% of sales
in 2000. The increase in sales and marketing expenses was
primarily due to increased headcount as well as increased
spending for promotional activities, such as tradeshows,
consulting fees for public relations and advertising and print
advertising. Amortization of intangible assets included in sales
and marketing expenses accounted for approximately
$4.3 million in 2001 compared to $3.0 million in 2000.
We expect sales and marketing expenses to continue to increase
as we expand our operations and release new products.

General and
Administrative.General and
administrative expenses primarily consist of salary and benefits
for administrative officers and support personnel, travel
expenses and legal, accounting and consulting fees. General and
administrative expenses increased to $31.3 million or 11.2%
of sales in the year ended December 31, 2001 from
$24.8 million or 7.3% of sales in 2000. The increase is
primarily due to amortization of intangible assets of
$4.6 million in 2001 compared to only $1.0 million in
2000 as well as increased headcount to support our operations.
We expect general and administrative expenses to continue to
increase as we expand our operations.

Goodwill
Amortization.The amortization of
goodwill arising from acquisitions completed during 2000 and
1999 decreased 57.0% to $25.4 million for the year ended
December 31, 2001 compared to $59.1 million for the
same period in 2000. This decrease was due to the write-down of
$572.8 million of acquired intangible assets during 2001.

Upon adoption of Statement of Financial
Accounting Standards (SFAS) No. 142 effective
January 1, 2002, we will no longer be required to amortize
the goodwill assets associated with our acquisitions from 1999
and 2000.

Restructuring Costs and Asset
Write-offs.In March 2001, we
evaluated the carrying value of certain long-lived assets and
acquired intangibles, consisting primarily of goodwill recorded
on our balance sheet. Pursuant to accounting rules, the majority
of the goodwill was recorded based on stock prices at the time
acquisition agreements were executed and announced. Goodwill and
other long-lived assets are reviewed for impairment whenever
events such as product discontinuance, plant closures, product
dispositions or other changes in circumstances indicate that the
carrying amount may not be recoverable. When such events occur,
we compare the carrying amount of the assets to undiscounted
expected future cash flows. If this comparison indicates that
there is an impairment, the amount of the impairment is based on
the fair value of the assets, typically calculated using
discounted expected future cash flows. The discount rate applied
to these cash flows is based on our weighted average cost of
capital, which represents the blended costs of debt and equity.

Downturns in the broadband services and
telecommunications markets created unique circumstances with
regard to the assessment of goodwill and other intangible assets
for recoverability. As a result of our decision to suspend
certain product lines and product development efforts during
2001, intangible assets totaling $163.1 million relating to
certain acquisitions were deemed to be impaired with no future
value and were written off. Further, the aforementioned
downturns in the principal markets in which we continue to
operate, have negatively impacted the forecasted revenues and
cash flows from certain other companies

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acquired during fiscal 1999 and 2000. In
accordance with our policy, the comparison of the discounted
expected future cash flows to the carrying amount of the related
intangible assets resulted in a write-down of these assets
related to both our Cable and Telecom segments of
$409.7 million during 2001.


During 2001, we recorded a deferred tax asset of
approximately $4.0 million and corresponding reduction of
goodwill, for the tax benefit of foreign net operating loss
carryforwards relating to a previous acquisition. Due to the
impairment write-off, the remaining net deferred tax liability
was also written-off.

We incurred restructuring charges in the amount
of $12.7 million and a write-down of impaired assets in the
amount of $1.6 million for the year ended December 31,
2001. The write-down of $1.6 million related to fixed
assets acquired from ANE which were determined to have no
remaining useful life. Of the total restructuring charges,
$3.2 million relates to employee termination costs covering
293 technical, production and administrative employees. As of
December 31, 2001, approximately 240 employees have been
terminated and we paid approximately $2.0 million in
termination costs. The remaining $9.5 million of
restructuring charges relates primarily to costs for excess
leased facilities. Included in the remaining $9.5 million
are $3.4 million of charges incurred in the fourth quarter
for revisions in estimates of excess facility charges. As of
December 31, 2001, we paid approximately $2.5 million
related to lease costs. At December 31, 2001, restructuring
charges of $8.2 million remain accrued, primarily related
to excess facility costs and employee terminations. We
anticipate utilizing the remaining restructuring accrual, which
relates to servicing operating lease payments or negotiated
buyout of operating lease commitments, through 2005. We expect
reductions in our overall operating expenses as a result of the
headcount reductions.

Interest Income and
Expense.Interest income was
$18.1 million in the year ended December 31, 2001
compared to $19.8 million in 2000. Interest expense was
$15.2 million in the year ended December 31, 2001
compared to $11.3 million in 2000. Interest income
primarily consisted of income from our cash and short-term
investments and decreased during 2001 due to lower invested cash
balances. Interest expense was primarily due to the sale in July
2000 of $500 million of 5% Convertible Subordinated Notes
due in August 2007 (Notes). During 2001, we repurchased
approximately $325.9 million in principal of the Notes.
This repurchase will reduce interest expense in future periods.

Other Expense.Other
expense for the year ended December 31, 2001 totaled
$2.9 million compared to $1.8 million in 2000. During
2001, we wrote down approximately $2.5 million of certain
investments in privately held companies which we felt were
impaired given their recent economic performance and considering
current market conditions.

Income Taxes.We
have generated operating losses since our inception. For the
year ended December 31, 2001, we recorded a benefit from
income taxes of $13.9 million which represents the
write-off of deferred tax assets and remaining net deferred tax
liabilities previously recorded for purchased acquired
intangibles, net of miscellaneous foreign income taxes. There
was no provision for income taxes for the years ended
December 31, 2000 and 1999.

Extraordinary Gain.We recorded an extraordinary gain on the repurchase of some of
the Notes. During the year ended December 31, 2001, we
recorded an extraordinary gain of $185.3 million as the
result of such repurchases.

Years Ended
December 31, 2000 and 1999

Revenues.Our
revenues increased to $339.5 million for the year ended
December 31, 2000 from $97.0 million in 1999. The
increased revenues in 2000 were largely attributable to
continuing deployments of our TeraComm system by new and
existing customers. In addition, sales of products from acquired
companies accounted for approximately $69.8 million of the
increased revenues in the year ended December 31, 2000.

Cost of Goods Sold.In the year ended December 31, 2000, we incurred cost of
goods sold of $289.5 million compared to $72.0 million
in 1999. Cost of goods sold for the year ended December 31,
2000 also included approximately $36.3 million of
amortization of acquired intangible assets and a special charge
of $19 million for vendor cancellation fees. Our cost of
goods sold increased in the year ended December 31,

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2000, compared to 1999, primarily due to
increased product shipments and the inclusion of the
amortization expense relating to acquired intangible assets.


Gross Profit.We
achieved a gross profit of $50.0 million in the year ended
December 31, 2000 compared to $25.0 million in 1999.
This improvement in our gross profit was largely the result of
increased product shipments and continued cost reduction
efforts, including the further integration of application
specific integrated circuit (ASIC) components, other design
changes and manufacturing efficiencies that aided us in the
early part of the year, but were offset by slower demand
beginning in the fourth quarter. Gross profit for the fourth
quarter of 2000 declined as the result of lower than expected
revenues, a shift in the mix of product shipped and an increase
in inventory reserves.

Research and
Development.Research and development
expenses increased to $68.3 million in the year ended
December 31, 2000 from $17.6 million in 1999. The
increase in research and development expenses was primarily the
result of increased personnel costs. The increased personnel
costs were a result of the expansion of our employee base and
the inclusion of employees from acquired companies as we
continued to focus our efforts on developing new products.

Cost of Product Development Assistance
Agreement.In March 1999, we entered
into a one-year Product Development Assistance Agreement with
Rogers Communications Inc. Under the terms of the Development
Agreement, Rogers was obligated to assist us with the
characterization and testing of our subscriber-end and head-end
voice-over-cable equipment. In addition, Rogers was obligated to
provide us with technology to assist us with our efforts to
develop high quality, field proved technology solutions that are
DOCSIS-compliant and packet-cable compliant. The Development
Agreement had a term of one year. In consideration of Rogers
entering into the Development Agreement, we issued Rogers two
fully vested and non-forfeitable warrants, each to purchase
2.0 million shares of common stock on a cashless basis. One
warrant had a exercise price of $0.50 per share and one warrant
had an exercise price of $18.50 per share. The fair value of the
two warrants was approximately $45.0 million and resulted
in a non-cash charge included in operations over the one-year
term of the Development Agreement. As a result of the
Development Agreement, our results for the year ended
December 31, 2000 include a non-cash charge of
$9.6 million compared to $35.1 million in 1999. In
March 2000, Rogers purchased 3,687,618 shares of our common
stock on a net exercise basis, resulting in no proceeds to us.

In-Process Research and
Development.We incurred charges of
$30.5 million in the year ended December 31, 2000
related to research and development projects in process at
Telegate, ANE, Combox, Internet Telecom, Ultracom, Mainsail, and
Digitrans at the time of the acquisitions. For the year ended
December 31, 1999, we incurred charges of
$14.6 million related to research and development projects
in process at Radwiz and Imedia at the time of the acquisitions.
The projects identified as in-process required additional effort
in order to establish technological feasibility.

Sales and Marketing.Sales and marketing expenses increased to $45.3 million in the
year ended December 31, 2000 from $15.7 million in
1999. The increase in sales and marketing expenses was due to
increased payroll costs related to additional sales and support
personnel necessary to support the expansion of our customer
base, increased payroll and associated costs from the expansion
in our employee base resulting from acquired companies and
increased commissions related to higher sales. Workforce
amortization accounted for approximately $3.0 million of
the increase.

General and
Administrative.General and
administrative expenses increased to $24.8 million in the
year ended December 31, 2000 from $7.5 million in
1999. The increase was primarily due to costs associated with
the increased infrastructure required to support our expanded
activities and increased personnel costs associated with
acquired companies.

Goodwill
Amortization.The amortization of
goodwill arising from acquisitions completed during 2000 totaled
$59.1 million and accounted for the significant increase in
goodwill amortization in 2000 as compared to 1999.

Interest Income and
Expense.Interest income was
$19.8 million in the year ended December 31, 2000
compared to $5.1 million in 1999. Interest expense was
$11.3 million in the year ended December 31, 2000

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compared to $93,000 in 1999. The increases to
interest income and interest expense were due to the sale of
$500 million of Notes resulting in net proceeds to us of
approximately $484.4 million.


Other Expense.Other
expense for the year ended December 31, 2000 consisted
primarily of approximately $1.0 million in amortization of
debt issuance costs, $508,000 in amortization of warrants issued
in conjunction with a debt obligation, and $0.2 million
loss on sale of property and equipment.

Income Taxes.We
have generated operating losses since our inception. Due to our
inability to recognize a benefit from these operating losses, we
had no provision for income taxes in 2000 and 1999.

Litigation

In September 1999, a group of prospective
investors in Imedia Corporation (Imedia), now our subsidiary,
named Imedia as a defendant in an action alleging that Imedia
breached its term sheet with the plaintiffs when Imedia
negotiated its acquisition by us and, as a result, did not
permit plaintiffs to invest in Imedia. The plaintiffs sought
damages in excess of $12.0 million. The terms of the Imedia
Agreement and Plan of Merger and Reorganization provided that
shares of our common stock that were to be issued to the former
shareholders of Imedia were placed in escrow to indemnify us for
any damages that are directly or indirectly suffered by us as a
result of plaintiffs claims. The value of the escrowed
shares was approximately $10.0 million based on the market
value of our common stock on or about the closing date of the
acquisition.

On or about September 5, 2000, the Company
received an amended complaint (Complaint) in a matter captioned
Evergreen Canada Israel Management, Ltd. v. Imedia
Corporation, Case no. 306185, pending in the Superior
Court of the State of California for the City and County of San
Francisco. The Complaint alleged both (i) intentional
interference with contractual relations and
(ii) intentional interference with prospective economic
advantage against us, claiming that we formed and operated a
conspiracy to deprive plaintiffs of the opportunity to invest in
Imedia. Plaintiffs argued that, prior to our purchase of the
Imedia shares, we knew of an alleged, pre-existing financing
agreement between plaintiffs and Imedia that contained a
no shop clause, prohibiting Imedia from seeking or
obtaining financing from any other sources, including
(apparently, in plaintiffs view) a prohibition against
Imedia selling its own stock or engaging in related transactions
that preceded the acquisition. We were subsequently served with
the Complaint and filed a demurrer challenging the legal
sufficiency of the two causes of action. Other defendants
demurred also. The demurrer hearing was held on January 16,
2001. Prior to the Court issuing a final ruling at that hearing,
Plaintiffs agreed to amend their complaint. Plaintiffs filed a
second amended complaint and, in response, we (and all other
defendants) filed demurrers challenging all the causes of
action. Our demurrer was heard on May 22, 2001, and the
Court ruled (by subsequent written decision) that three contract
claims and the tortuous interference with the prospective
economic advantage claims should be dismissed. The Court also
dismissed the two fraud claims with leave to amend.

The Plaintiffs then filed a third amended
complaint, and the defendants and motions to strike challenging
that pleading. A hearing date on the demurrers was set in
November for March 18, 2002. The demurrers and motions to
strike were argued on November 8, 2002.

Prior to a ruling on the demurrers and motions to
strike, the parties entered into a settlement agreement in which
Plaintiffs dismissed all claims with prejudice. The parties
agreed that the settlement agreement would not be construed to
be an admission of any liability on the part of the Company or
any of the other defendants. The lawsuit was dismissed with
prejudice on March 6, 2002.

Beginning in April 2000, several plaintiffs filed
lawsuits against us and certain of our officers and directors in
federal court. The plaintiff in the first of these lawsuits
purported to represent a class whose members purchased our
securities between February 2, 2000 and April 11,
2000. The complaint alleged that the defendants had violated the
federal securities laws by issuing materially false and
misleading statements and failing to disclose material
information regarding our technology. The allegations in the
other lawsuits were substantially the same and, on
August 24, 2000, all of these lawsuits were consolidated in
the United States District Court, Northern District of
California. The consolidated lawsuit is named In re Terayon
Communication Systems, Inc. Securities Litigation, Case
No. C 00-1967-MHP. The court hearing the consolidated action

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has appointed lead plaintiffs and lead
plaintiffs counsel pursuant to the Private Securities
Litigation Reform Act.


On September 21, 2000, the lead plaintiffs
filed a consolidated class action complaint containing factual
allegations nearly identical to those in the original lawsuits.
The consolidated class action complaint, however, alleged claims
on behalf of a class whose members purchased or otherwise
acquired our securities between November 15, 1999 and
April 11, 2000. On October 30, 2000, defendants moved
to dismiss the consolidated class action complaint. On
March 14, 2001, after defendants motion had been fully
briefed and argued, the court issued an order granting in part
defendants motion and giving plaintiffs leave to file an
amended complaint. On April 13, 2001, plaintiffs filed
their first amended consolidated class action complaint. On
June 15, 2001, defendants moved to dismiss this new
complaint and oral argument on the motion occurred on
December 17, 2001. As of March 28, 2002, we have not
received an order from the court regarding the motion to dismiss
argued on December 17, 2001.

The lawsuit seeks an unspecified amount of
damages, in addition to other forms of relief. We consider the
lawsuits to be without merit and we intend to defend vigorously
against these allegations. However, the litigation could prove
to be costly and time consuming to defend, and there can be no
assurances about the eventual outcome.

On October 16, 2000, a lawsuit was filed
against the Company and the individual defendants (Zaki Rakib,
Selim Rakib, and Raymond Fritz) in the superior court of San
Luis Obispo County, California. This lawsuit is titled
Bertram v. Terayon Communications Systems, Inc.,
Case No. CV 000900 (Bertram). The Bertram complaint
contains factual allegations similar to those alleged in the
federal securities class action lawsuit. The complaint asserts
causes of action under California Business &
Professions Code Sections 17200 et seq. and 17500 et seq.
for unlawful business practices, unfair and fraudulent business
practices, and false and misleading advertising. Plaintiffs
purport to bring the action on behalf of themselves and as
representatives of all persons or entities in the State of
California and such other persons or entities outside California
that have been and are adversely affected by defendants
activity, and as the Court shall determine is not inconsistent
with the exercise of the Courts jurisdiction.
Plaintiffs seek equitable and injunctive relief. Defendants
removed the Beltram case to the United States District, Central
District of California and, on January 19, 2001, filed a
motion to dismiss the complaint. A hearing on defendants
motion was held March 26, 2001 and the court granted
Defendants motion to dismiss the action and denied
Plaintiffs motion requesting remand. On April 5,
2001, Defendants moved for an order requiring further
proceedings, if any to take place in the Northern District of
California. Plaintiffs did not oppose this motion and eventually
entered into a stipulation to go forward in the Northern
District. On July 9, 2001, a status conference was held in
this case before Judge Patel. Plaintiffs did not appear for the
conference, and the court requested that defendants submit an
order dismissing the Bertram action with prejudice, which the
defendants have submitted to the court. We believe that these
allegations, as with the allegations in the federal securities
case, are without merit and intends to contest the matter
vigorously.

Liquidity and Capital Resources

At December 31, 2001, we had approximately
$100.3 million in cash and cash equivalents and
$233.6 million in short-term investments.

In July 2000, we issued $500 million of
Notes, resulting in net proceeds to us of approximately
$484.4 million. The Notes are our general unsecured
obligation and are subordinated in right of payment to all of
our existing and future senior indebtedness and to all of the
liabilities of our subsidiaries. The Notes are convertible into
shares of our common stock at a conversion price of $84.01 per
share at any time on or after October 24, 2000 through
maturity, unless previously redeemed or repurchased. Interest is
payable semiannually. Debt issuance costs related to the Notes
were approximately $15.6 million.

In 2001, we repurchased approximately
$325.9 million of the Notes for $113.4 million in cash
and $17.9 million in stock, resulting in an extraordinary
gain of approximately $185.3 million net of
$9.3 million of previously unamortized debt issuance costs.

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Cash used by operating activities for the year
ended December 31, 2001 was $94.9 million compared to
$20.7 million provided in 2000. In 2001, significant uses
of cash from operating activities included our losses from
operations as well as a decrease in accounts payable of
$81.1 million. Net cash used in operating activities were
partially offset by decreases in inventory and other current
assets of $71.1 million and $16.6 million,
respectively. Net cash provided by operating activities in 2000
were primarily due to increases in accounts payable and other
accrued liabilities of $110.8 million and
$35.2 million, respectively, mostly offset by increases in
accounts receivable of $28.8 million and inventory of
$82.8 million as well as the loss from operations of
$180.8 million.

Cash used in investing activities was
$27.0 million in 2001 compared to $206.7 million in
2000. Investing activities consisted primarily of net purchases
of short-term investments in 2001 and 2000.

Cash used by financing activities was
$124.2 million in 2001 compared to $500.6 million
provided by financing activities in 2000. In 2001, we paid
approximately $113.4 million to repurchase a portion of the
Notes and $24.4 million to retire short and long-term debt.
We received a total of $12.5 million from the exercise of
stock options. In 2000, we received net proceeds of
approximately $484.4 million from the issuance of the Notes
as well as proceeds of $14.2 million from the exercise of
stock options.

We believe that our current cash balances will be
sufficient to satisfy our cash requirements for at least the
next 12 months. This estimate is a forward-looking
statement that involves risks and uncertainties, and actual
results may vary as a result of a number of factors, including
those discussed under the risk factor Our Operating
Results May Fluctuate below and elsewhere. We may need to
raise additional funds in order to support more rapid expansion,
develop new or enhanced services, respond to competitive
pressures, acquire complementary businesses or technologies or
respond to unanticipated requirements. We may seek to raise
additional funds through private or public sales of securities,
strategic relationships, bank debt, financing under leasing
arrangements or otherwise. If additional funds are raised
through the issuance of equity securities, the percentage
ownership of our stockholders will be reduced, stockholders may
experience additional dilution or such equity securities may
have rights, preferences or privileges senior to those of the
holders of our common stock. There can be no assurance that
additional financing will be available on acceptable terms, if
at all. If adequate funds are not available or are not available
on acceptable terms, we may be unable to develop our products,
take advantage of future opportunities or respond to competitive
pressures or unanticipated requirements, which could have a
material adverse effect on our business, financial condition and
operating results.

The following summarizes our contractual
obligations at December 31, 2001, and the effect such
obligations are expected to have on our liquidity and cash flows
in future periods (in millions):

|                                   |  |                        |       |           |  |       |       |       |  |         |       |  |  |   |     |  |  |   |       | 
|---------------------------------- |  | ---------------------- | ----- | --------- |  | ----- | ----- | ----- |  | ------- | ----- |  |  | - | --- |  |  | - | ----- | 
|                                   |  |                       
|                                   |  | Payments Due by Period
|                                   |  |                       
|                                   |  |                        |       | Less than |  | 1-3   |       | 4-5   |  | After 5
|Contractual Obligations            |  | Total                  |       | 1 Year    |  | Years |       | Years |  | Years  
|                                   |  |                        |       |           |  |       |       |       |  |        
|Capital Lease Obligations          |  | $                      | 0.4   |           |  | $     | 0.15  |       |  | $       | 0.25  |  |  | $ |    |  |  | $ |      | 
|Unconditional Purchase Obligations |  |                        | 58.7  |           |  |       | 48.0  |       |  |         | 10.7  |  |  |   |    |  |  |   |      | 
|Long Term Debt                     |  |                        | 178.6 |           |  |       |      |       |  |         | 2.0   |  |  |   |    |  |  |   | 176.6 | 
|Operating Lease Obligations        |  |                        | 14.8  |           |  |       | 5.3   |       |  |         | 9.5   |  |  |   |    |  |  |   |      | 
|Other obligations                  |  |                        | 7.5   |           |  |       | 1.5   |       |  |         | 3.0   |  |  |   | 3.0 |  |  |   |      | 
|                                   |  |                        |       |           |  |       |       |       |  |         |       |  |  |   |     |  |  |   |       | 
|Total Contractual Commitments      |  | $                      | 260.0 |           |  | $     | 54.95 |       |  | $       | 25.45 |  |  | $ | 3.0 |  |  | $ | 176.6 | 

We have unconditional purchase obligations to
certain of our suppliers that support our ability to manufacture
our products. The obligations require us to purchase minimum
quantities of the suppliers products at a specified price.
During fiscal year 2001, we recorded special charges of
$33.5 million relating to vendor cancellation fees. As of
December 31, 2001, we had approximately $58.7 million
of purchase obligations, of which $17.3 million is included
on the balance sheet as accrued vendor cancellation charges. The
remaining obligations are expected to become payable at various
times through mid-2003.

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Other commercial commitments are as follows (in
millions):

|                             |  |                                            |     |           |  |       |     |       |  |        |   |  |  |   |   |  |  |   |   | 
|---------------------------- |  | ------------------------------------------ | --- | --------- |  | ----- | --- | ----- |  | ------ | - |  |  | - | - |  |  | - | - | 
|                             |  |                                           
|                             |  | Amount of Commitment Expiration Per Period
|                             |  |                                           
|                             |  | Total                                      |     |          
|                             |  | Amounts                                    |     | Less than |  | 1-3   |     | 4-5   |  | Over 5
|Other Commercial Commitments |  | Committed                                  |     | 1 Year    |  | Years |     | Years |  | Years 
|                             |  |                                            |     |           |  |       |     |       |  |       
|Standby Letters of Credit    |  | $                                          | 1.6 |           |  | $     | 1.6 |       |  | $      |  |  |  | $ |  |  |  | $ |  | 
|                             |  |                                            |     |           |  |       |     |       |  |        |   |  |  |   |   |  |  |   |   | 
|Total Commercial Commitments |  | $                                          | 1.6 |           |  | $     | 1.6 |       |  | $      |  |  |  | $ |  |  |  | $ |  | 

Recent Financial Accounting
Pronouncements

In August 2001, the Financial Accounting
Standards Board issued FAS No. 144, Accounting for
the Impairment or Disposal of Long-lived Assets. FAS
No. 144 supercedes FAS No. 121, Accounting for
the Impairment of Long-lived Assets and Assets to be Disposed
of and the accounting and reporting provisions of
Accounting Principles Board Opinion No. 30, Reporting
the Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual
and Infrequently Occurring Events and Transaction. FAS
No. 144 also amends Accounting Research Bulletin
No. 51, Consolidated Financial Statements, to
eliminate the exception to consolidation for a subsidiary for
which control is likely to be temporary. The provisions of FAS
No. 144 will be effective for fiscal years beginning after
December 15, 2001. The effect of adopting FAS No. 144
has been evaluated by us, and does not have a material adverse
effect on our financial position or results of operations.

In June 2001, the Financial Accounting Standards
Board issued Statements of Financial Accounting Standards
No. 141, Business Combinations, and No. 142, Goodwill
and Other Intangible Assets. Statement 141 requires that
the purchase method of accounting be used for all business
combinations initiated after June 30, 2001.
Statement 141 also includes guidance on the initial
recognition and measurement of goodwill and other intangible
assets arising from business combinations completed after
June 30, 2001. Statement 142 prohibits the
amortization of goodwill and intangible assets with indefinite
useful lives. Statement 142 requires that these assets be
reviewed for impairment at least annually. Intangible assets
with finite lives will continue to be amortized over their
estimated useful lives. Additionally, Statement 142
requires that goodwill included in the carrying value of equity
method investments no longer be amortized.

We will apply Statement 142 beginning in the
first quarter of 2002. Application of the nonamortization
provisions of Statement 142 will significantly reduce
amortization expense that was approximately $25.4 million
in fiscal 2001. We will reclassify identifiable intangible
assets with indefinite lives, as defined by Statement 142,
to goodwill at the date of adoption. We will test goodwill for
impairment using the two-step process prescribed in
Statement 142. The first step is a screen for potential
impairment, while the second step measures the amount of the
impairment, if any. We expect to perform the first of the
required impairment tests of goodwill and indefinite lived
intangible assets as of January 1, 2002 in the first
quarter of 2002. Any impairment charge resulting from these
transitional impairment tests will be reflected as the
cumulative effect of a change in accounting principle in the
first quarter of 2002. Based on the preliminary unaudited
analysis completed to date, we do not believe that the
application of these statements will have an adverse material
impact on the earnings and financial position of the Company.

RISK FACTORS

You should carefully consider 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.

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We Have a History of Losses.

It is difficult to predict our future operating
results. We began shipping products commercially in June 1997,
and we have been shipping products in volume since the first
quarter of 1998. As of December 31, 2001, we had an
accumulated deficit of $893.0 million. We believe that we
will continue to experience net losses for the foreseeable
future. We generally are unable to reduce our expenses
significantly in the short term to compensate for any unexpected
delay or decrease in anticipated revenues. In addition,
significant delays in our commercialization of new products will
adversely affect our business. Moreover, even though we have
experienced significant revenue growth since our inception, the
profit potential of our business remains unproven.

Our Operating Results May Fluctuate.

Our quarterly revenues are likely to fluctuate
significantly in the future due to a number of factors, many of
which are outside our control.

Factors that could affect our revenues include,
among others, the following:



| |   |                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------
| |  | variations in the timing of orders and shipments
	of our products;                                              
|
| |  | variations in the size of the orders by our
	customers;                                                         
|
| |  | new product introductions by competitors;                                                                       
|
| |  | delays in our introduction of new products;                                                                     
|
| |  | delays in our receipt of and cancellation of
	orders forecasted by customers;                                   
|
| |  | delays by our customers in the completion of
	upgrades to their cable infrastructures;                          
|
| |  | variations in capital spending budgets of
	broadband service providers; and                                     
|
| |  | adoption of industry standards and the inclusion
	in or compatibility of our technology with any such standards.

A variety of factors affecting our gross margin
include, among others, the following:



| |   |                                                                                               
| | - | ----------------------------------------------------------------------------------------------
| |  | the sales mix of our products;                                                                
|
| |  | the volume of products manufactured;                                                          
|
| |  | the type of distribution channel through which we
	sell our products;                         
|
| |  | the ASPs of our products; and                                                                 
|
| |  | the costs of manufacturing our products and the
	effectiveness of our cost reduction measures.

We anticipate that unit ASPs of our products will
continue to decline in the future. This could cause a decrease
in the gross margins for these products. In addition, the gross
margins we realize from the sale of our products are affected by
the mix of product sales between higher margin, lower volume
headend equipment, such as CMTSs, and lower margin, higher
volume CPE, such as modems. We typically sell more headend
equipment in connection with new deployments of our systems. As
deployments mature, we tend to sell more CPE into the
deployments compared to headend equipment. Sales of our CPE have
constituted, and we expect will continue to constitute, a
significant portion of our revenues.

Our expenses generally vary from quarter to
quarter depending on the level of actual and anticipated
business activities. Moreover, our research and development
expenses increase as we develop new products and our development
programs move to wafer fabrication and prototype development.

We Are Dependent on a Small Number of
Customers.

A substantial majority of our revenues have been
and will continue to be derived from sales to a relatively small
number of customers. Three customers (one of which is a related
party) accounted for approximately

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54% of our revenues for the year ended
December 31, 2001. The loss of any one of these customers
could have a material adverse effect on our results of
operations. In addition, sales to our customers are and will
continue to be focused on a limited number of projects.


The markets we serve are undergoing significant
consolidation in both North America and internationally, as a
limited number of service providers control an increasing number
of systems. Currently, ten cable operators in the United States
own and operate facilities passing approximately 82% of total
homes passed. In addition, the North American DSL market is
concentrated with the major ILECs constituting a significant
percentage of the market. As a result, our sales have been and
will continue to be dependent upon product acceptance by the
leading broadband service providers.

The timing and size of each customers order
is critical to our operating results. Our major customers have
significant negotiating leverage and sometimes attempt to change
the terms, including pricing, upon which we do business with
them. These customers may decide to purchase competitive
products from other vendors at any time and can reschedule or
cancel purchase orders on short notice. When purchasing product
from us, these customers are requiring longer payment terms than
in the past, which requires us to maintain additional capital to
meet our working capital needs. Reduced spending in the cable
and telecom industries has had and may continue to have a
negative impact on our operations.

Acquisitions Could Result In Dilution,
Operating Difficulties and Other Adverse Consequences.

We acquired ten companies from September 1999
through December 2000. We may acquire additional companies in
the future. During 2001, we wrote-down approximately
$572.8 million in intangible assets relating to these
acquisitions. The process of integrating any such acquired
company into our business and operations may be risky and may
create unforeseen operating difficulties and expenditures going
forward.

Future acquisitions could result in potentially
dilutive issuances of equity securities, the incurrence of
additional debt, contingent liabilities or amortization expenses
related to goodwill and other intangible assets, any of which
could harm our business. Future acquisitions also could require
us to obtain additional equity or debt financing, which may not
be available on favorable terms or at all. Even if available,
this financing may be dilutive.

The Sales Cycle for Our Products Is
Lengthy.

The sales cycle for our products typically is
lengthy, often lasting six months to more than a year. Our
customers typically conduct significant technical evaluations of
competing technologies prior to making a purchasing decision. In
addition, purchasing decisions may be delayed because of our
customers internal budget approval procedures. Sales also
generally are subject to customer trials, which typically last
more than three months. Because of the lengthy sales cycle and
the large size of customer orders, if orders forecasted for a
specific customer for a particular quarter do not occur in that
quarter, our revenues and operating results could suffer.

There Are Many Risks Associated with Our
Participation in DOCSIS.

In January 2002, CableLabs announced that it had
finished specifications for an advanced generation of cable
modems called DOCSIS 2.0. DOCSIS 2.0 incorporates two
advanced physical layer modulation techniques, S-CDMA and
A-TDMA, that four companies, including us, had helped to develop
over a period of four years. CableLabs further announced that
test plans were being finalized to allow for interoperability
testing in the first quarter of this year and possible
certification testing in the third quarter pending product
maturity.

In connection with the finalization of the
DOCSIS 2.0 specification, we have contributed some aspects
of our current proprietary S-CDMA technology to a royalty-free
intellectual property pool established by CableLabs to the
extent that the technology is included in the DOCSIS 2.0
specification. Regardless of our contribution of intellectual
property to the royalty-free intellectual property pool
established for DOCSIS 2.0,

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our products may not pass the testing required by
CableLabs for our products to be DOCSIS qualified or certified,
which could offset our future revenues and operation results.


The royalty-free pool established by CableLabs
for DOCSIS 2.0 facilitates the participation of as many
vendors as possible in providing equipment that is compatible
with the DOCSIS specification. As a result, any of our
competitors who join the DOCSIS intellectual property pool would
have access to these aspects of our technology and would not be
required to pay us any royalties or other compensation for the
use of our technology. If a competitor is able to duplicate the
functionality and capabilities of our technology, we could lose
some or all of the time-to-market advantage we might otherwise
have due to our familiarity with S-CDMA. This may adversely
affect our future revenues and operating results.

We believe the addition of advanced upstream
physical layer (PHY) capabilities to DOCSIS in the
DOCSIS 2.0 specification could increase the overall market
for DOCSIS-compatible products and, as such, could result in
increased competition in the cable modem market. This
competition could come from existing competitors or from new
competitors who enter the market. This increased competition is
likely to result in lower ASPs of cable products and could harm
revenues and gross margins. Because our competitors will be able
to incorporate some aspects of our technology into their
products, our current customers may choose alternate suppliers
or choose to purchase DOCSIS-compliant cable products with
advanced PHY capabilities from multiple suppliers. We may be
unable to produce DOCSIS compliant cable products with advanced
PHY capabilities more quickly or at lower cost than our
competitors. As a result of the inclusion of S-CDMA technology
in the DOCSIS 2.0 specification, competition for the
services of our existing employees who have experience with
S-CDMA could increase. The loss of these employees to one or
more competitors could harm our business.

DOCSIS standards have not yet been accepted in
Europe and Asia. An alternate specification for cable products,
called the Euro-DOCSIS specification, has been formalized, and
some European cable system operators have embraced it. We intend
to develop and sell products that comply with the Euro-DOCSIS
specification and to pursue having portions of our S-CDMA
technology included in a future version of the Euro-DOCSIS
specification. We may be unsuccessful in these efforts.

We Need to Develop New Products in Order to
Remain Competitive.

Our future success depends on our ability to
develop, market and sell new products in a timely manner. We
also must respond to competitive pressures, evolving industry
standards and technological advances. We are developing products
that include both S-CDMA and A-TDMA, the two modulation
techniques required by the DOCSIS 2.0 specification. There
is no guarantee that our products will pass testing to be DOCSIS
certified or qualified. If we are unable to certify or qualify
our products as DOCSIS compliant in a timely manner, we may lose
some or all of the time to market advantage we might otherwise
have had, and our future operating results may be adversely
affected.

Although we sell DOCSIS systems, the majority of
our sales are derived from our proprietary S-CDMA products,
which are not DOCSIS compliant. Last year, there were instances
where our customers and potential customers delayed or canceled
purchases of our proprietary products in order to purchase
products that comply with the DOCSIS specification. In addition,
there were instances where our existing customers and potential
new customers purchased DOCSIS-compliant products from one or
more of our competitors rather than purchasing our products. We
believe that this may be an increasing trend in the future as
service providers look to purchase DOCSIS certified or qualified
products. As a result, we have reduced our prices and continue
to experience customer demand to further reduce our prices in
order to promote sales of our current products. This has had and
may continue to have an adverse impact on our operating results
and gross margin.

Average Selling Prices of Broadband Access
Equipment Typically Decrease.

The broadband access market has been
characterized by erosion of ASPs. We expect this to continue.
This erosion is due to a number of factors, including
competition, rapid technological change and price performance
enhancements. The ASPs for our products may be lower than
expected as a result of competitive

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pricing pressures, promotional programs and
customers who negotiate price reductions in exchange for longer
term purchase commitments. We anticipate that ASPs and gross
margins for our products will decrease over their life cycles.
In addition, we believe that the widespread adoption of industry
standards is further eroding ASPs, particularly for cable modems
and other similar CPE. It is likely that widespread adoption of
industry standards will result in increased retail distribution
of cable modems and other similar CPE, which could put further
price pressure on our products. Decreasing ASPs could result in
decreased revenues even if the number of units sold increases.
As a result, we may experience substantial period-to-period
fluctuations in future revenue and operating results due to ASP
erosion. Therefore, we must continue to develop and introduce on
a timely basis next-generation products with enhanced
functionalities that can be sold at higher gross margins. Our
failure to do this could cause our revenues and gross margin to
decline.


We Must Achieve Cost Reductions.

Certain of our competitors currently offer
products at prices lower than ours. Market acceptance of our
products will depend in part on reductions in the unit cost of
our products. We expect that as CMTS equipment becomes more
widely deployed, the price of cable modems and other similar CPE
will decline. In particular, we believe that the widespread
adoption of industry standards such as DOCSIS will cause
increased price competition for CPE. However, we may be unable
to reduce the cost of our products sufficiently to enable us to
compete with other equipment manufacturers. Even if we achieve
certain cost reductions, it is not certain that these efforts
will allow us to keep pace with competitive pricing pressures or
lead to gross margin improvement.

Some of our competitors are larger and
manufacture products in significantly greater quantities than we
currently intend to manufacture for the foreseeable future.
Consequently, these competitors have more leverage in obtaining
favorable pricing from suppliers and manufacturers. In order to
remain competitive, we must significantly reduce the cost of
manufacturing our products through design and engineering
changes. We may not be successful in redesigning our products.
Even if we are successful, our redesign may be delayed or may
contain significant errors and product defects. In addition, any
redesign may not result in sufficient cost reductions to allow
us to reduce significantly the list price of our products or
improve our gross margin. Reductions in our manufacturing costs
will require us to use more highly integrated components in
future products and may require us to enter into high volume or
long-term purchase or manufacturing agreements. Volume purchase
or manufacturing agreements may not be available on acceptable
terms. We could incur expenses without related revenues if we
enter into a high volume or long-term purchase or manufacturing
agreement and then decide that we cannot use the products or
services offered by the agreement. We have incurred cancellation
charges in the past and may incur such charges in the future.

We Must Keep Pace with Rapid Technological
Change to Remain Competitive.

The markets for our products are characterized by
rapid technological change, evolving industry standards, changes
in end-user requirements and frequent new product introductions
and enhancements. Our future success will depend upon our
ability to enhance our existing products and to develop and
introduce new products that achieve market acceptance. Service
providers may adopt alternative technologies or may deploy
alternative services that are incompatible with our products.

In January 2002, CableLabs announced that it had
finished specifications for an advanced generation of cable
modems called DOCSIS 2.0. DOCSIS 2.0 incorporates two
advanced physical layer modulation techniques, S-CDMA and
A-TDMA. We believe that, as DOCSIS 2.0 gains acceptance
among cable operators, our future success depends on our ability
to manufacture, market and sell cable products certified and
qualified as meeting the DOCSIS 2.0 specification. Our
inability to produce DOCSIS 2.0 compliant cable products
more quickly or at lower cost than our competitors may adversely
affect our future results of operations.

Broadband Access Services Have Not Achieved
Widespread Market Acceptance, and Many Competing Technologies
Exist.

Our success will depend upon the widespread
acceptance of broadband services by providers and end users. The
markets for these services are not fully developed. We cannot
accurately predict the future growth

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rate or the ultimate size of the market for
broadband services. Potential users of our products may have
concerns regarding the security, reliability, cost, ease of
installation and use and capability of broadband services in
general.


The markets for our products may be impacted by
the development of other technologies that enable the
provisioning of broadband services and the deployment of
services over other media. Widespread acceptance of other
technologies or deployment of services over media not supported
by our products could materially limit acceptance of our
products. Broadband services based on our products and
technology may fail to gain widespread commercial acceptance by
service providers and end users. We may not be successful in
marketing and selling these products.

We Need to Develop Additional Distribution
Channels.

We presently market our products to service
providers. With changes in the industry, we may need to
establish new, additional distribution channels. For example, we
believe that much of the North American market for CPE may shift
to a retail distribution model. Accordingly, we may need to
redirect our future marketing efforts to sell our CPE directly
to retail distributors and end users. This shift would require
us to establish new distribution channels for these products.

We face many challenges in establishing these new
distribution channels. These challenges include, among others,
the following:



| |   |                                                                                                                                                                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our inability to hire additional personnel
	necessary to establish and enhance these new distribution
	channels;                                                                                                                                                                                                                                        
|
| |  | to the extent that large consumer electronics
	companies enter the cable modem market, their well-established
	retail distribution capabilities would provide them with a
	significant competitive advantage;                                                                                                                                           
|
| |  | our potential customers are likely to prefer
	purchasing products from established manufacturing companies
	that can demonstrate the capability to supply large volumes of
	products on short notice; and                                                                                                                                               
|
| |  | many of our potential customers may be reluctant
	to adopt technologies that have not gained acceptance among
	other providers of similar services. This reluctance could
	result in lengthy product testing and acceptance cycles for our
	products. Consequently, the impediments to our initial sales may
	be even greater than those to later sales.

The vast majority of our sales are to larger,
more established service providers that are critical to our
business. We do not have access to smaller or geographically
diverse service providers. Although we intend to establish
strategic relationships with leading distributors worldwide to
access these customers, we may not succeed in establishing these
relationships. Even if we do establish these relationships, the
distributors may not succeed in marketing our products to their
customers. Some of our competitors have already established,
long-standing relationships with these service providers that
may limit our and our distributors ability to sell our
products to those customers. Even if we were to sell our
products to those customers, it would likely not be based on
long-term commitments, and those customers would be able to
terminate their relationships with us at any time.

We Are Dependent on Service Providers Choosing
to Offer Additional Services to Their Customers.

We depend on service providers to purchase our
products. Service providers have a limited amount of available
bandwidth over which they can offer new services, such as high
speed Internet access and telephony. They may choose not to
provide these new services to their customers. When service
providers choose to provide these new services, we depend upon
them to market these services to their customers, to install our
equipment and to provide support to end-users. In addition, we
depend on these service providers to continue to maintain their
infrastructures in a manner that allows us to provide
consistently high performance and reliable services.

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Sales of Our Cable Products Are Dependent on
the Cable Industry Upgrading to Two-Way Cable
Infrastructure.

Demand for our cable products will depend, to a
significant degree, upon the magnitude and timing of capital
spending by cable operators for implementation of access systems
for data transmission over cable networks. This involves the
enabling of two-way transmission over existing coaxial cable
networks and the eventual upgrade to hybrid fiber coaxial
(HFC) in areas of higher penetration of data services. If
cable operators fail to complete these upgrades of their cable
infrastructures in a timely and satisfactory manner, the market
for our products could be limited. In addition, few businesses
in the United States currently have cable access. Cable
operators may not choose to upgrade existing residential cable
systems or to install new cable systems to serve business
locations.

The success and future growth of our cable
business will be subject to economic and other factors affecting
the cable television industry generally, particularly its
ability to finance substantial capital expenditures. Capital
spending levels in the cable industry in the United States and
internationally have fluctuated significantly in the past, and
we believe that such fluctuations will occur in the future. We
are currently experiencing reduced levels of spending in the
cable industry. The capital spending patterns of cable operators
are dependent on a variety of factors, including the following:



| |   |                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------
| |  | the availability of financing;                                                                                       
|
| |  | annual budget cycles, as well as the typical
	reduction in upgrade projects during the winter months;                
|
| |  | the status of federal, local and foreign
	government regulation and deregulation of the telecommunications
	industry;
|
| |  | overall demand for broadband services;                                                                               
|
| |  | competitive pressures (including the availability
	of alternative data transmission and access technologies);        
|
| |  | discretionary consumer spending patterns; and                                                                        
|
| |  | general economic conditions.                                                                                         

In recent years, the cable market has been
characterized by the acquisition of smaller and independent
cable operators by larger operators. We cannot predict the
effect, if any, that such consolidation will have on overall
capital spending patterns by cable operators. The effect on our
business of further industry consolidation also is uncertain.

Supply of Our Products Depends On Our Ability
to Forecast Demand Accurately.

The emerging nature of the broadband services
market makes it difficult for us to accurately forecast demand
for our products. Our inability to forecast accurately the
actual demand for our products may result in too much or too
little supply of product or an over/under capacity of
manufacturing or testing resources at any given point in time.
The existence of any one or more of these situations could have
a negative impact on our business, operating results or
financial condition. We had purchase obligations of
approximately $58.7 million as of December 31, 2001,
primarily to purchase minimum quantities of materials and
components used to manufacture our products. We must fulfill
these obligations even if demand for our products is lower than
we anticipate.

Our Business May Be Affected By Conditions In
Israel.

Our operations may be affected by conditions in
Israel because of our significant operations there. Since the
establishment of the State of Israel in 1948, a number of armed
conflicts have taken place between Israel and its Arab neighbors
and a state of hostility, varying in degree and intensity, has
led to security and economic problems for Israel. Hostilities
within Israel have continued to escalate over the past year,
which could disrupt some of our operations. We could be
adversely affected by any major hostilities involving Israel. As
a result of the hostilities and unrest presently occurring
within Israel, the future of the peace efforts

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between Israel and its Arab neighbors is
uncertain. A number of our employees based in Israel are
currently obligated to perform annual military reserve duty and
are subject to being called to active duty at any time under
emergency circumstances. We cannot assess the full impact of
these requirements and the hostilities on our workforce,
business or operations if conditions should change, and we
cannot predict the effect of any expansion or reduction of these
obligations or the hostilities.


We May Have Financial Exposure to Litigation
Against Our Directors and Officers.

We are obligated to indemnify our executive
officers and the members of our Board of Directors for certain
actions taken by such officers and directors on our behalf. In
order to protect ourselves against any financial exposure
resulting from the actions of our officers and directors, we
purchase directors and officers insurance policies every year to
cover litigation expenses and settlement awards or damage
awards. We purchase our directors and officers insurance in
layers of varying amounts with a different insurance company
underwriting each layer.

In October 2001, Reliance Insurance Co.
(Reliance) was liquidated by the State of Pennsylvania. Reliance
was the underwriter for the second $2.5 million layer of
the first $5 million of coverage for our directors and
officers insurance for the period covering the claims made
against our officers in pending securities litigation, as well
as other periods. Depending upon the outcome of our current
securities litigation and any future litigation that may be
brought against our officers and directors, we could be liable
and have to self-insure the second $2.5 million layer if
the attorneys fees and/or the settlement or damages award
exceeds the first $2.5 million layer.

We Are Dependent on Key Third-Party
Suppliers.

We manufacture all of our products using
components or subassemblies procured from third-party suppliers.
Some of these components are available from a sole source and
others are available from limited sources. All of our sales are
from products containing one or more components that are
available only from sole source suppliers.

In addition, some of our components are custom
parts produced to our specifications. For example, we have
relied and will continue to rely on sole source semiconductor
manufacturers to supply us with custom ASICs for use in our
products. Additional components, such as the radio frequency
tuner and some surface acoustic wave filters, are also procured
from sole source suppliers. Any interruption in the operations
of vendors of sole source parts could adversely affect our
ability to meet our scheduled product deliveries to customers.
We are dependent on semiconductor manufacturers and are affected
by worldwide conditions in the semiconductor market. If we are
unable to obtain a sufficient supply of components from our
current sources, we could experience difficulties in obtaining
alternative sources or in altering product designs to use
alternative components. Resulting delays or reductions in
product shipments could damage customer relationships. Further,
a significant increase in the price of one or more of these
components could harm our gross margin or operating results.

We May Be Unable to Migrate to New
Semiconductor Process Technologies Successfully or on a Timely
Basis.

Our future success will depend in part upon our
ability to develop products that utilize new semiconductor
process technologies. These technologies change rapidly and
require us to spend significant amounts on research and
development. We continuously evaluate the benefits of
redesigning our integrated circuits using smaller geometry
process technologies to improve performance and reduce costs.
The transition of our products to integrated circuits with
increasingly smaller geometries will be important to our
competitive position. Other companies have experienced
difficulty in migrating to new semiconductor processes and,
consequently, have suffered reduced yields, delays in product
deliveries and increased expense levels. Moreover, we depend on
our relationship with our third-party manufacturers to migrate
to smaller geometry processes successfully.

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Our Ability to Directly Control Product
Delivery Schedules and Product Quality Is Dependent on
Third-Party Contract Manufacturers.

Most of our products are assembled and tested by
contract manufacturers using testing equipment that we provide.
As a result of our dependence on these contract manufacturers
for assembly and testing of our products, we do not directly
control product delivery schedules or product quality. Any
product shortages or quality assurance problems could increase
the costs of manufacture, assembly or testing of our products.
In addition, as manufacturing volume increases, we will need to
procure and assemble additional testing equipment and provide it
to our contract manufacturers. The production and assembly of
testing equipment typically requires significant lead times. We
could experience significant delays in the shipment of our
products if we are unable to provide this testing equipment to
our contract manufacturers in a timely manner.

There Are Many Risks Associated with
International Operations.

We expect sales to customers outside of the
United States to continue to represent a significant percentage
of our revenues for the foreseeable future. International sales
are subject to a number of risks, including the following:



| |   |                                                                         
| | - | ------------------------------------------------------------------------
| |  | changes in foreign government regulations and
	communications standards;
|
| |  | export license requirements, tariffs and taxes;                         
|
| |  | trade barriers;                                                         
|
| |  | difficulty in protecting intellectual property;                         
|
| |  | difficulty in collecting accounts receivable;                           
|
| |  | difficulty in managing foreign operations; and                          
|
| |  | political and economic instability.                                     

If our customers are affected by currency
devaluations or general economic crises, such as the recent
economic crises affecting many Asian and Latin American
economies, their ability to purchase our products could be
reduced significantly. Payment cycles for international
customers typically are longer than those for customers in North
America. Foreign countries may decide to prohibit, terminate or
delay the construction of new broadband services infrastructures
for a variety of reasons. These reasons include environmental
issues, economic downturns, availability of favorable pricing
for other communications services or the availability and cost
of related equipment. Any action like this by foreign countries
would reduce the market for our products.

While we generally invoice our foreign sales in
U.S. dollars, we do invoice our sales into Brazil in reals and
our sales in Europe in euros. We currently do not engage in
foreign currency hedging transactions. As we expand our
international operations, payments to us in foreign currencies
and our exposure to losses as the result of foreign currency
fluctuations may increase. We may choose to limit our exposure
by the purchase of forward foreign exchange contracts or through
similar hedging strategies. No currency hedging strategy can
fully protect against exchange-related losses. In addition, if
the relative value of the U.S. dollar in comparison to the
currency of our foreign customers should increase, the resulting
effective price increase of our products to those foreign
customers could result in decreased sales.

We May Be Unable to Provide Adequate Customer
Support.

Our ability to achieve our planned sales growth
and retain current and future customers will depend in part upon
the quality of our customer support operations. Our customers
generally require significant support and training with respect
to our broadband products, particularly in the initial
deployment and implementation stages. To date, our sales have
been concentrated in a small number of customers. We have
limited experience with widespread deployment of our products to
a diverse customer base. We may not have adequate personnel to
provide the levels of support that our customers may require
during initial product deployment or on an ongoing basis. Our
inability to provide sufficient support to our customers could
delay or prevent the successful

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deployment of our products. In addition, our
failure to provide adequate support could harm our reputation
and relationship with our customers and could prevent us from
gaining new customers.


Our Industry Is Highly Competitive with Many
Established Competitors.

The market for our products is extremely
competitive and is characterized by rapid technological change.
Our direct competitors in the cable arena include Cisco Systems,
ADC, Arris, Juniper Networks, Com21, Motorola, Nortel Networks,
Thomson Consumer Electronics (which markets products under the
brand name RCA), Samsung, Scientific-Atlanta and Toshiba. We
also compete with companies that develop integrated circuits for
broadband products, such as Broadcom, Conexant and Texas
Instruments. In addition, we compete with companies in the DSL
arena such as Alcatel, Siemens, Lucent, Nortel Networks,
Efficient Networks, Zhone, Marconi, Charles Industries,
Accelerated Networks and Integral Access. The principal
competitive factors in our market include the following:



| |   |                                                        
| | - | -------------------------------------------------------
| |  | 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 providers of service
	providers; and
|
| |  | compliance with industry standards.                    

Some of these factors are outside of our control.
The existing conditions in the market for broadband services
could change rapidly and significantly as a result of
technological advancements. The development and market
acceptance of alternative technologies could decrease the demand
for our products or render them obsolete. Our competitors may
introduce products that are less costly, provide superior
performance or achieve greater market acceptance than our
products.

Many of our current and potential competitors
have greater financial, technical, marketing, distribution,
customer support and other resources, as well as better name
recognition and access to customers than we do. The widespread
adoption of DOCSIS and other industry standards is likely to
cause increased worldwide price competition, particularly in the
North American market. We believe that the adoption of these
standards have resulted in and are likely to continue to result
in lower sales of our proprietary S-CDMA products. Any increased
price competition or reduction in sales of our products,
particularly our higher margin headend products, would result in
downward pressure on our gross margin. These competitive
pressures have and are likely to continue to adversely impact
our business.

Our Business Is Dependent on the Internet and
the Development of Internet Infrastructure.

Our success depends on increased demand for
high-speed Internet services for commercial use. Critical issues
concerning the commercial use of the Internet remain largely
unresolved and are likely to affect the development of the
market for our products. These issues include security,
reliability, cost, ease of access and quality of service. Our
success also will depend on the growth of the use of the
Internet by businesses for multimedia applications that require
high bandwidth. The recent growth in the use of the Internet has
caused frequent periods of performance degradation. This has
required the upgrade of routers, telecommunications links and
other components forming the infrastructure of the Internet by
service providers and other organizations with links to the
Internet. Any perceived degradation in the performance of the
Internet as a whole could undermine the benefits of our products.

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We Are Dependent on Key Personnel.

Due to the specialized nature of our business, we
are highly dependent on the continued service of, and on the
ability to attract and retain, qualified engineering, sales,
marketing and senior management personnel. The competition for
some of these personnel is intense. The loss of any of these
individuals may harm our business. In addition, if we are unable
to hire qualified personnel as needed, we may be unable to
adequately manage and grow our business.

Highly skilled employees with the education and
training that we require, especially employees with significant
experience and expertise in both data networking and radio
frequency design, are in high demand. We may be unable to
continue to attract and retain qualified personnel necessary for
the development of our business. We do not have key
person insurance coverage for the loss of any of our
employees. Any officer or employee can terminate his or her
relationship with us at any time. Our employees are not bound by
non-competition agreements with us.

Our Business Is Subject to the Risks of
Product Returns, Product Liability and Product
Defects.

Products like ours are very complex and
frequently contain undetected errors or failures, especially
when first introduced or when new versions are released. Despite
testing, errors may occur. The occurrence of errors could result
in product returns and other losses to us and/or our customers.
This occurrence could result in the loss of or delay in market
acceptance of our products. We have limitation of liability
provisions in our standard terms and conditions of sale.
However, these terms and conditions may not be effective as a
result of federal, state or local laws or ordinances or
unfavorable judicial decisions in the United States or other
countries. The sale and support of our products entails the risk
of product liability claims. In addition, any failure by our
products to properly perform could result in claims against us
by our customers. We maintain insurance to protect against
certain claims associated with the use of our products, but our
insurance coverage may not adequately cover any claim asserted
against us. In addition, even claims that ultimately are
unsuccessful could result in our expenditure of funds in
litigation and management time and resources.

We May Be Unable to Adequately Protect or
Enforce Our Intellectual Property Rights.

We rely on a combination of patent, trade secret,
copyright and trademark laws and contractual restrictions to
establish and protect proprietary rights in our products. Even
though we seek to establish and protect proprietary rights in
our products, there are risks. Our pending patent applications
may not be granted. Even if they are granted, the claims covered
by the patent may be reduced from those included in our
applications. Any patent might be subject to challenge in court
and, whether or not challenged, might not be broad enough to
prevent third parties from developing equivalent technologies or
products without a license from us.

We have entered into confidentiality and
invention assignment agreements with our employees, and we enter
into non-disclosure agreements with many of our suppliers,
distributors and appropriate customers so as to limit access to
and disclosure of our proprietary information. These contractual
arrangements, as well as statutory protections, may not prove
sufficient to prevent misappropriation of our technology or
deter independent third-party development of similar
technologies. In addition, the laws of some foreign countries
may not protect our intellectual property rights to the same
extent as do the laws of the United States.

CableLabs DOCSIS 2.0 specification includes
two modulation techniques, S-CDMA and A-TDMA. In connection with
the development of the DOCSIS 2.0 specification by
CableLabs, we entered into an agreement with CableLabs whereby
we licensed to CableLabs any of our intellectual property rights
to the extent that such rights may be asserted against a party
desiring to design, manufacture or sell DOCSIS based products,
including DOCSIS 2.0 based products. This license agreement
grants to CableLabs the right to sublicense our intellectual
property, including our intellectual property rights in our
S-CDMA patents, to manufacturers that compete with us in the
marketplace for DOCSIS based products.

We pursue the registration of our trademarks in
the United States and have applications pending to register
several of our trademarks throughout the world. However, the
laws of certain foreign countries might

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not protect our products or intellectual property
rights to the same extent as the laws of the United States.
Effective trademark, copyright, trade secret and patent
protection may not be available in every country in which our
products may be manufactured, marketed or sold.


Our Business And Our Customers Are Subject to
Regulation.

Our business and customers are subject to varying
degrees of regulation by regulatory bodies in the United States
and foreign countries. Although these regulations have not
materially restricted our operations to date or the operations
of our customers, future regulations applicable to our business
or customers could be adopted. The adoption of future
regulations may adversely affect our customers, our ability to
sell our products and therefore our operating results.

Our Products Are Subject to Approvals and
Certifications.

In the United States, our products are required
to meet certain safety requirements. For example, we are
required to have our products certified by Underwriters
Laboratory in order to meet federal requirements relating to
electrical appliances to be used inside the home. Outside the
United States, our products are subject to the regulatory
requirements of each country in which the products are
manufactured or sold. These requirements are likely to vary
widely. We may be unable to obtain on a timely basis or at all
the regulatory approvals that may be required for the
manufacture, marketing and sale of our products. In addition to
regulatory compliance, some cable operators require that our
products be certified or qualified as having met DOCSIS or
Euro-DOCSIS specifications.

We Are Vulnerable to Earthquakes, Power
Outages and Other Unexpected Events.

Our corporate headquarters, as well as the
majority of our research and development activities and some
manufacturing operations are located in California, an area
known for seismic activity. In addition, the operations of some
of our key suppliers are also located in this area and in other
areas known for seismic activity, such as Taiwan. An earthquake,
or other significant natural disaster, could result in an
interruption in our business or the operations of one or more of
our key suppliers. Such an interruption could harm our operating
results. We may not carry sufficient business interruption
insurance to compensate for any losses that we may sustain as a
result of any natural disasters or other unexpected events.

Our Indebtedness Could Adversely Affect our
Financial Condition; We May Incur Substantially More
Debt.

As of December 31, 2001, we had
approximately $174.1 million of indebtedness outstanding.
This high level of indebtedness may adversely affect our
stockholders by:



| |   |                                                                                                                                                                                                                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | making it more difficult for us to satisfy our
	obligations with respect to our indebtedness;                                                                                                                                                                                                                         
|
| |  | increasing our vulnerability to general adverse
	economic and industry conditions;                                                                                                                                                                                                                                    
|
| |  | limiting our ability to obtain additional
	financing;                                                                                                                                                                                                                                                                 
|
| |  | requiring the dedication of a substantial portion
	of our cash flow from operations to the payment of principal of,
	and interest on, our indebtedness, thereby reducing the
	availability of our cash flow to fund our growth strategy,
	working capital, capital expenditures and other general
	corporate purposes;
|
| |  | limiting our flexibility in planning for, or
	reacting to, changes in our business and the industry; and                                                                                                                                                                                                              
|
| |  | placing us at a competitive disadvantage relative
	to our competitors with less debt.                                                                                                                                                                                                                                 

We may incur substantial additional debt in the
future. The terms of our outstanding debt do not fully prohibit
us from doing so. If new debt is added to our current levels,
the related risks described above could intensify.

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Our Stock Price Has Been and Is Likely to
Continue To Be Highly Volatile.

The trading price of our common stock has been
and is likely to continue to be highly volatile. Our stock price
could be subject to extreme fluctuations in response to a
variety of factors, including the following:



| |   |                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------
| |  | 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
	industry;                                                                  
|
| |  | changes in the economic performance and/or market
	valuations of Internet, online service or broadband service
	industries;
|
| |  | our announcement of significant acquisitions,
	strategic partnerships, joint ventures or capital commitments;              
|
| |  | 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;                                                                                  
|
| |  | sales of common stock; and                                                                                                 
|
| |  | other events or factors that may be beyond our
	control.                                                                   

In addition, the stock markets in general, and
the Nasdaq National Market and the market for broadband services
and technology companies in particular, have experienced extreme
price and volume volatility and a significant cumulative decline
over the last year. This volatility and decline has affected
many companies irrespective of or disproportionately to the
operating performance of these companies. Additionally, industry
factors may materially adversely affect the market price of our
common stock, regardless of our actual operating performance.




Item 7a.     Market
Risk Disclosure Information

Interest Rate Risk.Our exposure to market risk for changes in interest rates
relates primarily to our investment portfolio. The primary
objective of our investment activities is to preserve principal
while maximizing yields without significantly increasing risk.
This is accomplished by investing in widely diversified
short-term investments, consisting primarily of investment grade
securities, substantially all of which mature within the next
twenty-four months. A hypothetical 50 basis point increase in
interest rates would result in an approximate $800,000 decline
(less than 0.40%) in the fair value of our available-for-sale
securities.

Foreign Currency
Risk.A substantial majority of our
revenue, expense and capital purchasing activity are transacted
in U.S. dollars. However, we do enter into transactions from
Belgium, United Kingdom, Hong Kong, Canada, and Israel. An
adverse change of 10% in exchange rates would result in a
decline in income before taxes of approximately $545,000. All of
the potential changes noted above are based on sensitivity
analyses performed on our financial positions at
December 31, 2001. Actual results may differ materially.

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Item
8.     Financial Statements and
Supplementary Data

TERAYON COMMUNICATION SYSTEMS, INC.

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                   |  |      |       | 
|-------------------------------------------------- |  | ---- | ----- | 
|                                                   |  | Page
|                                                   |  |     
|Report of Ernst & Young LLP, Independent
	Auditors |  |      | 36    | 
|Consolidated Balance Sheets                        |  |      | 37    | 
|Consolidated Statements of Operations              |  |      | 38    | 
|Consolidated Statements of Stockholders
	Equity   |  |      | 39-40 | 
|Consolidated Statements of Cash Flows              |  |      | 41    | 
|Notes to Consolidated Financial Statements         |  |      | 42-73 | 

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REPORT OF ERNST & YOUNG LLP, INDEPENDENT
AUDITORS

The Board of Directors and Stockholders

Terayon Communication Systems, Inc.


We have audited the accompanying consolidated
balance sheets of Terayon Communication Systems, Inc. as of
December 31, 2001 and 2000, and the related consolidated
statements of operations, stockholders equity, and cash
flows for each of the three years in the period ended
December 31, 2001. Our audits also included the financial
statement schedule listed in the index at Item 14(a). These
financial statements and schedule are the responsibility of the
Companys management. Our responsibility is to express an
opinion on these financial statements and schedule based on our
audits.

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

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the consolidated financial position of Terayon
Communication Systems, Inc. at December 31, 2001 and 2000,
and the consolidated results of its operations and its cash
flows for each of the three years in the period ended
December 31, 2001, in conformity with accounting principles
generally accepted in the United States. Also, in our opinion,
the related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information set
forth therein.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

San Jose, California

January 28, 2002


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TERAYON COMMUNICATION SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

|                                               |                                                                                                 |                                                          |         |           |         |  |         |           |           | 
|---------------------------------------------- | ----------------------------------------------------------------------------------------------- | -------------------------------------------------------- | ------- | --------- | ------- |  | ------- | --------- | --------- | 
|                                               |                                                                                                 |                                                         
|                                               |                                                                                                 | December 31,                                            
|                                               |                                                                                                 |                                                         
|                                               |                                                                                                 | 2001                                                     |         | 2000     
|                                               |                                                                                                 |                                                          |         |          
|                                               |                                                                                                 |                                                         
|                                               |                                                                                                 | (In thousands,                                          
|                                               |                                                                                                 | except share data)                                      
|ASSETS                                        
|Current assets:                                |                                                                                                 |                                                          |         |           |         |  |         |          
|                                               | Cash and cash equivalents                                                                       |                                                          | $       | 100,274   |         |  | $       | 347,015   |          
|                                               | Short-term investments                                                                          |                                                          |         | 233,614   |         |  |         | 215,442   |          
|                                               | Accounts receivable, less allowance for doubtful
	accounts of $7,207 in 2001 and $6,542 in 2000 |                                                          |         | 48,386    |         |  |         | 42,772    |          
|                                               | Accounts receivable from related parties                                                        |                                                          |         | 4,006     |         |  |         | 17,454    |          
|                                               | Other current receivables                                                                       |                                                          |         | 7,476     |         |  |         | 32,027    |          
|                                               | Inventory                                                                                       |                                                          |         | 16,658    |         |  |         | 87,767    |          
|                                               | Other current assets                                                                            |                                                          |         | 13,462    |         |  |         | 7,021     |          
|                                               |                                                                                                 |                                                          |         |           |         |  |         |          
|                                               |                                                                                                 | Total current assets                                     |         |           | 423,876 |  |         |           | 749,498   | 
|Property and equipment, net                    |                                                                                                 |                                                          | 25,279  |           |         |  | 33,533  |          
|Intangibles and other assets, net              |                                                                                                 |                                                          | 17,491  |           |         |  | 643,696 |          
|                                               |                                                                                                 |                                                          |         |           |         |  |         |          
|                                               |                                                                                                 | Total assets                                             |         | $         | 466,646 |  |         | $         | 1,426,727 | 
|                                               |                                                                                                 |                                                          |         |           |         |  |         |          
|LIABILITIES AND STOCKHOLDERS
	EQUITY         
|Current liabilities:                           |                                                                                                 |                                                          |         |           |         |  |         |          
|                                               | Accounts payable                                                                                |                                                          | $       | 42,821    |         |  | $       | 123,994   |          
|                                               | Accrued payroll and related expenses                                                            |                                                          |         | 9,441     |         |  |         | 13,105    |          
|                                               | Deferred revenues                                                                               |                                                          |         | 4,169     |         |  |         | 4,998     |          
|                                               | Warranty reserves                                                                               |                                                          |         | 8,368     |         |  |         | 5,925     |          
|                                               | Accrued purchase price payable                                                                  |                                                          |         |          |         |  |         | 14,138    |          
|                                               | Accrued restructuring charges                                                                   |                                                          |         | 8,197     |         |  |         |          |          
|                                               | Accrued vendor cancellation charges                                                             |                                                          |         | 17,291    |         |  |         | 19,000    |          
|                                               | Other accrued liabilities                                                                       |                                                          |         | 14,015    |         |  |         | 6,719     |          
|                                               | Current portion of long-term debt                                                               |                                                          |         | 3,273     |         |  |         | 10,853    |          
|                                               | Short-term debt                                                                                 |                                                          |         |          |         |  |         | 2,697     |          
|                                               | Current portion of capital lease obligations                                                    |                                                          |         | 126       |         |  |         | 131       |          
|                                               |                                                                                                 |                                                          |         |           |         |  |         |          
|                                               |                                                                                                 | Total current liabilities                                |         |           | 107,701 |  |         |           | 201,560   | 
|Long-term debt                                 |                                                                                                 |                                                          | 2,467   |           |         |  | 119     |          
|Long-term portion of capital lease obligations |                                                                                                 |                                                          | 233     |           |         |  | 358     |          
|Other long-term obligations                    |                                                                                                 |                                                          | 1,800   |           |         |  | 3,444   |          
|Convertible subordinated notes                 |                                                                                                 |                                                          | 174,141 |           |         |  | 500,000 |          
|Deferred tax liability                         |                                                                                                 |                                                          |        |           |         |  | 18,565  |          
|Commitments and contingencies                  |                                                                                                 |                                                          |         |           |         |  |         |          
|Stockholders equity:                          |                                                                                                 |                                                          |         |           |         |  |         |          
|                                               | Preferred stock, $0.001 par value:                                                              |                                                          |         |           |         |  |         |           |          
|                                               |                                                                                                 | Authorized shares  5,000,000                            |         |           |         |  |         |           |           | 
|                                               |                                                                                                 | Issued and outstanding shares  none in
	2001 and 2000   |         |           |        |  |         |           |          | 
|                                               | Common stock, $0.001 par value:                                                                 |                                                          |         |           |         |  |         |           |          
|                                               |                                                                                                 | Authorized shares  200,000,000                          |         |           |         |  |         |           |           | 
|                                               |                                                                                                 | Issued   72,201,322 in 2001 and
	67,431,261 in 2000     |         |           |         |  |         |           |           | 
|                                               |                                                                                                 | Outstanding  72,073,483 in 2001 and
	67,396,539 in 2000 |         |           | 73      |  |         |           | 68        | 
|                                               | Additional paid in capital                                                                      |                                                          |         | 1,074,203 |         |  |         | 1,037,964 |          
|                                               | Accumulated deficit                                                                             |                                                          |         | (892,994  | )       |  |         | (329,148  | )        
|                                               | Deferred compensation                                                                           |                                                          |         | (458      | )       |  |         | (6,788    | )        
|                                               | Stockholders notes receivable                                                                  |                                                          |         |          |         |  |         | (3        | )        
|                                               | Treasury Stock, at cost; 127,839 shares in 2001
	and 34,722 shares in 2000                      |                                                          |         | (768      | )       |  |         | (73       | )        
|Accumulated other comprehensive income         |                                                                                                 |                                                          | 248     |           |         |  | 661     |          
|                                               |                                                                                                 |                                                          |         |           |         |  |         |          
|                                               |                                                                                                 | Total stockholders equity                               |         |           | 180,304 |  |         |           | 702,681   | 
|                                               |                                                                                                 |                                                          |         |           |         |  |         |          
|                                               |                                                                                                 | Total liabilities and stockholders equity               |         | $         | 466,646 |  |         | $         | 1,426,727 | 
|                                               |                                                                                                 |                                                          |         |           |         |  |         |          

See accompanying notes.

37



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |        |        |         |  
|----------------------------------------------------------------------------------------------------------- | ------------------------------------------------ | ------------------------------------- | ------------------------------ | ------- | ------- | -------- | -------- | ------- | ------- | -------- | ------- | ------ | ------ | ------- | -
|                                                                                                            |                                                  |                                      
|                                                                                                            |                                                  | Years Ended December 31,             
|                                                                                                            |                                                  |                                      
|                                                                                                            |                                                  | 2001                                  |                                | 2000    |         | 1999    
|                                                                                                            |                                                  |                                       |                                |         |         |         
|                                                                                                            |                                                  |                                      
|                                                                                                            |                                                  | (In thousands, except per share data)
|Revenues:                                                                                                   |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|                                                                                                            | Product revenues                                 |                                       | $                              | 227,036 |         |          | $        | 220,228 |         |          | $       | 57,345 |       
|                                                                                                            | Related party product revenues                   |                                       |                                | 52,445  |         |          |          | 119,321 |         |          |         | 39,664 |       
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|                                                                                                            |                                                  |                                       | Total revenues                 |         |         | 279,481  |          |         |         | 339,549  |         |        |        | 97,009  |  
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|Cost of goods sold:                                                                                         |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|                                                                                                            | Cost of product revenues                         |                                       |                                | 196,430 |         |          |          | 205,787 |         |          |         | 46,215 |       
|                                                                                                            | Cost of related party product revenues           |                                       |                                | 33,181  |         |          |          | 64,744  |         |          |         | 25,829 |       
|                                                                                                            | Special charges                                  |                                       |                                | 33,506  |         |          |          | 19,000  |         |          |         |       |       
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|                                                                                                            |                                                  |                                       | Total cost of goods sold       |         |         | 263,117  |          |         |         | 289,531  |         |        |        | 72,044  |  
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|Gross profit                                                                                                |                                                  |                                       | 16,364                         |         |         |          | 50,018   |         |         |          | 24,965  |       
|Operating expenses:                                                                                         |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|                                                                                                            | Research and development                         |                                       |                                | 79,927  |         |          |          | 68,270  |         |          |         | 17,579 |       
|                                                                                                            | Cost of product development assistance agreement |                                       |                                |        |         |          |          | 9,563   |         |          |         | 35,147 |       
|                                                                                                            | In-process research and development              |                                       |                                |        |         |          |          | 30,535  |         |          |         | 14,600 |       
|                                                                                                            | Sales and marketing                              |                                       |                                | 55,701  |         |          |          | 45,261  |         |          |         | 15,727 |       
|                                                                                                            | General and administrative                       |                                       |                                | 31,309  |         |          |          | 24,809  |         |          |         | 7,476  |       
|                                                                                                            | Goodwill amortization                            |                                       |                                | 25,410  |         |          |          | 59,057  |         |          |         | 3,524  |       
|                                                                                                            | Restructuring costs and asset write-offs         |                                       |                                | 587,149 |         |          |          |        |         |          |         |       |       
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|                                                                                                            |                                                  | Total operating expenses              |                                |         | 779,496 |          |          |         | 237,495 |          |         |        | 94,053 |        
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|Loss from operations                                                                                        |                                                  |                                       | (763,132                       | )       |         |          | (187,477 | )       |         |          | (69,088 | )     
|Interest income                                                                                             |                                                  |                                       | 18,132                         |         |         |          | 19,794   |         |         |          | 5,101   |       
|Interest expense                                                                                            |                                                  |                                       | (15,224                        | )       |         |          | (11,265  | )       |         |          | (93     | )     
|Other expense                                                                                               |                                                  |                                       | (2,864                         | )       |         |          | (1,819   | )       |         |          |        |       
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|Loss before extraordinary gain and tax benefit                                                              |                                                  |                                       | (763,088                       | )       |         |          | (180,767 | )       |         |          | (64,080 | )     
|Income tax benefit                                                                                          |                                                  |                                       | (13,915                        | )       |         |          |         |         |         |          |        |       
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|                                                                                                            |                                                  |                                       | Loss before extraordinary gain |         |         | (749,173 | )        |         |         | (180,767 | )       |        |        | (64,080 | )
|Extraordinary gain on early retirement of debt                                                              |                                                  |                                       | 185,327                        |         |         |          |         |         |         |          |        |       
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|Net loss                                                                                                    |                                                  | $                                     | (563,846                       | )       |         | $        | (180,767 | )       |         | $        | (64,080 | )     
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|Basic and diluted net loss per share before
	extraordinary gain                                             |                                                  | $                                     | (10.96                         | )       |         | $        | (2.95    | )       |         | $        | (1.55   | )     
|Extraordinary gain on early retirement of debt                                                              |                                                  |                                       | 2.71                           |         |         |          |         |         |         |          |        |       
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|Basic and diluted net loss per share                                                                        |                                                  | $                                     | (8.25                          | )       |         | $        | (2.95    | )       |         | $        | (1.55   | )     
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       
|Shares used in computing historical basic and
	diluted net loss per share applicable to common stockholders |                                                  |                                       | 68,331                         |         |         |          | 61,349   |         |         |          | 41,260  |       
|                                                                                                            |                                                  |                                       |                                |         |         |          |          |         |         |          |         |       

See accompanying notes.

38



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                              |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         |          |          |  
|----------------------------------------------------------------------------- | ------------------------------------------------------ | ------------------------------------ | ---------- | ---------- |  | ----------- | -- | -------- |  | ------------- | --------- | ------------- |  | -------------- | -------- | ------------- | - | ------ | ------ | ------ | - | - | --- | - |  | - | ---- | ----- | - |  | ------ |  |  | - | --- | - |  | - | ------- | -------- | -------- | -
|                                                                              |                                                        |                                      |            |            |  |             |    |          |  |               |           | Accumulated   |  |                |          |              
|                                                                              |                                                        | Common Stock                         |            | Additional |  |             |    |          |  | Stockholders |           | Other         |  | Treasury Stock |          | Total        
|                                                                              |                                                        |                                      |            | Paid-in    |  | Accumulated |    | Deferred |  | Notes         |           | Comprehensive |  |                |          | Stockholders
|                                                                              |                                                        | Shares                               |            | Amount     |  | Capital     |    | Deficit  |  | Compensation  |           | Receivable    |  | Income         |          | Shares        |   | Amount |        | Equity
|                                                                              |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |       
|                                                                              |                                                        |                                     
|                                                                              |                                                        | (In thousands, except share amounts)
|Balance at December 31, 1998                                                  |                                                        |                                      | 32,916,242 |            |  | $           | 16 |          |  | $             | 114,594   |               |  | $              | (84,301  | )             |   | $      | (2,184 | )      |   | $ | (22 | ) |  | $ |      |       |   |  |        |  |  | $ |     |   |  | $ | 28,103  |         
|Issuance of common stock, net issuance costs                                  |                                                        |                                      | 4,203,892  |            |  |             | 2  |          |  |               | 75,123    |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 75,125  |         
|Exercise of options for cash to purchase common
	stock                        |                                                        |                                      | 1,927,986  |            |  |             | 1  |          |  |               | 2,486     |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 2,487   |         
|Exercise of common stock warrant for cash                                     |                                                        |                                      | 6,000,000  |            |  |             | 3  |          |  |               | 19,497    |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 19,500  |         
|Cash proceeds from payment on a Stockholder note
	receivable                  |                                                        |                                      |           |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   | 16  |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 16      |         
|Amortization of unearned compensation related to
	stock                       |                                                        |                                      |           |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        | 631    |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 631     |         
|Issuance of warrant to purchase common stock                                  |                                                        |                                      |           |            |  |             |    |          |  |               | 35,587    |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 35,587  |         
|Issuance of common stock for Employee Stock
	Purchase Plan                    |                                                        |                                      | 202,326    |            |  |             |    |          |  |               | 1,170     |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 1,170   |         
|Compensation expense related to option
	acceleration for terminated employees |                                                        |                                      |            |            |  |             |    |          |  |               | 856       |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 856     |         
|Compensation expense for common stock issued in
	exchange for services        |                                                        |                                      |            |            |  |             |    |          |  |               | 61        |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 61      |         
|Compensation expense for common stock issued in
	lieu of bonus                |                                                        |                                      | 1,192      |            |  |             |    |          |  |               | 25        |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 25      |         
|Acquisition of Imedia Corporation                                             |                                                        |                                      | 1,714,814  |            |  |             | 1  |          |  |               | 106,737   |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 106,738 |         
|Acquisition of Radwiz Limited                                                 |                                                        |                                      | 1,992,306  |            |  |             | 1  |          |  |               | 52,718    |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 52,719  |         
|Comprehensive income:                                                         |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |        |         
|                                                                              | Increase in unrealized gain on short-term
	investments |                                      |            |           |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      | (283  | ) |  |        |  |  |   |     |   |  |   |         | (283     | )       
|                                                                              | Net loss                                               |                                      |            |           |  |             |    |          |  |               |           |               |  |                |          | (64,080       | ) |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | (64,080  | )       
|                                                                              |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         |         
|                                                                              |                                                        | Comprehensive loss                   |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         |          | (64,363  | )
|                                                                             
|Balance at December 31, 1999                                                  |                                                        |                                      | 48,958,758 |            |  |             | 24 |          |  |               | 408,854   |               |  |                | (148,381 | )             |   |        | (1,553 | )      |   |   | (6  | ) |  |   | (283 | )     |   |  |        |  |  |   |     |   |  |   | 258,655 |         
|                                                                             
|Exercise of option for cash to purchase common
	stock                         |                                                        |                                      | 1,935,675  |            |  |             | 3  |          |  |               | 14,180    |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 14,183  |         
|Repurchase of common stock                                                    |                                                        |                                      | (34,722    | )          |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  | 34,722 |  |  |   | (73 | ) |  |   | (73     | )       
|Cash proceeds from payment on stockholders notes
	receivable                  |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   | 3   |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 3       |         
|Unearned compensation related to stock options                                |                                                        |                                      |            |            |  |             |    |          |  |               | 3,497     |               |  |                |          |               |   |        | (3,497 | )      |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |        |         
|Amortization of unearned compensation related to
	stock                       |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        | 3,465  |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 3,465   |         
|Issuance of warrant to purchase common stock                                  |                                                        |                                      |           |            |  |             |    |          |  |               | 44,143    |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 44,143  |         
|Issuance of common stock for Employee Stock
	Purchase Plan                    |                                                        |                                      | 277,060    |            |  |             |    |          |  |               | 2,088     |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 2,088   |         
|Issuance of common stock in relation to Stock
	Split                          |                                                        |                                      |            |            |  |             | 22 |          |  |               | (22       | )             |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |        |         
|Cashless exercise of warrants                                                 |                                                        |                                      | 3,687,618  |            |  |             | 4  |          |  |               | (4        | )             |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |        |         
|Acquisitions:                                                                 |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |        |         
|                                                                              | Telgate                                                |                                      |            | 4,440,000  |  |             |    | 4        |  |               |           | 95,969        |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | 95,973   |         
|                                                                              | ANE                                                    |                                      |            | 1,404,552  |  |             |    | 2        |  |               |           | 83,475        |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | 83,477   |         
|                                                                              | Internet Telecom                                       |                                      |            | 377,380    |  |             |    | 1        |  |               |           | 46,473        |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | 46,474   |         
|                                                                              | Ultracom                                               |                                      |            | 536,766    |  |             |    | 1        |  |               |           | 58,637        |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | 58,638   |         
|                                                                              | Combox                                                 |                                      |            | 1,547,770  |  |             |    | 2        |  |               |           | 98,782        |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | 98,784   |         
|                                                                              | Mainsail                                               |                                      |            | 2,969,062  |  |             |    | 3        |  |               |           | 162,556       |  |                |          |               |   |        |        | (4,719 | ) |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | 157,840  |         
|                                                                              | Digitrans                                              |                                      |            | 762,133    |  |             |    | 1        |  |               |           | 15,320        |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | 15,321   |         
|                                                                              | True Chat                                              |                                      |            | 534,487    |  |             |    | 1        |  |               |           | 2,663         |  |                |          |               |   |        |        | (484   | ) |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | 2,180    |         
|Purchase price adjustment on 1999 acquisitions                                |                                                        |                                      |            |            |  |             |    |          |  |               | 1,353     |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   | 1,353   |         
|Comprehensive income:                                                         |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |        |         
|                                                                              | Increase to unrealized gain on short-term
	investments |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      | (153  | ) |  |        |  |  |   |     |   |  |   |         | (153     | )       
|                                                                              | Cumulative translation adjustment                      |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      | 1,097 |   |  |        |  |  |   |     |   |  |   |         | 1,097    |         
|                                                                              | Net loss                                               |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          | (180,767      | ) |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         | (180,767 | )       
|                                                                              |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         |         
|                                                                              |                                                        | Comprehensive loss                   |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |     |   |  |   |      |       |   |  |        |  |  |   |     |   |  |   |         |          | (179,823 | )
|                                                                             
|Balance at December 31, 2000                                                  |                                                        |                                      | 67,396,539 |            |  | $           | 68 |          |  | $             | 1,037,964 |               |  | $              | (329,148 | )             |   | $      | (6,788 | )      |   | $ | (3  | ) |  | $ | 661  |       |   |  | 34,722 |  |  | $ | (73 | ) |  | $ | 702,681 |         
|                                                                             

39



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY  (Continued)

|                                                                   |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   |         |          |          |  
|------------------------------------------------------------------ | ------------------------------------------------------ | ------------------------------------ | ---------- | ---------- |  | ----------- | -- | -------- |  | ------------- | --------- | ------------- |  | -------------- | -------- | ------------- | - | ------ | ----- | ------ |  | - | - |  |  | - | --- | ---- | - |  | ------- |  |  | - | ---- | - |  | - | ------- | -------- | -------- | -
|                                                                   |                                                        |                                      |            |            |  |             |    |          |  |               |           | Accumulated   |  |                |          |              
|                                                                   |                                                        | Common Stock                         |            | Additional |  |             |    |          |  | Stockholders |           | Other         |  | Treasury Stock |          | Total        
|                                                                   |                                                        |                                      |            | Paid-in    |  | Accumulated |    | Deferred |  | Notes         |           | Comprehensive |  |                |          | Stockholders
|                                                                   |                                                        | Shares                               |            | Amount     |  | Capital     |    | Deficit  |  | Compensation  |           | Receivable    |  | Income         |          | Shares        |   | Amount |       | Equity
|                                                                   |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |       
|                                                                   |                                                        |                                     
|                                                                   |                                                        | (In thousands, except share amounts)
|Exercise of option for cash to purchase common
	stock              |                                                        |                                      | 2,507,582  |            |  | $           | 4  |          |  | $             | 12,494    |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  | $ | 12,498  |         
|Repurchase of common stock                                         |                                                        |                                      | (93,117    | )          |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  | 93,117  |  |  |   | (695 | ) |  |   | (695    | )       
|Issuance of options                                                |                                                        |                                      |            |            |  |             |    |          |  |               | 719       |               |  |                |          |               |   |        | (719  | )      |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   |        |         
|Amortization of deferred compensation                              |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        | 5,815 |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   | 5,815   |         
|Adjustments to deferred compensation due to
	employee terminations |                                                        |                                      |            |            |  |             |    |          |  |               | (1,234    | )             |  |                |          |               |   |        | 1,234 |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   |        |         
|Issuance of restricted common stock for services
	provided         |                                                        |                                      | 275,250    |            |  |             |    |          |  |               | 1,237     |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   | 1,237   |         
|Issuance of common stock for Employee Stock
	Purchase Plan         |                                                        |                                      | 381,428    |            |  |             |    |          |  |               | 1,966     |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   | 1,966   |         
|Issuance of warrants to purchase common stock                      |                                                        |                                      |            |            |  |             |    |          |  |               | 1,187     |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   | 1,187   |         
|Issuance of common stock for tender offer                          |                                                        |                                      | 141,442    |            |  |             |    |          |  |               | 2,001     |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   | 2,001   |         
|Issuance of common stock for retirement of debt                    |                                                        |                                      | 1,464,359  |            |  |             | 1  |          |  |               | 17,869    |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   | 17,870  |         
|Cash proceeds from payment on stockholders notes
	receivable       |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |        |  |   | 3 |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   | 3       |         
|Comprehensive income:                                              |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   |        |         
|                                                                   | Increase to unrealized gain on short-term
	investments |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     | 208  |   |  |         |  |  |   |      |   |  |   |         | 208      |         
|                                                                   | Cumulative translation adjustment                      |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     | (621 | ) |  |         |  |  |   |      |   |  |   |         | (621     | )       
|                                                                   | Net loss                                               |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          | (563,846      | ) |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   |         | (563,846 | )       
|                                                                   |                                                        |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   |         |         
|                                                                   |                                                        | Comprehensive loss                   |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |       |        |  |   |   |  |  |   |     |      |   |  |         |  |  |   |      |   |  |   |         |          | (564,259 | )
|                                                                  
|Balance at December 31, 2001                                       |                                                        |                                      | 72,073,483 |            |  | $           | 73 |          |  | $             | 1,074,203 |               |  | $              | (892,994 | )             |   | $      | (458  | )      |  | $ |  |  |  | $ | 248 |      |   |  | 127,839 |  |  | $ | (768 | ) |  | $ | 180,304 |         
|                                                                  

See accompanying notes.

40



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                           |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |         |        | 
|------------------------------------------------------------------------------------------ | --------------------------------------------------------------------------------- | ---------------------------------------------------- | -------- | -------- | -------- | ---- | -------- | ------- | ------- | - | -------- | ------- | ------ | 
|                                                                                           |                                                                                   |                                                     
|                                                                                           |                                                                                   | Years Ended December 31,                            
|                                                                                           |                                                                                   |                                                     
|                                                                                           |                                                                                   | 2001                                                 |          | 2000     |          | 1999
|                                                                                           |                                                                                   |                                                      |          |          |          |     
|                                                                                           |                                                                                   |                                                     
|                                                                                           |                                                                                   | (In thousands)                                      
|Operating activities:                                                                      |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Net loss                                                                                   |                                                                                   | $                                                    | (563,846 | )        |          | $    | (180,767 | )       |         | $ | (64,080  | )      
|Adjustments to reconcile net loss to net cash
	(used in) provided by operating activities: |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|                                                                                           | Depreciation                                                                      |                                                      |          | 15,728   |          |      |          | 11,284  |         |   |          | 2,121   |       
|                                                                                           | Write-off and amortization of intangible assets                                   |                                                      |          | 619,157  |          |      |          | 106,305 |         |   |          | 6,089   |       
|                                                                                           | In-process research and development                                               |                                                      |          |         |          |      |          | 30,535  |         |   |          | 14,600  |       
|                                                                                           | Amortization related to stock options                                             |                                                      |          | 5,815    |          |      |          | 3,465   |         |   |          | 631     |       
|                                                                                           | Compensation expense relating to issuance of
	common stock to employees           |                                                      |          | 2,001    |          |      |          |        |         |   |          | 25      |       
|                                                                                           | Loss on disposal of fixed assets                                                  |                                                      |          | 1,600    |          |      |          |        |         |   |          | 33      |       
|                                                                                           | Extraordinary gain on early retirement of debt                                    |                                                      |          | (185,327 | )        |      |          |        |         |   |          |        |       
|                                                                                           | Compensation expense for common stock issued in
	exchange for consulting services |                                                      |          | 1,237    |          |      |          |        |         |   |          | 61      |       
|                                                                                           | Value of common and preferred stock warrants
	issued                              |                                                      |          | 505      |          |      |          | 9,563   |         |   |          | 35,587  |       
|                                                                                           | Option acceleration related to a terminated
	employee                             |                                                      |          |         |          |      |          |        |         |   |          | 856     |       
|Changes in operating assets and liabilities:                                               |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|                                                                                           | Accounts receivable                                                               |                                                      |          | (5,614   | )        |      |          | (28,757 | )       |   |          | (11,925 | )     
|                                                                                           | Accounts receivable from related parties                                          |                                                      |          | 13,448   |          |      |          | (10,173 | )       |   |          | (5,732  | )     
|                                                                                           | Inventory                                                                         |                                                      |          | 71,109   |          |      |          | (82,776 | )       |   |          | (1,041  | )     
|                                                                                           | Other assets                                                                      |                                                      |          | 16,606   |          |      |          | (18,876 | )       |   |          | (2,305  | )     
|                                                                                           | Accounts payable                                                                  |                                                      |          | (81,173  | )        |      |          | 110,777 |         |   |          | 4,617   |       
|                                                                                           | Accrued payroll and related expenses                                              |                                                      |          | (3,664   | )        |      |          | 7,167   |         |   |          | 3,463   |       
|                                                                                           | Deferred revenues                                                                 |                                                      |          | (829     | )        |      |          | 457     |         |   |          | 4,541   |       
|                                                                                           | Warranty reserves                                                                 |                                                      |          | 2,443    |          |      |          | 3,240   |         |   |          | 1,621   |       
|                                                                                           | Accrued restructuring charges                                                     |                                                      |          | 8,197    |          |      |          |        |         |   |          |        |       
|                                                                                           | Accrued vendor cancellation charges                                               |                                                      |          | (1,709   | )        |      |          | 19,000  |         |   |          |        |       
|                                                                                           | Other accrued liabilities                                                         |                                                      |          | 7,296    |          |      |          | 16,189  |         |   |          | 2,933   |       
|                                                                                           | Deferred taxes                                                                    |                                                      |          | (18,565  | )        |      |          | 7,567   |         |   |          |        |       
|                                                                                           | Current portion of long term debt                                                 |                                                      |          |         |          |      |          | 10,853  |         |   |          |        |       
|                                                                                           | Other non-current liabilities                                                     |                                                      |          | 704      |          |      |          | 5,661   |         |   |          | 5       |       
|                                                                                           |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Net cash (used in) provided by operating
	activities                                       |                                                                                   |                                                      | (94,881  | )        |          |      | 20,714   |         |         |   | (7,900   | )      
|                                                                                           |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Investing activities:                                                                      |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Purchases of short-term investments                                                        |                                                                                   |                                                      | (402,653 | )        |          |      | (376,108 | )       |         |   | (217,323 | )      
|Proceeds from sales and maturities of short-term
	Investments                              |                                                                                   |                                                      | 384,689  |          |          |      | 240,744  |         |         |   | 150,984  |        
|Purchases of property and equipment                                                        |                                                                                   |                                                      | (9,074   | )        |          |      | (38,534  | )       |         |   | (4,718   | )      
|Officer note receivable                                                                    |                                                                                   |                                                      |         |          |          |      |         |         |         |   | 100      |        
|Purchase of developed technology                                                           |                                                                                   |                                                      |         |          |          |      |         |         |         |   | (1,850   | )      
|Purchase of other assets                                                                   |                                                                                   |                                                      |         |          |          |      | (17,969  | )       |         |   | (508     | )      
|Cash received from acquisitions                                                            |                                                                                   |                                                      |         |          |          |      |         |         |         |   | 2,659    |        
|Cash paid for acquisition of businesses                                                    |                                                                                   |                                                      |         |          |          |      | (14,848  | )       |         |   | (250     | )      
|Pre-acquisition loan to Imedia                                                             |                                                                                   |                                                      |         |          |          |      |         |         |         |   | (1,800   | )      
|                                                                                           |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Net cash (used in) investing activities                                                    |                                                                                   |                                                      | (27,038  | )        |          |      | (206,715 | )       |         |   | (72,706  | )      
|                                                                                           |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Financing activities:                                                                      |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Principal payments on capital leases                                                       |                                                                                   |                                                      | (130     | )        |          |      | (12      | )       |         |   | (28      | )      
|Principal payments on long-term debt                                                       |                                                                                   |                                                      | (24,415  | )        |          |      |         |         |         |   |         |        
|Proceeds from long-term debt                                                               |                                                                                   |                                                      |         |          |          |      | 484,429  |         |         |   | 43       |        
|Increase in other non-current liabilities                                                  |                                                                                   |                                                      |         |          |          |      |         |         |         |   | 355      |        
|Exercise of options and warrant to purchase
	common stock                                  |                                                                                   |                                                      | 12,498   |          |          |      | 14,183   |         |         |   | 21,983   |        
|Payments on repurchase of common stock                                                     |                                                                                   |                                                      | (695     | )        |          |      | (73      | )       |         |   |         |        
|Principal payments on stockholder notes receivable                                         |                                                                                   |                                                      | 3        |          |          |      | 3        |         |         |   | 16       |        
|Debt repurchase of convertible notes                                                       |                                                                                   |                                                      | (113,428 | )        |          |      |         |         |         |   |         |        
|Proceeds from issuance of common stock                                                     |                                                                                   |                                                      | 1,966    |          |          |      | 2,088    |         |         |   | 76,293   |        
|                                                                                           |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|                                                                                           |                                                                                   | Net cash (used in) provided by financing
	activities |          |          | (124,201 | )    |          |         | 500,618 |   |          |         | 98,662 | 
|Effect of exchange rate changes                                                            |                                                                                   |                                                      | (621     | )        |          |      |         |         |         |   |         |        
|                                                                                           |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Net decrease in cash and cash equivalents                                                  |                                                                                   |                                                      | (246,741 | )        |          |      | 314,617  |         |         |   | 18,056   |        
|Cash and cash equivalents at beginning of year                                             |                                                                                   |                                                      | 347,015  |          |          |      | 32,398   |         |         |   | 14,342   |        
|Cash and cash equivalents at end of year                                                   |                                                                                   | $                                                    | 100,274  |          |          | $    | 347,015  |         |         | $ | 32,398   |        
|                                                                                           |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Supplemental disclosures of cash flow information:                                         |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Cash paid for income taxes                                                                 |                                                                                   | $                                                    | 31       |          |          | $    |         |         |         | $ |         |        
|Cash paid for interest                                                                     |                                                                                   | $                                                    | 20,810   |          |          | $    | 365      |         |         | $ |         |        
|Supplemental noncash investing and financing
	activities:                                  |                                                                                   |                                                      |          |          |          |      |          |         |         |   |          |        
|Common shares issued for settlement of
	convertible debt                                   |                                                                                   | $                                                    | 17,900   |          |          | $    |         |         |         | $ |         |        
|Acquisition of businesses                                                                  |                                                                                   | $                                                    |         |          |          | $    | 565,228  |         |         | $ | 161,864  |        
|Deferred Compensation relating to common stock
	issued to non-employees                    |                                                                                   | $                                                    | 684      |          |          |      |         |         |         | $ |         |        
|Reduction in deferred compensation due to
	termination of employees                        |                                                                                   | $                                                    | 1,234    |          |          | $    |         |         |         | $ |         |        
|Issuance of warrants in connection with purchase
	of TrueChat                              |                                                                                   | $                                                    | 682      |          |          | $    |         |         |         | $ |         |        

See accompanying notes.

41



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

1.     Organization
and Summary of Significant Accounting Policies



| |                        
| | -----------------------
| | Description of Business

Terayon Communication Systems, Inc. (the Company)
was incorporated under the laws of the state of California on
January 20, 1993. In July 1998, the Company reincorporated
in the State of Delaware.

The Company develops, markets and sells equipment
to cable television operators, telecom carriers and satellite
network operators who use the Companys products to deliver
broadband voice, video and data services to residential and
business subscribers.



| |                       
| | ----------------------
| | Basis of Consolidation

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



| |                 
| | ----------------
| | Use of Estimates

The preparation of the consolidated financial
statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those
estimates.



| |                             
| | ----------------------------
| | Foreign Currency Translation

For operations outside the U.S. that prepare
financial statements in currencies other than the
U.S. dollar, results of operations and cash flows are
translated at average exchange rates during the period, and
assets and liabilities are translated at end-of-period exchange
rates. Translation adjustments are included as a separate
component of accumulated other comprehensive income
(loss) in stockholders equity. For the three years
ended December 31, 2001, translation gains and losses were
not significant.



| |                                                                   
| | ------------------------------------------------------------------
| | Concentrations of Credit Risk, Customers,
	Suppliers, and Products

The Company operates in two principal operating
segments: Cable Broadband Access Systems (Cable) and Telecom
Access Systems (Telecom). The Company sells primarily to
customers within the cable and telecommunications industries,
including related parties (see Note 13). The Company
performs ongoing credit evaluations of its customers and
generally requires no collateral. A relatively small number of
customers account for a significant percentage of the
Companys revenues and accounts receivable. The Company
expects that the sale of its products to a limited number of
customers and resellers may continue to account for a high
percentage of revenues for the foreseeable future.

Currently, the Company relies on single source
suppliers of materials and labor for the significant majority of
its product inventory but is actively pursuing additional
supplier alternatives. As a result, should the Companys
current suppliers not produce and deliver inventory for the
Company to sell on a timely basis, operating results may be
adversely impacted.

Substantially all of the Companys revenues
have been attributable to sales of the TeraLink and the TeraPro.
These products are expected to account for a significant part of
the Companys revenues for the foreseeable future. As a
result, a decline in demand for or failure to achieve broad
market acceptance of the TeraLink or the TeraPro would adversely
affect operating results.

In addition, market acceptance of the
Companys products may be affected by the emergence and
evolution of industry standards. While the Company expects its
products to become compliant with industry standards, its
inability to do so may adversely affect operating results.

42



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Company invests its excess cash in debt
instruments of governmental agencies, and corporations with
credit ratings of AA/ AA- or better or A1/ P1 or better,
respectively. The Company has established guidelines relative to
diversification and maturities that attempt to maintain safety
and liquidity. The Company has not experienced any significant
losses on its cash equivalents or short-term investments.



| |                    
| | -------------------
| | Revenue Recognition

The Company sells its products directly to
broadband access service providers, system resellers and
distributors and recognizes revenue upon shipment to the
customer when title is transferred. Revenues related to product
sales are generally recognized when: (1) persuasive
evidence that an arrangement exists, (2) delivery has
occurred or services have been rendered, (3) the
sellers price to the buyer is fixed or determinable, and
(4) collectibility is reasonably assured. The
Companys existing agreements with its system resellers and
distributors do not contain price protection provisions and do
not grant return rights beyond those provided by the
Companys standard warranty.



| |                                   
| | ----------------------------------
| | Research and Development
	Expenses

Research and development expenses are charged to
expense as incurred.



| |                            
| | ---------------------------
| | Shipping and Handling Costs

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



| |                     
| | --------------------
| | Advertising Expenses

The Company accounts for advertising costs as
expense in the period in which they are incurred. Advertising
expense for the years ended December 31, 2001 and 2000 were
$2.3 million and $1.0 million, respectively.
Advertising expenses were not significant in 1999.

The Company has entered into co-marketing
arrangements with Rogers Cablesystems, Inc.
(Rogers), a related party (see Note 13)
and Shaw Communications, Inc. (Shaw). Such amounts,
totaling $7.5 million for Shaw and $2.9 million for
Rogers, are included in other current assets. The Company may be
required to charge such activities against revenues in
accordance with EITF 01-09, Accounting for Consideration
given by a Vendor to a Customer or Reseller in Connection with
the Purchase or Promotion of the Vendors Products.



| |                                                      
| | -----------------------------------------------------
| | Net Loss Per Share Applicable to Common
	Stockholders

Historical basic and diluted net loss per share
was computed using the weighted average number of common shares
outstanding. Options, warrants, restricted stock and preferred
stock were not included in the computation of historical diluted
net loss per share because the effect would be antidilutive.

Shares used in the calculation of historical
basic and diluted net loss per share follows (in thousands,
except per share data):

|                                                                          |  |                          |          |      |  |      |          |   |  |   |         |  
|------------------------------------------------------------------------- |  | ------------------------ | -------- | ---- |  | ---- | -------- | - |  | - | ------- | -
|                                                                          |  |                         
|                                                                          |  | Years Ended December 31,
|                                                                          |  |                         
|                                                                          |  | 2001                     |          | 2000 |  | 1999
|                                                                          |  |                          |          |      |  |     
|Net loss                                                                  |  | $                        | (563,846 | )    |  | $    | (180,767 | ) |  | $ | (64,080 | )
|                                                                          |  |                          |          |      |  |      |          |   |  |   |         |  
|Shares used in computing historical basic and
	diluted net loss per share |  |                          | 68,331   |      |  |      | 61,349   |   |  |   | 41,260  |  
|Historical basic and diluted net loss per share                           |  | $                        | (8.25    | )    |  | $    | (2.95    | ) |  | $ | (1.55   | )
|                                                                          |  |                          |          |      |  |      |          |   |  |   |         |  

43



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Options to purchase 20,007,686, 21,489,536 and
10,342,338 shares of common stock were outstanding at
December 31, 2001, 2000 and 1999, respectively, and
warrants to purchase 2,408,300, 2,072,318 and 4,072,318 shares
of common stock were outstanding at December 31, 2001, 2000
and 1999, respectively, but were not included in the computation
of diluted net loss per share, since the effect is antidilutive.



| |                                  
| | ---------------------------------
| | Derivative Financial
	Instruments

As of January 1, 2001, the Company adopted
Financial Accounting Standards Board Statement No. 133,
Accounting for Derivative Instruments and Hedging
Activities (SFAS 133). As a result of the adoption of
SFAS 133, the Company will recognize all derivative
financial instruments, such as foreign exchange contracts, in
the consolidated financial statements at fair value regardless
of the purpose or the intent for holding the instrument. Changes
in the fair value of derivative financial instruments are either
recognized periodically in income or in shareholders
equity as a component of comprehensive income depending on
whether the derivative financial instrument qualifies for
hedging accounting, and if so, whether it qualifies as a fair
value hedge or cash flow hedge. Generally, changes in fair
values of derivatives accounted for as fair value hedges are
recorded in income along with the portions of the changes in the
fair values of the hedged items that relate to the hedged risks.
Changes in fair values of derivatives accounted for as cash flow
hedges, to the extent they are effective as hedges, are recorded
in other comprehensive income, net of deferred taxes. Changes in
fair value of derivatives used as hedges of the net investment
in foreign operations are reported in other comprehensive income
as part of the cumulative translation adjustment. Changes in
fair value of derivatives not qualifying as hedges are reported
in income.

As the Company had no derivative financial
instruments outstanding as of December 31, 2001 or
December 31, 2000, the adoption of SFAS 133 had no
impact on the financial statements of the Company at
December 31, 2001 or December 31, 2000.



| |                                             
| | --------------------------------------------
| | Cash Equivalents and Short-Term
	Investments

The Company invests its excess cash in money
market accounts and debt instruments and considers all highly
liquid debt instruments purchased with an original maturity of
three months or less to be cash equivalents. Investments with an
original maturity at the time of purchase of over three months
are classified as short-term investments regardless of maturity
date as all investments are classified as available-for-sale and
can be readily liquidated to meet current operational needs.

The Company accounts for investments in
accordance with Statement of Financial Accounting Standards
No. 115, Accounting for Certain Investments in Debt
and Equity Securities. Management determines the
appropriate classification of debt securities at the time of
purchase and reevaluates such designation as of each balance
sheet date. The Companys short-term investments, which
consist primarily of commercial paper, U.S. government and
U.S. government agency obligations and fixed income
corporate securities, are classified as available-for-sale and
are carried at amortized cost which approximates fair market
value. Realized gains and losses and declines in value judged to
be other-than-temporary on available-for-sale securities are
included in interest income. The cost of securities sold is
based on the specific identification method. The Company had no
material investments in equity securities at either
December 31, 2001 or December 31, 2000.

44



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |          
| | ---------
| | Inventory

Inventory is stated at the lower of cost
(first-in, first-out) or market. The components of inventory are
as follows (in thousands):

|                |  |              |        |      |  |   |        | 
|--------------- |  | ------------ | ------ | ---- |  | - | ------ | 
|                |  |             
|                |  | December 31,
|                |  |             
|                |  | 2001         |        | 2000
|                |  |              |        |     
|Finished goods  |  | $            | 6,433  |      |  | $ | 64,987 | 
|Work-in process |  |              | 236    |      |  |   | 1,736  | 
|Raw materials   |  |              | 9,989  |      |  |   | 21,044 | 
|                |  |              |        |      |  |   |        | 
|                |  | $            | 16,658 |      |  | $ | 87,767 | 
|                |  |              |        |      |  |   |        | 



| |                          
| | -------------------------
| | Other Current Receivables

As of December 31, 2001, other current
receivables included approximately $5.2 million due from
contract manufacturers for raw materials purchased from the
Company.



| |                       
| | ----------------------
| | Property and Equipment

Property and equipment are carried at cost less
accumulated depreciation and amortization. Property and
equipment are depreciated for financial reporting purposes using
the straight-line method over the estimated useful lives,
generally three to five years. Leasehold improvements are
amortized using the straight-line method over the shorter of the
useful lives of the assets or the terms of the leases. The
recoverability of the carrying amount of property and equipment
is assessed based on estimated future undiscounted cash flows,
and if an impairment exists, the charge to operations is
measured as the excess of the carrying amount over the fair
value of the assets. Based upon this method of assessing
recoverability, the Company recorded $1.6 million in asset
impairment during 2001 related to assets acquired in the
purchase of Access Network Electronics Division of Tyco
Electronics Corporation (ANE). No asset impairment
occurred in 2000 or 1999.

Property and equipment are as follows (in
thousands):

|                                          |  |              |         |      |  |   |         |  
|----------------------------------------- |  | ------------ | ------- | ---- |  | - | ------- | -
|                                          |  |             
|                                          |  | December 31,
|                                          |  |             
|                                          |  | 2001         |         | 2000
|                                          |  |              |         |     
|Software and computers                    |  | $            | 25,328  |      |  | $ | 20,448  |  
|Furniture and equipment                   |  |              | 29,754  |      |  |   | 25,708  |  
|Leasehold improvements                    |  |              | 3,573   |      |  |   | 3,090   |  
|Automobiles                               |  |              | 37      |      |  |   | 58      |  
|Construction in progress                  |  |              | 4,805   |      |  |   | 5,119   |  
|                                          |  |              |         |      |  |   |         |  
|                                          |  |              | 63,497  |      |  |   | 54,423  |  
|Accumulated depreciation and amortization |  |              | (38,218 | )    |  |   | (20,890 | )
|                                          |  |              |         |      |  |   |         |  
|Property and equipment, net               |  | $            | 25,279  |      |  | $ | 33,533  |  
|                                          |  |              |         |      |  |   |         |  

45



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                             
| | ----------------------------
| | Intangibles and Other Assets

Intangibles and other assets consisted of the
following (in thousands):

|                         |                                    |              |         |        |  |   |          |         | 
|------------------------ | ---------------------------------- | ------------ | ------- | ------ |  | - | -------- | ------- | 
|                         |                                    |             
|                         |                                    | December 31,
|                         |                                    |             
|                         |                                    | 2001         |         | 2000  
|                         |                                    |              |         |       
|Goodwill                 |                                    | $            | 3,072   |        |  | $ | 503,606  |        
|Assembled workforce      |                                    |              | 20,769  |        |  |   | 28,300   |        
|Other intangibles        |                                    |              |        |        |  |   | 202,730  |        
|                         |                                    |              |         |        |  |   |          |        
|                         |                                    |              | 23,841  |        |  |   | 734,636  |        
|Accumulated amortization |                                    |              | (20,074 | )      |  |   | (112,394 | )      
|                         |                                    |              |         |        |  |   |          |        
|Intangibles, net         |                                    |              | 3,767   |        |  |   | 622,242  |        
|Other assets             |                                    |              | 13,724  |        |  |   | 21,454   |        
|                         |                                    |              |         |        |  |   |          |        
|                         | Total intangibles and other assets |              | $       | 17,491 |  |   | $        | 643,696 | 
|                         |                                    |              |         |        |  |   |          |        

Goodwill is the excess of the purchase price over
the fair value of identifiable net assets acquired in business
combinations accounted for as purchases. During 2001,
$0.7 million was added to goodwill relating to an increase
in the purchase price of TrueChat (see Note 14) and
$4.5 million was added to assembled workforce relating to
retention payments in conjunction with the acquisition of ANE
(see Note 14).



| |                                                    
| | ---------------------------------------------------
| | Impairment of Goodwill and Other Long-Lived
	Assets

Goodwill and other long-lived assets are reviewed
for impairment whenever events such as product discontinuance,
plant closures, product dispositions or other changes in
circumstances indicate that the carrying amount may not be
recoverable. When such events occur, the Company compares the
carrying amount of the assets to undiscounted expected future
cash flows. If this comparison indicates that there is an
impairment, the amount of the impairment is typically calculated
using discounted expected future cash flows. The discount rate
applied to these cash flows is based on the Companys
weighted average cost of capital, which represents the blended
costs of debt and equity.

During 2001, the Company recorded impairment
charges for goodwill and other intangible assets (see Note
6).



| |                  
| | -----------------
| | Warranty Reserves

The Company provides a standard warranty for most
of its products, generally lasting one year from the date of
purchase. The Company provides for the estimated cost of product
warranties at the time revenue is recognized. The Companys
warranty obligation is affected by product failure rates,
material usage and service delivery costs incurred in correcting
a product failure. Reserve estimates are based on historical
experience and expectation of future conditions.



| |                         
| | ------------------------
| | Stock-Based Compensation

The Company accounts for its employee stock plans
in accordance with Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to
Employees (APB Opinion No. 25), and includes the
disclosure-only provisions as required under Statement of
Financial Accounting Standards No. 123, Accounting
for Stock-Based Compensation (SFAS 123).

46



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                               
| | ----------------------------------------------
| | Accumulated Other Comprehensive Income
	(Loss)

Accumulated other comprehensive income presented
in the accompanying consolidated balance sheets and statements
of stockholders equity consists of net unrealized gain on
short-term investments and accumulated net foreign currency
translation losses.

The following are the components of comprehensive
income (loss):

|                         |                                                                     |      |          |      |   |      |          |       |   |   |         |      |  
|------------------------ | ------------------------------------------------------------------- | ---- | -------- | ---- | - | ---- | -------- | ----- | - | - | ------- | ---- | -
|                         |                                                                     | 2001 |          | 2000 |   | 1999
|                         |                                                                     |      |          |      |   |     
|Net loss                 |                                                                     | $    | (563,846 | )    |   | $    | (180,767 | )     |   | $ | (64,080 | )   
|                         | Cumulative translation adjustments                                  |      |          | (621 | ) |      |          | (153  | ) |   |         |     |  
|                         | Change in unrealized gain (loss) on
	available-for-sale investments |      |          | 208  |   |      |          | 1,097 |   |   |         | (283 | )
|                         |                                                                     |      |          |      |   |      |          |       |   |   |         |     
|Total comprehensive loss |                                                                     | $    | (564,259 | )    |   | $    | (179,823 | )     |   | $ | (64,363 | )   
|                         |                                                                     |      |          |      |   |      |          |       |   |   |         |     



| |                 
| | ----------------
| | Reclassification

Certain amounts reported in previous years have
been reclassified to conform to the 2001 presentation.



| |                                                
| | -----------------------------------------------
| | Impact of Recently Issued Accounting
	Standards

In August 2001, the Financial Accounting
Standards Board issued FAS No. 144, Accounting for
the Impairment or Disposal of Long-lived Assets. FAS
No. 144 supercedes FAS No. 121, Accounting for
the Impairment of Long-lived Assets and Assets to be Disposed
of and the accounting and reporting provisions of
Accounting Principles Board Opinion No. 30, Reporting
the Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual
and Infrequently Occurring Events and Transaction. FAS
No. 144 also amends Accounting Research Bulletin
No. 51, Consolidated Financial Statements, to
eliminate the exception to consolidation for a subsidiary for
which control is likely to be temporary. The provisions of FAS
No. 144 will be effective for fiscal years beginning after
December 15, 2001. The effect of adopting FAS No. 144
has been evaluated by the Company, and does not have a material
adverse effect on Terayons financial position or results
of operations.

In June 2001, the Financial Accounting Standards
Board issued Statements of Financial Accounting Standards
No. 141, Business Combinations, and No. 142, Goodwill
and Other Intangible Assets. Statement 141 requires that
the purchase method of accounting be used for all business
combinations initiated after June 30, 2001.
Statement 141 also includes guidance on the initial
recognition and measurement of goodwill and other intangible
assets arising from business combinations completed after
June 30, 2001. Statement 142 prohibits the
amortization of goodwill and intangible assets with indefinite
useful lives. Statement 142 requires that these assets be
reviewed for impairment at least annually. Intangible assets
with finite lives will continue to be amortized over their
estimated useful lives. Additionally, Statement 142
requires that goodwill included in the carrying value of equity
method investments no longer be amortized.

The Company will apply Statement 142
beginning in the first quarter of 2002. Application of the
nonamortization provisions of Statement 142 will
significantly reduce amortization expense that was approximately
$25.4 million in fiscal 2001. The Company will reclassify
identifiable intangible assets with indefinite lives, as defined
by Statement 142, to goodwill at the date of adoption. The
Company will test goodwill for impairment using the two-step
process prescribed in Statement 142. The first step is a
screen for potential impairment, while the second step measures
the amount of the impairment, if any. The Company expects to
perform the first of the required impairment tests of goodwill
and indefinite lived intangible assets as of January 1,
2002 in the first quarter of 2002. Any impairment charge
resulting from these transitional impairment tests will be
reflected as the cumulative effect of a change in accounting
principle in the first

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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

quarter of 2002. Based on the preliminary
unaudited analysis completed to date, we do not believe that the
application of these statements will have an adverse material
impact on the earnings and financial position of the Company.

2.     Fair Value of
Financial Instruments

The following estimated fair value amounts have
been determined using available market information and
appropriate valuation methodologies. However, considerable
judgment is required in interpreting market data to develop the
estimates of fair value. Accordingly, the estimates presented
herein are not necessarily indicative of the amounts that the
Company could realize in a current market exchange.

|                                           |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |         |         | 
|------------------------------------------ | ----- | ----------------- | ------ | ---------- | ------- | ---------- | --- | ---------- | ----- | - | - | - | - | - | ------ | ------- | ------- | 
|                                           |       |                  
|                                           |       | December 31, 2001
|                                           |       |                  
|                                           |       |                   |        | Gross      |         | Gross      |     |           
|                                           |       | Amortized         |        | Unrealized |         | Unrealized |     | Estimated 
|Short-term Investments                     |       | Cost              |        | Gains      |         | Losses     |     | Fair Value
|                                           |       |                   |        |            |         |            |     |           
|                                           |       |                  
|                                           |       | (In thousands)   
|Investments maturing in less than
	1 year: |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |        
|Commercial paper                           |       | $                 | 77,670 |            |         | $          | 24  |            |       | $ |  |   |   | $ | 77,694 |        
|Fixed income corporate securities          |       |                   | 40,194 |            |         |            | 6   |            |       |   |  |   |   |   | 40,200 |        
|Government agency obligations              |       |                   | 7,954  |            |         |            | (6  | )          |       |   |  |   |   |   | 7,948  |        
|                                           |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |        
|                                           | Total |                   | $      | 125,818    |         |            | $   | 24         |       |   | $ |  |   |   | $      | 125,842 |        
|Investments maturing in
	1 - 2 years:      |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |        
|Fixed income corporate securities          |       |                   | 31,276 |            |         |            | 568 |            |       |   |  |   |   |   | 31,844 |        
|Government agency obligations              |       |                   | 75,498 |            |         |            | 430 |            |       |   |  |   |   |   | 75,928 |        
|                                           |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |        
|                                           | Total |                   | $      | 106,774    |         |            | $   | 998        |       |   | $ |  |   |   | $      | 107,772 |        
|                                           |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |        
|                                           |       | Total             |        | $          | 232,592 |            |     | $          | 1,022 |   |   | $ |  |   |        | $       | 233,614 | 
|                                           |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |        

|                                           |       |                   |        |            |  |            |     |            |  |   |   |   |  |   |        |         | 
|------------------------------------------ | ----- | ----------------- | ------ | ---------- |  | ---------- | --- | ---------- |  | - | - | - |  | - | ------ | ------- | 
|                                           |       |                  
|                                           |       | December 31, 2000
|                                           |       |                  
|                                           |       |                   |        | Gross      |  | Gross      |     |           
|                                           |       | Amortized         |        | Unrealized |  | Unrealized |     | Estimated 
|Short-term Investments                     |       | Cost              |        | Gains      |  | Losses     |     | Fair Value
|                                           |       |                   |        |            |  |            |     |           
|                                           |       |                  
|                                           |       | (In thousands)   
|Investments maturing in less than
	1 year: |       |                   |        |            |  |            |     |            |  |   |   |   |  |   |        |        
|Commercial paper                           |       | $                 | 86,638 |            |  | $          |    |            |  | $ |  |   |  | $ | 86,638 |        
|Fixed income corporate securities          |       |                   | 84,557 |            |  |            | 190 |            |  |   |  |   |  |   | 84,747 |        
|Government agency obligations              |       |                   | 44,000 |            |  |            | 57  |            |  |   |  |   |  |   | 44,057 |        
|                                           |       |                   |        |            |  |            |     |            |  |   |   |   |  |   |        |        
|                                           | Total |                   | $      | 215,195    |  |            | $   | 247        |  |   | $ |  |  |   | $      | 215,442 | 
|                                           |       |                   |        |            |  |            |     |            |  |   |   |   |  |   |        |        

Realized gains and losses were insignificant for
each of the years in the three year period ended
December 31, 2001.

3.     Commitments



| |       
| | ------
| | Leases

The Company leases its facilities and certain
equipment under operating leases. The operating leases for the
Companys facilities expire in 2002 and 2003. Rent expense
was approximately $7,249,940, $4,165,600, and $1,013,000, for
the years ended December 31, 2001, 2000, and 1999,
respectively. In October 1999, the Company subleased the
facilities formerly occupied by Imedia Corporation to a third
party through 2003. Sublease rental income was approximately
$90,914 and $243,600 for the years ended December 31, 2001
and

48



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

2000 and $57,400 for the period from
September 16, 1999 (acquisition date) to December 31,
1999. The lease was terminated in 2001.

The Company leases certain equipment under
noncancelable lease agreements that are accounted for as capital
leases. Equipment under capital lease arrangements included in
property and equipment aggregated approximately $1,207,461 and
$1,273,960 at December 31, 2001 and 2000, respectively.
Related accumulated amortization was approximately $796,376 and
$432,398 at December 31, 2001 and 2000, respectively.
Amortization expense related to assets under capital leases is
included in depreciation expense. The capital leases are secured
by the related equipment and the Company is required to maintain
liability and property damage insurance.

Future minimum lease payments under noncancelable
operating leases and capital leases are as follows (in
thousands):

|                                  |  |                   |        |                |  |   |     | 
|--------------------------------- |  | ----------------- | ------ | -------------- |  | - | --- | 
|                                  |  |                  
|                                  |  | December 31, 2001
|                                  |  |                  
|                                  |  | Operating Leases  |        | Capital Leases
|                                  |  |                   |        |               
|2002                              |  | $                 | 5,316  |                |  | $ | 154 | 
|2003                              |  |                   | 3,954  |                |  |   | 169 | 
|2004                              |  |                   | 3,160  |                |  |   | 80  | 
|2005                              |  |                   | 2,391  |                |  |   |    | 
|                                  |  |                   |        |                |  |   |     | 
|Total minimum payments            |  | $                 | 14,821 |                |  |   | 403 | 
|                                  |  |                   |        |                |  |   |     | 
|Less amount representing interest |  |                   |        |                |  |   | 44  | 
|                                  |  |                   |        |                |  |   |     | 
|                                  |  |                   |        |                |  |   | 359 | 
|Less current portion              |  |                   |        |                |  |   | 126 | 
|                                  |  |                   |        |                |  |   |     | 
|Long term portion                 |  |                   |        |                |  | $ | 233 | 
|                                  |  |                   |        |                |  |   |     | 

There are no future minimum sublease payments to
be received under noncancelable subleases due to the termination
of the lease.



| |                     
| | --------------------
| | Purchase Obligations

The Company has purchase obligations to certain
of its suppliers that support the Companys ability to
manufacture its products. The obligations require the Company to
purchase minimum quantities of the suppliers products at a
specified price. During fiscal year 2001, the Company recorded
special charges of $33.5 million relating to vendor
cancellation fees. As of December 31, 2001, the Company had
approximately $58.7 million of purchase obligations, of
which $17.3 million is included on the balance sheet as
accrued vendor cancellation charges. The remaining obligations
are expected to become payable at various times through mid-2003.

As of December 31, 2001 the Company had
$1.6 million in unused letters of credit outstanding.



| |          
| | ---------
| | Royalties

The Company has purchased, through its
acquisition of Radwiz Limited (Radwiz), certain
technology that was developed by Radwiz and a former sister
company utilizing funding provided by the Israeli Chief
Scientist of the Ministry of Industry and Trade
(OCS). The purchase of the technology was approved
by the OCS. As a condition for this approval, the Company has
committed to pay royalties to the Government of Israel on
proceeds from sales of products based on this technology.
Royalty rates are 3% - 5%. Royalties are payable from
the commencement of sales of products based on the technology
until the cumulative amount of the royalties paid and accrued by
the Company equals 100% of the funding received from the OCS. The

49



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Companys total obligation for royalties,
based on royalty-bearing government participations received or
accrued, net of royalties paid or accrued, totaled approximately
$2.0 million at December 31, 2001.

4.     Debt
Obligations

In connection with the acquisition of Mainsail
Networks the Company assumed $3,520,000 Senior Secured
Promissory Note. The note is secured by the general assets of
Mainsail Networks and bears an interest rate equal to ten
percent per annum. Interest accrued monthly. The promissory note
was subsequently paid in full on April 30, 2001.

5.     Accrued
Severance Pay

Several of the Companys subsidiaries are
subject to Israeli law and labor agreements, under which they
are required to make severance payments to dismissed employees
and employees leaving its employment in certain other
circumstances. The subsidiaries severance pay liability to
its employees, which is calculated on the basis of the salary of
each employee for the last month of the reported year multiplied
by the years of such employees employment is included in
the Companys consolidated balance sheet on the accrual
basis, and is partially funded by a purchase of insurance
policies in the subsidiaries name. At December 31,
2001, approximately $1,800,000 for accrued severance pay was
included in other long-term obligations. Approximately
$1,115,000 relating to the amounts funded by the purchase of
insurance policies was included in other assets at
December 31, 2001.

6.     Restructuring
Charges and Asset Write-offs

The Company incurred restructuring charges in the
amount of $12.7 million and a write-down of impaired assets
in the amount of $1.6 million for the year ended
December 31, 2001. The write-down of $1.6 million
related to fixed assets acquired from ANE that were determined
to have no remaining useful life. Of the total restructuring
charges, $3.2 million relates to employee termination costs
covering 293 technical, production and administrative employees.
As of December 31, 2001, approximately 240 employees have
been terminated and we paid approximately $2.0 million in
termination costs. The remaining $9.5 million of
restructuring charges relates primarily to costs for excess
leased facilities. Included in the remaining $9.5 million
are $3.4 million of charges incurred in the fourth quarter
for revisions in estimates of excess facility charges. As of
December 31, 2001, the Company paid approximately
$2.5 million related to lease costs. At December 31,
2001, restructuring charges of $8.2 million remain accrued,
primarily related to excess facility costs and employee
terminations. The Company anticipates utilizing the remaining
restructuring accrual, which relates to servicing operating
lease payments or negotiated buyout of operating lease
commitments, through 2005.

Restructuring costs are summarized below (in
millions):

|                             |  |              |      |                |  |       |      |   |  |   |      |  
|---------------------------- |  | ------------ | ---- | -------------- |  | ----- | ---- | - |  | - | ---- | -
|                             |  |              |      | Excess Leased  |  |      
|                             |  |              |      | Facilities and |  |      
|                             |  | Involuntary  |      | Cancelled      |  |      
|                             |  | Terminations |      | Contracts      |  | Total
|                             |  |              |      |                |  |      
|Balance at December 31, 2000 |  | $            | 0.0  |                |  | $     | 0.0  |   |  | $ | 0.0  |  
|Additions                    |  |              | 3.2  |                |  |       | 9.5  |   |  |   | 12.7 |  
|Cash Payments                |  |              | (2.0 | )              |  |       | (2.5 | ) |  |   | (4.5 | )
|                             |  |              |      |                |  |       |      |   |  |   |      |  
|Balance at December 31, 2001 |  | $            | 1.2  |                |  | $     | 7.0  |   |  | $ | 8.2  |  
|                             |  |              |      |                |  |       |      |   |  |   |      |  

In March 2001, the Company evaluated the carrying
value of certain long-lived assets and acquired intangibles,
consisting primarily of goodwill recorded on its balance sheet.
Pursuant to accounting rules, the majority of the goodwill was
recorded based on stock prices at the time acquisition
agreements were executed

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

and announced. Goodwill and other long-lived
assets are reviewed for impairment whenever events such as
product discontinuance, plant closures, product dispositions or
other changes in circumstances indicate that the carrying amount
may not be recoverable. When such events occur, the Company
compares the carrying amount of the assets to undiscounted
expected future cash flows. If this comparison indicates that
there is an impairment, the amount of the impairment is based on
the fair value of the assets, typically calculated using
discounted expected future cash flows. The discount rate applied
to these cash flows is based on the Companys weighted
average cost of capital, which represents the blended costs of
debt and equity.

Downturns in the broadband services and
telecommunications markets created unique circumstances with
regard to the assessment of goodwill and other intangible assets
for recoverability. As a result of managements decision to
suspend certain product lines and product development efforts
during 2001, intangible assets totaling $163.1 million
relating to certain acquisitions with no future value were
written off. Further, the aforementioned downturns in the
principal markets in which the Company continues to operate,
have negatively impacted the forecasted revenues and cash flows
from certain other businesses acquired during fiscal 1999 and
2000. As a result of these events, in accordance with the
Companys policy, the comparison of the undiscounted
expected future cash flows to the carrying amount of the related
intangible assets resulted in an impairment and accordingly the
Company recorded a write-down of these assets related to both of
the Companys Cable and Telecom segments of
$409.7 million during 2001 to reflect the fair value of
such assets.

During 2001, the Company recorded a deferred tax
asset of approximately $4.0 million and corresponding
reduction of goodwill, for the tax benefit of foreign net
operating loss carryforwards relating to a previous acquisition.
Due to the impairment write-off, the deferred tax asset, and
remaining net deferred tax liability were also written-off.

7.     Convertible
Subordinated Notes

In July 2000, the Company issued
$500 million of 5% Convertible Subordinated Notes due in
August 2007 (the Convertible Notes) resulting in net
proceeds to the Company of approximately $484.4 million.
The Convertible Notes are the Companys general unsecured
obligation and are subordinated in right of payment to all
existing and future senior indebtedness and to all of the
liabilities of the Companys subsidiaries. The Convertible
Notes are convertible into shares of the Companys common
stock at a conversion price of $84.01 per share at any time on
or after October 24, 2000 through maturity, unless
previously redeemed or repurchased. The Company may redeem some
or all of the Convertible Notes at any time on or after
October 24, 2000 and before August 7, 2003 at a
redemption price of $1,000 per $1,000 principal amount of the
Convertible Notes, plus accrued and unpaid interest, if any, if
the closing price of the Companys stock exceeds 150% of
the conversion price, or $126.01 for at least 20 trading days
within a period of 30 consecutive trading days ending on the
trading day prior to the date of mailing of the redemption
notice. The Company will also make an additional payment of
$193.55 per $1,000 principal amount of Convertible Notes, less
the amount of any interest actually paid on the Convertible
Notes before the date of redemption. The Company may redeem the
Notes at any time on or after August 7, 2003 at specified
prices plus accrued and unpaid interest. Interest is payable
semiannually. Debt issuance costs related to the Convertible
Notes were approximately $15.6 million and are amortized over
seven years. At December 31, 2001 amortization of debt
issuance costs totaled $1.1 million.

In 2001, the Company repurchased approximately
$325.9 million of the Convertible Subordinated Notes for
$113.4 million in cash and $17.9 million in stock,
resulting in an extraordinary gain of approximately
$185.3 million net of related unamortized issuance costs of
$9.3 million.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

8.     Contingencies



| |           
| | ----------
| | Litigation

In September 1999, a group of prospective
investors in Imedia Corporation (Imedia), now our subsidiary,
named Imedia as a defendant in an action alleging that Imedia
breached its term sheet with the plaintiffs when Imedia
negotiated its acquisition by us and, as a result, did not
permit plaintiffs to invest in Imedia. The plaintiffs sought
damages in excess of $12.0 million. The terms of the Imedia
Agreement and Plan of Merger and Reorganization provided that
shares of our common stock that were to be issued to the former
shareholders of Imedia were placed in escrow to indemnify us for
any damages that are directly or indirectly suffered by us as a
result of plaintiffs claims. The value of the escrowed
shares was approximately $10.0 million based on the market
value of our common stock on or about the closing date of the
acquisition.

On or about September 5, 2000, the Company
received an amended complaint (Complaint), Evergreen Canada
Israel Management, Ltd. v. Imedia Corporation, pending in
the Superior Court of the State of California. The Complaint
alleged both (i) intentional interference with contractual
relations and (ii) intentional interference with
prospective economic advantage against the Company, claiming
that the Company formed and operated a conspiracy to deprive
plaintiffs of the opportunity to invest in Imedia. Plaintiffs
argued that, prior to the Companys purchase of the Imedia
shares, the Company knew of an alleged, pre-existing financing
agreement between the plaintiffs and Imedia that contained a
no shop clause, prohibiting Imedia from seeking or
obtaining financing from any other sources, including a
prohibition against Imedia selling its own stock or engaging in
related transactions that preceded the acquisition. The Company
was subsequently served with the Complaint and filed a demurrer
challenging the legal sufficiency of the two causes of action.
Other defendants demurred also. The demurrer hearing was held on
January 16, 2001. Prior to the Court issuing a final ruling
at that hearing, the Plaintiffs agreed to amend their complaint.
The Plaintiffs filed a second amended complaint and, in
response, the Company filed demurrers challenging all the causes
of action. The Companys demurrer was heard on May 22,
2001, and the Court ruled that three contract claims and the
tortuous interference with the prospective economic advantage
claims should be dismissed. The Court also dismissed the two
fraud claims with leave to amend.

The Plaintiffs then filed a third amended
complaint, and the defendants each filed demurrers and motions
to strike challenging that pleading. The demurrers and motions
to strike were argued in November 2001.

Prior to a ruling on the demurrers and motions to
strike, the parties entered into a settlement agreement in which
Plaintiffs dismissed all claims with prejudice. The parties
agreed that the settlement agreement would not be construed to
be an admission of any liability on the part of the Company or
any of the other defendants. The lawsuit was dismissed with
prejudice in March 2002.

Beginning in April 2000, several plaintiffs filed
lawsuits against the Company and certain of its officers and
directors in federal court. The plaintiff in the first of these
lawsuits purported to represent a class whose members purchased
our securities between February 2, 2000 and April 11,
2000. The complaint alleged that the defendants had violated the
federal securities laws by issuing materially false and
misleading statements and failing to disclose material
information regarding our technology. The allegations in the
other lawsuits were substantially the same and, on
August 24, 2000, all of these lawsuits were consolidated in
the United States District Court, Northern District of
California. The consolidated lawsuit is named In re Terayon
Communication Systems, Inc. Securities Litigation. The court
hearing the consolidated action has appointed lead plaintiffs
and lead plaintiffs counsel pursuant to the Private
Securities Litigation Reform Act.

On September 21, 2000, the lead plaintiffs
filed a consolidated class action complaint containing factual
allegations nearly identical to those in the original lawsuits.
The consolidated class action complaint, however, alleged claims
on behalf of a class whose members purchased or otherwise
acquired our securities between November 15, 1999 and
April 11, 2000. On October 30, 2000, defendants moved
to dismiss the consolidated class action complaint. On
March 14, 2001, after defendants motion had been fully
briefed and argued, the

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

court issued an order granting in part
defendants motion and giving plaintiffs leave to file an
amended complaint. On April 13, 2001, plaintiffs filed
their first amended consolidated class action complaint. On
June 15, 2001, defendants moved to dismiss this new
complaint and oral argument on the motion occurred on
December 17, 2001. The Company has not received an order
from the court regarding the motion to dismiss argued on
December 17, 2001.

The lawsuit seeks an unspecified amount of
damages, in addition to other forms of relief. The Company
considers the lawsuits to be without merit and we intend to
defend vigorously against these allegations. However, the
litigation could prove to be costly and time consuming to
defend, and there can be no assurances about the eventual
outcome.

On October 16, 2000, a lawsuit was filed
against the Company and the individual defendants (Zaki Rakib,
Selim Rakib, and Raymond Fritz) in the superior court of San
Luis Obispo County, California. This lawsuit is titled
Bertram v. Terayon Communications Systems, Inc(Bertram).
The Bertram complaint contains factual allegations similar to
those alleged in the federal securities class action lawsuit.
The complaint asserts causes of action for unlawful business
practices, unfair and fraudulent business practices, and false
and misleading advertising. Plaintiffs purport to bring the
action on behalf of themselves and as representatives of
all persons or entities in the State of California and
such other persons or entities outside California that have been
and are adversely affected by defendants activity, and as
the Court shall determine is not inconsistent with the exercise
of the Courts jurisdiction. Plaintiffs seek
equitable and injunctive relief. Defendants removed the Bertram
case to the United States District Court, Central District of
California and, on January 19, 2001, filed a motion to
dismiss the complaint. A hearing on defendants motion was
held March 26, 2001 and the court granted Defendants
motion to dismiss the action and denied Plaintiffs motion
requesting remand. On April 5, 2001, Defendants moved for
an order requiring further proceedings, if any to take place in
the Northern District of California. Plaintiffs did not oppose
this motion and eventually entered into a stipulation to go
forward in the Northern District. On July 9, 2001, a status
conference was held in this case before Judge Patel. Plaintiffs
did not appear for the conference, and the court requested that
defendants submit an order dismissing the Bertram action with
prejudice, which the defendants have submitted to the court. The
Company believes that these allegations, as with the allegations
in the federal securities case, are without merit and intends to
contest the matter vigorously.

9.     Stockholders
Equity



| |                 
| | ----------------
| | Public Offerings

In January 1999, the Company completed a public
offering of 6,500,000 shares of common stock, of which 3,500,000
shares were offered by the Company and 3,000,000 shares were
offered by existing stockholders. The public offering resulted
in proceeds to the Company of approximately $62,500,000, net of
underwriting discounts, commissions, and other offering costs.
In February 1999, the underwriters purchased an additional
975,000 shares of common stock as a result of the exercise of
the over-allotment option, of which 703,892 and 271,108 shares
of common stock were purchased from the Company and certain
existing stockholders, respectively. This additional sale of
common stock resulted in additional proceeds of approximately
$12,700,000 to the Company.



| |                        
| | -----------------------
| | Stockholder Rights Plan

In February 2001, the Companys Board of
Directors approved the adoption of a Stockholder Rights Plan
under which all stockholders of record as of February 20,
2001 received rights to purchase shares of a new series of
Preferred Stock. The rights were distributed as a non-taxable
dividend and will expire in ten years from the record date. The
rights will be exercisable only if a person or group acquires
15 percent or more of the Companys Common Stock or
announces a tender offer for 15 percent or more of the
Companys Common Stock. If a person or group acquires
15 percent or more of the Companys Common Stock, all
rights holders

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

except the buyer will be entitled to acquire the
Companys Common Stock at a discount. The Board may
terminate the Rights Plan at any time or redeem the rights prior
to the time a person or group acquires more than 15 percent
of the Companys Common Stock.



| |             
| | ------------
| | Common Stock

In February 2000, the Companys board of
directors approved a two-for-one split of the Companys
outstanding shares of common stock to be effected in the form of
a stock dividend, subject to stockholder approval of an increase
in the Companys authorized shares of common stock. In
April 2000, the Companys stockholders approved an increase
in the Companys authorized shares to 200,000,000. The
Companys Board of Directors subsequently established the
record date for the stock split as April 25, 2000 and the
stock dividend was distributed on May 5, 2000. The changes
in the capital structure resulting from the split were given
retroactive effect in the consolidated financial statements.

In June 2001, the Company issued 160,000 shares
of the Companys common stock to members of their Board of
Advisors and recorded $595,000 in related compensation expense.
The compensation expense was calculated using the closing price
of the Companys common stock on the date the stock was
issued of $3.72 per share.

In November 2001, the Companys Board of
Directors approved a tender offer which permitted employees and
members of the Board of Directors the ability to exchange all
unvested options granted with an exercise price per share equal
to or greater than $9.00 for a common stock award. On
December 6, 2001, 9,480,629 outstanding options were
exchanged for 141,442 shares of common stock. The value of the
common stock issued was $2,001,000, using the closing price of
the Companys common stock on the date of issuance of
$14.15 per share, and was recorded as compensation expense in
2001.

During 2001, the Company issued 115,250 shares of
common stock to its employees, and recorded $642,000 in related
compensation expense. The compensation expense was calculated
using the closing price of the Companys common stock on
the date of issuance.



| |                      
| | ---------------------
| | Common Stock Warrants

In conjunction with a Series F convertible
preferred stock financing in April 1998, the Company issued a
warrant to purchase 6,000,000 shares of the Companys
common stock at an exercise price of $3.25 per share to Shaw
Communications, Inc. (the Shaw Warrant). In
addition, the Company issued a warrant (the Anti-Dilution
Warrant) to purchase an indeterminate number of shares of
common stock. The Anti-Dilution Warrant is exercisable at the
option of Shaw Communications, Inc. (Shaw) during
the period that Shaw owns equity in the Company and in the event
the Company issues new equity securities at below the current
market price defined in the Anti-Dilution warrant. The aggregate
exercise price is $0.50. The Company issued certain equity
securities that, as of December 31, 2001 and 1999, required
the Company to issue an additional 35,982 and 33,936 warrants to
purchase shares of common stock, respectively, pursuant to the
Anti-Dilution warrant. During the year ended December 31,
2000 no equity securities were issued that resulted in the
increase in the number of shares issuable pursuant to the
Anti-Dilution warrant. The Company recorded expenses of
approximately $226,000 and $439,000 relating to the issuance of
warrants pursuant to the Anti-Dilution Warrant, in 2001 and
1999, respectively, and none in 2000. As of December 31,
2001, the Anti-Dilution Warrant was exercisable for an aggregate
of 108,300 shares of the Companys common stock.

In March 1999, Shaw purchased 3,000,000 shares of
the Companys common stock at $3.25 per share and in
November 1999 Shaw purchased an additional 3,000,000 shares of
the Companys common stock at $3.25 per share, resulting in
net proceeds to the Company of $19.5 million. The shares
were purchased pursuant to the exercise of the Shaw Warrant.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

On March 18, 1999, the Company entered into
a one-year Product Development Assistance Agreement
(Development Agreement) with Rogers Communications
Inc (Rogers). Under the terms of the Development
Agreement, Rogers agreed to provide the Company assistance with
the characterization and testing of the Companys
subscriber-end and head-end voice over cable equipment. In
addition, Rogers agreed to provide the Company technology to
assist the Company in connection with its efforts to develop
high quality, field proven technology solutions that are DOCSIS
(1.0, 1.1 and 1.2)-compliant and packet cable-compliant. In
consideration of Rogers entering into the Development Agreement,
the Company issued Rogers two fully vested and non-forfeitable
warrants, each to purchase 2,000,000 shares of common stock. One
warrant has an exercise price of $0.50 per share and one warrant
has an exercise price of $18.50 per share. The warrants were
exercisable in full or in part through March 31, 2000. The
fair value of the two warrants was approximately $45,000,000 and
resulted in a noncash charge included in operations over the
term of the Product Development Assistance Agreement. As a
result of the Development Agreement, the Companys results
of operations for the years ended December 31, 2000 and
1999 include noncash charges of $9.6 million and
$35.1 million, respectively. In February 2000, Rogers
exercised the warrants on a cashless basis, resulting in the
issuance of 3,687,618 shares of the Companys common stock
and no proceeds to the Company.

In October 1999, a customer of the Company
entered into an agreement with Telegate Ltd. whereby the
Customer committed to an investment in Telegate in connection
with the acquisition of all the outstanding shares of Telegate
by the Company. The Customer committed to provide this
investment in the event that the acquisition of Telegate by the
Company were not to have closed. In January 2000, the Company
issued the customer a warrant to purchase 2,000,000 shares of
the Companys common stock at a price of $30.75 per share;
the closing price of the Companys common stock on the date
the warrant was issued. The warrant is fully vested,
non-forfeitable, and immediately exercisable and has a term of
three years. The fair value of the warrant, determined as
approximately $34,600,000 using the Black Scholes model, was
included in the Telegate purchase price and was associated with
the value of the customer relationship. The value of the warrant
resulted in a non-cash charge to cost of goods sold to be
amortized over the three- year term of the warrant. For the year
ended December 31, 2001 and 2000, the Company incurred
approximately $2,900,000 and $11,500,000 in amortization expense
related to the Warrant, respectively. The Company did not record
any related amortization expense in 1999. In the first quarter
of 2001, the Company wrote-off the intangible assets relating to
the purchase of Telegate (see Note 6).

In February 2001, the Company issued a warrant to
purchase 200,000 shares of the Companys common stock at a
price of $5.4375 per share, the closing price of the
Companys common stock on the date the warrant was issued,
in connection with the December 2000 acquisition of TrueChat,
Inc. Under terms of the warrant 100,000 shares are vested and
exercisable immediately and the remaining 100,000 shares vest
and become exercisable at the rate of  1/24 per month,
beginning January 31, 2001. The fair value of the warrant
of approximately $682,000 was calculated using the Black-Scholes
method and was recorded as additional consideration relating to
the purchase of TrueChat, Inc.

In June 2001, the Company issued a fully vested,
immediately exercisable, warrant to purchase 100,000 shares of
the Companys Common Stock at a price of $5.98 per share to
Philips Semiconductors Inc. in consideration for the
continuation of their strategic relationship with the Company.
The fair value of the warrant, calculated using the Black
Scholes method of approximately $280,000 was recorded as cost of
goods sold during 2001.

55



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                      
| | ---------------------
| | Common Stock Reserved

Common stock reserved for issuance is as follows:

|                             |  |              |            | 
|---------------------------- |  | ------------ | ---------- | 
|                             |  | December 31,
|                             |  | 2001        
|                             |  |             
|Common stock options         |  |              | 40,405,352 | 
|Common stock warrants        |  |              | 2,408,300  | 
|Employee stock purchase plan |  |              | 539,186    | 
|                             |  |              |            | 
|                             |  |              | 43,352,838 | 
|                             |  |              |            | 



| |                         
| | ------------------------
| | Stock-Based Compensation

In March 1995, the Board of Directors approved a
stock option plan (the 1995 Plan), that authorized
shares for future issuance to be granted as options to purchase
shares of the Companys common stock. As of
December 31, 2001 a total of 4,229,494 shares have been
authorized for issuance related to the 1995 Plan.

In February 1997, the Board of Directors approved
an equity incentive plan (the 1997 Plan), that
authorized 2,100,000 shares for future issuance to be granted as
options to purchase shares of the Companys common stock.
In June 1998, the Companys Board of Directors authorized
the adoption of the amended 1997 Plan, increasing the aggregate
number of shares authorized for issuance under the 1997 Plan to
6,600,000 shares (4,500,000 additional shares). The amendment
also provided for an increase to the authorized shares each year
on January 1, starting with January 1, 1999, if the
number of shares reserved for future issuance was less than five
percent (5%) of the Companys outstanding common stock,
then the authorized shares would be increased to a balance equal
to 5% of the common stock outstanding. There were no increases
to the 1997 Plan in 1998 or 1999. On January 1, 2000,
2,384,528 shares were added to the 1997 Plan for a total of
8,984,528 shares.

The 1997 Plan was amended on June 13, 2000
to increase the number of shares of common stock from 8,984,528
to 12,754,528 (3,770,000 additional shares) and to provide for
an increase in the number of shares of common stock
(Evergreen Provision) on January 1, 2000
through and including January 1, 2007, by the lesser of
five percent (5%) of the common stock outstanding on such
January 1 or 3,000,000 shares. On January 1, 2001,
3,000,000 shares were added to the 1997 plan pursuant to the
evergreen provision.

In June 1998, the Companys Board of
Directors authorized the adoption of the 1998 Non-Employee
Directors Stock Option Plan (the 1998 Plan),
pursuant to which 400,000 shares of the Companys common
stock have been reserved for future issuance to non-employee
directors of the Company.

In September 1999, the Companys Board of
Directors authorized the adoption of the 1999 Non-Officers
Equity Incentive Plan (the 1999 Plan), pursuant to
which 6,000,000 shares of the Companys common stock have
been reserved for future issuance to non-officer employees of
the Company. In 2000, the Companys Board of Directors
amended the 1999 Plan to increase the number of authorized
shares to 18,500,000. In 2001, the Companys Board of
Directors amended the 1999 Plan to increase the number of
authorized shares to 28,500,000.

At December 31, 2001, the total authorized
number of shares under the 1995, 1997, 1998 and 1999 plans was
4,229,494, 15,754,528, 400,000 and 28,500,000 respectively. All
Plans are administered by the Board of Directors.

The 1995 and 1997 Plans provide for incentive
stock options or nonqualified stock options to be issued to
employees, directors, and consultants of the Company. Prices for
incentive stock options may not be less than the fair market
value of the common stock at the date of grant. Prices for
nonqualified stock options may not be less than 85% of the fair
market value of the common stock at the date of grant. Options
are immediately

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

exercisable and vest over a period not to exceed
five years from the date of grant. Any unvested stock issued is
subject to repurchase by the Company at the original issuance
price upon termination of the option holders employment.
Unexercised options expire ten years after the date of grant.

The 1998 Plan provides for non-discretionary
nonqualified stock options to be issued to non-employee
directors of the Company automatically as of the effective date
of their election to the Board of Directors and annually
following each Annual Stockholder meeting. Prices for
nonqualified options may not be less than 100% of the fair
market value of the common stock at the date of grant. Options
vest and become exercisable over a period not to exceed three
years from the date of grant. Unexercised options expire ten
years after the date of grant.

The 1999 Plan provides for nonqualified stock
options to be issued to non-officer employees and consultants of
the Company. Prices for nonqualified stock options many not be
less than 85% of the fair market value of the common stock at
the date of the grant. Options vest and become exercisable over
a period not to exceed five years from the date of grant.
Unexercised options expire ten years after date of grant.

During the year ended December 31, 2001 and
2000, the Company recorded aggregate deferred compensation of
approximately $35,000 and $3,500,000, respectively, representing
the difference between the grant price and the deemed fair value
of the Companys common stock options granted during the
period. The amortization of deferred compensation is being
charged to operations and is being amortized over the vesting
period of the options, which is typically five years. For the
years ended December 31, 2001, 2000 and 1999, the
amortization expense was approximately $456,000, $631,000 and
$631,000, respectively.

The following is a summary of additional
information with respect to the 1995 Stock Option Plan, the 1997
Equity Incentive Plan, the 1998 Non-Employee Directors
Stock Option Plan, the 1999 Non-Officer Equity Incentive Plan,
outstanding options assumed by Terayon in conjunction with its
business acquisitions of (see Note 14) and option
grants made outside the Plans:

|                              |                    |           |            |                     |   |                  |            |             |   |   |       |       | 
|----------------------------- | ------------------ | --------- | ---------- | ------------------- | - | ---------------- | ---------- | ----------- | - | - | ----- | ----- | 
|                              |                    |           |            |                    
|                              |                    |           |            | Options Outstanding
|                              |                    |           |            | and Exercisable    
|                              |                    |           |            |                    
|                              |                    | Options   |            | Number              |   | Weighted-Average
|                              |                    | Available |            | of                  |   | Exercise        
|                              |                    | for Grant |            | Shares              |   | Price           
|                              |                    |           |            |                     |   |                 
|Balance at December 31, 1998. |                    |           | 4,157,483  |                     |   |                  | 5,382,468  |             |   | $ | 2.27  |      
|                              | Options authorized |           |            | 6,000,000           |   |                  |            |            |   |   |       |      | 
|                              | Options granted    |           |            | (7,826,568          | ) |                  |            | 7,826,568   |   |   | $     | 22.00 | 
|                              | Options exercised  |           |            |                    |   |                  |            | (1,927,986  | ) |   | $     | 1.73  | 
|                              | Options canceled   |           |            | 938,712             |   |                  |            | (938,712    | ) |   | $     | 5.83  | 
|                              |                    |           |            |                     |   |                  |            |             |   |   |       |      
|Balance at December 31, 1999. |                    |           | 3,269,627  |                     |   |                  | 10,342,338 |             |   | $ | 16.78 |      
|                              | Options authorized |           |            | 18,654,528          |   |                  |            |            |   |   |       |      | 
|                              | Options granted    |           |            | (15,937,301         | ) |                  |            | 15,937,301  |   |   | $     | 51.14 | 
|                              | Options exercised  |           |            |                    |   |                  |            | (1,936,867  | ) |   | $     | 7.26  | 
|                              | Options canceled   |           |            | 2,853,236           |   |                  |            | (2,853,236  | ) |   | $     | 1.36  | 
|                              |                    |           |            |                     |   |                  |            |             |   |   |       |      
|Balance at December 31, 2000  |                    |           | 8,840,090  |                     |   |                  | 21,489,536 |             |   | $ | 39.27 |      
|                              | Options authorized |           |            | 13,000,000          |   |                  |            |            |   |   |       |      | 
|                              | Options granted    |           |            | (22,925,565         | ) |                  |            | 22,925,565  |   |   | $     | 6.25  | 
|                              | Options exercised  |           |            |                    |   |                  |            | (2,924,274  | ) |   | $     | 4.59  | 
|                              | Options canceled   |           |            | 21,483,141          |   |                  |            | (21,483,141 | ) |   | $     | 35.99 | 
|                              |                    |           |            |                     |   |                  |            |             |   |   |       |      
|Balance at December 31, 2001  |                    |           | 20,397,666 |                     |   |                  | 20,007,686 |             |   | $ | 9.75  |      
|                              |                    |           |            |                     |   |                  |            |             |   |   |       |      

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In addition, the following table summarizes
information about stock options that were outstanding and
exercisable at December 31, 2001:

|                         |       |                                     |            |                  |  |                  |        |  |  |  |      |  | 
|------------------------ | ----- | ----------------------------------- | ---------- | ---------------- |  | ---------------- | ------ |  |  |  | ---- |  | 
|                         |       |                                    
|                         |       | Options Outstanding and Exercisable
|                         |       |                                    
|                         |       |                                     |            | Weighted-Average
|                         |       | Number                              |            | Weighted-Average |  | Remaining       
|                         |       | of                                  |            | Exercise         |  | Contractual Life
|Range of Exercise Prices |       | Shares                              |            | Price            |  | (in Years)      
|                         |       |                                     |            |                  |  |                 
|$ 0.01 - $ 6.52          |       |                                     | 6,252,038  |                  |  | $                | 4.65   |  |  |  | 8.69 | 
|$ 6.54 - $ 6.81          |       |                                     | 10,594,391 |                  |  | $                | 6.81   |  |  |  | 9.13 | 
|$ 6.86 - $31.41          |       |                                     | 2,043,321  |                  |  | $                | 20.25  |  |  |  | 8.29 | 
|$31.47 - $69.75          |       |                                     | 1,067,603  |                  |  | $                | 43.82  |  |  |  | 8.23 | 
|$82.78 - $123.50         |       |                                     | 50,333     |                  |  | $                | 112.12 |  |  |  | 8.21 | 
|                         |       |                                     |            |                  |  |                  |        |  |  |  |      | 
|                         | Total |                                     |            | 20,007,686       |  |                  |        |  |  |  |      |  | 
|                         |       |                                     |            |                  |  |                  |        |  |  |  |      | 

At December 31, 2001, approximately
6,437,117 options issued and outstanding were exercisable and
approximately 18,835 shares of common stock outstanding were
subject to repurchase by the Company. Common stock subject to
repurchase represents any unvested shares of common stock held
by an optionholder which, upon termination of the
optionholders employment, may be repurchased by the
Company. Such shares are subject to repurchase at their original
issuance price. Repurchased shares are recorded as Treasury
stock.

In June 1998, the Board of Directors approved,
and the Company adopted, the 1998 Employee Stock Purchase Plan
(the ESPP), which is designed to allow eligible
employees of the Company to purchase shares of common stock at
semiannual intervals through periodic payroll deductions. An
aggregate of 1,400,000 shares of common stock has been reserved
for the ESPP, and 860,814 shares have been issued through
December 31, 2001. The Purchase Plan is implemented in a
series of successive offering periods, each with a maximum
duration of 24 months. Eligible employees can have up to
15% of their base salary deducted that is to be used to purchase
shares of the common stock on specific dates determined by the
Board of Directors (up to a maximum of $25,000 per year based
upon the fair market value of the shares at the beginning date
of the offering). The price of common stock purchased under the
Purchase Plan will be equal to 85% of the lower of the fair
market value of the common stock on the commencement date of
each offering period or the specified purchase date.

The Company has elected to follow APB Opinion
No. 25 and related interpretations in accounting for its
employee stock plans because, as discussed below, the
alternative fair value accounting provided for under
FAS 123 requires the use of valuation models that were not
developed for use in valuing employee stock instruments. Under
APB Opinion No. 25, when the exercise price of the
Companys employee stock options equals the market price of
the underlying stock on the date of grant, no compensation
expense is recognized.

Pro forma information regarding net loss is
required under FAS 123 and is calculated as if the Company
had accounted for its employee stock options granted during the
years ended December 31, 2001, 2000 and 1999 and for its
ESPP shares to be issued under the fair value method of
FAS 123. The fair value for employee stock options granted
was estimated at the date of grant based on the Black-Scholes
model using the following weighted average assumptions:
risk-free interest rates of 4.50%, 5.98%, and 6.70%, for 2001,
2000, and 1999, respectively; no dividend yield; volatility
factors of 1.50, 1.20, and 0.80 for 2001, 2000, and 1999,
respectively and a weighted average expected life of the option
of five years. The fair value for employee stock purchase plan
shares to be issued was estimated using the following weighted
average assumptions: risk-free interest rate of 4.14%, 6.35% and
6.71% for 2001, 2000 and 1999, respectively, no dividend yield,
volatility factors of 1.50, 1.20, and 0.80 for 2001, 2000, and
1999, respectively and a weighted average expected life of the
shares of six months.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

As discussed above, the valuation models used
under FAS 123 were developed for use in estimating the fair
value of traded options that have no vesting restrictions and
are fully transferable. In addition, valuation models require
the input of highly subjective assumptions, including the
expected life of the option. Because the Companys employee
stock options have characteristics significantly different from
those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimate,
in managements opinion, the existing models do not
necessarily provide a reliable single measure of the fair value
of its employee stock instruments.

For purposes of pro forma disclosures, the
estimated fair value of the options granted and ESPP shares to
be issued is amortized to expense over their respective vesting
periods. Had compensation cost for the Companys
stock-based compensation plans been determined based on the fair
value at the grant dates for awards under those plans consistent
with the method of FAS 123, the Companys net loss
applicable to common stockholders and net loss per share
applicable to common stockholders would have been increased to
the pro forma amounts indicated below (in thousands, except per
share data):

|                                               |  |                          |          |      |  |      |          |   |  |   |         |  
|---------------------------------------------- |  | ------------------------ | -------- | ---- |  | ---- | -------- | - |  | - | ------- | -
|                                               |  |                         
|                                               |  | Years Ended December 31,
|                                               |  |                         
|                                               |  | 2001                     |          | 2000 |  | 1999
|                                               |  |                          |          |      |  |     
|Pro forma net loss                             |  | $                        | (692,779 | )    |  | $    | (300,666 | ) |  | $ | (75,321 | )
|                                               |  |                          |          |      |  |      |          |   |  |   |         |  
|Pro forma basic and diluted net loss per share |  | $                        | (10.14   | )    |  | $    | (4.90    | ) |  | $ | (1.83   | )
|                                               |  |                          |          |      |  |      |          |   |  |   |         |  

The pro forma impact of options granted and ESPP
shares to be issued on the net loss applicable to common
stockholders for the years ended December 31, 2001, 2000
and 1999 is not representative of the effects on net income
(loss) for future years, as future years will include the
effects of options vesting as well as the impact of multiple
years of stock option grants.

The options weighted average grant date
fair value, which is the value assigned to the options under
FAS 123, was $5.83, $43.81, and $28.31, for options granted
during 2001, 2000, and 1999,respectively. The weighted average
grant date fair value of ESPP shares to be issued was $3.99,
$9.30 and $8.40 for the years ended December 31, 2001, 2000
and 1999, respectively.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

10.     Income
Taxes

For the year ended December 31, 2001, the
Company had a benefit from Income Taxes of $13.9 million.
Due to operating losses and the inability to recognize the
benefits, there is no provision for income taxes for the years
ended December 31, 2000 and 1999.

|          |         |                         |         |         |         |      |   |   |   |   |   |   |   | 
|--------- | ------- | ----------------------- | ------- | ------- | ------- | ---- | - | - | - | - | - | - | - | 
|          |         |                        
|          |         | Year Ended December 31,
|          |         |                        
|          |         | 2001                    |         | 2000    |         | 1999
|          |         |                         |         |         |         |     
|          |         |                        
|          |         | (In thousands)         
|Current:  |         |                         |         |         |         |      |   |   |   |   |   |  
|          | Federal |                         | $       |        |         |      | $ |  |   |   | $ |  |  
|          | State   |                         | $       |        |         |      | $ |  |   |   | $ |  |  
|          | Foreign |                         | $       | 831     |         |      | $ |  |   |   | $ |  |  
|          |         |                         |         |         |         |      |   |   |   |   |   |  
|          |         | Total current           |         | $       | 831     |      |   | $ |  |   |   | $ |  | 
|Deferred: |         |                         |         |         |         |      |   |   |   |   |   |  
|          | Federal |                         | $       |        |         |      | $ |  |   |   | $ |  |  
|          | State   |                         | $       |        |         |      | $ |  |   |   | $ |  |  
|          | Foreign |                         | $       | (14,746 | )       |      | $ |  |   |   | $ |  |  
|          |         |                         |         |         |         |      |   |   |   |   |   |  
|          |         | Total deferred          |         | $       | (14,746 | )    |   | $ |  |   |   | $ |  | 
|          |         |                         |         |         |         |      |   |   |   |   |   |  
|Total     |         | $                       | (13,915 | )       |         | $    |  |   |   | $ |  |  

During 2001, the Company recorded a deferred tax
asset of approximately $4.0 million and corresponding
reduction of goodwill, for the tax benefit of foreign net
operating loss carryforwards relating to a previous acquisition.
Due to the impairment write-off, the deferred tax asset, and
remaining net deferred tax liability were also written-off.

The reconciliation of income tax benefit
attributable to net loss applicable to common stockholders
computed at the U.S. federal statutory rates to income tax
benefit (in thousands):

|                                                         |  |                          |          |      |  |      |         |   |  |   |         |  
|-------------------------------------------------------- |  | ------------------------ | -------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                         |  |                         
|                                                         |  | Years Ended December 31,
|                                                         |  |                         
|                                                         |  | 2001                     |          | 2000 |  | 1999
|                                                         |  |                          |          |      |  |     
|Tax benefit at U.S. statutory rate                       |  | $                        | (197,346 | )    |  | $    | (63,268 | ) |  | $ | (22,428 | )
|Goodwill amortization                                    |  |                          | 2,849    |      |  |      | 19,405  |   |  |   | 1,233   |  
|In-process research and development                      |  |                          |         |      |  |      | 8,698   |   |  |   | 5,110   |  
|Loss for which no tax benefit is currently
	recognizable |  |                          | 179,338  |      |  |      | 34,529  |   |  |   | 16,085  |  
|Other, net                                               |  |                          | 1,244    |      |  |      | 636     |   |  |   |        |  
|                                                         |  |                          |          |      |  |      |         |   |  |   |         |  
|                                                         |  | $                        | (13,915  | )    |  | $    |        |   |  | $ |        |  
|                                                         |  |                          |          |      |  |      |         |   |  |   |         |  

Deferred income taxes reflect the net tax effects
of temporary differences between the carrying amounts of assets
and liabilities for financial reporting purposes and the amounts
used for income tax purposes.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Significant components of the Companys
deferred tax assets and liabilities as of December 31, 2001
and 2000 are as follows (in thousands):

|                         |                                      |                              |   |          |   |  |   |          |         |  
|------------------------ | ------------------------------------ | ---------------------------- | - | -------- | - |  | - | -------- | ------- | -
|                         |                                      |                             
|                         |                                      | December 31,                
|                         |                                      |                             
|                         |                                      | 2001                         |   | 2000    
|                         |                                      |                              |   |         
|Deferred tax assets:     |                                      |                              |   |          |   |  |   |         
|                         | Net operating loss carryforwards     |                              | $ | 130,321  |   |  | $ | 100,477  |        
|                         | Tax credit carryforwards             |                              |   | 13,047   |   |  |   | 6,808    |        
|                         | Reserves and accruals                |                              |   | 58,418   |   |  |   | 8,760    |        
|                         | Capitalized research and development |                              |   | 7,580    |   |  |   | 4,232    |        
|                         | Intangibles amortization             |                              |   | 8,396    |   |  |   | 9,078    |        
|                         | Deferred revenue                     |                              |   |         |   |  |   | 1,353    |        
|                         | Other, net                           |                              |   | 610      |   |  |   | 994      |        
|                         |                                      |                              |   |          |   |  |   |         
|                         | Gross deferred tax assets            |                              |   | 218,372  |   |  |   | 131,702  |        
|                         | Valuation allowance                  |                              |   | (218,372 | ) |  |   | (131,702 | )      
|                         |                                      |                              |   |          |   |  |   |         
|                         |                                      | Total deferred tax assets    |   |          |  |  |   |          |        |  
|Deferred tax liabilities |                                      |                              |   |          |   |  |   |         
|                         | Acquired intangibles                 |                              |   |         |   |  |   | (18,565  | )      
|                         |                                      |                              |   |          |   |  |   |         
|                         |                                      | Net deferred tax liabilities |   | $        |  |  |   | $        | (18,565 | )
|                         |                                      |                              |   |          |   |  |   |         

Realization of deferred tax assets is dependent
on future earnings, if any, the timing and the amount of which
are uncertain. Accordingly, a valuation allowance has been
established to reflect these uncertainties as of
December 31, 2001 and 2000. The change in the valuation
allowance was a net increase of approximately $86,670,000,
$88,182,000, and $18,976,000 for the years ended
December 31, 2001, 2000, and 1999, respectively.
Approximately $47,172,000 of the valuation allowance will be
credited to equity when realized.

As of December 31, 2001, the Company had
federal, California and foreign net operating loss carryforwards
of approximately $281,923,000, $126,338,000 and $111,283,000,
respectively. The Company also had federal and California tax
credit carryforwards of approximately $7,776,000 and $8,109,000,
respectively. The federal and California net operating loss and
credit carryforwards will expire at various dates beginning in
the years 2002 through 2021, if not utilized. The foreign net
operating losses have an unlimited carryover period.

Utilization of net operating loss and tax credit
carryforwards may be subject to a substantial annual limitation
due to the ownership change limitations provided by the Internal
Revenue Code of 1986, as amended, and similar state provisions.
The annual limitation may result in the expiration of net
operating loss and tax credit carryforwards before full
utilization.

11.     Segments of
an Enterprise and Related Information

The Chief Executive Officer has been identified
as the Chief Operating Decision Maker (CODM) because he has
final authority over resource allocation decisions and
performance assessment. The CODM allocates resources to each
segment based on their business prospects, competitive factors,
revenues and operating results.

The Company views its business as having two
principal operating segments: Cable Broadband Access Systems
(Cable) and Telecom Carrier Access Systems
(Telecom). The Cable segment consists primarily of
the TeraComm system, the CherryPicker Digital Video Management
Systems, and the Multigate Telephony and Data Access Systems
which are sold primarily to cable operators for the deployment
of data,

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

video and voice services over the existing cable
infrastructure. The Telecom segment consists primarily of the
Miniplex DSL Systems, the IPTL Converged Voice and Data Service
System and the Highlink, which are sold to providers of
broadband services for the deployment of voice and data services
over the existing copper wire infrastructure.

Information on reportable segments is as follows
(in thousands):

|                                  |                                       |                          |         |          |         |      |           |          |         |   |        |         |        | 
|--------------------------------- | ------------------------------------- | ------------------------ | ------- | -------- | ------- | ---- | --------- | -------- | ------- | - | ------ | ------- | ------ | 
|                                  |                                       |                         
|                                  |                                       | Years Ended December 31,
|                                  |                                       |                         
|                                  |                                       | 2001                     |         | 2000     |         | 1999
|                                  |                                       |                          |         |          |         |     
|Cable Broadband Access Segment:   |                                       |                          |         |          |         |      |           |          |         |   |        |        
|                                  | Revenues                              |                          | $       | 245,828  |         |      | $         | 303,524  |         |   | $      | 97,009  |       
|                                  | Operating loss                        |                          |         | (465,435 | )       |      |           | (132,643 | )       |   |        | (69,088 | )     
|                                  | Total assets                          |                          |         | 455,836  |         |      |           | 902,262  |         |   |        | 301,236 |       
|Telecom Broadband Access Segment: |                                       |                          |         |          |         |      |           |          |         |   |        |        
|                                  | Revenues                              |                          |         | 33,653   |         |      |           | 36,025   |         |   |        |        |       
|                                  | Operating loss                        |                          |         | (297,697 | )       |      |           | (54,834  | )       |   |        |        |       
|                                  | Total assets                          |                          |         | 10,810   |         |      |           | 524,465  |         |   |        |        |       
|Total Revenues                    |                                       | $                        | 279,481 |          |         | $    | 339,549   |          |         | $ | 97,009 |        
|Operating loss:                   |                                       |                          |         |          |         |      |           |          |         |   |        |        
|                                  | Operating loss by reportable segments |                          | $       | (763,132 | )       |      | $         | (187,477 | )       |   | $      | (69,088 | )     
|                                  | Unallocated amounts:                  |                          |         |          |         |      |           |          |         |   |        |         |       
|                                  | Interest and other income, net        |                          |         | 44       |         |      |           | 6,710    |         |   |        | 5,008   |       
|                                  | Extraordinary gain                    |                          |         | 185,327  |         |      |           |         |         |   |        |        |       
|                                  | Tax Benefit                           |                          |         | 13,915   |         |      |           |         |         |   |        |        |       
|                                  |                                       |                          |         |          |         |      |           |          |         |   |        |        
|                                  | Net loss                              |                          | $       | (563,846 | )       |      | $         | (180,767 | )       |   | $      | (64,080 | )     
|                                  |                                       |                          |         |          |         |      |           |          |         |   |        |        
|Geographic areas:                 |                                       |                          |         |          |         |      |           |          |         |   |        |        
|                                  | Revenues:                             |                          |         |          |         |      |           |          |         |   |        |         |       
|                                  |                                       | United States            |         | $        | 50,291  |      |           | $        | 83,974  |   |        | $       | 15,598 | 
|                                  |                                       | Canada                   |         |          | 113,300 |      |           |          | 118,491 |   |        |         | 41,008 | 
|                                  |                                       | Europe and Israel        |         |          | 51,480  |      |           |          | 61,741  |   |        |         | 24,746 | 
|                                  |                                       | Asia                     |         |          | 61,815  |      |           |          | 60,985  |   |        |         | 12,755 | 
|                                  |                                       | South America            |         |          | 2,595   |      |           |          | 14,358  |   |        |         | 2,902  | 
|                                  |                                       |                          |         |          |         |      |           |          |         |   |        |        
|                                  | Total                                 |                          | $       | 279,481  |         |      | $         | 339,549  |         |   | $      | 97,009  |       
|                                  |                                       |                          |         |          |         |      |           |          |         |   |        |        
|Long-lived assets:                |                                       |                          |         |          |         |      |           |          |         |   |        |        
|                                  |                                       | United States            |         | $        | 36,106  |      |           | $        | 339,559 |   |        |         |        | 
|                                  |                                       | Canada                   |         |          | 256     |      |           |          |        |   |        |         |        | 
|                                  |                                       | Europe and Israel        |         |          | 4,145   |      |           |          | 337,493 |   |        |         |        | 
|                                  |                                       | Asia                     |         |          | 243     |      |           |          | 177     |   |        |         |        | 
|                                  |                                       | South America            |         |          | 2,020   |      |           |          |        |   |        |         |        | 
|                                  |                                       |                          |         |          |         |      |           |          |         |   |        |        
|                                  |                                       | Total Long-lived assets  |         |          | 42,770  |      |           |          | 677,229 |   |        |         |        | 
|Total current assets              |                                       |                          | 423,876 |          |         |      | 749,498   |          |         |   |        |        
|                                  |                                       |                          |         |          |         |      |           |          |         |   |        |        
|Total Assets                      |                                       | $                        | 466,646 |          |         | $    | 1,426,727 |          |         |   |        |        
|                                  |                                       |                          |         |          |         |      |           |          |         |   |        |        

62



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Two customers, both related to Cable, accounted
for 10% or more of total revenues (33% and 13%) for the year
ended December 31, 2001. Three customers, all of which
related to Cable, accounted for 10% or more of total revenues
(17%, 17%, and 11%) for the year ended December 31, 2000.
Four customers accounted for 10% or more of total revenues (24%,
17%, 14% and 11%) for the year ended December 31, 1999. No
other customer accounted for more than 10% of revenues during
these years.

12.     Defined
Contribution Plan

During 1995, the Company adopted a 401(k) Profit
Sharing Plan and Trust that allows eligible employees to make
contributions subject to certain limitations. The Company may
make discretionary contributions based on profitability as
determined by the Board of Directors. No amount was contributed
by the Company to the plan during the years ended
December 31, 2001, 2000, and 1999.

13.     Related Party
Transactions

During the years ended December 31, 2001,
2000 and 1999, the Company recognized revenue of $52,445,000,
$119,321,000 and $39,664,000, respectively in connection with
product shipments made to Shaw and Rogers, each of which has one
representative on the Companys Board of Directors and is a
significant stockholder. Beginning in the third quarter of 2001,
as Shaw was no longer a significant stockholder and the board
member from Shaw resigned, Shaw was no longer considered a
related party. Revenues from Shaw are not included as revenue
from related parties after the second quarter of 2001, when Shaw
ceased to be a related party. Cost of related party product
revenues consists of direct product costs. Accounts receivable
from Rogers totaled approximately $4,006,000 at
December 31, 2001. At December 31, 2000, accounts
receivable from Shaw and Rogers totaled approximately
$17,454,000.

On March 18, 1999, the Company entered into
a Supply Agreement with Rogers, formerly Rogers Cablesystems
Limited, a subsidiary of Rogers Communications. The Supply
Agreement and the Development Agreement did not constitute a
commitment to purchase or deploy any particular volume or
quantity of the Companys product. Such commitment was only
made when a valid purchase order was issued to the Company.
Under the Supply Agreement, the Company agreed to make available
to Rogers its current TeraLink Gateway, TeraLink 1000
Master Controller, TeraPro Cable Modems and specified software.
The Company also committed to certain product pricing and
specifications. Under the terms of the Supply Agreement, Rogers
retained the right to return to the Company all products
purchased until certain conditions specified in the agreement
were met by the Company. Accordingly, the Company did not
recognize revenue on shipments to Rogers until the conditions
specified in the Agreement were met or Rogers had waived the
right to return the product. The Company deferred recognition of
revenue for shipments to Rogers until the quarter ended
September 30, 1999 when the first waiver was received from
Rogers. The Company subsequently recognized revenue only to the
extent that Rogers had waived the rights of return for such
product. As of March 31, 2000, Rogers had waived all rights
of return under the Supply Agreement; accordingly, the only
rights of return that remain available to Rogers are those
provided under the Companys standard warranty policy. The
Supply Agreement expired on April 1, 2000.

During the years ended December 31, 1999,
the Company incurred approximately $200,000 of expense related
to consulting services performed by a member of the
Companys Board of Directors. There were no consulting
services performed by any member of the Companys Board of
Directors during the year ended December 31, 2001 and 2000.

During 2001, the Company paid to Rogers a total
of approximately $2,920,000 for co-marketing activities (see
Note 1).

63



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

14.     Business
Combinations

During 1999 and 2000, the Company completed a
total of ten acquisitions. There were no acquisitions during
2001. Each of the acquisitions was accounted for under the
purchase method of accounting. The respective purchase prices
were allocated to the assets acquired and liabilities assumed
based on a determination from an independent appraisal of their
respective fair values. The methodologies used to value
intangible assets acquired were consistently applied to each of
the acquisitions.

To determine the value of the developed
technology, the expected future cash flow attributed to all
existing technology was discounted, taking into account risks
related to the characteristics and application of the
technology, existing and future markets and assessments of the
life cycle stage of the technology.

The value of the in-process research and
development was determined based on the expected cash flow
attributed to the in-process projects, taking into account
revenue that is attributable to previously developed technology,
the level of effort to date in the in-process research and
development, the percentage of completion of the project and the
level of risk associated with the in-process technology. The
projects identified as in-process are those that were underway
at each of the acquisitions at the time of the acquisition and
that required additional efforts in order to establish
technological feasibility. The value of in-process research and
development was included in the Companys results of
operations during the period of the acquisition.

The value of the assembled workforce was derived
by estimating the costs to replace the existing employees,
including recruiting, hiring and training costs for each
category of employee.



| |                   
| | ------------------
| | Imedia Corporation

In July 1999, the Company entered into an
Agreement and Plan of Reorganization (the Agreement)
to acquire Imedia Corporation (Imedia), a California
corporation. Imedia produces routing and re-multiplexing systems
for digital video that enable cable operators to select and
customize their program lineup for viewer preferences, while
maximizing video capacity and quality over standards-based
set-top boxes. The Imedia acquisition was completed on
September 16, 1999 (the Closing Date).

In accordance with the Agreement, the Company
issued 1,714,814 shares of common stock and 309,256 options and
warrants to purchase common stock to the vested and unvested
optionholders and warrantholders of Imedia on the Closing Date.

Tangible assets acquired principally include
cash, accounts receivable and property and equipment.
Liabilities assumed principally include accounts payable and
accrued liabilities. At the Closing Date, the Company forgave
Imedias note payable obligation of $1,000,000.

The analysis of the expected future cash flows
attributed to all existing technology resulted in a valuation of
approximately $27,000,000 for developed technology that had
reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $11,000,000, consists primarily of major additions
to Imedias core technology, which was related to
Imedias planned development of new features. The majority
of the intended functionality of these new features was not
supported by Imedias existing technology. Intended new
features included offering high quality video service over the
Internet and multiplexing data with video. Development of this
technology was completed in 2001.



| |            
| | -----------
| | Radwiz Ltd.

In October 1999, the Company entered into a Share
Purchase Agreement to acquire Radwiz Ltd. (Radwiz),
an Israeli company. Radwiz produced communication access systems
based on high-speed IP

64



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

routing, integrated with telephony. Radwizs
systems included both central office Digital Subscriber Line
Access Multiplexers (DSLAMs) and customer premises equipment for
small office, home office (SOHO) business broadband
services. The Radwiz acquisition was completed on
November 22, 1999.

In accordance with the acquisition agreement, the
Company paid $250,000 in cash and issued 1,992,306 shares of
Terayon common stock to the former shareholders of Radwiz and
issued options to purchase 267,959 shares of Terayon common
stock to the unvested optionholders of Radwiz on the Closing
Date. In addition, the unvested optionholders of Radwiz options
also received options to purchase the Companys common
stock, the fair value of which was included in the purchase
price.

The approximate purchase price was determined to
be $52,700,000. This represents the minimum purchase price, as
specified in the acquisition agreement, to be issued to the
shareholders and vested option holders of Radwiz ($50,000,000)
plus the value of the options issued to unvested option holders
of Radwiz ($2,700,000) based on the market value of the
Companys common stock on the date the acquisition was
announced. Proceeds to be received from the Radwiz optionholders
upon exercise of their options were not significant.

Tangible assets acquired principally included
cash, accounts receivable, inventory and property and equipment.
Liabilities assumed included accounts payable and accrued
liabilities.

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $29,850,000 for developed technology that had
reached technological feasibility and therefore was
capitalizable.

In-process technology acquired in the
transaction, valued at approximately $3,000,000 consists
primarily of additions to Radwizs core technology, which
is related to Radwizs planned development of new features.
The majority of the intended functionality of these new features
is not supported by Radwizs current technology. Intended
new features include offering: end-to-end carrier quality of
service; allowing access via an ATM network; and, providing ISDN
line functionality. The Company completed most of this
development work in 2001, and the Company decided to no longer
pursue the ISDN line functionality.



| |              
| | -------------
| | Telegate Ltd.

In October 1999, the Company entered into a Share
Purchase Agreement (Telegate Agreement) to acquire
Telegate Ltd (Telegate), an Israeli company.
Telegate produces telephony and data access platforms that are
deployed by service providers to deliver efficient carrier-class
voice services over cable. Telegate also provides in-home
networking capability for telephony and data, based on the
Digital Enhanced Cordless Telephony (DECT) standard. The
transaction was completed on January 2, 2000.

In accordance with the Telegate Agreement, the
Company issued 4,440,000 shares of common stock and paid
approximately $2,500,000 in cash on January 2, 2000. The
Company made an additional cash payment of approximately
$858,000 during the third quarter of 2000. In addition, the
Company issued a warrant to purchase 2,000,000 shares of the
Companys common stock, valued at approximately
$34.6 million under the terms of an agreement between
Telegate and a customer of the Company (See Note 9).The
value of the warrant was included in the purchase price and was
associated with the value of the customer relationship.

Tangible assets acquired principally included
cash, accounts receivable, inventory and property and equipment.
Liabilities assumed principally included accounts payable and
accrued liabilities.

The value of the customer relationship was
determined as the value of the warrant using the Black Scholes
model. The warrant was fully vested, non-forfeitable, and
immediately exercisable and has a term of three years. The value
of the customer relationship is being amortized to cost of goods
sold on a straight-line basis over a three-year period.

65



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $21,500,000 for developed technology, that had
reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $7,500,000, consisted primarily of major additions
to Telegates core technology, which was related to
Telegates planned development of new features. The
majority of the intended functionality of these new features was
not supported by Telegates current technology. Intended
new features included: connection on demand functionality to
extend the products ISDN compatibility; the ability to use
cordless technology for either voice or data applications; and,
a subscriber end unit that can be used in multi-dwelling units.
During 2001, the Company decided to no longer pursue the
cordless technology and the subscriber end unit technology.



| |                                                                     
| | --------------------------------------------------------------------
| | Access Network Electronics Division of Tyco
	Electronics Corporation

In February 2000, the Company entered into an
Asset Purchase Agreement (the ANE Agreement) to
acquire certain assets and assume certain liabilities of the
Access Network Electronics Division (ANE) of Tyco
Electronics Corporation, a subsidiary of Tyco International Ltd.
ANE produces DSL (Digital Subscriber Line) systems that provide
multiple phone lines over the existing copper telephony network.
The transaction was completed on April 22, 2000.

In accordance with the ANE Agreement, the Company
issued 1,404,552 shares of common stock, valued at approximately
$83,500,000 based on the maximum purchase price specified in the
ANE Agreement. In addition, the Company agreed to establish an
employee retention program for purposes of retaining certain
identified employees of ANE. The retention program provides for
up to 3 annual payments to the identified employees in a
total amount of approximately $4,200,000 provided the employees
remain employed by the Company. The retention payments are being
charged to expense over the employees respective periods
of service.

Tangible assets acquired principally included
accounts receivable, inventory and property and equipment.
Liabilities assumed principally included accounts payable and
warranty obligations. During 2001, the Company increased its
intangible assets for assembled workforce by $4.5 million
relating to retention payments in conjunction with the
acquisition of ANE.

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $12,600,000 for developed technology, which had
reached technological feasibility and therefore was
capitalizable.

To determine the value of the customer base the
expected future cash flows attributed to existing customers was
discounted. The analysis yielded a valuation of approximately
$2,400,000.

In-process technology acquired in the
transaction, valued at approximately $750,000, consisted
primarily of additions to ANEs core technology, which is
related to ANEs planned development of new features. A
portion of the intended functionality of these new features is
not supported by ANEs current technology. The resultant
technology is intended to allow the transmission from a 56Kbps
modem without the loss of transmission rate. During 2001, the
Company decided to no longer pursue the development of this
technology.



| |            
| | -----------
| | Combox Ltd.

In February 2000, the Company entered into a
Share Purchase Agreement (the Combox Agreement) to
acquire Combox Ltd (Combox), an Israeli company.
Combox is a manufacturer of broadband data systems and satellite
communications based on international standards. Comboxs
cable data access systems conform to the growing EuroModem
international specification, based on the Digital Video
Broadcasting (DVB) standard. The transaction was completed
on April 18, 2000.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In accordance with the Combox Agreement, the
Company issued 1,547,770 shares of common stock and made a cash
payment of approximately $250,000. In addition, the Company
issued options to purchase common stock of the Company to the
unvested option holders of Combox options. The approximate
purchase price was determined as the value of Terayons
common stock issued at closing ($92,000,000) and the value of
the options to purchase Terayons shares issued to the
unvested option holders ($6,800,000) based on the fair market
value of Terayons common stock on the days immediately
preceding and following the date the acquisition was announced.
In addition, the cash payment of approximately $250,000 was
included in the purchase price. Proceeds to be received from the
option holders and warrant holders upon exercise are not
significant.

Tangible assets acquired principally include cash
and cash equivalents and accounts receivable. Liabilities
assumed principally include short and long term debt, accounts
payable and accrued liabilities.

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $12,500,000 for developed technology, which had
reached technological feasibility and therefore was
capitalizable.

In-process technology acquired valued at
approximately $8,000,000 consists primarily of additions to
Comboxs core technology, which was related to
Comboxs planned development of new features. A portion of
the intended functionality of these new features was not
supported by Comboxs current technology. During 2001, the
Company decided to no longer pursue these new features.



| |                      
| | ---------------------
| | Internet Telecom Ltd.

In March 2000, the Company and Telegate, a
subsidiary of the Company, entered into an Asset Purchase
Agreement (Internet Telecom Agreement) under which
Telegate agreed to purchase certain assets of Internet Telecom
Ltd. (Internet Telecom or IT), an
Israeli company. Internet Telecom is a supplier of PacketCable
and other standards-based, voice-over-IP (Internet
Protocol) systems and technologies. The transaction was
completed on April 18, 2000.

In accordance with the Internet Telecom
Agreement, the Company issued 377,380 shares of common stock
valued at approximately $46,000,000 based on the fair market
value of the Companys common stock on the days immediately
preceding and following the announcement of the acquisition and
issued options of 10,898 to purchase common stock of the Company
to the unvested option holders of Internet Telecom and paid
approximately $2,000,000 in cash. In addition, as a result of
certain conditions in the Agreement with regards to the price of
the Companys common stock, an additional accrued purchase
price payable of approximately $14.1 million is included in
the consolidated balance sheet as of December 31, 2000.
This amount was paid during 2001.

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $5,950,000 for developed technology, which had
reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $2,550,000, consists primarily of additions to
Internet Telecoms core technology, which was related to
Internet Telecoms planned development of new features. A
portion of the intended functionality of these new features was
not supported by Internet Telecoms current technology.
During 2001, the Company decided to no longer develop the new
features from Internet Telecom.

67



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |              
| | -------------
| | Ultracom Ltd.

In March 2000, the Company entered into a Share
Purchase Agreement to acquire Ultracom Communication Holdings
(1995) Ltd. (Ultracom), an Israeli company.
Ultracom is a supplier of broadband systems-on-silicon. The
transaction was completed on April 19, 2000.

In accordance with the Ultracom Agreement, the
Company issued 536,766 shares of common stock, made a cash
payment of approximately $245,000 and issued 14,403 options to
purchase common stock of the Company to the shareholders and
unvested option holders of Ultracom options. The approximate
purchase price was determined as the value of Terayons
common stock issued at the closing ($57,600,000) and the value
of the options to purchase Terayons shares issued to the
unvested option holders ($578,000) based on the fair market
value of Terayons common stock on the days immediately
preceding and following the date the acquisition was announced.
In addition, the cash payment of approximately $245,000 is
included in the purchase price.

Tangible assets acquired principally included
cash and cash equivalents, accounts receivable and property and
equipment. Liabilities assumed principally included long-term
debt, accounts payable and accrued liabilities.

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $1,050,000 for developed technology that had
reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $1,800,000, consisted primarily of additions to
Ultracoms core technology, which is related to
Ultracoms planned development of new features. A portion
of the intended functionality of these new features was not
supported by Ultracoms current technology. During 2001,
the Company determined that it would no longer continue
development on the Ultracom technology.



| |                  
| | -----------------
| | Mainsail Networks

In August 2000, the Company entered into an
Agreement and Plan of Merger and Reorganization to acquire
Mainsail Networks, Inc. (Mainsail). Mainsail
develops and markets next-generation broadband networks that
enable telecommunications carriers to deliver multiple services
over a single network infrastructure. The transaction was
completed on September 29, 2000.

In accordance with the Mainsail Agreement, the
Company issued 2,969,062 shares of common stock and 138,193
options to purchase shares of common stock to the Mainsail
shareholders and option holders. The approximate purchase price
was determined based on the fair market value of Terayons
common stock on the days immediately preceding and following the
date the acquisition was announced ($171,275,000) less the
intrinsic value of the unvested options recorded as deferred
compensation ($4,719,000). Deferred compensation is amortized
over the option holders vesting period.

Tangible assets acquired principally included
cash, inventory and property and equipment. Liabilities assumed
principally included accounts payable, accrued liabilities and
notes payable.

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $49,000,000 for developed technology that had
reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $5,000,000, consisted primarily of additions to
Mainsails core technology, which is related to
Mainsails planned development of new features. A portion
of the intended functionality of these new features was not
supported by Mainsails current technology. The resultant
technology was intended to provide a high capacity CPE (customer
premise equipment) and low cost gateway. This development was
completed in 2001.

68



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |          
| | ---------
| | Digitrans

On September 27, 2000, the Company acquired
Digital Transmission Equipment (Digitrans) pursuant
to the terms of a Stock Purchase Agreement between the Company
and the former owner of Digitrans. Digitrans develops, markets
and sells digital equipment solutions that enable broadcasters,
satellite operators and cable television system operators to
optimize network services.

In accordance with the Digitrans Agreement, the
Company issued 394,329 shares of common stock. The approximate
purchase price was $15,921,000 based on the fair market value of
Terayons common stock on the days immediately preceding
and following the date the acquisition was announced. In
addition, as a result of certain conditions stipulated in the
Agreement with regards with the price of the Companys
common stock, the company issued 367,804 additional shares of
common stock to the former owner of Digitrans.

Tangible assets acquired principally included
cash and cash equivalents, accounts receivable and property and
equipment. Liabilities assumed principally included long-term
debt, accounts payable and accrued liabilities.

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $550,000 for developed technology that had reached
technological feasibility and therefore was capitalizable.

In-process technology acquired, valued at
approximately $4,950,000, consists primarily of additions to
Digitrans core technology, which was related to
Digitrans planned development of new features. A portion
of the intended functionality of these new features was not
supported by Digitrans current technology. Intended new
features included system on chip solutions for DOCSIS and DVB/
DAVIC cable modems. During 2001, the Company decided not to
pursue these development efforts.



| |         
| | --------
| | TrueChat

On December 22, 2000, the Company, acquired
TrueChat, Inc., (TrueChat), pursuant to the terms of
an Agreement and Plan of Merger and Reorganization. TrueChat
develops communication systems that enable multimedia
teleconferencing and provide increased control over
teleconference parameters.

In accordance with the TrueChat Agreement the
Company issued 534,487 shares of common stock and made a cash
payment of $209,928. In addition, the former option holders of
TrueChat received options to purchase 126,061 shares of the
Companys common stock. Deferred compensation relating to
the options is amortized over the option holders vesting
period. Approximately $2.4 million of goodwill was recorded
as part of this transaction. In addition, during 2001, the
Company added $0.7 million to goodwill in conjunction with
warrants issued subsequent to the acquisition (see
Note 9).

69



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

A summary of the purchase price allocations
pertaining to the above acquisitions and the amortization
periods of the intangible assets acquired is as follows (in
thousands):

|                                          |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |       | 
|----------------------------------------- | ---------------------------------------------- | -------- | ------- | ------ | - | ------ | ------ | ------ |  | -------- | ------ | -------- | - | --------- | ------ | -------- |  | - | ------ | ------ | - | - | ------- | ------- | - | - | ------ | ----- |  | - | ----- | ----- | 
|2000 Acquisitions:                        |                                                | Telegate |         | ANE    |   | Combox |        | IT     |  | Ultracom |        | Mainsail |   | Digitrans |        | TrueChat
|                                          |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |         
|Approximate purchase price Purchase price |                                                | $        | 130,553 |        |   | $      | 83,477 |        |  | $        | 98,784 |          |   | $         | 62,265 |          |  | $ | 57,621 |        |   | $ | 166,556 |         |   | $ | 15,921 |       |  | $ | 2,664 |      
|                                          | Transaction and other direct acquisition costs |          |         | 4,483  |   |        |        | 265    |  |          |        | 672      |   |           |        | 1,486    |  |   |        | 598    |   |   |         | 2,641   |   |   |        | 116   |  |   |       | 210   | 
|                                          |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|                                          |                                                | $        | 135,036 |        |   | $      | 83,742 |        |  | $        | 99,456 |          |   | $         | 63,751 |          |  | $ | 58,219 |        |   | $ | 169,197 |         |   | $ | 16,037 |       |  | $ | 2,874 |      
|                                          |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|Allocation of purchase price:             |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|                                          | Historical net tangible assets acquired        |          | $       | (5,580 | ) |        | $      | 14,145 |  |          | $      | 2,308    |   |           |        |          |  |   | $      | 1,116  |   |   | $       | (15     | ) |   | $      | 306   |  |   |       |       | 
|                                          | Convertible loans                              |          |         | 12,482 |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |       | 
|                                          |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|                                          |                                                |          | 6,902   |        |   |        | 14,145 |        |  |          | 2,308  |          |   |           |       |          |  |   | 1,116  |        |   |   | (15     | )       |   |   | 306    |       |  |   |      |      
|                                          |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|Intangible assets acquired:               |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|                                          | Customer relationship or base                  |          |         | 34,580 |   |        |        | 2,400  |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |       | 
|                                          | Developed technology                           |          |         | 21,500 |   |        |        | 12,600 |  |          |        | 12,500   |   |           |        | 5,950    |  |   |        | 1,050  |   |   |         | 49,000  |   |   |        | 550   |  |   |       |       | 
|                                          | Assembled workforce                            |          |         | 4,200  |   |        |        | 12,200 |  |          |        | 1,100    |   |           |        | 500      |  |   |        | 1,100  |   |   |         | 2,800   |   |   |        | 1,100 |  |   |       |       | 
|                                          | Trademark                                      |          |         |        |   |        |        | 600    |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |       | 
|                                          | In-process research and development            |          |         | 7,500  |   |        |        | 750    |  |          |        | 8,000    |   |           |        | 2,550    |  |   |        | 1,800  |   |   |         | 5,000   |   |   |        | 4,950 |  |   |       |       | 
|                                          | Goodwill                                       |          |         | 66,382 |   |        |        | 44,047 |  |          |        | 80,444   |   |           |        | 54,751   |  |   |        | 53,927 |   |   |         | 107,692 |   |   |        | 9,131 |  |   |       | 2,390 | 
|                                          | Deferred tax liability                         |          |         | (6,028 | ) |        |        |        |  |          |        | (4,896   | ) |           |        |          |  |   |        | (774   | ) |   |         |         |   |   |        |       |  |   |       |       | 
|                                          | Deferred compensation                          |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         | 4,719   |   |   |        |       |  |   |       | 484   | 
|                                          |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|                                          |                                                | $        | 135,036 |        |   | $      | 86,742 |        |  | $        | 99,456 |          |   | $         | 63,751 |          |  | $ | 58,219 |        |   | $ | 169,196 |         |   | $ | 16,037 |       |  | $ | 2,874 |      
|                                          |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|Amortization period (in years):           |                                                |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |      
|                                          | Customer relationship or base                  |          |         | 3      |   |        |        | 5      |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |       | 
|                                          | Developed technology                           |          |         | 6      |   |        |        | 5      |  |          |        | 5        |   |           |        | 6        |  |   |        | 6      |   |   |         | 5       |   |   |        | 5     |  |   |       |       | 
|                                          | Assembled workforce                            |          |         | 2      |   |        |        | 2      |  |          |        | 2        |   |           |        | 2        |  |   |        | 2      |   |   |         | 2       |   |   |        | 2     |  |   |       |       | 
|                                          | Trademark                                      |          |         |        |   |        |        | 5      |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |       |  |   |       |       | 
|                                          | Goodwill                                       |          |         | 6      |   |        |        | 5      |  |          |        | 5        |   |           |        | 6        |  |   |        | 6      |   |   |         | 5       |   |   |        | 5     |  |   |       | 5     | 
|                                          | Deferred compensation                          |          |         |        |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         | 1.5     |   |   |        |       |  |   |       | 1.5   | 

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                |                                                |        |         |         |   |   |        |         |  
|------------------------------- | ---------------------------------------------- | ------ | ------- | ------- | - | - | ------ | ------- | -
|1999 Acquisitions:              |                                                | Imedia |         | Radwiz 
|                                |                                                |        |         |        
|Approximate purchase price:     |                                                |        |         |         |   |   |        |        
|                                | Purchase price                                 |        | $       | 106,347 |   |   | $      | 52,667  |  
|                                | Transaction and other direct acquisition costs |        |         | 2,345   |   |   |        | 1,086   |  
|                                |                                                |        |         |         |   |   |        |        
|                                |                                                | $      | 108,692 |         |   | $ | 53,753 |        
|                                |                                                |        |         |         |   |   |        |        
|Allocation of purchase price:   |                                                |        |         |         |   |   |        |        
|                                | Historical net tangible assets acquired        |        | $       | (355    | ) |   | $      | 3,058   |  
|                                | Forgiveness of note payable                    |        |         | 1,000   |   |   |        |         |  
|                                |                                                |        |         |         |   |   |        |        
|                                |                                                |        | 645     |         |   |   | 3,058  |        
|                                |                                                |        |         |         |   |   |        |        
|Intangible assets acquired:     |                                                |        |         |         |   |   |        |        
|                                | Developed technology                           |        |         | 27,000  |   |   |        | 29,850  |  
|                                | Assembled workforce                            |        |         | 2,500   |   |   |        | 2,800   |  
|                                | Trademark                                      |        |         | 4,000   |   |   |        | 1,150   |  
|                                | In-process research and development            |        |         | 11,000  |   |   |        | 3,600   |  
|                                | Goodwill                                       |        |         | 63,547  |   |   |        | 24,293  |  
|                                | Deferred tax liability                         |        |         |         |   |   |        | (10,998 | )
|                                |                                                |        |         |         |   |   |        |        
|                                |                                                | $      | 108,692 |         |   | $ | 53,753 |        
|                                |                                                |        |         |         |   |   |        |        
|Amortization period (in years): |                                                |        |         |         |   |   |        |        
|                                | Developed technology                           |        |         | 6       |   |   |        | 6       |  
|                                | Assembled workforce                            |        |         | 2       |   |   |        | 2       |  
|                                | Trademark                                      |        |         | 6       |   |   |        | 6       |  
|                                | Goodwill                                       |        |         | 6       |   |   |        | 6       |  

As discussed in Note 6, the Company
recorded impairment losses of approximately $572.8 million
of intangible assets relating to these acquisitions.
Approximately $3.8 million of intangible assets remained at
December 31, 2001.



| |                            
| | ---------------------------
| | Pro Forma Financial Results

The following selected unaudited pro forma
combined results of operations for the year ended
December 31, 2000 of the Company, Telegate, Combox,
Ultracom, ANE, Internet Telecom, Mainsail, Digitrans and
TrueChat have been prepared assuming that the acquisitions
occurred at the beginning of the period presented. The following
selected unaudited pro forma combined results of operations for
the year ended December 31, 1999 of the Company, Radwiz and
Imedia have been prepared assuming that the acquisitions
occurred at the beginning of the period presented. The following
selected unaudited pro forma financial information is not
necessarily indicative of the results that would have occurred
had the acquisitions

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

been completed at the beginning of the period
indicated nor is it indicative of future operating results (in
thousands, except per share data):

|                                                 |  |              |         |              |  |   |         |  
|------------------------------------------------ |  | ------------ | ------- | ------------ |  | - | ------- | -
|                                                 |  | Year Ended   |         | Year Ended  
|                                                 |  | December 31, |         | December 31,
|                                                 |  | 2000         |         | 1999        
|                                                 |  |              |         |             
|Revenues                                         |  | $            | 358,559 |              |  | $ | 189,213 |  
|Net loss(1)                                      |  | $            | (71,343 | )            |  | $ | (40,728 | )
|Net loss per share(1)                            |  | $            | (1.16   | )            |  | $ | (0.70   | )
|Shares used in calculation of net loss per share |  |              | 61,349  |              |  |   | 58,416  |  



---



|    |                                                                                                                                                           
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Net loss and net loss per share excludes
	approximately $30,535,000 of in-process research and development
	charges for the years ended December 31, 2000.

17.     Subsequent
Events (Unaudited)

As discussed in Note 8, the Plaintiffs in
the complaint Evergreen Canada Israel Management,
Ltd. v Imedia Corporationvoluntarily dismissed
the complaint on March 7, 2002, and the lawsuit was
dismissed with prejudice.

18.     Unaudited
Quarterly Financial Data

Summarized quarterly financial data for 2001 and
2000 is as follows (in thousands, except per share data):

|                                                                                |  |         |          |        |  |       |         |        |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------- |  | ------- | -------- | ------ |  | ----- | ------- | ------ |  | - | ------- | - |  | - | ------- | -
|                                                                                |  |        
|                                                                                |  | Quarter
|                                                                                |  |        
|2001                                                                            |  | First   |          | Second |  | Third |         | Fourth
|                                                                                |  |         |          |        |  |       |         |       
|Revenues                                                                        |  | $       | 53,984   |        |  | $     | 65,733  |        |  | $ | 79,603  |   |  | $ | 80,161  |  
|Gross profit (loss)(4)                                                          |  |         | (869     | )      |  |       | (15,731 | )      |  |   | 10,368  |   |  |   | 22,445  |  
|Restructuring costs and asset write-offs(2)                                     |  |         | (574,744 | )      |  |       | (2,549  | )      |  |   | (5,301  | ) |  |   | (3,449  | )
|Net Loss before extraordinary gain                                              |  |         | (629,694 | )      |  |       | (62,504 | )      |  |   | (38,752 | ) |  |   | (18,223 | )
|Extraordinary gain on early retirement of debt(3)                               |  |         | 121,494  |        |  |       |        |        |  |   | 51,834  |   |  |   | 11,999  |  
|Net profit (loss)                                                               |  |         | (508,200 | )      |  |       | (62,504 | )      |  |   | 13,082  |   |  |   | (6,224  | )
|Basic and diluted loss per common share before
	extraordinary gain(1)           |  | $       | (9.33    | )      |  | $     | (0.93   | )      |  | $ | (0.57   | ) |  | $ | (0.26   | )
|Extraordinary gain on early retirement of debt
	per share, basic and diluted(3) |  | $       | 1.80     |        |  |       |        |        |  | $ | 0.76    |   |  | $ | 0.17    |  
|Basic and diluted loss per share after
	extraordinary gain                      |  | $       | (7.53    | )      |  | $     | (0.93   | )      |  | $ | 0.19    |   |  | $ | (0.09   | )

|                                         |  |         |         |        |  |       |         |        |  |   |         |   |  |   |         |  
|---------------------------------------- |  | ------- | ------- | ------ |  | ----- | ------- | ------ |  | - | ------- | - |  | - | ------- | -
|                                         |  |        
|                                         |  | Quarter
|                                         |  |        
|2000                                     |  | First   |         | Second |  | Third |         | Fourth
|                                         |  |         |         |        |  |       |         |       
|Revenues                                 |  | $       | 59,337  |        |  | $     | 92,019  |        |  | $ | 125,301 |   |  | $ | 62,892  |  
|Gross profit (loss)(5)                   |  |         | 15,389  |        |  |       | 25,519  |        |  |   | 34,170  |   |  |   | (25,060 | )
|Net Loss                                 |  |         | (28,394 | )      |  |       | (34,364 | )      |  |   | (26,454 | ) |  |   | (91,555 | )
|Net Loss per share, basic and diluted(1) |  | $       | (0.52   | )      |  | $     | (0.57   | )      |  | $ | (0.43   | ) |  | $ | (1.38   | )



---



|    |                                                                                                                                                                                                                                                     
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Earnings per share are computed independently for
	each of the quarters presented. The sum of the quarterly
	earnings per share in 2001 and 2000 does not equal the total
	computed for the year due to changes in shares outstanding and
	rounding.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |                                                                                                                                                                                                                                            
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | See Note 6 of Notes to Consolidated Financial
	Statements for an explanation for restructuring and asset
	write-offs.                                                                                                                      
|   
|(3) | See Note 7 of Notes to Consolidated Financial
	Statements for an explanation of the repurchase of subordinated
	convertible notes.                                                                                                         
|   
|(4) | The gross profit (loss) includes the effect of
	special charges of none in the first quarter of 2001,
	$28,704,000 in the second quarter of 2001, $6,424,000 in the
	third quarter of 2001 and ($1,622,000) in the fourth quarter of
	2001.
|   
|(5) | The gross profit (loss) includes the effect of
	special charges of $19,000,000 in the fourth quarter of 2000 and
	none in any other quarter presented.                                                                                     

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

Not applicable.




PART III




Item
10.     Directors and Officers of
the Registrant

Certain information regarding our executive
officers and directors as of March 28, 2002, is set forth
below.

|                             |  |  |  |     |    |          |  |                                                                        
|---------------------------- |  |  |  | --- | -- | -------- |  | -----------------------------------------------------------------------
|Name                         |  |  |  | Age |    | Position
|                             |  |  |  |     |    |         
|Zaki Rakib(2)                |  |  |  |     | 43 |          |  | Chief Executive Officer, Secretary and Director                        
|Shlomo Rakib                 |  |  |  |     | 45 |          |  | Chairman of the Board, President, Chief Technical
	Officer and Director
|Carol Lustenader(3)          |  |  |  |     | 47 |          |  | Chief Financial Officer                                                
|Ray Fritz(4)                 |  |  |  |     | 56 |          |  | Chief Financial Officer                                                
|Alek Krstajic                |  |  |  |     | 38 |          |  | Director                                                               
|Christopher J. Schaepe(1)(2) |  |  |  |     | 38 |          |  | Director                                                               
|Lewis Solomon(1)             |  |  |  |     | 68 |          |  | Director                                                               



---



|    |                                                
|--- | -----------------------------------------------
|(1) | Member of Audit Committee                      
|   
|(2) | Member of Compensation Committee               
|   
|(3) | Chief Financial Officer as of November 1,
	2001
|   
|(4) | Chief Financial Officer until November 1,
	2001

The Board of Directors (Board) is divided into
three classes, each having a three-year term. Mr. Krstajic
and Mr. Solomon are Class I directors, whose terms
expire in 2002. Mr. Shlomo Rakib are Class II
directors, whose terms expire in 2003. Mr. Schaepe and
Dr. Zaki Rakib are Class III directors, whose terms
expire in 2001.

Zaki Rakibco-founded Terayon Communication
Systems, Inc. (Company) and has served as Chief Executive
Officer, Secretary and as a director of the Board since January
1993. From January 1993 to July 1998, Dr. Rakib also served
as our Chief Financial Officer. Prior to co-founding the
Company, Dr. Rakib served as Director of Engineering for
Cadence Design Systems, an electronic design automation software
company, from 1990 to 1994. Prior to joining Cadence,
Dr. Rakib was Vice President of Engineering at Helios
Software, which was acquired by Cadence in 1990. Dr. Rakib
is a director of a privately held company. Dr. Rakib holds
B.S., M.S. and Ph.D. degrees in engineering from Ben-Gurion
University in Israel. Dr. Rakib is the brother of Shlomo
Rakib, our Chairman of the Board, President and Chief Technical
Officer and a director on the Board.

Shlomo Rakibco-founded the Company in 1993 and has
served as Chairman of the Board and President since January 1993
and as Chief Technical Officer since February 1995. Prior to
co-founding the Company, Mr. Rakib served as Chief Engineer
at PhaseCom, Inc. a communications products company, from 1981
to 1993, where he pioneered the development of data and
telephony applications over cable. Mr. Rakib is the
inventor of several patented technologies in the area of data
and telephony applications over cable. Mr. Rakib is a
director of a privately held company. Mr. Rakib holds a
B.S.E.E. degree from Technion University in Israel.
Mr. Rakib is the brother of Zaki Rakib, our Chief Executive
Officer, Secretary and a director on the Board.

Ray M. Fritzretired
from his position as our Chief Financial Officer in October
2001. Mr. Fritz served as our Chief Financial Officer from
July 1998 until October 2001. From December 1997 to July 1998,
Mr. Fritz was Vice President of Finance and Operations and
Chief Financial Officer of Gigalabs Inc., a provider of high
performance input/output switching solutions. From August 1994
until August 1997, Mr. Fritz was with

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Clarify, Inc. a provider of front office
automation systems, as its Vice President, Finance and
Operations and Chief Financial Officer. From May 1990 to August
1994, he served as Director, Finance of Synopsys, Inc., an
electronics design automation company, and from April 1986 to
May 1990, Mr. Fritz served as Vice President and Controller
of LSI Logic Corporation, a semiconductor company. Prior to
that, he held a variety of finance positions with Xerox
Corporation, The Singer Company and Shell Oil Company.
Mr. Fritz is a director of a couple privately held
companies. Mr. Fritz holds a B.S. degree in finance/
business administration from Benedictine College, a M.B.A.
degree from Atlanta University and a M.S. degree in tax from
Golden Gate University.


Carol Lustenaderjoined us in March 1999 as Director of
Finance (Financial Planning and Analysis) and was later promoted
to Group Director, Financial Planning and Analysis and then Vice
President of Finance. In November 2001, she was promoted to
Chief Financial Officer. Prior to joining us, from December 1997
to October 1998, Ms. Lustenader was Manager of Financial
Planning, Corporate Controller and Chief Financial Officer of
GigaLabs, Inc., a provider of high performance input/ output
switching solutions. From August 1995 until December 1997,
Ms. Lustenader was Manager of Financial Planning and
Analysis at Clarify, Inc., a provider of front office automation
systems. Prior to that, Ms. Lustenader held a variety of
senior financial management positions at Nellcor Puritan Bennett
Incorporation, Pyramid Technology Corporation and Xerox
Corporation. Ms. Lustenader holds a B.A. in Music from
Wells College and a M.B.A. degree from the University of
Rochester.

Alek Krstajichas
served as a director on our Board since July 1999.
Mr. Krstajic is the Senior Vice President Interactive
Services, Sales and Product Development for Rogers
Communications, Inc. (Rogers), and has held a variety of senior
management positions at Rogers since 1994. Mr. Krstajic is
a director of several privately held companies.
Mr. Krstajic holds a B.A. degree in economics from the
University of Toronto in Canada and attended the executive
educational program at Wharton School of Business at the
University of Pennsylvania.

Christopher J. Schaepehas served as a director on our Board
since March 1995. Mr. Schaepe is a General Partner of
Lightspeed Venture Partners, a technology-focused venture
capital firm specializing in early stage communications and
Internet software infrastructure investments. From October 1991
until October 2000, he served as a General Partner of Weiss,
Peck & Greer Venture Partners. In October 2000, Weiss,
Peck & Greer Venture Partners became Lightspeed Venture
Partners, an entity independent of Weiss, Peck & Greer,
L.L.C. Mr. Schaepe continues to serve as a Managing
Director of Weiss, Peck & Greer, L.L.C., a
technology-focused venture capital firm. From July 1986 to July
1989, Mr. Schaepe served in corporate finance and capital
markets roles at Goldman, Sachs & Company after his
employment as a software engineer at IBM Corporation. He is
a director of several privately held companies. Mr. Schaepe
holds B.S. and M.S. degrees in computer science from the
Massachusetts Institute of Technology and an M.B.A. degree from
Stanford Business School.

Lewis Solomonhas
served as a director on our Board since March 1995.
Mr. Solomon has been a principal of G&L Investments, a
consulting firm, since 1989 and currently serves as Chief
Executive Officer and Chairman of the Board of Broadband
Services, Inc. From 1983 to 1988, he served as Executive Vice
President at Alan Patricof Associates, a venture capital firm
focused on high technology, biotechnology and communications
industries. Prior to that, Mr. Solomon served in various
capacities with General Instrument Corporation, most recently as
Senior Vice President. From April 1986 to January 1997, he
served as Chairman of the Board of Cybernetic Services, Inc., a
LED systems manufacturer, which commenced a Chapter 7
bankruptcy proceeding in April 1997. Mr. Solomon serves on
the boards of Anadigics, Inc. a manufacturer of integrated
circuits; Harmonic, Inc., a manufacturer of digital and
fiberoptic systems; and Artesyn Technologies, Inc. a power
supply and power converter supply company. Mr. Solomon also
serves on the boards of several privately held companies.

Section 16(a) Beneficial Ownership
Reporting Compliance

Section 16(a) of the Securities Exchange Act
of 1934, as amended (Section 16(a)), requires our directors
and executive officers, and persons who own more than
10 percent of a registered class of our equity

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securities, to file with the SEC initial reports
of ownership and report of changes in ownership of our common
stock and other equity securities. Officers, directors and
greater than 10 percent stockholders are required by SEC
regulation to furnish us with copies of all Section 16(a)
forms they file.


To our knowledge, based solely on review of the
copies of such reports furnished to us and written
representations that no other reports were required, during the
year ended December 31, 2001, all Section 16(a) filing
requirements applicable to our directors, officers and greater
than 10 percent beneficial owners were complied with
except: (i) Mr. Krstajic filed two late reports
covering two transactions and (ii) Mr. Schaepe filed
one late report covering one transaction. Dr. Rakib,
Mr. Rakib, Mr. Stevens and Ms. Lustenader each
had one late report covering one transaction that resulted from
an immaterial error on the initial filing that was corrected.




Item
11.     Executive
Compensation

The information required by this Item is
incorporated by reference to the Proxy Statement.




Item
12.     Security Ownership of
Certain Beneficial Owners and Management

The information required by this Item is
incorporated by reference to the Proxy Statement.




Item
13.     Certain Relationship and
Related Transactions

The information required by this Item is
incorporated by reference to the Proxy Statement.




PART IV




Item
14.     Exhibits, Financial
Statement Schedules, and Reports on Form 8-K

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



| |                                                                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1.     Consolidated
	Financial Statements. The following consolidated financial
	statements of Terayon Communication Systems, Inc. and related
	Independent Auditors Report are filed as part of this
	report of Form 10-K:

* Independent Auditors Report.

* Consolidated Balance Sheets, as of
December 31, 2001 and 2000.



| |   |                                                                                                                                                                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | Consolidated Statements of Operations,
	Consolidated Statements of Stockholders Equity (Net
	Capital Deficiency), Consolidated Statements of Cash Flows and
	Notes to Consolidated Financial Statements for the years ended
	December 31, 2001, 2000 and 1999.



| |                                                                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 2.     Consolidated
	Financial Statement Schedules. The following consolidated
	financial statement schedules of Terayon Communication Systems,
	Inc. are filed as part of this report on Form 10-K and
	should be read in conjunction with the Consolidated Financial
	statements of Terayon Communication Systems, Inc:



| |   |                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------
| | * | Schedule II of Valuation and Qualifying
	Accounts for the years ended December 31, 2001, 2000 and 1999.



| |                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Schedules not listed above are omitted because
	they are not required, they are not applicable or the
	information is already included in the consolidated financial
	statements or notes thereto.
|
| | 3. Exhibits. The exhibits listed on
	the accompanying Index to Exhibits are filed or incorporated by
	reference as part of this report on Form 10-K.                                              

(b) Reports on Form 8-K.

None.

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EXHIBIT INDEX

|        |      |                     |  |                                                                                                                                                                                    
|------- | ---- | ------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |      |                    
|Number  |      | Exhibit Description
|        |      |                    
|        | 3.1  |                     |  | Amended and Restated Certificate of Incorporation
	of Terayon Communication Systems, Inc.(7)                                                                                       
|        | 3.2  |                     |  | Bylaws of Terayon Communication Systems, Inc.(2)                                                                                                                                   
|        | 3.3  |                     |  | Certificate of Amendment to Amended and Restated
	Certificate of Incorporation of Terayon Communication Systems,
	Inc.(7)                                                          
|        | 3.4  |                     |  | Certificate of Designation of Series A
	Junior Participating Preferred Stock.(9)                                                                                                   
|        | 4.1  |                     |  | Specimen Common Stock Certificate.(2)                                                                                                                                              
|        | 4.2  |                     |  | Amended and Restated Information and Registration
	Rights Agreement dated April 6, 1998.(2)                                                                                        
|        | 4.3  |                     |  | Form of Security for Terayon Communication
	Systems, Inc.s 5% Convertible Subordinated Notes due
	August 1, 2007.(8)                                                              
|        | 4.4  |                     |  | Registration Rights Agreement by and among
	Terayon Communication Systems, Inc. and Deutsche Bank
	Securities, Inc. and Lehman Brothers, Inc.(8)                                   
|        | 4.5  |                     |  | Indenture between Terayon Communication Systems,
	Inc. and State Street Bank and Trust Company of California, N.A.
	dated July 26, 2000.(8)                                        
|        | 10.1 |                     |  | Form of Indemnity Agreement between Terayon
	Communication Systems, Inc. and each of its directors and
	officers.(2)                                                               
|        | 10.2 |                     |  | 1995 Stock Option Plan, as amended on
	March 26, 1996.(2)                                                                                                                          
|        | 10.3 |                     |  | 1997 Equity Incentive Plan, as amended on
	July 31, 2000.                                                                                                                          
|        | 10.4 |                     |  | 1998 Employee Stock Purchase Plan, as amended on
	July 31, 2000.(9)                                                                                                                
|        | 10.5 |                     |  | 1998 Non-Employee Directors Stock Option Plan.(2)                                                                                                                                  
|        | 10.6 |                     |  | 1998 Employee Stock Purchase Plan Offering for
	Foreign Employees, adopted July 31, 2000.(9)                                                                                       
|        | 10.7 |                     |  | Anti-Dilution Warrant to Purchase Shares of
	Common Stock dated April 6, 1998 issued to Shaw
	Communications Inc.(2)                                                               
|        | 10.8 |                     |  | Lease Agreement dated April 20, 1998 between
	Imedia Corporation and Martin CL Associate, L.P.(5)                                                                                  
|        | 10.9 |                     |  | Sublease Agreement dated November 15, 1999
	between Imedia Corporation and ISP Channel, Inc.(5)                                                                                    
|        | 10.1 | 0                   |  | 1999 Non-Officer Equity Incentive Plan, as
	amended February 14, 2001.(9)                                                                                                          
|        | 10.1 | 1                   |  | Form of Non-Statutory Stock Option Agreement Used
	in Connection with the 1999 Non-Officer Equity Incentive Plan.(6)                                                               
|        | 10.1 | 2                   |  | Real Property Lease, dated March 1, 1990,
	among Menlo Business Park and Raychem Corporation.(10)                                                                                  
|        | 10.1 | 3                   |  | Assignment and Guarantee Agreement, dated
	April 21, 2000, by and between Terayon Communication
	Systems, Inc. Tyco Electronics Corporation and Menlo Business
	Park, LLC.(10)     
|        | 10.1 | 4                   |  | Azrieli Center Offices Lease Agreement, dated
	January 23, 2002, between Canit HaShalom Investments Ltd.
	and Terayon Communication Systems, Inc.                                  
|        | 10.1 | 5                   |  | Data Over Cable Service Interface Specifications
	License Agreement, dated December 21, 2001, between Terayon
	Communication Systems, Inc. and Cable Television Laboratories,
	Inc.
|        | 10.1 | 6                   |  | Amendment to DOCSIS IPR Agreement to cover DOCSIS
	2.0, dated December 21, 2001, between Terayon Communication
	Systems, Inc. and Cable Television Laboratories, Inc.              
|        | 10.1 | 7                   |  | Data Over Cable Service Interface Specifications
	License Agreement, dated December 21, 2001, between Imedia
	Semiconductor Corporation and Cable Television Laboratories, Inc.    
|        | 10.1 | 8                   |  | Amendment to DOCSIS IPR Agreement to cover
	DOCSIS 2.0, dated December 21, 2001, between Imedia
	Semiconductor Corporation and Cable Television Laboratories, Inc.                 
|        | 21.1 |                     |  | List of Subsidiaries.                                                                                                                                                              
|        | 23.1 |                     |  | Consent of Independent Auditors.                                                                                                                                                   

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---



|    |                                                                                                                                   
|--- | ----------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference to exhibits to our
	Registration Statement on Form S-1 filed on
	December 24, 1998 (File No. 333-69699).
|   
|(2) | Incorporated by reference to exhibits to our
	Registration Statement on Form S-1 filed on June 16,
	1998 (File No. 333-56911).    
|   
|(3) | Incorporated by reference to our Report on
	Form 10-Q filed on November 12, 1998 (File
	No. 000-24647).                           
|   
|(4) | Incorporated by reference to our Report on
	Form 10-Q filed on August 13, 1999.                                                   
|   
|(5) | Incorporated by reference to our Report on
	Form 10-Q filed on November 15, 1999.                                                 
|   
|(6) | Incorporated by reference to our Registration
	Statement on Form S-8 filed on December 29, 1999.                                  
|   
|(7) | Incorporated by reference to our Report on
	Form 10-K filed on March 30, 2000.                                                    
|   
|(8) | Incorporated by reference to our Registration
	Statement on Form S-3 filed on October 24, 2000 (File
	No. 333-48536)              
|   
|(9) | Incorporated by reference to our Report on
	Form 10-K filed on April 2, 2001.                                                     



|     |                                                                             
|---- | ----------------------------------------------------------------------------
|(10) | Incorporated by reference to our Report on
	Form 10-Q filed on May 15, 2001.

78



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the Registrant
has caused this report to be signed on its behalf by the
undersigned, thereunto due authorized, in County of Santa Clara,
State of California, on the 30th day of March, 2002.



| |                                    
| | -----------------------------------
| | TERAYON COMMUNICATION SYSTEMS, INC.



| |     |                     
| | --- | --------------------
| | By: | /s/ CAROL LUSTENADER

| |                        
| | -----------------------
| |                        
| | Carol Lustenader       
| | Chief Financial Officer

Each person whose signature appears below
constitutes Dr. Zaki Rakib, Shlomo Rakib and Carol
Lustenader his true and lawful attorney-in-fact and agent, each
acting alone, with full power of substitution and
resubstitution, for him and in his name, place and stead, in any
and all capacities, to sign any or all amendments to this Annual
Report on Form 10-K, and to file the same, with all
exhibits thereto, and all documents in connection therewith,
with the Securities and Exchange Commission, granting unto said
attorney-in- fact and agent, full power and authority to do and
perform each and every act and thing requisite and necessary to
be done in and about the premises, as fully to all intents and
purposes as he might or could do in person, hereby ratifying and
confirming all that said attorney-in-fact and agent, each acting
alone, or his or her substitutes, may lawfully do or cause to be
done by virtue hereof.

Pursuant to the requirements of the Securities
Act of 1934, this report has been signed below by the following
persons on behalf of the Registrant and in the capacities and on
the dates indicated.

|                                                 |  |                                                                       |  |                |  | 
|------------------------------------------------ |  | --------------------------------------------------------------------- |  | -------------- |  | 
|                                                 |  |                                                                       |  |               
|Signature                                        |  | Title                                                                 |  | Date          
|                                                 |  |                                                                       |  |               
|                                                
|/s/ ZAKI RAKIBDr. Zaki Rakib                     |  | Chief Executive Officer and Director (Principal
	Executive Officer)   |  | March 28, 2002
|                                                
|/s/ CAROL LUSTENADERCarol Lustenader             |  | Chief Financial Officer (Principal Financial and
	Accounting Officer) |  | March 28, 2002
|                                                
|/s/ SHLOMO RAKIBShlomo Rakib                     |  | Chairman of the Board of Directors                                    |  | March 28, 2002
|                                                
|/s/ CHRISTOPHER J. SCHAEPEChristopher J. Schaepe |  | Director                                                              |  | March 28, 2002
|                                                
|/s/ LEWIS SOLOMONLewis Solomon                   |  | Director                                                              |  | March 28, 2002
|                                                
|/s/ ALEK KRSTAJICAlek Krstajic                   |  | Director                                                              |  | March 28, 2002

79



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SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

|                              |                                 |                |   |            |  |            |  |         |  |  |  |       |  |  |   |        | 
|----------------------------- | ------------------------------- | -------------- | - | ---------- |  | ---------- |  | ------- |  |  |  | ----- |  |  | - | ------ | 
|                              |                                 | Balance        |   | Additions  |  |            |  | Balance
|                              |                                 | at             |   | Charged to |  |            |  | At     
|                              |                                 | Beginning      |   | Costs and  |  |            |  | End of 
|                              |                                 | of Period      |   | Expenses   |  | Write-offs |  | Period 
|                              |                                 |                |   |            |  |            |  |        
|                              |                                 |               
|                              |                                 | (In thousands)
|Year ended December 31, 2001. |                                 |                |   |            |  |            |  |         |  |  |  |       |  |  |   |       
|                              | Allowance for doubtful accounts |                | $ | 6,542      |  |            |  | 4,494   |  |  |  | 3,829 |  |  | $ | 7,207  | 
|                              | Warranty reserve                |                | $ | 5,925      |  |            |  | 7,956   |  |  |  | 5,513 |  |  | $ | 8,368  | 
|                              | Obsolescence reserve            |                | $ | 16,323     |  |            |  | 24,670  |  |  |  | 3,812 |  |  | $ | 37,181 | 
|                             
|Year ended December 31, 2000  |                                 |                |   |            |  |            |  |         |  |  |  |       |  |  |   |       
|                              | Allowance for doubtful accounts |                | $ | 1,461      |  |            |  | 5,126   |  |  |  | 45    |  |  | $ | 6,542  | 
|                              | Warranty reserve                |                | $ | 2,685      |  |            |  | 5,991   |  |  |  | 2,751 |  |  | $ | 5,925  | 
|                              | Obsolescence reserve            |                | $ | 3,212      |  |            |  | 13,914  |  |  |  | 803   |  |  | $ | 16,323 | 
|                             
|Year ended December 31, 1999  |                                 |                |   |            |  |            |  |         |  |  |  |       |  |  |   |       
|                              | Allowance for doubtful accounts |                | $ | 594        |  |            |  | 867     |  |  |  |      |  |  | $ | 1,461  | 
|                              | Warranty reserve                |                | $ | 1,064      |  |            |  | 2,951   |  |  |  | 1,330 |  |  | $ | 2,685  | 
|                              | Obsolescence reserve            |                | $ | 2,286      |  |            |  | 926     |  |  |  |      |  |  | $ | 3,212  | 

80



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##### Table of Contents






EXHIBIT INDEX

|        |       |                     |  |                                                                                                                                                                                    
|------- | ----- | ------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |                    
|Number  |       | Exhibit Description
|        |       |                    
|        | 3.1   |                     |  | Amended and Restated Certificate of Incorporation
	of Terayon Communication Systems, Inc.(7)                                                                                       
|        | 3.2   |                     |  | Bylaws of Terayon Communication Systems, Inc.(2)                                                                                                                                   
|        | 3.3   |                     |  | Certificate of Amendment to Amended and Restated
	Certificate of Incorporation of Terayon Communication Systems,
	Inc.(7)                                                          
|        | 3.4   |                     |  | Certificate of Designation of Series A
	Junior Participating Preferred Stock.(9)                                                                                                   
|        | 4.1   |                     |  | Specimen Common Stock Certificate.(2)                                                                                                                                              
|        | 4.2   |                     |  | Amended and Restated Information and Registration
	Rights Agreement dated April 6, 1998.(2)                                                                                        
|        | 4.3   |                     |  | Form of Security for Terayon Communication
	Systems, Inc.s 5% Convertible Subordinated Notes due
	August 1, 2007.(8)                                                              
|        | 4.4   |                     |  | Registration Rights Agreement by and among
	Terayon Communication Systems, Inc. and Deutsche Bank
	Securities, Inc. and Lehman Brothers, Inc.(8)                                   
|        | 4.5   |                     |  | Indenture between Terayon Communication Systems,
	Inc. and State Street Bank and Trust Company of California, N.A.
	dated July 26, 2000.(8)                                        
|        | 10.1  |                     |  | Form of Indemnity Agreement between Terayon
	Communication Systems, Inc. and each of its directors and
	officers.(2)                                                               
|        | 10.2  |                     |  | 1995 Stock Option Plan, as amended on
	March 26, 1996.(2)                                                                                                                          
|        | 10.3  |                     |  | 1997 Equity Incentive Plan, as amended on
	July 31, 2000.                                                                                                                          
|        | 10.4  |                     |  | 1998 Employee Stock Purchase Plan, as amended on
	July 31, 2000.(9)                                                                                                                
|        | 10.5  |                     |  | 1998 Non-Employee Directors Stock Option Plan.(2)                                                                                                                                  
|        | 10.6  |                     |  | 1998 Employee Stock Purchase Plan Offering for
	Foreign Employees, adopted July 31, 2000.(9)                                                                                       
|        | 10.7  |                     |  | Anti-Dilution Warrant to Purchase Shares of
	Common Stock dated April 6, 1998 issued to Shaw
	Communications Inc.(2)                                                               
|        | 10.8  |                     |  | Lease Agreement dated April 20, 1998 between
	Imedia Corporation and Martin CL Associate, L.P.(5)                                                                                  
|        | 10.9  |                     |  | Sublease Agreement dated November 15, 1999
	between Imedia Corporation and ISP Channel, Inc.(5)                                                                                    
|        | 10.10 |                     |  | 1999 Non-Officer Equity Incentive Plan, as
	amended February 14, 2001.(9)                                                                                                          
|        | 10.11 |                     |  | Form of Non-Statutory Stock Option Agreement Used
	in Connection with the 1999 Non-Officer Equity Incentive Plan.(6)                                                               
|        | 10.12 |                     |  | Real Property Lease, dated March 1, 1990,
	among Menlo Business Park and Raychem Corporation.(10)                                                                                  
|        | 10.13 |                     |  | Assignment and Guarantee Agreement, dated
	April 21, 2000, by and between Terayon Communication
	Systems, Inc. Tyco Electronics Corporation and Menlo Business
	Park, LLC.(10)     
|        | 10.14 |                     |  | Azrieli Center Offices Lease Agreement, dated
	January 23, 2002, between Canit HaShalom Investments Ltd.
	and Terayon Communication Systems, Inc.                                  
|        | 10.15 |                     |  | Data Over Cable Service Interface Specifications
	License Agreement, dated December 21, 2001, between Terayon
	Communication Systems, Inc. and Cable Television Laboratories,
	Inc.
|        | 10.16 |                     |  | Amendment to DOCSIS IPR Agreement to cover
	DOCSIS 2.0, dated December 21, 2001, between Terayon
	Communication Systems, Inc. and Cable Television Laboratories,
	Inc.             
|        | 10.17 |                     |  | Data Over Cable Service Interface Specifications
	License Agreement, dated December 21, 2001, between Imedia
	Semiconductor Corporation and Cable Television Laboratories, Inc.    
|        | 10.18 |                     |  | Amendment to DOCSIS IPR Agreement to cover
	DOCSIS 2.0, dated December 21, 2001, between Imedia
	Semiconductor Corporation and Cable Television Laboratories, Inc.                 
|        | 21.1  |                     |  | List of Subsidiaries.                                                                                                                                                              
|        | 23.1  |                     |  | Consent of Independent Auditors.                                                                                                                                                   

81



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##### Table of Contents





---



|    |                                                                                                                                   
|--- | ----------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference to exhibits to our
	Registration Statement on Form S-1 filed on
	December 24, 1998 (File No. 333-69699).
|   
|(2) | Incorporated by reference to exhibits to our
	Registration Statement on Form S-1 filed on June 16,
	1998 (File No. 333-56911).    
|   
|(3) | Incorporated by reference to our Report on
	Form 10-Q filed on November 12, 1998 (File
	No. 000-24647).                           
|   
|(4) | Incorporated by reference to our Report on
	Form 10-Q filed on August 13, 1999.                                                   
|   
|(5) | Incorporated by reference to our Report on
	Form 10-Q filed on November 15, 1999.                                                 
|   
|(6) | Incorporated by reference to our Registration
	Statement on Form S-8 filed on December 29, 1999.                                  
|   
|(7) | Incorporated by reference to our Report on
	Form 10-K filed on March 30, 2000.                                                    
|   
|(8) | Incorporated by reference to our Registration
	Statement on Form S-3 filed on October 24, 2000 (File
	No. 333-48536)              
|   
|(9) | Incorporated by reference to our Report on
	Form 10-K filed on April 2, 2001.                                                     



|     |                                                                             
|---- | ----------------------------------------------------------------------------
|(10) | Incorporated by reference to our Report on
	Form 10-Q filed on May 15, 2001.

82