##### 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,
    2002                                             
|          
|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) |  | (I.R.S. Employer
    Identification No.)

4988 Great America Parkway

Santa Clara, California 95054


(408) 235-5500


(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:

|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of Each Class |  | Name of Each Exchange on Which Registered
|                    |  |                                          
|None                |  | None                                     

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

Common Stock, par value $0.001 per
share


(Title of Class)


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.     o

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Act).     Yes þ          No o

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 June 30, 2002 as reported
on the Nasdaq National Market, was approximately $61,237,967.
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 18, 2003, registrant had
outstanding 73,717,018 shares of common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement to be
filed with the Securities and Exchange Commission in April 2003,
pursuant to Regulation 14A of the Securities Exchange Act
of 1934, in connection with the 2003 Annual Meeting of
Stockholders of Terayon Communication Systems, are incorporated
by reference into Part II, Item 5 and Part III of
this Annual Report.



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TABLE OF CONTENTS



|                                                                                    |                                                                                               |  |  |  |  |  |  | 
|----------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS                                         
|PART I                                                                             
|                                                                                    | Item 1. Business                                                                             
|DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES                                    
|                                                                                    | 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
|RISK FACTORS                                                                       
|                                                                                    | Item 7a. Market Risk Disclosure Information                                                  
|                                                                                    | ITEM 8. Financial Statements and Supplementary Data                                          
|REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS                                  
|TERAYON COMMUNICATION SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS                    
|TERAYON COMMUNICATION SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS          
|TERAYON COMMUNICATION SYSTEMS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
|TERAYON COMMUNICATION SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS          
|TERAYON COMMUNICATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS     
|                                                                                    | 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                                       
|                                                                                    | Item 14. Controls and Procedures                                                             
|PART IV                                                                            
|                                                                                    | Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K                    
|EXHIBIT INDEX                                                                      
|SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS                                      
|SIGNATURES                                                                         
|EXHIBIT INDEX                                                                      
|EXHIBIT 10.13                                                                      
|EXHIBIT 10.21                                                                      
|EXHIBIT 10.22                                                                      
|EXHIBIT 10.23                                                                      
|EXHIBIT 21.1                                                                       
|EXHIBIT 23.1                                                                       
|EXHIBIT 99.1                                                                       
|EXHIBIT 99.2                                                                       



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##### Table of Contents






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.

This Report on Form 10-K includes trademarks
and registered trademarks of Terayon. Products or service names
of other companies mentioned in this Report on Form 10-K
may be trademarks or registered trademarks of their respective
owners.

2



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##### Table of Contents






PART I




Item 1.     Business

Overview

Terayon was founded in 1993 by Zaki Rakib, our
Chief Executive Officer, and Shlomo Rakib, our Chief Technical
Officer, to develop, market and sell broadband cable data
equipment for cable television operators to provide high-speed
Internet access to residential subscribers. Our first product
line was the TeraComm® cable data system, which is
comprised of our TeraPro® cable modems and TeraLink®
Cable Modem Termination Systems (CMTS). The TeraComm cable data
system, which we began shipping in 1997, is based on our
patented proprietary Synchronous Code Division Multiple Access
(S-CDMA) technology.

In the late 1990s, the growing demand for
broadband voice, video and data services fueled explosive growth
in equipment purchases by cable, telecom and satellite service
providers building networks and infrastructure to meet this
growing demand. To take advantage of this market opportunity, we
decided to expand our product offerings beyond cable data
systems to include a complete range of solutions for the
delivery of broadband voice, data and video services by cable,
telecom and satellite service providers. To offer this broad
range of solutions, we acquired companies with products and
technologies that allowed us to quickly expand our product
portfolio.

We expanded our cable product offerings with the
addition of digital video and broadband voice solutions. In
1999, we added the CherryPicker digital video management
system with the acquisition of Imedia Corporation (Imedia). We
complemented the CherryPicker product line with our purchase of
a line of digital video receivers in our acquisition of Digital
Transmission Equipment Company (Digitrans) in 2000. We added
broadband voice solutions to our cable product portfolio with
the 2000 acquisition of Telegate Ltd. (Telegate)and its
Multigate cable telephony system. In 2000, we also acquired
Internet Telecom Ltd (Internet Telecom), Ultracom Communications
Systems Holdings 1995 Ltd. (Ultracom) and TrueChat, Inc.
(TrueChat) for their Voice-over-Internet Protocol (VoIP)
technology to incorporate into our future VoIP cable telephony
products.

We established our telecom business with the
acquisition of Radwiz Ltd. (Radwiz) in 1999, which provided us
with an Internet-Protocol-in-The-Loop (IPTL) access system that
enables international telecom providers to offer integrated
high-speed Internet access and VoIP services. With the
acquisition of the Access Network Electronics (ANE) division of
Tyco Electronics Corporation, a subsidiary of Tyco International
Ltd., in 2000 we added ANEs established MiniPlex®
system for delivering multiple phone lines over a single
telephone wire, and its well-established distribution channels
into the U.S. Incumbent Local Exchange Carriers (ILEC).
MainSail Networks, Inc. (MainSail) was acquired in 2000
for its next-generation MainSail Multi-service Multi-function
Access Platform (MMAP), which enables telecom carriers to
deliver a wide range of broadband access services.

We entered the Internet-over-satellite market in
2000 with the acquisition of ComBox Ltd., (ComBox), which had a
line of products for delivering high-speed Internet access via
satellite.

In October 2001, we took our captive
semiconductor capabilities and established Imedia
Semiconductor to design, develop, manufacture and sell
advanced standards-based broadband silicon and software to cable
broadband equipment manufacturers.

Since late 2000, the worldwide telecom and
satellite industries have experienced severe downturns that have
resulted in significantly reduced purchases of new broadband
equipment. Because of this overall drop in demand, we have
refocused our efforts on the cable industry 
traditionally our strongest market  and have reduced
our investment in our telecom and satellite businesses. We have
discontinued our Internet-over-Satellite product line and
reduced our research and development activities in addition to
our sales and marketing efforts in telecom.

In 2003, the cable industry continues to face
many challenges. One of the largest US cable companies is
still in bankruptcy while other large cable operators are
experiencing significant cash constraints. Conse-

3



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quently, capital equipment expenditures by cable
operators may continue to be restricted for the foreseeable
future.


Despite the urgent state of the cable industry in
general, there continues to be growing subscriber demand for
broadband services, which has been fueled by the proliferation
of broadband services delivered by operators. Residential and
commercial subscribers are using a variety of data, video and
voice applications, including high-speed Internet access, online
gaming, file sharing, telecommuting, High Definition TV (HDTV),
Video-On-Demand (VOD) and cable telephony services.

As cable operators add new residential and
business subscribers for broadband voice, data and video
services, they must deploy Customer Premise Equipment (CPE) such
as cable modems and embedded Multimedia Terminal Adapters (MTA),
and install corresponding central office equipment such as Cable
Modem Termination Systems (CMTS) and video head-ends to operate
the CPE. The DellOro Group, an industry research firm, has
released its estimates of the number of worldwide cable modem
users in 2002 at approximately 21.7 million, up 51% from
14.4 million in 2001. DellOro further projects that
the number of cable modem users will continue to grow in 2003,
reaching approximately 30 million, an increase of 38% over
2002.

Web site access to companys
reports

Our Internet Web site address is
www.terayon.com. Our annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on
Form 8-K, and amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the
Exchange Act are available free of charge through our Web site
as soon as reasonably practicable after they are electronically
filed with, or furnished to, the Securities and Exchange
Commission. We will also provide those reports in electronic or
paper form free of charge upon request. Furthermore, all reports
we file with the Commission are available free of charge via
EDGAR through the Commissions Web site at
www.sec.gov. In addition, the public may read and copy
materials filed by us at the Commissions public reference
room located at 450 Fifth St., N.W., Washington, D.C.,
20549.

Business

We are an experienced partner for broadband
service providers, but we are primarily focused on cable
operators. Our mission is to deliver innovative broadband data,
video and voice solutions for the deployment of
revenue-generating services today and tomorrow.

We are structured around the following operating
segments: Cable Broadband Access Systems (Cable) and Telecom
Carrier Systems (Telecom). Currently, 92% of our total revenues
are derived from Cable and 8% from Telecom. We believe Cable
will continue to generate the vast majority of our revenues in
the foreseeable future. See Note 12 in our Notes to
Consolidated Financial Statements.

In 2001 and 2002, we implemented significant
changes in our company structure and business in response to the
downturns in the worldwide telecom, cable and satellite
industries that began in late 2000. The worldwide downturn in
the telecommunications industry caused us to discontinue
investment in certain product lines, reassess the value of
acquisitions that occurred during 1999 and 2000, reduce the size
of our workforce, consolidate facilities and write-down certain
strategic investments in private companies. These activities
resulted in combined charges of approximately
$596.1 million in 2001 and 2002.

During the first quarter of 2001, sales of our
products slowed due to the dramatic downturn in the
telecommunications industry. We believed and continue to believe
that this downturn will be prolonged and can significantly
impact future demand for our products. In response to these
market conditions, we reexamined our business and our analysis
led us to (1) discontinue our investments in the ComBox and
Ultracom product lines, (2) recognize an impairment of
goodwill and other intangible assets associated with each of our
other acquisitions and (3) focus our efforts on our most
promising product lines: our DOCSIS cable modems, DOCSIS CMTSs,
CherryPicker and the MainSail MMAP. We also reduced the size of
our workforce and consolidated our facilities. As a result, we
took a restructuring charge of approximately $587.2 million
in the first quarter 2001.

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Subsequent to the first quarter of 2001 and with
the continued downturn of the worldwide telecommunications
market, we continually reassess the deployment of our resources
to focus on our most promising markets and product lines. As a
result we have taken the following additional steps: (1) we
recognized further impairment of the remaining goodwill and
intangibles related to our acquisitions; (2) we recognized
an impairment of our two investments in private companies;
(3) we have further focused our efforts on developing,
marketing and selling our cable products while limiting further
investment in the MainSail MMAP; (4) we have executed
additional workforce reductions and (5) we have further
consolidated our facilities. Between the second quarter of 2001
and second quarter of 2002, these actions resulted in additional
charges of approximately $8.9 million, and left us, as of
December 31, 2002, with no remaining goodwill and
intangible assets related to our acquisitions and no investments
in private companies.

We were incorporated in California in 1993,
reincorporated in Delaware in 1998 and have been a publicly
traded company on the Nasdaq National Market since 1998.

Business Strategy

Our business strategy focuses on the development
and deployment of cable broadband access technologies that will
improve cable operators return on investment by leveraging
their existing infrastructure to deliver new broadband services
at less expense. We believe that this strategy will provide the
following benefit to our customers: 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. In order to
devote more of our resources to the execution of our
cable-focused business strategy, we have reduced our investments
in telecom and are supporting only existing telecom customers.
We are not currently pursuing new customers for telecom-related
products or further telecom-related product development.

Initially, our strategy focused on the production
of our proprietary S-CDMA products, which we sold to cable
operators around the world. However, while we sold our
proprietary systems, some operators, especially operators in the
United States, elected to purchase only products compliant with
the then emerging industry specification, the Data Over Cable
Service Interface Specification (DOCSIS), propounded by Cable
Television Laboratories, Inc. (CableLabs), a cable industry
consortium in the United States. Cable operators elected to
purchase only DOCSIS certified or qualified equipment because it
permitted them to purchase compatible and interoperable
equipment from a variety of vendors, which, in turn, did not
leave them dependent on one or two vendors for equipment. As it
became apparent that our customer base was transitioning to
purchasing only DOCSIS based products, we decided that we would
manufacture and sell DOCSIS based products, as well as our own
proprietary based products. In December 2001, CableLabs adopted
a new version of the DOCSIS specification, DOCSIS 2.0,
which included advanced physical layer technology and two
modulation techniques, advanced TDMA and S-CDMA. With the
adoption of DOCSIS 2.0, we transitioned from being a
manufacturer of proprietary products to producing DOCSIS based
products.

We currently continue to transition from our
proprietary S-CDMA-based products to products based on the
DOCSIS. DOCSIS 2.0, the latest version of the DOCSIS
specification combines two advanced modulation techniques,
S-CDMA and advanced Time Division Multiple Access (A-TDMA). In
December 2002, we received DOCSIS 2.0 certification for our
TJ 715 cable modem and DOCSIS 2.0 qualification for
our Bluewave 3500 CMTS. Currently, we are the only vendor
to the cable industry with a DOCSIS 2.0 qualified CMTS and
a complete, end-to-end DOCSIS 2.0 cable data system.

The benefit of DOCSIS 2.0 is that it greatly
increases the upstream throughput of cable networks, which
enables cable operators to better handle the greater upstream
traffic from subscribers to the Internet and to create new
services for residential and business markets. These services
include but are not limited to, video conferencing, telephone
service and peer-to-peer computing. Additionally,
DOCSIS 2.0 better resists noise interference, which can
disrupt broadband service delivery. We believe that this
combination of factors will drive demand for DOCSIS 2.0
products.

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We believe the future of broadband communication
will be characterized by the convergence of video, voice and
data services that are based on Internet Protocol (IP) and
delivered primarily by cable operators. We are developing
integrated solutions to enable cable operators to provide these
converged, IP-based services to their subscribers. The solutions
we are developing leverage our expertise in voice, video and
data technologies and our experience in designing, developing
and manufacturing complex equipment, such as CMTSs and digital
video head-end equipment (i.e., CherryPicker).

Cable

Our Cable business includes products for
delivering broadband data, video and voice services. Most of our
Cable business revenue comes from sales of our products for the
delivery of data. In 2002 we began transitioning from the sale
of our proprietary TeraComm cable data system to standards-based
DOCSIS cable modems, MTAs and CMTSs. Our other Cable products
include the CherryPicker digital video management system and the
Multigate circuit-switch cable telephony system. We market and
sell our Cable products to Multiple System Operators (MSO) in
the cable industry worldwide. Our Cable business represented
approximately 92% of our total revenue in 2002.



| |         
| | --------
| | Products



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

We offer a line of high-performance cable modems
certified to meet the DOCSIS 1.1 and 2.0 and
Euro-DOCSIS 1.0 cable modem specifications. These fully
certified modems can interoperate with other DOCSIS and
Euro-DOCSIS equipment.



| |                                                 
| | ------------------------------------------------
| | Terayon Bluewave 3000 Family of DOCSIS
    CMTSs

Our Bluewave 3000 family of DOCSIS CMTSs is
composed of our DOCSIS 1.1 and 2.0 qualified Bluewave 3500,
a scalable, carrier-class solution for cable operators
most demanding broadband applications, and our DOCSIS 1.1
qualified and 2.0-based Bluewave 3200, a compact solution
ideal for smaller or segmented cable networks. This product
family is designed from the outset to support integrated voice,
video, and data broadband services.

In 2002 we had limited sales of our BE 2000
family of CMTSs and discontinued this line with the introduction
of the Bluewave 3000 CMTS family.



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

Our proprietary 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 head-end and
TeraPro® cable modems installed at subscribers homes.
As we transitioned to our standards-based products, sales of our
TeraComm cable data system in 2002 were limited.



| |                                                          
| | ---------------------------------------------------------
| | Terayon CherryPicker Digital 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 seamlessly inserting digital
advertising into digital programming. In 2002, we introduced the
DM 6400 network CherryPicker.



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

6



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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 head-end of a cable
operators network, and CPE located in subscribers
homes.




| |          
| | ---------
| | 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:



| |   |                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------
| |  | Adelphia Communications Corporation                                                                       
|
| |  | Comcast Corporation                                                                                       
|
| |  | Cross Beam Networks Corporation (Cross Beam
    Networks), a subsidiary of Sumitomo Corporation (Sumitomo)
|
| |  | i-CABLE Communications Limited                                                                            
|
| |  | Rogers Communications, Inc. (Rogers)                                                                      

During 2002, one of our principal customers,
Rogers, was a related party by virtue of Alek Krstajic, a Rogers
employee, also being one of our Board members. Mr. Krstajic
resigned from Rogers in January 2003. In May 2003, Rogers will
no longer be a related party to us. In addition, one customer
accounted for more than 10% of our total revenues for the year
ended December 31, 2002, two customers accounted for 10% or
more of the total revenues for the year ended December 31,
2001, and three customers accounted for 10% or more of total
revenues for the year ended December 31, 2000. No other
customer accounted for more than 10% of revenues during these
years.

We believe that the loss of any of our principal
customers will have a materially adverse effect 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 cable equipment vendors 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 vendors
proprietary technology, and as a result, CPE only worked with
CMTSs from the same vendor, therefore operators generally 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 CPE from a variety of equipment
manufacturers.

According to the DellOro Group, the market
leader in CMTSs is Cisco Systems, with greater than 50% market
share in 2002, based on transmit ports shipped. Cisco Systems
sells DOCSIS based CMTSs, as does ADC, Arris, Juniper Networks,
Motorola and Com21. Though we began shipping our standards based
DOCSIS solution in October 2001, the majority of our CMTS
shipments in 2002 were based on our proprietary S-CMDA
technology.

Again, according to the DellOro Group, the
worldwide market leader in modems is Motorola, with over 30%
market share, based on both manufacturers revenue and
units shipped. 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 2002 were DOCSIS
based. Approximately half of our modem shipments in 2002 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. However, several
companies have entered this market, including Cisco, Motorola
and privately-held BigBand Networks. Though we do not believe
that any of these

7



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entrants to the market have yet achieved
significant market share, we do expect to see our market share
drop as customers seek to diversify equipment vendors.


We sell our Multigate product into the market for
cable telephony systems. We believe that the market for
circuit-switch cable telephony products is transitioning to VoIP
products. As a result, we have few customers and limited sales
of our Multigate product as we transition to our MTA product.

Telecom

In Telecom, we offer two product lines, the
MiniPlex digital subscriber line multiplexer system and the IPTL
Symmetric DSL (SDSL) system. The vast majority of Telecoms
revenue in 2002 came from the MiniPlex products. Telecom
represented approximately 8% of our total revenues in 2002.



| |         
| | --------
| | Products



| |                                                                 
| | ----------------------------------------------------------------
| | 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 sell our products to telecom carriers
including Incumbent Local Exchange Carriers (ILECs) and
Competitive Local Exchange Carriers (CLECs). To date, sales of
our IPTL systems have been limited and concentrated outside of
the United States. None of our telecom customers accounted for
more than 10% of our total revenues for the year ended
December 31, 2002.

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 cable
operators 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
system that includes cable modems and CMTSs, which we
commercialized in 2002. Our current research and development
efforts include development of multimedia platforms for the
convergence of data, voice and video over existing cable
infrastructures. Total research and development costs were
$58.7 million, $79.9 million, $68.3 million for
the years ended December 31, 2002, 2001, and 2000,
respectively.

Sales and Marketing

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

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 service providers on

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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 cable industry in the United States and
throughout the world. Industry referrals and reference accounts
are significant marketing tools we develop and utilize.


International Sales

We have international sales offices in Belgium,
Hong Kong, the United Kingdom, Canada and Israel. In fiscal
2002, 2001, and 2000, approximately 68%, 82% and 75%,
respectively of our net revenues were from customers outside of
the U.S. Sales to Canada were approximately 13%, 41% and
35% of our net revenues in fiscal 2002, 2001, and 2000,
respectively. Sales to Japan were 28%, 13% and 11%, in fiscal
2002, 2001 and 2000, respectively. See Note 12 in our Notes
to Consolidated Financial Statements.

Almost all of our international sales are
currently invoiced in U.S. dollars. However, we do enter
into certain transactions originating in 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. Invoicing in other currencies will subject us
to the risk associated with foreign exchange rate fluctuations.
Although we do not currently have any foreign currency hedging
arrangement in place, 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 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 2002, we produced modems
primarily in Thailand. Currently, our modems are sole sourced
from our manufacturer in Thailand. Our data and video head-end
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 we believe 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.

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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.

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.

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 on a
royalty-free basis 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 letters claiming that our
technology infringes the intellectual property rights of others.
We are in the process of reviewing the allegations made and,
after consulting with patent counsel, we believe that the claims
alleging infringement are without merit. However, 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, divert our
managements resources, 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, 2002, we had 487
employees, of which 332 were located in the United States, 102
in Israel and 53 in Canada, Europe, South America and Asia. We
had 272 employees in research and development, 95 in marketing,
sales and customer support, 51 in operations and 69 in general
and

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administrative functions. None of our employees
are represented by collective bargaining agreements. We believe
that our relations with our employees are good.





DIRECTORS, EXECUTIVE OFFICERS AND KEY
EMPLOYEES

Certain information regarding our executive
officers as of March 27, 2003, is set forth below.

|                                |  |     |    |          |  |                                                                           
|------------------------------- |  | --- | -- | -------- |  | --------------------------------------------------------------------------
|Name                            |  | Age |    | Position
|                                |  |     |    |         
|Zaki Rakib(2)(3)                |  |     | 44 |          |  | Chief Executive Officer, Secretary and Director                           
|Shlomo Rakib                    |  |     | 46 |          |  | Chairman of the Board, President,
    Chief Technical Officer and Director
|Arthur T. Taylor                |  |     | 46 |          |  | Chief Financial Officer                                                   
|Alek Krstajic(2)                |  |     | 39 |          |  | Director                                                                  
|Christopher J. Schaepe(1)(2)(3) |  |     | 39 |          |  | Director                                                                  
|Lewis Solomon(1)(3)             |  |     | 69 |          |  | Director                                                                  
|David Woodrow(1)(3)             |  |     | 57 |          |  | Director                                                                  



---



|    |                                   
|--- | ----------------------------------
|(1) | Member of Audit Committee         
|   
|(2) | Member of Compensation Committee  
|   
|(3) | Member of the Nominating Committee

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 2005. Mr. Woodrow and 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 2004.

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.

Arthur T.
Taylorjoined the Company in February
2003 as Senior Vice President and Chief Financial Officer. Prior
to joining us, Mr. Taylor served as Vice President, Chief
Financial Officer and Secretary of Evolve Software, Inc., an
enterprise software company, from July 2002 until February 2003.
From March 2001 to July 2002, Mr. Taylor was Vice President
and Chief Financial Officer for Docent, Inc., an eLearning
enterprise software company. From August 1998 to March 2001,
Mr. Taylor was Vice President and Corporate Treasurer for
3Com Corporation, a high technology networking company. From
June 1997 to July 1998, Mr. Taylor was Chief Financial
Officer, Treasurer, and Vice President, Finance for ReSound
Corporation, a hearing health care company. Prior to that
Mr. Taylor held several senior financial management
positions at Allergan, Inc., an eye and skin care pharmaceutical
and medical device company.

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Mr. Taylor received a Bachelor of Science in
Business Administration from San Diego State University and an
MBA from the University of Southern California. Mr. Taylor
is also a Certified Management Accountant.


Alek Krstajichas
served as a director of the Company since July 1999.
Mr. Krstajic is a consultant to providers of broadband
services and broadband equipment manufacturers.
Mr. Krstajic held a variety of senior management positions
at Rogers Cable, Inc., most recently as Senior Vice President,
Sales and Marketing, from 1994 through January of 2003.
Mr. Krstajic is a director of Vix Systems, Inc., a
privately held company. Mr. Krstajic holds a B.A. degree in
economics from the University of Toronto in Canada and attended
the executive education program at Wharton School of Business at
the University of Pennsylvania.

Christopher J.
Schaepehas served as a director of
the Company 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 software infrastructure investments. From October 1991 until
October 2000, he served in various roles, including General
Partner, at Weiss, Peck & Greer Venture Partners, which
became Lightspeed Venture Partners in October 2000. 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 of the Company 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 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 company
that designs, manufacturers and markets 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. Mr. Solomon
holds a B.S. degree in Physics from St. Josephs
College.

David Woodrowhas
served as a director on our Board since June 2002. From
September 2000 until March 2002, Mr. Woodrow served as the
Chief Executive Officer and President of Qwest Digital Media
LLC, a production and digital media management company. From
1982 until his retirement in September 2000, Mr. Woodrow
held a number of senior management positions, most recently the
Executive Vice President, Broadband Services, with Cox
Communications, Inc., a major cable operator in the United
States. Mr. Woodrow is a director of several privately held
companies. Mr. Woodrow holds a B.S. and M.S. degree in
mechanical engineering from Purdue University and a M.B.A. from
the University of Connecticut.






|        |           
|------- | ----------
|Item 2. | Properties

Our principal executive offices are located in
Santa Clara, California where we lease approximately 141,000
square feet used by our Cable and Telecom segments under a lease
that expires in October 2009. In the United States, we also have
facilities in Mountain View and Costa Mesa, California;
Denver, Colorado; and Alpharetta, Georgia used by our Cable
segment. We have a facility in Fremont, California used by our
Telecom segment.

In addition, we lease properties worldwide. We
have a facility in Tel Aviv, Israel consisting of approximately
82,000 square feet used by our Cable and Telecom segments under
a lease that expires in October 2005. We have offices in
Hong Kong; Brussels, Belgium; Prague, Czech Republic; and
Ontario, Canada used by our Cable segment. We believe that our
existing facilities are adequate to meet our needs for the
immediate future.

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

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 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. On March 29, 2002, the court denied
the defendants motion to dismiss. The parties are now in
the discovery process. In addition, the court has certified the
plaintiffs proposed class and scheduled trial to begin on
November 4, 2003.

The lawsuit seeks an unspecified amount of
damages, in addition to other forms of relief. We consider the
lawsuits to be without merit and 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 us and the individual defendants (Zaki Rakib, Selim
Rakib and Raymond Fritz) in the California Superior Court, San
Luis Obispo County. 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. On
August 7, 2002, the court held another conference at which
it entered an order dismissing the Bertram case. The
courts order permits the individual plaintiffs in the
Bertram case to pursue any claims that they may have as
members of the purported class in the related, consolidated
class action discussed above. Plaintiffs have appealed this
order, and the Court of Appeals has set a briefing schedule for
the appeal.

We believe that the allegations in the
Bertram case, as with the allegations in the federal
securities case, are without merit and intend to contest the
matter vigorously.

On May 7, 2002, a shareholder filed a
derivative lawsuit purportedly on behalf of us against five of
its current directors, two former directors and two former
officers. This lawsuit is titled Campbell vs. Rakib,
et al., and is pending in the California Superior
Court, Santa Clara County. We are a nominal defendant in this

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lawsuit, which alleges claims relating to
essentially the same purportedly misleading statements that are
at issue in the pending securities class action. In that
litigation, we dispute making any misleading statements. The
derivative complaint also alleges claims relating to stock sales
by certain of the director and officer defendants.


On July 12, 2002, a shareholder filed a
derivative lawsuit purportedly on behalf of us against three of
our current directors, one former officer and three former
investors. This lawsuit is titled OBrien vs.
Rakib, et al., and is pending in the California
Superior Court, San Francisco County. We are a nominal defendant
in this lawsuit, which alleges claims relating to essentially
the same purportedly misleading statements that are at issue in
the pending securities class action. In that litigation, we
dispute making any misleading statements. The derivative
complaint also alleges claims relating to stock sales by certain
of the director and officer defendants. The plaintiff in the
OBrien case has dismissed the investor defendants
without prejudice.

Since the Campbell and OBrien
cases were filed, the parties have taken steps to have these
cases consolidated in the California Superior Court, County of
Santa Clara. On October 4, 2002, the California Superior
Court, County of San Francisco entered an order providing for
the transfer of the OBrien case. On
October 29, 2002, plaintiff in the OBrien case
submitted certain materials to the California Superior Court,
County of Santa Clara to effectuate that transfer, which is now
complete. The OBrien case is now consolidated with
the Campbell case.

We believe that there are many defects in the
Campbell and OBrien derivative complaints.

On January 19, 2003, Omniband Group Limited,
a Russian company, (Omniband) filed a request for arbitration
with the Zurich Chamber of Commerce, claiming damages in an
amount of $2,094,970 allegedly caused by our breach of an
agreement to sell to Omniband certain equipment pursuant to an
agreement between Omniband and Radwiz Ltd., our subsidiary,
dated February 22, 2000. On February 10, 2003, the
President of the Zurich Chamber of Commerce appointed the
Chairman of a three member panel to preside over the arbitration
proceedings. We believe that the allegations are without merit
and intend to present a vigorously defense in the arbitration
proceedings.

On September 3, 2002, Uniscor Ltd. (an
Israeli company under voluntary liquidation) and Flextronics
(Israel) Ltd., an Israeli company (Flextronics) filed a claim
with the Tel Aviv District Court in Israel against us and
Radwiz, our subsidiary, alleging that damages of NIS 25,000,000
(approximately $5 million US dollars) were caused to
them by our alleged failure to comply with its contractual
obligations to accept and pay for components manufactured by
Flextronics in the first quarter of 2001 pursuant to projections
it had received from Radwiz. We filed a statement of defense
denying the allegations, after which the parties accepted the
Courts recommendation to transfer the case to non-binding
mediation.

We are currently a party to various other legal
proceedings, in addition to those noted above, and may become
involved from time to time in other legal proceedings in the
future. While we currently believe that the ultimate outcome of
these other proceedings, individually and in the aggregate, will
not have a material adverse effect on our financial position or
overall trends in results of operations, litigation is subject
to inherent uncertainties. Were an unfavorable ruling to occur
in any of our legal proceedings, there exists the possibility of
a material adverse impact on our results of operations for the
period in which the ruling occurs. The estimate of the potential
impact on our financial position or overall results of
operations for any of the above legal proceedings could change
in the future.

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|        |                                                        
|------- | -------------------------------------------------------
|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 2002.




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 of our common stock, as reported by the
Nasdaq National Market.

|      |                |      |   |       |  |  |   |      | 
|----- | -------------- | ---- | - | ----- |  |  | - | ---- | 
|      |                | High |   | Low  
|      |                |      |   |      
|2002: |                |      |   |       |  |  |   |     
|      | First Quarter  |      | $ | 9.35  |  |  | $ | 5.48 | 
|      | Second Quarter |      | $ | 8.48  |  |  | $ | 0.86 | 
|      | Third Quarter  |      | $ | 3.62  |  |  | $ | 1.10 | 
|      | Fourth Quarter |      | $ | 2.97  |  |  | $ | 1.51 | 
|2001: |                |      |   |       |  |  |   |     
|      | First Quarter  |      | $ | 9.13  |  |  | $ | 3.50 | 
|      | Second Quarter |      | $ | 7.60  |  |  | $ | 2.36 | 
|      | Third Quarter  |      | $ | 7.55  |  |  | $ | 3.98 | 
|      | Fourth Quarter |      | $ | 14.75 |  |  | $ | 6.75 | 

As of March 18, 2003, there were
approximately 684 holders of record of our common stock, as
shown on the records of our transfer agent. The number of record
holders does not include shares held in street name
through brokers.

We do not pay any cash dividends on our common
stock. We currently expect to retain future earnings, if any,
for use in the operation and expansion of our business and do
not anticipate paying any cash dividends in the foreseeable
future.

Certain information related to securities
authorized for issuance under our equity compensation plans is
incorporated by reference to the information to be included in
our Proxy Statement for our 2003 Annual Meeting of Stockholders.

15



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Item
6.     Selected Financial
Data

The following tables contain selected financial
data as of and for each of the five years ended
December 31, 1998, 1999, 2000, 2001 and 2002 and are
derived from our financial statements. The selected financial
data are qualified by reference to, and should be read in
conjunction with, our financial statements and the notes to
those financial statements and Managements Discussion and
Analysis of Financial Condition and Results of Operations.

|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |        | 
|------------------------------------------------------------------------------------------------------ | ------------------------------------------------------- | ------------------------------------- | ------- | ------- |  | ---- | -------- | ------- |  | ---- | -------- | ------- |  | - | ------- | ------ |  | - | ------- | ------ | 
|                                                                                                       |                                                         |                                      
|                                                                                                       |                                                         | Years Ended December 31,             
|                                                                                                       |                                                         |                                      
|                                                                                                       |                                                         | 2002                                  |         | 2001    |  | 2000 |          | 1999    |  | 1998
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |     
|                                                                                                       |                                                         |                                      
|                                                                                                       |                                                         | (in thousands, except per share data)
|Consolidated statement of operations
    data:                                                         |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Revenues                                                                                               |                                                         | $                                     | 129,403 |         |  | $    | 279,481  |         |  | $    | 339,549  |         |  | $ | 97,009  |        |  | $ | 31,696  |       
|Cost of goods sold                                                                                     |                                                         |                                       | 100,949 |         |  |      | 263,117  |         |  |      | 289,531  |         |  |   | 72,044  |        |  |   | 34,518  |       
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Gross profit (loss)                                                                                    |                                                         |                                       | 28,454  |         |  |      | 16,364   |         |  |      | 50,018   |         |  |   | 24,965  |        |  |   | (2,822  | )     
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Operating expenses:                                                                                    |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|                                                                                                       | Research and development                                |                                       |         | 58,696  |  |      |          | 79,927  |  |      |          | 68,270  |  |   |         | 17,579 |  |   |         | 10,685 | 
|                                                                                                       | Cost of product development assistance
    agreement(1) |                                       |         |        |  |      |          |        |  |      |          | 9,563   |  |   |         | 35,147 |  |   |         |       | 
|                                                                                                       | In-process research and development(2)                  |                                       |         |        |  |      |          |        |  |      |          | 30,535  |  |   |         | 14,600 |  |   |         |       | 
|                                                                                                       | Sales and marketing                                     |                                       |         | 35,704  |  |      |          | 55,701  |  |      |          | 45,261  |  |   |         | 15,727 |  |   |         | 6,947  | 
|                                                                                                       | General and administrative                              |                                       |         | 14,715  |  |      |          | 31,309  |  |      |          | 24,809  |  |   |         | 7,476  |  |   |         | 3,223  | 
|                                                                                                       | Goodwill amortization                                   |                                       |         |        |  |      |          | 25,410  |  |      |          | 59,057  |  |   |         | 3,524  |  |   |         |       | 
|                                                                                                       | Restructuring and asset write-offs(3)                   |                                       |         | 8,922   |  |      |          | 587,149 |  |      |          |        |  |   |         |       |  |   |         |       | 
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|                                                                                                       | Total operating expenses                                |                                       |         | 118,037 |  |      |          | 779,496 |  |      |          | 237,495 |  |   |         | 94,053 |  |   |         | 20,855 | 
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Loss from operations                                                                                   |                                                         |                                       | (89,583 | )       |  |      | (763,132 | )       |  |      | (187,477 | )       |  |   | (69,088 | )      |  |   | (23,677 | )     
|Interest (expense) income, net                                                                         |                                                         |                                       | (3,481  | )       |  |      | 44       |         |  |      | 6,710    |         |  |   | 5,008   |        |  |   | 449     |       
|Gain on early retirement of debt(4)                                                                    |                                                         |                                       | 49,089  |         |  |      | 185,327  |         |  |      |         |         |  |   |        |        |  |   |        |       
|Income tax (expense) benefit                                                                           |                                                         |                                       | (238    | )       |  |      | 13,915   |         |  |      |         |         |  |   |        |        |  |   |        |       
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Net loss                                                                                               |                                                         | $                                     | (44,213 | )       |  | $    | (563,846 | )       |  | $    | (180,767 | )       |  | $ | (64,080 | )      |  | $ | (23,228 | )     
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Series F convertible preferred stock dividend                                                          |                                                         |                                       |        |         |  |      |         |         |  |      |         |         |  |   |        |        |  |   | 23,910  |       
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Net loss applicable to common stockholders                                                             |                                                         | $                                     | (44,213 | )       |  | $    | (563,846 | )       |  | $    | (180,767 | )       |  | $ | (64,080 | )      |  | $ | (47,138 | )     
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Basic and diluted net loss per share                                                                   |                                                         | $                                     | (0.61   | )       |  | $    | (8.25    | )       |  | $    | (2.95    | )       |  | $ | (1.55   | )      |  | $ | (2.62   | )     
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       
|Shares used in computing basic and diluted net
    loss per share applicable to common stockholders(5) |                                                         |                                       | 72,803  |         |  |      | 68,331   |         |  |      | 61,349   |         |  |   | 41,260  |        |  |   | 17,972  |       
|                                                                                                       |                                                         |                                       |         |         |  |      |          |         |  |      |          |         |  |   |         |        |  |   |         |       

|                                                  |  |                |          |      |  |      |          |      |  |      |           |   |  |   |          |   |  |   |         |  
|------------------------------------------------- |  | -------------- | -------- | ---- |  | ---- | -------- | ---- |  | ---- | --------- | - |  | - | -------- | - |  | - | ------- | -
|                                                  |  |               
|                                                  |  | December 31,  
|                                                  |  |               
|                                                  |  | 2002           |          | 2001 |  | 2000 |          | 1999 |  | 1998
|                                                  |  |                |          |      |  |      |          |      |  |     
|                                                  |  |               
|                                                  |  | (in thousands)
|Consolidated Balance Sheet Data:                  |  |                |          |      |  |      |          |      |  |      |           |   |  |   |          |   |  |   |         |  
|Cash, cash equivalents and short-term investments |  | $              | 206,503  |      |  | $    | 333,888  |      |  | $    | 562,457   |   |  | $ | 112,992  |   |  | $ | 28,880  |  
|Working capital                                   |  |                | 172,829  |      |  |      | 316,175  |      |  |      | 547,938   |   |  |   | 112,374  |   |  |   | 24,422  |  
|Total assets                                      |  |                | 275,710  |      |  |      | 466,646  |      |  |      | 1,426,727 |   |  |   | 301,236  |   |  |   | 42,146  |  
|Long-term obligations (less current portion)(4)   |  |                | 68,580   |      |  |      | 178,641  |      |  |      | 500,477   |   |  |   | 37       |   |  |   | 10      |  
|Accumulated deficit                               |  |                | (937,207 | )    |  |      | (892,994 | )    |  |      | (329,148  | ) |  |   | (148,381 | ) |  |   | (84,301 | )
|Total stockholders equity                        |  | $              | 137,142  |      |  | $    | 180,304  |      |  | $    | 702,681   |   |  | $ | 258,655  |   |  | $ | 28,103  |  

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---



|    |                                                                                                                                                                                    
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 9 of Notes to Consolidated
    Financial Statements for an explanation of the product
    development assistance agreement.                                               
|   
|(2) | See Note 14 of Notes to Consolidated
    Financial Statements for an explanation regarding business
    acquisitions.                                                              
|   
|(3) | See Note 5 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 and reclassification of related
    gains. 
|   
|(5) | 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.






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|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 are an experienced partner for broadband
service providers, but are primarily focused on cable operators.
Our mission is to deliver innovative broadband data, video and
voice solutions for 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, 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
segments: Cable Broadband Access Systems (Cable) and Telecom
Carrier Systems (Telecom). The products sold in Cable consist of
DOCSIS standards based products, 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 consist 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. During fiscal 2002, 92% of our total revenues
were derived from Cable and 8% from Telecom.

Our customers, which primarily consist of U.S.
and international cable operators, are currently moving towards
products which are standards-based or, in other
words, based on a set of generally accepted industry standards.
We have been challenged to develop a new line of products that
incorporate the DOCSIS standard technologies and to establish
ourselves through this our new product line as a supplier to the
DOCSIS market. Revenues from proprietary S-CDMA systems are
declining as we are in a transitional period of launching our
DOCSIS-based systems. As a supplier of standards-based products,
we face a more competitive market. These standards are shared,
at no cost, with us and our competitors, which means that it
will be increasingly difficult for us to differentiate our
products to compete with other companies who are producing
similar products. Consequently, we will need to find other ways
(i.e. price, quality, level of service) to differentiate
ourselves from our competitors. In the current marketplace, we
have been affected by the move to standards-based products
through increased competition, which has driven down average
selling prices (ASPs) sharply. These ASP decreases, without a
corresponding decrease in the cost of goods sold, could cause us
to not be successful in transitioning to a standards based
technology.

The evolution of broadband has resulted in cable
television operators, providers of telephone service and other
service providers seeking to provide a bundle of voice, data and
video services to their residential and commercial subscribers
over existing and new infrastructures. Recognizing this trend,
from September 1999 through December 2000, we acquired ten
companies: in the following chronological order: Imedia, Radwiz,
Telegate, ANE, ComBox, certain assets of Internet Telecom,
Ultracom, Digitrans, MainSail and TrueChat.

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The intended result of these acquisitions was to
offer customers and potential customers a robust family of
product offerings that integrated many of the acquired
technologies. Additionally, we sought to expand our portfolio of
broadband products to support high-speed delivery of voice, data
and video services over cable, DSL and wireless. In order to
achieve the expected integration of the products and realize the
synergies of combined infrastructures, the technologies needed
to be further developed, and the products needed to obtain
market acceptance. Given market conditions at the time of the
acquisitions, we paid high values to acquire these technologies.
Although we were successful incorporating a number of these
technologies into our products, significant downturns in the
broadband services and telecommunication markets and our
decision to suspend certain product lines and product
development efforts, caused us to reassess the goodwill and
other intangible assets acquired in the acquisitions for
recoverability. For more information relating to the
acquisitions, see Note 14 of the Notes to Consolidated
Financial Statements.


The general economic slowdown, and the technology
sector slowdown in particular, had a significant impact on our
operating results. Prior to the fourth quarter of 2000, we had
experienced significant quarter-over-quarter growth. However,
during the first quarter of 2001, we recognized that
significantly more than company-specific issues were occurring
and that the general economic conditions in our industry were
likely to permanently impact our ability to recover the carrying
amount of intangible assets from the acquisitions on our balance
sheet. Due to these economic conditions, none of the products
from our acquired businesses have achieved the level of market
acceptance that was forecasted at the time of their
acquisitions. Additionally, certain product groups have not
achieved the level of technological development needed to be
marketable or to expand the market.

Early in the second quarter of 2001 and again in
the first and second quarter of 2002, we reviewed impairment
indicators, which were present for our acquisitions. The overall
impairment indicator was the decrease in demand for our
products. Since the long-lived assets were not projected to
generate sufficient undiscounted cash flows to recover their
value over the remaining lives of the assets, our asset
impairment policy directed that the value of the assets be
written down to fair value. In the case of assets for which the
expected future cash flows were negative, all intangibles were
written off ($4.0 million in 2002 and $572.8 million
in 2001). No intangible assets remained at December 31,
2002.

During 2001, our Board of Directors approved a
restructuring plan to streamline our worldwide organizational
structure. Additionally, in the third quarter of fiscal 2002,
our Board of Directors approved a restructuring plan to scale
back our business due to the significant decline in revenues in
the second and third quarters of 2002. These restructuring
programs included a worldwide workforce reduction throughout all
departments within the company and consolidation of excess
facilities. As a consequence of our restructuring plan, we
expect to continue to invest in research and development,
primarily in our Cable segment, at slightly reduced levels in
the future. We currently expect sales and marketing and general
and administrative expenses to continue to decrease in 2003 as a
result of the restructuring. For additional information
regarding the restructuring program, see Note 5 of the
Notes to Consolidated Financial Statements.

On March 14, 2003, we initiated a worldwide
reduction in force of approximately 100 employees, or
20 percent of the workforce, and the closure of certain
remote facilities. We expect to record total charges in the
range of approximately $4 million to $5 million
associated with the realignment and the write-down of certain
related assets in the quarter ending March 31, 2003.

We had a net loss of $44.2 million,
$563.8 million and $180.8 million in the years ended
December 31, 2002, 2001, and 2000, respectively. We had an
accumulated deficit of $937.2 million and
$893.0 million as of December 31, 2002 and 2001,
respectively. A significant portion of the loss in 2001 was due
to the write-off of intangible assets and restructuring charges,
but was partially offset by 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 anticipate that we will spend approximately
$4 million to $6 million on capital expenditures
during the year ending December 31, 2003. Anticipated
capital expenditures consist of purchases of computer hardware,
furniture and leasehold improvements for our facilities, and
software and equipment. We expect to continue to incur losses
for the foreseeable future.

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Critical Accounting Policies

We consider certain accounting policies related
to revenue recognition, bad debt reserves, inventory valuation,
impairment of long-lived assets, warranty returns,
restructuring, accounting for share based compensation and
contingencies to be critical policies due to the estimation
processes involved in each. We discuss each of our critical
accounting policies, in addition to certain less significant
accounting policies, with senior members of management and the
audit committee, as appropriate.

Use of Estimates.The preparation of the
consolidated financial statements and related disclosures in
conformity with accounting principles generally accepted in the
United States requires us to establish accounting policies that
contain estimates and assumptions that affect the amounts
reported in the consolidated financial statements and
accompanying notes. On an on-going basis, we evaluate our
estimates, including those related to product returns, bad
debts, inventories, investments, intangible assets and
contingencies and litigation. We base our estimates on
historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results
of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent
from other sources. These policies include:



| |   |                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | revenue recognition;                                                                                                                                                                 
|
| |  | the allowance for doubtful accounts, which
    impacts revenue;                                                                                                                      
|
| |  | the valuation of exposures associated with the
    contract manufacturing operations and estimating future warranty
    costs, which impact cost of goods sold and gross margins; and
|
| |  | the valuation of certain long-lived assets,
    especially goodwill and other purchased intangible assets, which
    has resulted in impairment, which impacts operating expenses.   

We have other equally important accounting
policies and practices which may not require us to make
significant estimates or assumptions. Despite our intention to
establish accurate estimates and assumptions, actual results
could differ from those estimates under different assumptions or
conditions.

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 there be changes to managements judgments, 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.

Inventory Valuation.Our policy for valuation of
inventory and commitments to purchase inventory, including the
determination of obsolete or excess inventory, requires us to
perform a detailed assessment of inventory at each balance sheet
date which includes a review of, among other factors, an
estimate of future demand for products within specific time
horizons, generally six months or less, as well as product
lifecycle and product development plans. The estimates of future
demand that we use in the valuation of inventory are the basis
for the revenue forecast, which is also consistent with our
short-term manufacturing plan. Based on this analysis, we reduce
the cost of inventory that it specifically identified and
considered obsolete or excessive to fulfill future sales
estimates. We define obsolete inventory as inventory that will
no longer be used in the manufacturing process. Excess inventory
is generally defined as inventory in excess of projected usage,
and is

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##### Table of Contents



determined using our best estimate of future
demand at the time, based upon information then available. We
dispose of excess and obsolete inventories in the normal course
of business.


We have increased 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 for our product. We
generally purchase our inventory through purchase orders with
fixed pricing and do not have supply agreements with our
vendors, which provide pricing or volume discounts. If future
demand is less favorable than projected, and we fail to reduce
manufacturing output accordingly, additional inventory reserves
may be required which would have a negative impact on our gross
margin.

Impairment of Long-Lived Assets.Our long-lived assets have
included long-term investments, goodwill and other intangible
assets. Our estimate of the fair value of the long-term
investments was 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
companies business forecasts were not met, we had to
record additional impairment charges. During the year ended
December 31, 2002, we recognized approximately
$4.5 million of impairment losses related to our long-term
investments as other income (expense) in our Consolidated
Statements of Operations.

We adopted Statement of Financial Accounting
Standards (SFAS) No. 142, Goodwill and Other
Intangible Assets, (SFAS No. 142) on January 1,
2002. We reclassified $1.3 million of assembled workforce,
net of accumulated amortization, with an indefinite life, to
goodwill at the date of adoption of this standard. We test
goodwill for impairment using the two-step process prescribed in
SFAS No. 142. The first step is a screen for potential
impairment, while the second step measures the amount of the
impairment, if any. We completed the initial goodwill impairment
review as of the beginning of 2002, and found no impairment.
During the first and second quarters of 2002, we completed a
restructuring and impairment review as further discussed in
Note 5 of the Notes to the Consolidated Financial
Statements. Due to a difficult economic environment and
heightened price competition in the modem and telecom businesses
during the second quarter of 2002, we experienced a significant
drop in our market capitalization and therefore proceeded to
perform an interim test to measure goodwill and intangible
assets for impairment. The outcome of this test resulted in a
non-cash charge of $4.0 million to write-off goodwill in
both the Cable and Telecom segments during the second quarter of
2002. At December 31, 2002, we had no other intangible
assets recorded on the Consolidated Balance Sheets.

The following pro forma information reflects the
impact on net income (loss) and net income (loss) per share
assuming the adoption of SFAS No. 142 had occurred on
January 1, 2000 (in thousands):

|                                      |                                                                                                |                     |         |             |   |             |          |        |   |   |          |         |  
|------------------------------------- | ---------------------------------------------------------------------------------------------- | ------------------- | ------- | ----------- | - | ----------- | -------- | ------ | - | - | -------- | ------- | -
|                                      |                                                                                                |                    
|                                      |                                                                                                | Twelve months ended
|                                      |                                                                                                |                    
|                                      |                                                                                                |                     |         | 2001        |   | 2000       
|                                      |                                                                                                | 2002                |         | (Pro forma) |   | (Pro forma)
|                                      |                                                                                                |                     |         |             |   |            
|Reported net loss                     |                                                                                                | $                   | (44,213 | )           |   | $           | (563,846 | )      |   | $ | (180,767 | )      
|                                      | Amortization of goodwill and intangible assets
    with indefinite lives                       |                     |         |            |   |             |          | 53,846 |   |   |          | 104,015 |  
|                                      |                                                                                                |                     |         |             |   |             |          |        |   |   |          |        
|Pro forma net loss                    |                                                                                                | $                   | (44,213 | )           |   | $           | (510,000 | )      |   | $ | (76,752  | )      
|                                      |                                                                                                |                     |         |             |   |             |          |        |   |   |          |        
|Basic and diluted net loss per share: |                                                                                                |                     |         |             |   |             |          |        |   |   |          |        
|                                      | Reported net loss                                                                              |                     | $       | (0.61       | ) |             | $        | (8.25  | ) |   | $        | (2.95   | )
|                                      | Adjustment related to amortization of goodwill
    and intangible assets with indefinite lives |                     |         |            |   |             |          | 0.79   |   |   |          | 1.70    |  
|                                      |                                                                                                |                     |         |             |   |             |          |        |   |   |          |        
|Pro forma net loss per share          |                                                                                                | $                   | (0.61   | )           |   | $           | (7.46    | )      |   | $ | (1.25    | )      
|                                      |                                                                                                |                     |         |             |   |             |          |        |   |   |          |        

Warranty Reserves.We provide a standard warranty for
most of our products, generally lasting one to five years 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 our
expectation of future conditions. Should actual product

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failure rates, material usage or service delivery
costs differ from our estimates, revision to the warranty
liability would be required, resulting in decreased gross
profits.


Restructuring and Other Related Charges.During 2001 and 2002, we implemented
restructuring programs to focus and streamline our business and
reduce operating expenses. In connection with these programs, we
reduced headcount and abandoned facilities. As a result of these
actions, we recorded restructuring and other related charges
consisting of cash severance payments to be made to severed
employees, lease payments related to property abandoned as a
result of our facilities consolidation, and legal and other
costs. Each reporting period, we review these estimates based on
the status of execution of our restructuring plan and, to the
extent that these assumptions change due to changes especially
in real estate market conditions, the ultimate restructuring
expenses could vary.

As of December 31, 2002, our restructuring
actions related to employee severance were nearly complete and
we had $0.1 million remaining related to severance
obligations. The $6.7 million of cash expenditures related
to our restructuring liability as of December 31, 2002, are
expected to be paid over the remaining term of our facility
lease through 2005.

Deferred Compensation.Deferred compensation for options
granted to employees has been determined as the difference
between the deemed fair market value of our common stock on the
date options were granted and the exercise price. Deferred
compensation for options granted to non-employees has been
determined in accordance with Statement of Financial Accounting
Standards No. 123 as the fair value of the equity
instruments issued. Deferred compensation for options granted to
non-employees is remeasured at each reporting period as the
underlying options vest.

As of December 31, 2002, we recorded
deferred compensation on our balance sheet of $25,000 in
connection with options granted to a non-employee. This deferred
compensation is amortized over the two year vesting period of
the related options. During 2002, 2001, and 2000, we amortized
$0.5 million, $0.5 million, and $0.6 million of
deferred share compensation, respectively, primarily related to
option grants to non-employees and grants of restricted stock to
employees.

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



| |                                                             
| | ------------------------------------------------------------
| | Comparison of the years ended
    December 31, 2002 and 2001



| |         
| | --------
| | Revenues

|                  |                |                    |         |                 |  |           |         |         |  |  |     |     |   
|----------------- | -------------- | ------------------ | ------- | --------------- |  | --------- | ------- | ------- |  |  | --- | --- | --
|                  |                |                    |         |                
|                  |                | For the year ended |         |                
|                  |                | December 31,       |         |                
|                  |                |                    |         | Annual % Change
|                  |                | 2002               |         | 2001            |  | 2002/2001
|                  |                |                    |         |                 |  |          
|                  |                |                    |         |                
|                  |                | (in thousands)     |         |                
|Product revenues: |                |                    |         |                 |  |           |         |         |  |  |     |    
|Cable revenues    |                | $                  | 118,929 |                 |  | $         | 245,828 |         |  |  | (52 | )% 
|Telecom revenues  |                |                    | 10,474  |                 |  |           | 33,653  |         |  |  | (69 | )% 
|                  |                |                    |         |                 |  |           |         |         |  |  |     |    
|                  | Total revenues |                    | $       | 129,403         |  |           | $       | 279,481 |  |  |     | (54 | )%
|                  |                |                    |         |                 |  |           |         |         |  |  |     |    

We sell our products directly to broadband
service providers, and to a lesser extent, resellers and system
integrators. Revenues related to product sales are 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. A provision is
made for estimated product returns as product

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shipments are made. Our existing agreements
typically do not grant return rights beyond those provided by
the warranty.


Revenues consist primarily of sales of products
to new and existing customers providing broadband services. Our
revenues decreased 54% to $129.4 million for the year ended
December 31, 2002 from $279.5 million in 2001.
Revenues in North America, which includes the United States and
Canada decreased 64% to $58.4 million in 2002, down from
$163.6 million in 2001. Revenues from international
locations decreased 39% to $71.0 million in 2002 down from
$115.9 million in 2001. One customer, Cross Beam Networks,
a subsidiary of Sumitomo, accounted for more than 10% of our
total revenues for the year ended December 31, 2002.
Decrease in revenues, year over year and decrease in North
American revenues were primarily due to the slowdown in the
general economy, over-capacity of broadband products especially
in North America, and constraints on technology-related capital
spending, in particular cable service providers.

Cable Broadband Access Systems (Cable)
Revenue.Revenues from Cable were
$118.9 million for the year ended December 31, 2002,
down 52% from $245.8 million in 2001 due to lower shipments
of modems and head-ends in 2002 than in 2001, as well as a
continued decline in average selling prices (ASPs) year over
year as ongoing competitive pricing pressures affected revenue
performance in several of our Cable products.

Telecom Carrier Access Systems (Telecom)
Revenue.Revenues from Telecom were
$10.5 million, down 69% from $33.7 million in 2001. We
have a small customer base, and revenues were impacted by
significant declines in telecom industry spending. Additionally,
we continue to decrease focus on our Telecom segment and apply
our resources to our Cable segment.

During 2002, the cable industry moved to
purchasing more standards-based DOCSIS products as opposed to
our proprietary modems and head-ends, and we faced increasingly
strong competition from multiple vendors, which unfavorably
impacted revenues. Further, during 2001 and 2002, we were
unfavorably impacted by declines in average selling prices
(ASPs) of our modems. In addition, revenues from our Telecom
segment were impacted by declines in telecom industry spending.
The intensely competitive nature of the market for broadband
products resulted in significant price erosion in 2002. 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
declines in ASP. We intend to continue to implement cost
reduction efforts, including design changes and manufacturing
efficiencies.

|                        |                |                    |       |                 |  |           |        |        |  |  |     |     |   
|----------------------- | -------------- | ------------------ | ----- | --------------- |  | --------- | ------ | ------ |  |  | --- | --- | --
|                        |                |                    |       |                
|                        |                | For the year ended |       |                
|                        |                | December 31,       |       |                
|                        |                |                    |       | Annual % Change
|                        |                | 2002               |       | 2001            |  | 2002/2001
|                        |                |                    |       |                 |  |          
|                        |                |                    |       |                
|                        |                | (in thousands)     |       |                
|Related party revenues: |                |                    |       |                 |  |           |        |        |  |  |     |    
|Rogers revenues         |                | $                  | 8,040 |                 |  | $         | 21,045 |        |  |  | (62 | )% 
|Harmonic revenues       |                |                    | 1,057 |                 |  |           |       |        |  |  |    |    
|Shaw revenue            |                |                    |      |                 |  |           | 31,400 |        |  |  |    |    
|                        |                |                    |       |                 |  |           |        |        |  |  |     |    
|                        | Total revenues |                    | $     | 9,097           |  |           | $      | 52,445 |  |  |     | (83 | )%
|                        |                |                    |       |                 |  |           |        |        |  |  |     |    

Related party revenues decreased 83% to
$9.1 million for the year ended December 31, 2002 from
$52.4 million in 2001. Related party revenues in 2002
include revenues from Rogers Communications, Inc. (Rogers) and
Harmonic, Inc. (Harmonic). Alek Krstajic, a member of our board
of directors, was the Senior Vice President of Interactive
Services, Sales and Product Development for Rogers until January
2003. Effective in May 2003, Rogers will no longer be a related
party to us. Lewis Solomon, another member of our board of
directors, is a member of the board of directors of Harmonic.
The decline in related party revenues is primarily due to the
same economic and competitive pressures discussed above. In
addition, Shaw Communications, Inc. (Shaw) was a related party
during the first three quarters of 2001. In the fourth quarter
of 2001, Shaw was no longer determined to be a related party as
they no longer exercised voting rights over their shares of our
stock, and a board member that was an employee of Shaw resigned
from our Board of Directors. Accordingly, revenues from Shaw
were no longer included in related party revenues beginning in
the fourth

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quarter of 2001. See Note 13 of Notes to the
Consolidated Financial Statements. None of our related parties
is a supplier to us.


Cost of Goods Sold

|                   |  |                    |         |                 |  |           |         |  |  |  |     |   
|------------------ |  | ------------------ | ------- | --------------- |  | --------- | ------- |  |  |  | --- | --
|                   |  |                    |         |                
|                   |  | For the year ended |         |                
|                   |  | December 31,       |         |                
|                   |  |                    |         | Annual % Change
|                   |  | 2002               |         | 2001            |  | 2002/2001
|                   |  |                    |         |                 |  |          
|                   |  |                    |         |                
|                   |  | (in thousands)     |         |                
|Cost of goods sold |  | $                  | 100,949 |                 |  | $         | 263,117 |  |  |  | (62 | )%

Cost of goods sold consists of direct product
costs as well as the cost of our manufacturing operations. The
cost of the manufacturing includes contract manufacturing, test
and quality assurance for products, warranty costs and
associated costs of personnel and equipment. In 2002, cost of
goods sold decreased 62% to $100.9 million or 78% of
revenues from $263.1 million or 94% of revenues in 2001.
Cost of goods sold in 2002 included a reversal of approximately
$15.3 million in special charges taken in 2001 for vendor
cancellation charges and inventory previously reserved for
obsolescence. We reversed this provision as we were able to sell
inventory originally considered to be in excess. In addition, we
were able to negotiate downward certain vendor cancellation
claims to terms more favorable to us. Cost of goods sold for the
year ended December 31, 2001 included special charges of
$33.5 million and approximately $13.9 million of
amortization of acquired intangible assets. Additionally, during
2002, we recorded an inventory charge of $6.1 million to
reduce some of our inventory to the lower of its cost or market
value as ASPs fell below the cost of these products. No charge
to record a lower of cost or market value was recorded by us in
2001 or 2000. In accordance with SFAS No. 142, there was no
amortization of acquired intangible assets in 2002.

Gross Profit

|             |  |                    |        |                 |  |           |        |  |  |  |    |  
|------------ |  | ------------------ | ------ | --------------- |  | --------- | ------ |  |  |  | -- | -
|             |  |                    |        |                
|             |  | For the year ended |        |                
|             |  | December 31,       |        |                
|             |  |                    |        | Annual % Change
|             |  | 2002               |        | 2001            |  | 2002/2001
|             |  |                    |        |                 |  |          
|             |  |                    |        |                
|             |  | (in thousands)     |        |                
|Gross profit |  | $                  | 28,454 |                 |  | $         | 16,364 |  |  |  | 74 | %

We achieved a gross profit of $28.5 million
or 22% of sales in the year ended December 31, 2002
compared to $16.4 million or 6% in 2001. The increase in
our gross profit was primarily related to a $15.3 million
reversal of special charges in 2002, in comparison to
$33.5 million of special charges for vendor cancellation
charges and inventory obsolescence reserves incurred in 2001.
Excluding the reversal of special charges, gross profit for the
year ended December 31, 2002 was 10% of sales. Excluding
special charges and amortization costs, gross profit for the
year ended December 31, 2001 was 23% of sales. This
decrease in gross profit excluding special charges and
amortization was primarily due to decreases in ASPs.
Additionally, we were not able to decrease our cost of goods
sold as quickly as the decrease in ASPs. During 2002, we
recorded an inventory charge of $6.1 million to reduce some
of our inventory to the lower of its cost or market value as
ASPs fell below the cost of these products. No charge to record
a lower of cost or market value was recorded by us in 2001 or
2000. During 2003, we anticipate further decreases in our ASPs
and continued pressure on our margins, and we expect to see
decreasing margins in 2003 unless and until we can produce lower
cost products and increase sales of our higher-margin head-end
products. These ASP decreases, without a corresponding decrease
in our product costs, will likely have an adverse impact on our
operating results through at least 2003.

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##### Table of Contents



Operating Expenses

|                           |  |                    |        |          |  |           |        |  |  |  |      |  
|-------------------------- |  | ------------------ | ------ | -------- |  | --------- | ------ |  |  |  | ---- | -
|                           |  |                    |        |         
|                           |  | For the year ended |        |         
|                           |  | December 31,       |        | Annual  
|                           |  |                    |        | % Change
|                           |  | 2002               |        | 2001     |  | 2002/2001
|                           |  |                    |        |          |  |          
|                           |  |                    |        |         
|                           |  | (in thousands)     |        |         
|Research and development   |  | $                  | 58,696 |          |  | $         | 79,927 |  |  |  | (27% | )
|Sales and marketing        |  | $                  | 35,704 |          |  | $         | 55,701 |  |  |  | (36% | )
|General and administrative |  | $                  | 14,715 |          |  | $         | 31,309 |  |  |  | (53% | )
|Goodwill amortization      |  |                    |       |          |  | $         | 25,410 |  |  |  |     |  

Research and
Development.Research and
development expenses consist primarily of personnel costs,
internally designed prototype material expenditures, outside
engineering consultants, equipment and supplies required to
develop and enhance our products. Research and development
expenses decreased to $58.7 million or 45% of sales in the
year ended December 31, 2002 from $79.9 million or 29%
of sales in 2001. The decrease of $21.2 million is
attributable to a $7.5 million decline in spending in our
Cable segment, an $8.0 million decline in spending in our
Telecom segment, and a $5.7 million reduction in
amortization of intangible assets. Research and development
expenses in the Cable segment decreased primarily due to
reductions in employee related expenses and outside engineering
consultants. Discontinuing the development of our Digitrans
product line contributed $1.6 million of the Cable segment
expense reduction. Additionally, we have reduced research and
development efforts in our Telecom segment by $8.0 million
due to market conditions in the Telecom sector. In 2001, we
recorded amortization of acquired intangible assets of
$5.7 million. In accordance with SFAS No. 142, there
was no amortization in 2002. 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 intend to continue our investment in research
and development primarily in our Cable segment related to DOCSIS
standards-based products. In connection with our worldwide
restructuring plan announced on March 14, 2003, we
currently expect research and development to decrease
in 2003.

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
decreased by $20.0 million to $35.7 million or 28% of
sales in the year ended December 31, 2002 from
$55.7 million or 20% of sales in 2001. The decrease in
sales and marketing expenses was primarily due to
$8.5 million in decreased headcount from the restructuring
and other expenses in our Telecom segment, and $7.2 million
in decreased spending for promotional activities in our Cable
Segment. The decreased spending for promotional activities in
the Cable segment, includes a $2.2 million decrease in
employee salaries and related costs, a $2.0 million
decrease in co-marketing activities, a $1.8 million
decrease for advertising, a $1.8 million decrease for field
trials, a $1.1 million decrease for tradeshows, a
$1.1 million decrease for public relations and other
consulting services, and a $0.8 million decrease in
promotional literature. These spending decreases were partially
offset by $3.6 million of additional expenses in 2002
related to an aircraft lease obtained in early 2002.
Additionally, in 2001, we recorded amortization of acquired
intangible assets of $4.3 million. In accordance with SFAS
No. 142, there was no amortization in 2002. In connection
with our worldwide restructuring plan announced on
March 14, 2003, we currently expect sales and marketing
expenses to continue to decrease in 2003.

General and
Administrative.General and
administrative expenses consist primarily of salary and benefits
for administrative officers and support personnel, travel
expenses and legal, accounting and consulting fees. General and
administrative expenses decreased 53% to $14.7 million or
11% of sales in the year ended December 31, 2002 from
$31.3 million or 11% of sales in 2001. The decrease is
primarily due to lower headcount from the restructuring and
reduced legal and information technology expenditures in 2002.
Additionally, in 2001, general and administrative expenses
included $4.6 million of amortization of acquired
intangible assets. In accordance with SFAS No. 142, there
was no amortization in 2002. In connection with our worldwide
restructuring plan announced on March 14, 2003, we
currently expect general and administrative expenses to continue
to decrease in 2003.

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Goodwill
Amortization.The amortization of
goodwill arising from acquisitions completed during 2000 and
1999 was $25.4 million for the year ended December 31,
2001.

Upon adoption of SFAS No. 142, effective
January 1, 2002, we were no longer required to amortize the
goodwill of assets associated with our acquisitions in 1999 and
2000. Consequently, we recorded no amortization in 2002.

Restructuring Costs and Asset
Write-offs

|                                         |  |                    |       |      |  |   |         | 
|---------------------------------------- |  | ------------------ | ----- | ---- |  | - | ------- | 
|                                         |  |                   
|                                         |  | For the year ended
|                                         |  | December 31,      
|                                         |  |                   
|                                         |  | 2002               |       | 2001
|                                         |  |                    |       |     
|                                         |  |                   
|                                         |  | (in thousands)    
|Restructuring charges                    |  | $                  | 3,641 |      |  | $ | 12,669  | 
|Long-lived assets written-off            |  |                    | 1,309 |      |  |   | 1,688   | 
|Intangible assets written off            |  |                    | 3,972 |      |  |   | 572,792 | 
|                                         |  |                    |       |      |  |   |         | 
|Restructuring costs and asset write-offs |  | $                  | 8,922 |      |  | $ | 587,149 | 
|                                         |  |                    |       |      |  |   |         | 

Restructuring
CostsIn the third quarter of
2002, we initiated a restructuring program to conform our
expense and revenue levels and to better position us for future
growth and eventual profitability. As part of this program, we
restructured our worldwide operations including a worldwide
reduction in workforce and the consolidation of excess
facilities. We incurred additional restructuring charges of
$3.6 million in 2002. Of the total restructuring charge,
$2.3 million is related to employee termination costs. The
remaining $1.3 million relates primarily to costs for
excess leased facilities. During 2002, the employment of
147 employees was terminated and we made cash payments of
$2.1 million against the restructuring accrual.
Additionally, in 2002, we reclassed $0.1 million from
employee termination costs to excess lease facility costs. We
anticipate that the remaining employee termination costs of
$0.1 million related to an additional 6 employees will
be paid in 2003. At December 31, 2002, restructuring
charges of $1.5 million remain accrued, primarily related
to excess facility costs. We anticipate utilizing the remaining
restructuring accrual, which relates to servicing operating
lease payments or negotiated buyout of operating lease
commitments, through 2005.

A summary of the 2002 accrued restructuring
charges is as follows (in millions):

|                             |  |              |      |                |  |       |     |  |  |   |      |  
|---------------------------- |  | ------------ | ---- | -------------- |  | ----- | --- |  |  | - | ---- | -
|                             |  |              |      | Excess Leased  |  |      
|                             |  |              |      | Facilities and |  |      
|                             |  | Involuntary  |      | Cancelled      |  |      
|                             |  | Terminations |      | Contracts      |  | Total
|                             |  |              |      |                |  |      
|Total Charge                 |  | $            | 2.3  |                |  | $     | 1.3 |  |  | $ | 3.6  |  
|Cash Payments                |  |              | (2.1 | )              |  |       |    |  |  |   | (2.1 | )
|Reclassification             |  |              | (0.1 | )              |  |       | 0.1 |  |  |   |     |  
|                             |  |              |      |                |  |       |     |  |  |   |      |  
|Balance at December 31, 2002 |  | $            | 0.1  |                |  | $     | 1.4 |  |  | $ | 1.5  |  
|                             |  |              |      |                |  |       |     |  |  |   |      |  

We incurred restructuring charges of
$12.7 million in 2001. Of the total restructuring charges
recorded, $3.2 million related to employee termination
costs covering 293 technical, production, and administrative
employees. The remaining $9.5 million of restructuring
charges related primarily to costs for excess leased facilities.
During 2002, we made cash payments of $2.9 million against
the restructuring accrual. In 2002, we reclassified
$1.1 million, which had originally been accrued for as
employee termination costs to accrued excess lease facility
costs due to a revision in estimate. As of December 31,
2002, restructuring charges of $5.3 million remain accrued,
primarily related to excess facility costs. We anticipate
utilizing the remaining restructuring accrual, which relates to
servicing operating lease payments or negotiated buyout of
operating lease commitments, through 2005.

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The following table summarizes the costs and
activities during 2002, related to the 2001 restructuring (in
millions):

|                             |  |              |      |                |  |       |      |   |  |   |      |  
|---------------------------- |  | ------------ | ---- | -------------- |  | ----- | ---- | - |  | - | ---- | -
|                             |  |              |      | Excess Leased  |  |      
|                             |  |              |      | Facilities and |  |      
|                             |  | Involuntary  |      | Cancelled      |  |      
|                             |  | Terminations |      | Contracts      |  | Total
|                             |  |              |      |                |  |      
|Balance at December 31, 2001 |  | $            | 1.2  |                |  | $     | 7.0  |   |  | $ | 8.2  |  
|Cash Payments                |  |              | (0.1 | )              |  |       | (2.8 | ) |  |   | (2.9 | )
|Reclassification             |  |              | (1.1 | )              |  |       | 1.1  |   |  |   |     |  
|                             |  |              |      |                |  |       |      |   |  |   |      |  
|Balance at December 31, 2002 |  | $            |     |                |  | $     | 5.3  |   |  | $ | 5.3  |  
|                             |  |              |      |                |  |       |      |   |  |   |      |  

Asset Write-offs.In
connection with our restructuring in 2002, we wrote-off
$1.3 million of fixed assets which were determined to have
no remaining useful life. In 2001, we wrote-off
$1.6 million of impaired fixed assets, acquired during our
acquisition of ANE, which were determined to have no remaining
useful life.

Downturns in the broadband services and
telecommunications markets created unique circumstances with
regard to the assessment of goodwill and other intangible assets
for recoverability during 2001. As a result of our decision to
suspend certain product lines and product development efforts
during the first quarter of 2001, intangible assets totaling
$163.1 million related 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, negatively impacted the
forecasted revenues and cash flows from certain other companies
acquired during fiscal 1999 and 2000. In accordance with our
policy and accounting standards applicable at that date, 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 the first quarter 2001.

We adopted SFAS No. 142 on January 1,
2002. We reclassified $1.3 million of assembled workforce,
net of accumulated amortization, with an indefinite life, to
goodwill at the date of adoption. We test goodwill for
impairment using the two-step process prescribed in SFAS
No. 142. The first step is a screen for potential
impairment, while the second step measures the amount of the
impairment, if any. The first step was completed during the
second quarter of 2002. We completed the initial goodwill
impairment review as of the beginning of 2002, and found no
impairment. Due to a difficult economic environment and
heightened price competition in the modem and telecom businesses
during the three months ended June 30, 2002, we experienced
a significant drop in its market capitalization, and therefore
proceeded to perform an interim test to measure goodwill and
intangible assets for impairment at June 30, 2002. Based on
our forecast, the estimated undiscounted future cash flows from
the use of the goodwill would be less than its carrying amount.
We determined that the outcome of this test reflected that the
fair value of the goodwill was zero. This resulted in a non-cash
charge of $4.0 million to write off the remaining goodwill
of which $3.0 million is related to the Cable segment and
$1.0 million is related to the Telecom segment.

Non-operating Expenses

|                                 |  |                    |        |                 |  |           |         |  |  |  |     |   
|-------------------------------- |  | ------------------ | ------ | --------------- |  | --------- | ------- |  |  |  | --- | --
|                                 |  |                    |        |                
|                                 |  | For the year ended |        |                
|                                 |  | December 31,       |        |                
|                                 |  |                    |        | Annual % Change
|                                 |  | 2002               |        | 2001            |  | 2002/2001
|                                 |  |                    |        |                 |  |          
|                                 |  |                    |        |                
|                                 |  | (in thousands)     |        |                
|Interest income                  |  | $                  | 6,838  |                 |  | $         | 18,132  |  |  |  | (62 | )%
|Interest expense                 |  | $                  | 6,174  |                 |  | $         | 15,224  |  |  |  | (59 | )%
|Other expense                    |  | $                  | 4,145  |                 |  | $         | 2,864   |  |  |  | 45  | % 
|Gain on early retirement of debt |  | $                  | 49,089 |                 |  | $         | 185,327 |  |  |  | (74 | )%

Interest Income.Interest income decreased 62% to $6.8 million in 2002
compared to $18.1 million in 2001. The decrease in interest
income was primarily due to lower invested average cash balances
due to the

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use of cash to repurchase Convertible
Subordinated Notes (Notes) in 2001 and 2002 and usage of cash
for operations, as well as lower interest rates.


Interest Expense.Interest expense, which relates primarily to interest on our
Notes due in 2007, decreased 59% to $6.2 million during
2002 compared to $15.2 million in 2001 primarily due to the
repurchase of $325.9 million of the Notes in 2001 and
$109.1 million of the Notes in 2002.

Other Expense.We
accounted for our equity investment in accordance with SFAS
No. 115, Accounting for Certain Investments in Debt
and Equity Securities (SFAS No. 115), and Securities
and Exchange Commission (SEC) Staff Accounting Bulletin (SAB)
59, Accounting for Noncurrent Marketable Equity
Securities (SAB 59), which provides guidance in
determining when an investment is other-than-temporarily
impaired. In applying this guidance we evaluated, among other
factors, the duration and extent to which the fair value of the
investment was less than its cost, the financial health of and
business outlook for the investee, including factors such as
industry and sector performance, changes in technology, and
operational and financing cash flow, available financial
information, and our intent and ability to hold the investment.
During 2001, based upon this analysis, we wrote off
$2.5 million of our long-term equity investment, which was
included in our Cable segment and was charged to other expense.
During 2002, based upon additional analysis, we wrote off
$4.5 million of this long-term equity investment, which was
charged to other expense in the Consolidated Statements of
Operations.

Gain on early retirement of
debt.In 2001, we repurchased
approximately $325.9 million of our Notes for
$113.4 million in cash and $17.9 million in stock,
resulting in a gain of approximately $185.3 million net of
related unamortized issuance costs of $9.3 million. In
April 2002, we adopted SFAS No. 145, Rescission of
FASB Statements No. 4, 44 and 64, Amendment of FASB
Statement No. 13, and Technical Corrections (SFAS
No. 145). Prior to the adoption of SFAS No. 145 we had
reported the gain from early retirement of our debt as an
extraordinary item. In accordance with SFAS No. 145, we now
report our gain from retirement of our Notes in operations. All
prior periods retroactively reflect the adoption of SFAS
No. 145. In 2002, we repurchased approximately
$109.1 million of our Notes for $57.6 million in cash,
resulting in a gain included in operations of approximately
$49.1 million net of related unamortized issuance costs of
$2.4 million.

Income Taxes

|                             |  |                    |     |      |  |   |        | 
|---------------------------- |  | ------------------ | --- | ---- |  | - | ------ | 
|                             |  |                   
|                             |  | For the year ended
|                             |  | December 31,      
|                             |  |                   
|                             |  | 2002               |     | 2001
|                             |  |                    |     |     
|                             |  |                   
|                             |  | (in thousands)    
|Income tax (expense) benefit |  | ($                 | 238 | )    |  | $ | 13,915 | 

We have generated operating losses since our
inception. In 2002, we recorded an income tax expense of
$0.2 million, which was related primarily to foreign taxes.
During 2001 we recorded a benefit of $13.9 million, which
consisted of a reduction of deferred tax liabilities related to
the Telegate, Radwiz, Ultracom, and ComBox acquisitions and a
$0.8 million provision for foreign taxes.

Comparison of the years ended
December 31, 2001 and 2000



| |         
| | --------
| | Revenues

|                  |                  |                    |         |                 |  |           |         |         |  |  |     |     |   
|----------------- | ---------------- | ------------------ | ------- | --------------- |  | --------- | ------- | ------- |  |  | --- | --- | --
|                  |                  |                    |         |                
|                  |                  | For the year ended |         |                
|                  |                  | December 31,       |         |                
|                  |                  |                    |         | Annual % Change
|                  |                  | 2001               |         | 2000            |  | 2001/2000
|                  |                  |                    |         |                 |  |          
|                  |                  |                    |         |                
|                  |                  | (in thousands)     |         |                
|Product revenues: |                  |                    |         |                 |  |           |         |         |  |  |     |    
|                  | Cable revenues   |                    | $       | 245,828         |  |           | $       | 303,524 |  |  |     | (19 | )%
|                  | Telecom revenues |                    |         | 33,653          |  |           |         | 36,025  |  |  |     | (7  | )%
|                  |                  |                    |         |                 |  |           |         |         |  |  |     |    
|Total revenues    |                  | $                  | 279,481 |                 |  | $         | 339,549 |         |  |  | (18 | )% 
|                  |                  |                    |         |                 |  |           |         |         |  |  |     |    

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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 18% to $279.5 million in 2001
from $339.5 million in 2000. Revenues in North America,
which includes the United States and Canada decreased 19% to
$163.6 million in 2001, down from $202.5 million in
2000. Revenues from international locations decreased 16% to
$115.9 million in 2001 down from $137.0 million in
2000.

Cable Broadband Access Systems (Cable)
Revenue.Revenues from Cable amounted
to $245.8 million in 2001, down 19% 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.

Telecom Carrier Access Systems (Telecom)
Revenue.Revenues from Telecom were
$33.7 million, down 6% from $36.0 million in 2000. We
have a relatively small customer base, and revenues were
impacted by declines in telecom industry spending.

During 2001, the cable industry moved to purchase
more standards-based products, and we faced increasingly strong
competition from multiple vendors, which drove down revenues
through lower unit prices partially offset by higher unit
volumes. Further, during 2001, we were unfavorably impacted by
declines in average selling prices (ASPs) of our modems. In
addition, revenues from our Telecom segment were impacted by
declines in telecom industry spending. The intensely competitive
nature of the market for broadband products resulted in
significant price erosion in 2001.

|                        |  |                    |        |                 |  |           |         |  |  |  |     |   
|----------------------- |  | ------------------ | ------ | --------------- |  | --------- | ------- |  |  |  | --- | --
|                        |  |                    |        |                
|                        |  | For the year ended |        |                
|                        |  | December 31,       |        |                
|                        |  |                    |        | Annual % Change
|                        |  | 2001               |        | 2000            |  | 2001/2000
|                        |  |                    |        |                 |  |          
|                        |  |                    |        |                
|                        |  | (in thousands)     |        |                
|Related party revenues: |  |                    |        |                 |  |           |         |  |  |  |     |   
|Rogers revenues         |  | $                  | 21,045 |                 |  | $         | 62,701  |  |  |  | (66 | )%
|Shaw revenue            |  |                    | 31,400 |                 |  |           | 56,620  |  |  |  | (45 | )%
|                        |  |                    |        |                 |  |           |         |  |  |  |     |   
|Total revenues          |  | $                  | 52,445 |                 |  | $         | 119,321 |  |  |  | (56 | )%
|                        |  |                    |        |                 |  |           |         |  |  |  |     |   

Related party revenues decreased 56% to
$52.4 million for the year ended December 31, 2001
from $119.3 million in 2000. The decline in related party
revenues is primarily due to the same economic and competitive
pressures discussed above. In addition, Shaw was a related party
only during the first three quarters of 2001. In the fourth
quarter of 2001, Shaw was no longer determined to be a related
party as they no longer exercised voting rights over their
shares of our stock, and a board member from Shaw resigned from
our Board of Directors. Accordingly, revenues from Shaw were no
longer included in related party revenues beginning in the
fourth quarter of 2001. See Note 14 of Notes to the
Consolidated Financial Statements.

Cost of Goods Sold

|                   |  |                    |         |                 |  |           |         |  |  |  |    |   
|------------------ |  | ------------------ | ------- | --------------- |  | --------- | ------- |  |  |  | -- | --
|                   |  |                    |         |                
|                   |  | For the year ended |         |                
|                   |  | December 31,       |         |                
|                   |  |                    |         | Annual % Change
|                   |  | 2001               |         | 2000            |  | 2001/2000
|                   |  |                    |         |                 |  |          
|                   |  |                    |         |                
|                   |  | (in thousands)     |         |                
|Cost of goods sold |  | $                  | 263,117 |                 |  | $         | 289,531 |  |  |  | (9 | )%

Cost of goods sold consists of direct product
costs as well as the cost of our manufacturing. The cost of the
manufacturing includes contract manufacturing, test and quality
assurance for products, warranty costs and associated costs of
personnel and equipment. In 2001, cost of goods sold decreased
9% to $263.1 million from $289.5 million in 2000. In
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
in 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
$18.6 million or 8% due primarily to lower sales, largely
offset by the usage, in the first three quarters of 2001,

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of higher priced inventories purchased in the
fourth quarter of 2000. The offset due to usage of higher priced
inventories results from the fact that we record cost of goods
sold on a first-in, first-out basis. Although certain of our
component prices declined in 2001, we continued to consume
higher cost inventory in the first nine months of 2001, which we
purchased in the fourth quarter of 2000.


Gross Profit

|             |  |                    |        |                 |  |           |        |  |  |  |     |   
|------------ |  | ------------------ | ------ | --------------- |  | --------- | ------ |  |  |  | --- | --
|             |  |                    |        |                
|             |  | For the year ended |        |                
|             |  | December 31,       |        |                
|             |  |                    |        | Annual % Change
|             |  | 2001               |        | 2000            |  | 2001/2000
|             |  |                    |        |                 |  |          
|             |  |                    |        |                
|             |  | (in thousands)     |        |                
|Gross profit |  | $                  | 16,364 |                 |  | $         | 50,018 |  |  |  | (67 | )%

We achieved a gross profit of $16.4 million
or 6% of sales in 2001 compared to $50.0 million or 15% 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 products, utilization of higher priced
inventory primarily purchased in 2000, and special charges
described above.

Operating Expenses

|                                                 |  |                    |         |                 |  |           |        |  |  |  |     |   
|------------------------------------------------ |  | ------------------ | ------- | --------------- |  | --------- | ------ |  |  |  | --- | --
|                                                 |  |                    |         |                
|                                                 |  | For the year ended |         |                
|                                                 |  | December 31,       |         |                
|                                                 |  |                    |         | Annual % Change
|                                                 |  | 2001               |         | 2000            |  | 2001/2000
|                                                 |  |                    |         |                 |  |          
|                                                 |  |                    |         |                
|                                                 |  | (in thousands)     |         |                
|Research and development                         |  | $                  | 79,927  |                 |  | $         | 68,270 |  |  |  | 17  | % 
|Cost of product development assistance agreement |  |                    |        |                 |  | $         | 9,563  |  |  |  |    |   
|In-process research and development              |  |                    |        |                 |  | $         | 30,535 |  |  |  |    |   
|Sales and marketing                              |  | $                  | 55,701  |                 |  | $         | 45,261 |  |  |  | 23  | % 
|General and administrative                       |  | $                  | 31,309  |                 |  | $         | 24,809 |  |  |  | 26  | % 
|Goodwill amortization                            |  | $                  | 25,410  |                 |  | $         | 59,057 |  |  |  | (57 | )%
|Restructuring costs and asset write-offs         |  | $                  | 587,149 |                 |  |           |       |  |  |  |    |   

Research and Development.Research and development expenses
consist primarily of personnel costs, internally designed
prototype material expenditures, non-recurring outside
engineering, equipment and supplies required to develop and
enhance our products. Research and development expenses
increased to $79.9 million or 29% of sales in the year
ended December 31, 2001 from $68.3 million or 20% of
sales in 2000. The increase of $11.6 million is primarily
attributable to three factors: $5.8 million was spent on
the development of our DOCSIS cable equipment, approximately
$4.7 million was spent on development efforts in our
Telecom segment, and we amortized $1.1 million of
intangible assets. Research and development expenses increased
$5.8 million primarily due to the development of our new
line of DOCSIS standards-based products within our Cable
segment. Additionally, we have continued to invest in research
and development efforts related to our Telecom segment.
Approximately $4.7 million of our increase in research and
development spending is attributable to increases in our Telecom
research and development efforts primarily related to
development of integrated access devices acquired from our
MainSail acquisition in the third quarter of 2000. Also included
in research and development costs is the amortization of
intangible assets of approximately $5.7 million in fiscal
2001 compared to $4.6 million in fiscal 2000.

Cost of Product Development Assistance
Agreement.In March 1999, we
entered into a one-year Product Development Assistance Agreement
with Rogers. 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 proven 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 our common stock on a cashless basis.
One warrant had a exercise price of $0.50

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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 included a
non-cash charge of $9.6 million. 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.There were no charges
for in-process research and development in the year ended
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 of
acquisition, the companies were, Imedia, Radwiz, Telegate, ANE,
ComBox, certain assets of Internet Telecom, Ultracom, Digitrans
and MainSail. On the date of each acquisition, the projects
identified as in-process research and development required
additional efforts in order to establish technological
feasibility.

In-process technology acquired relating to the
acquisitions of Telegate, ComBox, Internet Telecom, Ultracom and
Digitrans, all in 2000, and Imedia Corporation and Radwiz Ltd.,
in 1999, was valued at approximately $7.5 million,
$8.0 million, $2.6 million, $1.8 million,
$4.9 million, $11.0 million and $3.6 million,
respectively. During 2001, we decided not to pursue any further
development efforts on these projects for the following reasons:

Imedia.Market
interest in the capabilities represented by Imedias
in-process research and development changed after our
acquisition. In-process research and development concentrated on
improvements to the Internet and on interactive services. During
2001, as we realized the market opportunities for Internet video
delivery and interactive services were significantly less than
anticipated, we redirected our engineering resources into
improving the existing developed technology.

Radwiz.We continued
the development of Radwizs in-process research and
development throughout 2000. By the fourth quarter of 2000, it
was becoming apparent that engineering issues were proving to be
more difficult to resolve than originally expected. During 2001,
we refocused engineering efforts on satisfying particular
customer requirements, rather than completing the development
efforts underway in 2000.

Telegate.We
continued the development of in-process research and development
acquired in connection with the Telegate acquisition throughout
2000. During the first quarter of 2001, Telegates largest
customer indicated that they would be significantly decreasing
future purchases. Further, in April 2001, circuit-switch based
cable over telephony systems were no longer considered viable.
We elected to concentrate future research and development
resources on sustaining engineering activities and not to pursue
in-process research and development projects related to Telegate
technology.

ANE.Development of
in-process technology acquired in connection with the ANE
acquisition, valued at approximately $0.8 million, was
completed during the second quarter of 2001.

ComBox.The success
of the ComBox acquisition was primarily based on the success of
one key customer. During the first quarter of 2001, this
customer decided to no longer resell the ComBox system as the
customer was unable to achieve sufficient profitability on its
sales. At this point, we elected to abandon all future
development efforts related to the ComBox technology.

Internet Telecom.In-process research and development
activities related to Internet Telecom were focused on creating
a Voice-over-IP system, a market that at the time of our
acquisition, many considered poised to grow quickly in the near
future. During 2001, we re-assessed the economic viability of
the cost of development of the in-process research and
development, the strength of other competitors systems,
and the lack of demand from potential customers, and determined
that further development would not produce a commercially viable
product. Over several quarters in 2001, the Internet Telecom
engineering resources were redeployed to focus on projects based
on developed other technologies.

Ultracom.During the
first quarter of 2001, we determined, due to manufacturing and
production issues, the Ultracom wireless chip would be difficult
and expensive to produce. Meanwhile, competitors had reached the
market with alternative wireless technologies, further reducing
the available market potential for the Ultracom chip. After
investigating engineering solutions, we determined we would have
to create a new design

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concept, which would require several years of
effort. Given this, we chose to abandon the in-process research
and development related to the Ultracom technology.


Digitrans.During
2001, we recognized that the product roadmap for Digitrans
products would not be on the timetable originally established at
the time of the Digitrans acquisition. In an effort to ensure
returns from engineering resources, we chose to focus
development efforts on roadmap deliverables that were based on
developed technologies and therefore did not continue investing
in in-process research and development efforts related to the
Digitrans technology.

MainSail.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.

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, advertising, consulting and travel. Sales and
marketing expenses increased by $10.4 million 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 $3.1 million related to increased
headcount, as well as increased spending for promotional
activities, including a $1.7 million increase for
tradeshows and field trials, a $1.1 million increase for
consulting services for public relations, a $0.5 million
increase for advertising, a $1.6 million increase for
administrative fees, and a $1.1 million increase in other
sales and marketing expenses. Also, amortization of intangible
assets included in sales and marketing expenses accounted for
approximately $4.3 million in 2001, an increase of
$1.3 million compared to $3.0 million in 2000.

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%
of sales in 2001 from $24.8 million or 7% 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.

Goodwill
Amortization.The amortization of
goodwill arising from acquisitions completed during 2000 and
1999 decreased 57% to $25.4 million in 2001 compared to
$59.1 million in 2000. This decrease was due to the
write-down of $572.8 million of acquired intangible assets
during 2001.

Upon adoption of SFAS No. 142 effective
January 1, 2002, we were no longer required to amortize the
goodwill assets associated with our acquisitions in 1999 and
2000.

Non-operating Expenses

|                                 |  |                    |         |                 |  |           |        |  |  |  |    |   
|-------------------------------- |  | ------------------ | ------- | --------------- |  | --------- | ------ |  |  |  | -- | --
|                                 |  |                    |         |                
|                                 |  | For the year ended |         |                
|                                 |  | December 31,       |         |                
|                                 |  |                    |         | Annual % Change
|                                 |  | 2001               |         | 2000            |  | 2001/2000
|                                 |  |                    |         |                 |  |          
|                                 |  |                    |         |                
|                                 |  | (in thousands)     |         |                
|Interest income                  |  | $                  | 18,132  |                 |  | $         | 19,794 |  |  |  | (8 | )%
|Interest expense                 |  | $                  | 15,224  |                 |  | $         | 11,265 |  |  |  | 35 | % 
|Other expense                    |  | $                  | 2,864   |                 |  | $         | 1,819  |  |  |  | 57 | % 
|Gain on early retirement of debt |  | $                  | 185,327 |                 |  |           |       |  |  |  |   |   

Interest
Income.Interest income decreased
8% to $18.1 million in 2001 compared to $19.8 million
in 2000. The decrease in interest income was primarily due to
lower interest rates as well as lower invested average cash
balances due to the use of cash to repurchase Convertible
Subordinated Notes (Notes) in 2001 and usage of cash for
operations.

Interest
Expense.Interest expense is
primarily related to the sale in July 2000 of $500 million
of 5% Notes due in August 2007. Interest expense increased 35%
to $15.2 million during 2001 compared to

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$11.3 million in 2000 primarily due to a
full year of debt related to the Notes in 2001. During 2001, we
repurchased approximately $325.9 million in principal of
the Notes.


Other Expense.Other expense for the year ended
December 31, 2001 totaled $2.9 million compared to
$1.8 million in 2000. We accounted for an equity investment
in accordance with SFAS No. 115, and SAB No. 59, which
provides guidance in determining when an investment is
other-than-temporarily impaired. In applying this guidance we
evaluated, among other factors, the duration and extent to which
the fair value of the investment was less than its cost, the
financial health of and business outlook for the investee,
including factors such as industry and sector performance,
changes in technology, and operational and financing cash flow,
available financial information, and our intent and ability to
hold the investment. During 2001, we estimated the fair value of
the long-term investment, which was included in our Cable
segment (as defined by SFAS No. 131, Disclosures
about Segment of an Enterprise and Related Information),
based on these criteria, and consequently wrote down
approximately $2.5 million of an investment in a privately
held company, which was determined to be impaired. There were no
write-downs of investments in 2000.

Gain on early retirement of
debt.In 2001, we repurchased
approximately $325.9 million of our Convertible
Subordinated Notes (Notes) for $113.4 million in cash and
$17.9 million in stock, resulting in a gain of
approximately $185.3 million net of related unamortized
issuance costs of $9.3 million. In April 2002, we adopted
SFAS No. 145, Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13,
and Technical Corrections (SFAS No. 145). Prior to
the adoption of SFAS No. 145 we had reported the gain from
early retirement of our debt as an extraordinary item.
Accordingly, we now report our gain from retirement of our Notes
in operations. All prior periods reflect the adoption of SFAS
No. 145. No debt was repurchased in 2000.

Income Taxes

|                             |  |                |        |      |  |  |   | 
|---------------------------- |  | -------------- | ------ | ---- |  |  | - | 
|                             |  |               
|                             |  | For the year  
|                             |  | ended         
|                             |  | December 31,  
|                             |  |               
|                             |  | 2001           |        | 2000
|                             |  |                |        |     
|                             |  |               
|                             |  | (in thousands)
|Income tax (expense) benefit |  | $              | 13,915 |      |  |  |  | 

We have generated operating losses since our
inception. In 2001, we recorded a benefit from income taxes of
$13.9 million, which represented 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 in 2000.

Stock Option Accounting

We have elected to continue using the
intrinsic-value method of accounting for stock-based awards
granted to employees until a uniform method of valuing and
expensing stock options is promulgated. Accordingly, we have not
recognized compensation expense for the fair value of our
stock-based awards to employees in our Consolidated Statements
of Income. Companies electing to remain with the intrinsic-value
method accounting in APB 25 must make pro forma
disclosures, as if the fair value based method of accounting had
been applied.

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The following table reflects pro forma net loss
and loss per share had we elected to record an expense for
employee stock options pursuant to the provisions of
SFAS 123.

|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|---------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | -------- | - |  | - | -------- | -
|                                               |  |                         
|                                               |  | Years Ended December 31,
|                                               |  |                         
|                                               |  | 2002                     |         | 2001 |  | 2000
|                                               |  |                          |         |      |  |     
|Net loss                                       |  | $                        | (44,213 | )    |  | $    | (563,846 | ) |  | $ | (180,767 | )
|Stock option plans                             |  |                          | (33,747 | )    |  |      | (126,721 | ) |  |   | (118,909 | )
|Employee stock purchase plan                   |  |                          | (1,990  | )    |  |      | (2,212   | ) |  |   | (990     | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|Pro forma net loss                             |  | $                        | (79,950 | )    |  | $    | (692,779 | ) |  | $ | (300,666 | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|Pro forma basic and diluted net loss per share |  | $                        | (1.10   | )    |  | $    | (10.14   | ) |  | $ | (4.90    | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  

Litigation

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 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. On March 29, 2002, the court denied
the defendants motion to dismiss. The parties are now in
the discovery process. In addition, the court has certified the
plaintiffs proposed class and scheduled trial to begin on
November 4, 2003.

The lawsuit seeks an unspecified amount of
damages, in addition to other forms of relief. We consider the
lawsuits to be without merit and 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 us and the individual defendants (Zaki Rakib, Selim
Rakib and Raymond Fritz) in the California Superior Court, San
Luis Obispo County. 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

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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. On August 7, 2002, the court held
another conference at which it entered an order dismissing the
Bertram case. The courts order permits the
individual plaintiffs in the Bertram case to pursue any
claims that they may have as members of the purported class in
the related, consolidated class action discussed above.
Plaintiffs have appealed this order, and the Court of Appeals
has set a briefing schedule for the appeal.


We believe that the allegations in the
Bertram case, as with the allegations in the federal
securities case, are without merit and intend to contest the
matter vigorously.

On May 7, 2002, a shareholder filed a
derivative lawsuit purportedly on behalf of us against five of
its current directors, two former directors and two former
officers. This lawsuit is titled Campbell vs. Rakib, et
al., and is pending in the California Superior Court, Santa
Clara County. We are a nominal defendant in this lawsuit, which
alleges claims relating to essentially the same purportedly
misleading statements that are at issue in the pending
securities class action. In that litigation, we dispute making
any misleading statements. The derivative complaint also alleges
claims relating to stock sales by certain of the director and
officer defendants.

On July 12, 2002, a shareholder filed a
derivative lawsuit purportedly on behalf of us against three of
our current directors, one former officer and three former
investors. This lawsuit is titled OBrien vs. Rakib, et
al., and is pending in the California Superior Court, San
Francisco County. We are a nominal defendant in this lawsuit,
which alleges claims relating to essentially the same
purportedly misleading statements that are at issue in the
pending securities class action. In that litigation, we dispute
making any misleading statements. The derivative complaint also
alleges claims relating to stock sales by certain of the
director and officer defendants. The plaintiff in the
OBrien case has dismissed the investor defendants
without prejudice.

Since the Campbell and OBrien
cases were filed, the parties have taken steps to have these
cases consolidated in the California Superior Court, County of
Santa Clara. On October 4, 2002, the California Superior
Court, County of San Francisco entered an order providing for
the transfer of the OBrien case. On
October 29, 2002, plaintiff in the OBrien case
submitted certain materials to the California Superior Court,
County of Santa Clara to effectuate that transfer, which is now
complete. The OBrien case is now consolidated with
the Campbell case.

We believe that there are many defects in the
Campbell and OBrien derivative complaints.

On January 19, 2003, Omniband Group Limited,
a Russian company, (Omniband) filed a request for arbitration
with the Zurich Chamber of Commerce, claiming damages in an
amount of $2,094,970 allegedly caused by our breach of an
agreement to sell to Omniband certain equipment pursuant to an
agreement between Omniband and Radwiz Ltd., our subsidiary,
dated February 22, 2000. On February 10, 2003, the
President of the Zurich Chamber of Commerce appointed the
Chairman of a three member panel to preside over the arbitration
proceedings. We believe that the allegations are without merit
and intend to present a vigorously defense in the arbitration
proceedings.

On September 3, 2002, Uniscor Ltd. (an
Israeli company under voluntary liquidation) and Flextronics
(Israel) Ltd., an Israeli company (Flextronics) filed a claim
with the Tel Aviv District Court in Israel against us and
Radwiz, our subsidiary, alleging that damages of NIS 25,000,000
(approximately $5 million US dollars) were caused to
them by our alleged failure to comply with its contractual
obligations to accept and pay for components manufactured by
Flextronics in the first quarter of 2001 pursuant to projections
it had received from Radwiz. We filed a statement of defense
denying the allegations, after which the parties accepted the
Courts recommendation to transfer the case to non-binding
mediation.

We are currently a party to various other legal
proceedings, in addition to those noted above and may become
involved from time to time in other legal proceedings in the
future. While we currently believe that the ultimate outcome of
these other proceedings, individually and in the aggregate, will
not have a material adverse effect on our financial position or
overall trends in results of operations, litigation is subject
to inherent uncertainties. Were an unfavorable ruling to occur
in any of our legal proceedings, there exists the possibility

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of a material adverse impact on our results of
operations for the period in which the ruling occurs. The
estimate of the potential impact on our financial position or
overall results of operations for any of the above legal
proceedings could change in the future.


Liquidity and Capital Resources

At December 31, 2002, we had approximately
$117.1 million in cash and cash equivalents and
$89.4 million in short-term investments. 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 semi-annually. Debt issuance costs related to the Notes
were approximately $15.6 million.

Through December 31, 2002, we had
repurchased approximately $434.9 million of the Notes for
$171.0 million in cash and $17.9 million in stock,
resulting in a gain on early retirement of debt of approximately
$234.4 million net of related unamortized issuance costs of
$11.6 million.

Cash used in operating activities for the year
ended December 31, 2002 was $66.7 million compared to
$102.5 million used in 2001. In 2002, significant uses of
cash from operating activities included our losses from
operations, as well as a decrease in accounts payable of
$18.9 million. Net cash used in operating activities were
partially offset by decreases in accounts receivable of
$25.8 million in 2002. Net cash used in operating
activities in 2001 were primarily due to losses from operations
as well as a decrease in accounts payable of $81.1 million,
partially offset by decreases in inventory and other current
assets of $71.1 million and $16.6 million,
respectively.

Cash provided by investing activities was
$139.0 million in 2002 compared to a usage of
$27.0 million in 2001. Investing activities consisted
primarily of net purchases of short-term investments in 2002 and
2001.

Cash used by financing activities was
$53.9 million in 2002 compared to $116.6 million in
2001. In 2002, we paid approximately $57.6 million to
repurchase a portion of the Notes. We received a total of
$1.7 million from the exercise of stock options. 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 in
2001 from the exercise of stock options.

In 2002, we entered into an operating lease
arrangement to lease a corporate aircraft. This lease
arrangement was secured by a $9.0 million letter of credit.
See Note 3 of Notes to Consolidated Financial Statements.
The letter of credit was reduced to $7.5 million in
February 2003. This lease commitment is included in the table
below. From time to time, our Chief Executive Officer,
Dr. Rakib, uses the aircraft for personal use and
reimburses us for this usage. Dr. Rakib reimbursed us for
$35,000 of personal aircraft usage during fiscal 2002.

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The following summarizes our contractual
obligations at December 31, 2002, 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
|                                   |  | Total |       | 1 year                 |  | years |      | years |  | years  
|                                   |  |       |       |                        |  |       |      |       |  |        
|Capital Lease Obligations          |  | $     | 0.2   |                        |  | $     | 0.2  |       |  | $       |     |  |  | $ |    |  |  | $ |     | 
|Unconditional Purchase Obligations |  |       | 45.5  |                        |  |       | 45.5 |       |  |         |     |  |  |   |    |  |  |   |     | 
|Long Term Debt                     |  |       | 68.5  |                        |  |       |     |       |  |         | 1.7  |  |  |   |    |  |  |   | 66.8 | 
|Operating Lease Obligations        |  |       | 29.8  |                        |  |       | 6.9  |       |  |         | 14.3 |  |  |   | 3.0 |  |  |   | 5.6  | 
|Aircraft Lease                     |  |       | 6.1   |                        |  |       | 1.5  |       |  |         | 3.0  |  |  |   | 1.6 |  |  |   |     | 
|                                   |  |       |       |                        |  |       |      |       |  |         |      |  |  |   |     |  |  |   |      | 
|Total Contractual Commitments      |  | $     | 150.1 |                        |  | $     | 54.1 |       |  | $       | 19.0 |  |  | $ | 4.6 |  |  | $ | 72.4 | 
|                                   |  |       |       |                        |  |       |      |       |  |         |      |  |  |   |     |  |  |   |      | 

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.
As of December 31, 2002, we had approximately
$45.5 million of purchase obligations, of which
$13.9 million is included in the Consolidated Balance
Sheets as accrued vendor cancellation charges, and the remaining
$31.6 is attributable to open purchase orders. The remaining
obligations are expected to become payable at various times
through 2003.

Other commercial commitments, primarily required
to support operating leases, are as follows (in millions):

|                             |  |                                            |     |           |  |       |     |       |  |        |   |  |  |   |     |  |  |   |     | 
|---------------------------- |  | ------------------------------------------ | --- | --------- |  | ----- | --- | ----- |  | ------ | - |  |  | - | --- |  |  | - | --- | 
|                             |  |                                           
|                             |  | Amount of Commitment Expiration Per Period
|                             |  |                                           
|                             |  | Total                                      |     |          
|                             |  | Amounts                                    |     | Less than |  | 1-3   |     | 4-5   |  | Over 5
|                             |  | Committed                                  |     | 1 year    |  | years |     | years |  | years 
|                             |  |                                            |     |           |  |       |     |       |  |       
|Deposits                     |  | $                                          | 0.5 |           |  | $     | 0.5 |       |  | $      |  |  |  | $ |    |  |  | $ |    | 
|Standby Letters of Credit    |  | $                                          | 8.4 |           |  | $     | 0.7 |       |  | $      |  |  |  | $ | 7.5 |  |  | $ | 0.2 | 
|                             |  |                                            |     |           |  |       |     |       |  |        |   |  |  |   |     |  |  |   |     | 
|Total Commercial Commitments |  | $                                          | 8.9 |           |  | $     | 1.2 |       |  | $      |  |  |  | $ | 7.5 |  |  | $ | 0.2 | 
|                             |  |                                            |     |           |  |       |     |       |  |        |   |  |  |   |     |  |  |   |     | 

During the third quarter of 2002, we received
approximately 35.9 million shares of Net Servicos de
Comunicacao SA (Net Servicos), a customer, valued at
approximately $2.5 million as settlement for all
outstanding accounts receivables due from Net Servicos to us.
The shares of Net Servicos are traded on the Sao Paulo Stock
Exchange, and the share price has traditionally been volatile
and subject to significant price fluctuations. At
December 31, 2002, we had sold 32.9 million shares for
$2.3 million. The remaining 3.0 million shares are
classified as available-for-sale and are included in the
Consolidated Balance Sheets as short-term investments. The
volatility of the share price could result in potential future
losses to the market value of the remaining 3.0 million
shares unless and until we are able to sell them.

On February 26, 2003, we entered into an
agreement with Solectron Corporation (Solectron) to settle all
outstanding obligations under two manufacturing agreements
between us and Solectron. Under the terms of the settlement
agreement, we paid Solectron approximately $3.9 million,
and each party released any and all claims that it may have had
against the other party. Additionally, Terayon received selected
inventory from Solectron. We previously accrued the
$3.9 million settlement as a vendor cancellation in the
fourth quarter of 2000 and the second quarter of 2001.

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

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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
continue operations, 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.


On March 14, 2003, we announced a worldwide
reduction in force of approximately 100 employees, or
20 percent of the workforce, and the closure of certain
remote facilities. We expect to record total charges in the
range of approximately $4 million to $5 million
associated with the realignment and the writedown of certain
related assets in the quarter ending March 31, 2003. We
anticipate realizing annualized savings of approximately $12 to
$15 million from these actions combined with related
operational savings including the curtailment of certain program
and discretionary expenditures.

Impact of Recently Issued Accounting
Standards

In December 2002, the Financial Accounting
Standards Board (FASB) issued Statement of Financial Accounting
Standards No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure 
an amendment of SFAS 123(SFAS No. 148). This
statement amends SFAS No. 123, Accounting for
Stock-Based Compensation, to provide alternative methods
of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. In
addition, this statement amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both
annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect
of the method used on reported results. We will adopt the annual
disclosure provisions of SFAS No. 148 in our quarterly
financial reports beginning in the first quarter of 2003. As the
adoption of this standard involves disclosures only, we do not
expect a material impact on our results of operations, financial
position or liquidity.

In November 2002, the FASB issued Financial
Interpretation No. (FIN) 45, Guarantors Accounting
and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (FIN 45). The
provisions of FIN 45 are effective for year-end 2002.
Recognition and measurement provisions of FIN 45 become
effective for guarantees issued or modified on or after
January 1, 2003. We adopted the disclosure provisions of
SFAS No. 148 as of December 31, 2002. We do not expect
the adoption of FIN 45 to have a material impact on our
results of operations, financial position or liquidity.

In July 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities (SFAS No. 146), which requires us to
recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an
exit or disposal plan. SFAS No. 146 replaces Emerging
Issues Task Force (EITF) Issue No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring). The provisions of SFAS No. 146 are to
be applied prospectively to exit or disposal activities
initiated after December 31, 2002. The effect of adoption
of SFAS No. 146 is dependent on our related activities
subsequent to the date of adoption.

In April 2002, the FASB issued SFAS No. 145,
Rescission of FASB Statements No. 4, 44 and 64,
Amendment of FASB Statement No. 13, and Technical
Corrections (SFAS No. 145). SFAS No. 145 allows
only those gains and losses on the extinguishment of debt that
meet the criteria of extraordinary items to be treated as such
in the consolidated financial statements. SFAS No. 145 also
requires sales-leaseback accounting for certain lease
modifications that have economic effects that are similar to
lease-back transactions. We adopted the provisions of SFAS
No. 145 in the second quarter of 2002. In accordance with
our adoption of SFAS No. 145, all prior periods reflect the
adoption of SFAS No. 145 in our Consolidated Financial
Statements.

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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.



| |                                                                                
| | -------------------------------------------------------------------------------
| | We Have a History of Losses and May
    Continue to Incur Losses in the Future.

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, 2002, we had an
accumulated deficit of $937.2 million. We believe that we
will continue to experience difficulties in selling our products
at a profit and continue to operate with net losses for the
foreseeable future. Moreover, we have had declining revenue
since 2000. In the twelve-month period ended December 31,
2002, our revenues decreased 54% from the same period in 2001.
Additionally, we generally are unable to reduce our expenses
significantly in the short term to compensate for any unexpected
delay in generating, or decrease in anticipated revenues. For
example, we have fixed commitments with some of our suppliers
that require us to purchase minimum quantities of their products
at a specified price irrespective of whether we can subsequently
use such quantities in our products. Because in the past, we
have been unable to use all of the products that we purchased
from our suppliers, we have taken charges as a result of these
fixed commitments, and we may have to take additional charges in
the future if we are unable to use all of the products that we
purchase from our suppliers. During 2002, we recorded an
inventory charge of $6.1 million to reduce some of the
inventories to the lower of cost or market as average selling
prices fell below the cost of these products. In addition, we
have significant operating lease commitments for facilities and
equipment that generally cannot be cancelled in the short-term
without substantial penalties.

Our business may be adversely affected by delays
in, or our failure to, commercialize new products or cost reduce
our current products. Moreover, given the conditions in the
broadband equipment market, the profit potential of our business
remains unproven.



| |                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------
| | We May Experience Fluctuations in Our
    Operating Results and Face Unpredictability in Our Future
    Revenues.

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

Factors that 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 and pricing concessions on volume sales;                                                                
|
| |  | new product introductions by competitors;                                                                                                                         
|
| |  | delays in our introduction of new products;                                                                                                                       
|
| |  | delays in our introduction of added features to
    our products;                                                                                                 
|
| |  | delays in reducing the cost of our products;                                                                                                                      
|
| |  | delays in commercialization of products that are
    competitive in the marketplace;                                                                              
|
| |  | delays in our receipt of and cancellation of
    orders forecasted by customers;                                                                                  
|
| |  | variations in capital spending budgets of cable
    operators and other broadband service providers;                                                              
|
| |  | international conflicts, including war with Iraq,
    and acts of terrorism and the impact of adverse economic, market
    and political conditions worldwide; and
|
| |  | ability of our products to be qualified or
    certified as meeting industry standards.                                                                           

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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;                                               
|
| |  | the costs of manufacturing our products; and                            
|
| |  | the effectiveness of our cost reduction measures.                       

The unit ASPs of our products have declined
considerably in 2002, and we anticipate that unit ASPs of our
products will continue to decline in the future. This has caused
and will continue to cause a decrease in our gross margins if we
are unable to off-set the decline in ASPs with cost reduction
measures. 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 head-end equipment, such as
Cable Modem Termination Systems (CMTSs), and lower margin,
higher volume Customer Premise Equipment (CPE), such as modems.
In 2003 we expect that sales of our low-margin CPE will continue
to make up a significant portion of our revenues.

Our operating expenses generally vary from
quarter to quarter depending on the level of actual and
anticipated business activities. However, a significant
percentage of these operating expenses are fixed due to
operating leases for our facilities and equipment. Also, we have
fixed commitments with some of our suppliers that require us to
purchase minimum quantities of their products at a specified
price. As of December 31, 2002, $45.5 million of
purchase obligations are outstanding. Moreover, our research and
development expenses fluctuate in response to new product
development, changing industry requirements and customer demands.



| |                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We Are Dependent on a Small Number of
    Customers and our Business Could be Harmed by the Loss of Any of
    These Customers or Reductions in Their Purchasing
    Volumes.

The markets we serve have and are continuing to
undergo significant consolidation in both North America and
internationally, as a limited number of cable operators control
an increasing number of systems. For example, the top ten cable
operators in the United States own and operate systems that
service approximately 81% of homes that receive cable services
in the United States, and the top ten cable operators in Europe
own and operate systems that service approximately 53% of homes
that receive cable services in Europe. As a result of the
consolidation among cable operators, our revenue has been and
will continue to be dependent on sales to the few leading cable
operators worldwide and the continued consolidation may also
reduce the number of potential customers. For example, one of
our customers accounted for more than 10% of our total revenues
for the twelve months ended December 31, 2002 and in the
same period, four of our customers accounted for 45% of our
total revenues. We may not succeed in attracting new customers
as many of our potential customers have pre-existing
relationships with our current or potential competitors and the
continued consolidation of the cable industry reduces the number
of potential customers. To attract new customers, we may be
faced with intense price competition which may affect our gross
margins. Moreover, we do not typically require our customers to
purchase a minimum quantity of our products, and our customers
can generally cancel their orders on short notice without
significant penalties. The loss of any of our customers can have
a material adverse effect on our results of operations. Further,
any reduction in orders from a given customer can likewise have
a material adverse affect on our results of operations.



| |                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------------------------------------
| | The Sales Cycle for Certain of Our Products
    Is Lengthy, Which Makes Forecasting of Our Customer Orders and
    Revenue Difficult.

The sales cycle for certain of our products, such
as our CMTS, is lengthy, often lasting nine months to more than
a year. Our customers generally conduct significant technical
evaluations, including customer trials, of our products as well
as competing products prior to making a purchasing decision. In
addition, purchasing decisions may also be delayed because of
our customers internal budget approval processes. Because
of the lengthy sales cycle and the size of customer orders, if
orders forecasted for a specific customer for a particular

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period do not occur in that period, our revenues
and operating results for that particular quarter could suffer.
Moreover, a portion of our expenses related to an anticipated
order is fixed and difficult to reduce or change, which may
further impact our revenues and operating results for a
particular period.




| |                                                                                  
| | ---------------------------------------------------------------------------------
| | There Are Many Risks Associated with Our
    Participation in Industry Standards.

In connection with the development of the
DOCSIS 2.0 specification by Cable Television Laboratories,
Inc. a cable industry consortium that establishes cable
technology standards and administers compliance testing
(CableLabs), we entered into an agreement with CableLabs whereby
we licensed to CableLabs on a royalty-free basis any of our
intellectual property rights, including rights to our
proprietary S-CDMA technology, 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. As a result of this license to CableLabs, our
competitors that produce DOCSIS-based products have access to
our technology without having to pay us any royalties or other
compensation for the use of our technology. As a result of our
contribution of technology to the DOCSIS intellectual property
pool, we may have foregone significant revenue from the
potential licensing of our proprietary technology, and we may be
unable to recoup the investment in the research and development
efforts to develop the intellectual property contributed to the
DOCSIS technology pool.

Additionally, the agreement that we signed with
CableLabs to participate in the DOCSIS intellectual property
pool may make it difficult for us to enforce our intellectual
property rights against other companies. Certain cable equipment
vendors manufacture and sell DOCSIS based and DOCSIS certified
and qualified product without sublicensing from CableLabs the
technology in the CableLabs intellectual property pool.
Due to the interests of cable operators in having as many
equipment vendors as possible, we may feel constrained by
competitive pressures from pursuing the enforcement of our
intellectual property rights against our competitors that have
not entered into sublicenses with CableLabs. Moreover, if we
seek to enforce our intellectual property rights against other
equipment manufacturers that access technology from the
CableLabs intellectual property pool, our license to the
technology in the pool may be jeopardized. Certain contributors
of technology to the CableLabs intellectual property pool
are our competitors and may elect to revoke our license to their
technology if we attempt to enforce our intellectual property
rights against them.

We may have lost any competitive advantage that
our proprietary S-CDMA technology may have provided us in the
marketplace by licensing it to CableLabs, and we may face
increased competition because our competitors have the ability
to incorporate our technology into their products. We believe
that this increased competition could come from existing
competitors or from new competitors who enter the market and
that such competition is likely to result in lower product ASPs,
which could harm our revenues and gross margins. Additionally,
because our competitors will be able to incorporate our
technology into their products, our current customers may choose
alternate suppliers or choose to purchase DOCSIS-compliant
products from multiple suppliers. We may be unable to
effectively compete with the other vendors if we cannot produce
DOCSIS compliant cable products more quickly or at lower cost
than our competitors.

DOCSIS specifications have not yet been accepted
in Europe and Asia, although an increasing number of Asian cable
operators are requiring product to be DOCSIS qualified or
certified. An alternate specification for cable products, called
the Euro-DOCSIS specification, has been formalized by tComLabs
for European cable operators, and some European and Asian cable
operators have embraced it. We intend to develop and sell
products that comply with the Euro-DOCSIS specification, which
may require the contribution of certain of our technologies,
including our proprietary S-CDMA technology, to the Euro-DOCSIS
specification. We may be unsuccessful in these efforts, and even
if we are successful, we may face some of the same risks
associated with our contribution of intellectual property to
CableLabs DOCSIS intellectual property pool.

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| |                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------
| | We Need to Certify and Qualify Our New and
    Existing Products to Meet Industry Specifications in Order to
    Remain Competitive.

Major cable operators worldwide have endorsed the
DOCSIS and PacketCable specifications and rarely purchase
equipment that is not certified or qualified as compliant with
these specifications. Cable operators have chosen to purchase
only product meeting industry specifications because the
specifications enable interoperability among products from
multiple vendors, which leads to increased competition among
equipment manufacturers and consequently lowers product ASPs.
Consequently, our future success depends on our ability to
compete effectively in this marketplace by developing, marketing
and selling products that are certified and qualified to
industry standards in a timely fashion.

The DOCSIS and PacketCable specifications are
promulgated by CableLabs. Currently these specifications have
been widely adopted by cable operators in North America and by
some cable operators in Asia, Latin America and Europe. The
Euro-DOCSIS specifications has been developed by tComLabs, a
cable technology consortium of European cable operators,
specifically to meet the requirements of European operators, and
has found some acceptance in China as well. There is no
guarantee that our products will be DOCSIS, EuroDOCSIS or
PacketCable certified or qualified. If we are unable to certify
or qualify our products as DOCSIS, EuroDOCSIS or PacketCable
compliant in a timely manner, we may be unable to sell our
products and may lose some or all of any advantage we might
otherwise have had, and our future operating results may be
adversely affected.

Though we sell DOCSIS certified and qualified
products, there have been and may continue to be instances where
our existing customers and potential new customers elect to
purchase DOCSIS products from one or more of our competitors
rather than from us. In response to this situation, 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 revenues, operating results and gross
margin.

Developing products to meet these various
industry specifications has several risks. The first is the cost
and effort to engineer standards-based products and to then
prepare them for compliance testing. Not only do we have to
certify or qualify new products, but any of our currently
certified or qualified products must be re-certified or
re-qualified should they be changed in any way. Second, there is
no guarantee that these products will be certified or qualified
as meeting these specifications in a timely fashion, if ever.
Because most cable operators purchase only those products that
have been certified or qualified as meeting these
specifications, it is highly unlikely that we will be able to
sell our products until they achieve certification or
qualification, which can be a lengthy process. As a result, we
may incur significant research and development expenses to
develop new products that may not receive certification or
qualification and we cannot recoup the costs of these research
and development expenses by marketing uncertified or unqualified
products. Moreover, a consequence of cable operators only
purchasing products certified or qualified as meeting industry
specifications is the increased competition between equipment
vendors, which has resulted in a steady and ongoing decline in
equipment prices as vendors compete for cable operators
business. Third, there is no guarantee that we will be able to
support all future cable industry specifications, which will
likely have an adverse impact on future revenues.



| |                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------
| | Average Selling Prices of Broadband
    Equipment Continue to Decline, Which is Decreasing Our Gross
    Margins.

The broadband equipment market has been
characterized by erosion of product ASPs. We expect this erosion
to continue. The ASPs for our products are likely to continue to
decline due to competitive pricing pressures, promotional
programs and customers possessing strong negotiating positions
who require price reductions as a condition of purchase. In
addition, we believe that the widespread adoption of industry
specifications, such as the DOCSIS and EuroDOCSIS
specifications, is further eroding ASPs as cable modems and
other similar CPE become commodity products. Decreasing ASPs
could result in decreased revenues even if the number of units
sold increases. Decreasing ASPs may also require us to sell our
products at much lower gross margin than in the past, and in
fact, we may sell products at a loss. The primary reason

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that our gross profits have declined year-over
year is the decline in products ASPs. As a result, we may
experience substantial period-to-period fluctuations in future
revenue, gross margin and operating results due to ASP erosion.
Therefore, we must continue to develop and introduce on a timely
basis and a cost-effective manner new products or
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 to Attain
    Profitability.

As product ASPs and revenue have declined in
recent years, we have not sufficiently decreased our costs,
including operating expenses and the costs associated with our
products, to offset declining ASPs and revenue. This has
resulted in increased losses making it difficult for us to
attain profitability. During 2002, we saw an increase in the
unit sales of our products; however, we experienced a decrease
in revenue of 54% from the same period in 2001, which was, in
large part, due to declining product ASPs. In order to achieve
profitability, we must significantly reduce our operating
expenses and the cost of our products.

We have made several attempts to lower our
operating expenses. Although we have implemented expense
reduction and restructuring plans in the past, including the
latest restructuring in March 2003, that have focused on cost
reductions and operating efficiencies, we have not been
successful in lowering our operating expenses to keep pace with
the decline in revenues, and we cannot be certain that our
future efforts implementing operating expense reduction will be
successful. A large portion of our expenses, including rent, and
operating lease expenditures, is fixed and difficult to reduce
or change. Accordingly, if our revenue does not meet our
expectations, we may not be able to adjust our expenses quickly
enough to compensate for the shortfall in revenue. In that
event, our business, financial condition and results of
operations could be materially and adversely affected.

As product ASPs rapidly decline, we need to
reduce the cost of our products through design and engineering
changes. We may not be successful in redesigning our products,
and, even if we are successful, our efforts may be delayed or
our redesigned products 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 product costs will require us to use
lower-priced components that are highly integrated 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, if at all, and we could incur significant expenses
without related revenues if we cannot use the products or
services offered by such agreements. We have incurred
significant cancellation charges related to volume purchase and
manufacturing agreements in the past and may incur such charges
in the future.



| |                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------
| | Broadband Services Delivered by Cable
    Operators Have Not Achieved Widespread Market Penetration, and
    Other Competing Service Providers Exist.

Our success will depend upon the widespread
penetration of broadband services delivered by cable television
operators. The markets for these services are growing, but are
not fully developed nor exploited. Additionally, these markets
may not grow as cable operators have a limited amount of
available bandwidth over which they can offer new services, such
as high-speed Internet access and telephony. Cable operators may
elect not to provide any or all of these new services to their
customers or may not aggressively market these services to their
customers. If cable operators elect not to deploy such new
services or if customers elect not to subscribe to such
services, it may affect our ability to sell products to cable
operators as their existing equipment may meet their current
infrastructure demands. We depend on cable operators to provide
new services and maintain their infrastructure in such a manner
that allows us to continue to sell products to them.

Cable operators must also compete with other
service providers in the delivery of services to their
customers. CLECs, ILECs, satellite TV and broadband service
providers are aggressively competing with the cable industry to
deliver broadband services via DSL or satellite broadcast
technologies. We cannot accurately predict the future growth
rate or the ultimate size of the market for broadband services
delivered via cable. The success of CLECs, ILECs, satellite TV
and other broadband service providers may slow or hamper the

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continued acceptance of cable operators
broadband services, which in turn may impact demand for our
products by cable operators.




| |                                                                                         
| | ----------------------------------------------------------------------------------------
| | We Need to Develop Additional Distribution
    Channels to Market and Sell Our Products.

We presently market our products primarily to
cable operators worldwide. To increase worldwide sales of our
products, we need to establish new distribution channels.

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



| |   |                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the ability to hire additional personnel
    necessary to establish and enhance these new distribution
    channels;                                                                               
|
| |  | the extent to which consumer electronics
    companies enter the cable modem market, as their retail
    distribution capabilities would provide them with a significant
    competitive advantage;
|
| |  | the ability to find and train channels to
    effectively market our more complex products, such CMTSs and
    CherryPickers;                                                                      
|
| |  | the ability to maintain acceptable margins for
    our low margin products, such as cable modems, when sold through
    a distributor; and                                                         
|
| |  | our potential distribution partners are likely to
    prefer purchasing products from larger, more established
    manufacturers.                                                                  

The vast majority of our sales are to large cable
operators. However, we currently have limited access to smaller
or geographically diverse cable operators. 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
cable operators 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
without significant penalties.

In addition, we anticipate that the North
American cable modem market may at some point shift to a
consumer purchase model. In this occurs, our success will depend
on our ability to effectively sell our products in the consumer
market. We may not have the capital required or the necessary
personnel or expertise to develop these distribution channels.
Also, some of our competitors, including Motorola and Thomson
Consumer Electronics, have well-established retail distribution
capabilities and existing brands with market acceptance that
would provide them with a significant competitive advantage.



| |                                                                                          
| | -----------------------------------------------------------------------------------------
| | Reduced Capital Spending by Cable Operators
    Could Impact Sales of Our Cable Products.

Our success and future growth will be subject to
economic and other factors affecting cable operators,
particularly their 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 by cable operators. 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;                                                                                     

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| |   |                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------
| |  | 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 consolidation. 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.



| |                                                                         
| | ------------------------------------------------------------------------
| | We May Fail to Accurately Forecast Customer
    Demand For Our Products.

The nature of the cable industry 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 products
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 $45.5 million as of
December 31, 2002, 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.



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

We and/or our directors and officers are
defendants in a number of lawsuits, including securities
litigation lawsuits. As a result, we may have financial exposure
to litigation as a defendant and because we are obligated to
indemnify our officers and members of our Board of Directors for
certain actions taken by our officers and directors on our
behalf. In order to limit financial exposure arising from
litigation and/or our obligation to indemnify our officers and
directors, we have historically purchased directors and officers
insurance (D&O Insurance). However, the availability of
D&O Insurance is becoming more difficult for companies to
attain as a number of insurance underwriters no longer offer
D&O Insurance and the remaining insurance underwriters
offering D&O Insurance have significantly increased the
premiums of such coverage. During 2002, we experienced a
significant increase in the cost of our D&O Insurance, and
there can be no assurance that D&O Insurance will be
available to us in the future or, if D&O Insurance is
available, it may be prohibitively expensive.

Additionally, some insurance underwriters who
offered D&O Insurance in the past have been placed into
liquidation or may be, at some future point, placed into
liquidation. In October 2001, one of the insurance underwriters
from which we purchased D&O Insurance, Reliance Insurance
Co. (Reliance), was placed into liquidation by the state of
Pennsylvania. Reliance was the underwriter for one excess layer
of our D&O Insurance for the period covering the claims made
against us and our officers in the pending securities
litigation. Because Reliance is in liquidation, we will be
responsible for the amount insured under the Reliance policy,
which is approximately $2.5 million.



| |                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------
| | We Are Dependent on Key Third-Party
    Suppliers and Any Failure by Them to Deliver Components Could
    Limit Our Ability to Satisfy Customer Demand.

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. A majority of our
sales are from products containing one or more components that
are available only from sole source suppliers. Additionally,
some of our components are custom parts that are produced to our
specifications, and it may be difficult to move the
manufacturing of such components from one vendor to another
vendor.

Any interruption in the operations of our vendors
of sole source or custom product parts could adversely affect
our ability to meet our scheduled product deliveries to
customers. 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

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shipments could damage customer relationships and
expose us to potential damages that may arise from our inability
to supply our customers with products. 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.



| |                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------
| | 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.
Currently, our modems are sole sourced from our manufacturer in
Thailand. As a result of our dependence on these contract
manufacturers for the 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 manufacturing, assembling or testing
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. In fiscal 2002, 2001
and 2000, approximately 68%, 82% and 75%, respectively, of our
net revenues were from customers outside of the U.S.
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;                              
|
| |  | currency fluctuations                                                      
|
| |  | difficulty in managing foreign operations; and                             
|
| |  | political and economic instability.                                        

If our customers are affected by currency
devaluations or general economic downturns, such as the economic
downturns affecting many Asian, European 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 cable infrastructures for a
variety of reasons. These reasons include environmental issues,
economic downturns and availability of favorable pricing for
other communications services or the

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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 invoice the majority of our sales in
Europe in Euros. Since we have also elected to take payment in
Euros from our customers in Europe and may elect to take payment
in other foreign currencies, we are exposed to losses as the
result of foreign currency fluctuations. We currently do not
engage in foreign currency hedging transactions. 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.



| |                                                          
| | ---------------------------------------------------------
| | Our Business May Be Affected By Conditions
    In Israel.

We have significant operations in Israel. Our
operations in Israel consist primarily of research and
development, and to a lesser extent sales and manufacturing.
Revenues generated by our business in Israel were
$8.3 million, $16.5 million and $23.9 million for
the twelve months ending December 31, 2002, 2001 and 2000,
respectively. Our research and development operations may be
significantly affected by conditions in Israel. 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 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 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 products, particularly in the initial deployment and
implementation stages. Spikes in demand of our support services
may cause us to be unable to serve our customers. 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 especially during peak periods. Our
inability to provide sufficient support to our customers could
delay or prevent the successful deployment of our products. In
addition, our failure to provide adequate support could harm our
reputation and relationships with our customers and could
prevent us from selling product to existing customers or 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 include Cisco Systems, ADC, Arris,
BigBand Networks, Juniper Networks, Com21, Motorola, Thomson
Consumer Electronics (which markets products under the brand
name RCA), Scientific-Atlanta and Toshiba. We also compete with
companies that develop integrated circuits for broadband
products, such as Broadcom, Conexant and Texas Instruments. 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;                      

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| |   |                                                           
| | - | ----------------------------------------------------------
| |  | 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.
Conditions in the market 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 has and is
likely to continue to cause increased price competition. We
believe that the adoption of these standards have resulted in
and are likely to continue to result in lower ASPs for our
products. Any increased price competition or reduction in sales
of our products, particularly our higher margin head-end
products, has and will continue to result in decreased revenue
and downward pressure on our gross margin. These competitive
pressures have and are likely to continue to adversely impact
our business.



| |                                       
| | --------------------------------------
| | 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 can
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.

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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 also believe that companies may be
increasingly subject to infringement claims as distressed
companies and individuals attempt to generate cash by enforcing
their patent portfolio against a wide range of products. We have
received a letter from a company claiming that our technology
and products infringe on its patents. We have consulted with our
patent counsel and are in the process of reviewing the
allegations made by such company. There can be no assurance
that, if the issue were to be submitted to a court, such court
would not find that our products infringe the patents, nor that
the company will not continue to allege infringement. If we are
found to have infringed such companys patents, we could be
subject to substantial damages and/or an injunction preventing
us from conducting our business. Additionally, there can be no
assurance that other third parties will not assert infringement
claims against us in the future. Any such claim, 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 agreements. Such royalty or licensing
agreements may not be available on terms acceptable to us or at
all, which could have a material adverse effect upon our
business, operating results and financial condition.

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 trade secrets or
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, on a royalty-free
basis, whereby we licensed to CableLabs many 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 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 Safety
    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

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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.




| |                                                                                
| | -------------------------------------------------------------------------------
| | We Are Vulnerable to Earthquakes, Labor
    Issues 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. Our business may also be impacted by labor
issues related to our operations and/or those of our suppliers,
service providers, or customers. 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, 2002, we had
approximately $65.3 million of indebtedness outstanding.
This 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.



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

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| |   |                                                                   
| | - | ------------------------------------------------------------------
| |  | 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 stock price for broadband
services and technology companies in particular, have
experienced extreme price and volume volatility and a
significant cumulative decline since the second quarter of 2000.
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.



| |                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Current War with Iraq and Threatened
    Terrorist Attacks May Negatively Impact All Aspects of Our
    Operations, Revenues, Costs and Stock Price.

The current war with Iraq and the events of
September 11, 2001, as well as future events occurring in
response to or in connection with them, including, without
limitation, future terrorist attacks against United States
targets, or military or trade disruptions impacting our domestic
or foreign suppliers of components required for the
manufacturing of our products, may cause delays or losses of
customer orders. More generally, any of these events could cause
consumer confidence and spending to decrease or result in
increased volatility in the United States and worldwide
financial markets and economic. They also could result in
economic recession in the United States or abroad. Any of these
occurrences could have a significant impact on our operating
results, revenues and costs.



| |                                                                                     
| | ------------------------------------------------------------------------------------
| | We May Not Be Able to Raise Additional
    Funds to Continue Operating Our Business.

Our main source of liquidity continues to be our
unrestricted cash on hand. In addition and as a result of our
history of operating losses, we expect to continue to use our
unrestricted cash to fund operating losses in the future. We
believe that our current unrestricted cash on hand should be
adequate to fund our working capital needs through 2003.
However, if our operating losses are more severe than expected
or continue longer than expected, we may find it necessary or
desirable to seek other sources of financing to support our
capital needs and provide available funds for working capital.
Given the current state of the telecommunications industry
(including equipment manufacturers that supply product to the
telecommunications industry) and the capital markets, there are
few available sources of financing. Commercial bank financing
may not be available to us on acceptable terms. Accordingly, any
plan to raise additional capital, if available to us, would
likely involve an equity-based or equity-linked financing, such
as the issuance of convertible debt, common stock or preferred
stock, which would be dilutive to our stockholders. If we are
unable to procure additional working capital, as necessary, we
may be unable to continue operations.



| |                                                                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our Restructuring Efforts Could Result in
    the Erosion of Employee Morale, Legal Actions Against Us and
    Management Distractions, and Could Impair Our Ability to Respond
    Rapidly to Growth Opportunities in the Future.

As a result of the significant economic downturn
and the related uncertainties in the technology sector, we have
implemented a number of restructuring plans, including the most
recent in March 2003, which has resulted in personnel reduction.
These reductions could result in an erosion of morale, and
affect the focus and productivity of our remaining employees,
including those directly responsible for revenue generation,
which in turn may affect our revenue in the future.
Additionally, employees directly affected by the reductions may
seek future employment with our business partners, customers or
competitors. Although all employees are required to sign a
proprietary information agreement with us at the time of hire,
there can be no assurances that the confidential nature of our
proprietary information will be maintained in the course of such
future employment. Additionally, we may face wrongful
termination, discrimination, or other claims from employees
affected by the reduction related to their employment and
termination. We could incur substantial costs in

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defending ourselves or our employees against such
claims, regardless of the merits of such actions. Furthermore,
such matters could divert the attention of our employees,
including management, away from our operations, harm
productivity, harm our reputation and increase our expenses. We
cannot assure you that our restructuring efforts will be
successful, and we may need to take additional restructuring
efforts, including additional personnel reduction, in the future.




| |                                                                                             
| | --------------------------------------------------------------------------------------------
| | We May Dispose of Existing Product Lines,
    Which May Adversely Impact Our Future Results.

On an ongoing basis, we evaluate our various
product offerings in order to determine whether any should be
discontinued or, to the extent possible, divested. Moreover, the
worldwide downturn in the telecommunications industry led us to
reassess our business strategy, which in turn caused us to
discontinue investment in certain product lines. For example, we
have reduced our investment in the telecom and satellite spaces
and discontinued our Internet-over-Satellite product line. We
cannot assure you that we correctly forecasted the right product
lines to discontinue or that our decision to discontinue various
investments and product lines is prudent if market conditions
change. In addition, we cannot assure you that the
discontinuance of various product lines will reduce our
operating expenses. Furthermore, future plans to discontinue
existing product lines entail various risks, including the risks
that we will not be able to find a buyer for a product line or
the purchase price obtained will not be equal to the book value
of the assets for the product line.



| |                                                                                   
| | ----------------------------------------------------------------------------------
| | Products Currently Under Development May
    Fail to Realize Anticipated Benefits.

The markets in which we operate are characterized
by rapidly changing technologies, evolving industry standards,
frequent new product introductions and relatively short product
life. The pursuit of necessary technological advances and the
development of new products require substantial time and
expense. For example, we made ten acquisitions during the period
between 1999 and 2000. Due to various economic conditions, none
of the products from our acquired businesses have achieved the
level of market acceptance that was forecasted at the time of
their acquisitions. Additionally, certain product groups have
not achieved the level of technological development needed to be
marketable or to expand the market. As a result, we recorded
various impairment charges and wrote-off significant amounts of
in-process research and development related to the acquired
technologies, both of which negatively impacted our operating
results. We cannot assure you that technologies currently under
development will achieve feasibility or that even if we are
successful, the developed product will be accepted by the
market. We may not be able to recover the costs of existing and
future product developments and our failure to do so may
materially and adversely impact our business, financial
condition and results of operations.



| |                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------
| | We Are Exposed to the Credit Risk of Our
    Customers and to Credit Exposures in Weakened Markets, Which
    Could Result in Material Losses.

Most of our sales are on an open
credit basis, with payment terms of 30 days typically
in the United States, and because of local customs or
conditions, longer in some markets outside the United States. We
monitor individual customer payment capability in granting such
an open credit arrangement, seek to limit such open credit to
amounts we believe the customers can pay and maintain reserves
we believe are adequate to cover exposure for doubtful accounts.
Beyond our open credit arrangements, we have also experienced a
request for customer financing and facilitation of leasing
arrangements, which we have not provided to date and do not
expect to provide in the future. We expect demand for enhanced
open credit terms, for example, longer payment terms, customer
financing and leasing arrangements to continue and believe that
such arrangements are a competitive factor in obtaining
business. Our decision not to provide these types of financing
arrangements may adversely affect our ability to sell product,
and therefore, our revenue, operations and business.

Because of the current slowdown in the global
economy, our exposure to credit risks relating to sales on an
open-credit basis have increased. Although we
monitor and attempt to mitigate the associated risk, including
monitoring customers located in certain geographic areas, there
can be no assurance that our efforts will be effective in
reducing credit risk. Additionally, there have been significant
insolvencies and bankruptcies among our customers, which have
and may continue to cause us to incur economic and financial
losses. There

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can be no assurance that additional losses would
not be incurred and that such losses would not be material.
Although these losses have generally not been material to date,
future losses, if incurred, could harm our business and have a
material adverse effect on our operating results and financial
condition.




| |                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We Have and We May Seek to Expand Our
    Business Through Acquisitions; Acquisitions Could Disrupt Our
    Business Operations and Harm Our Operating
    Results.

In order to expand our business, we may make
strategic acquisitions of other companies. We plan to continue
to evaluate opportunities for strategic acquisitions from time
to time, and may make an acquisition at some future point.
However, the current volatility in the stock market and the
current price of our common stock may adversely affect our
ability to make such acquisitions.

Any acquisition that we make involves substantial
risks, including the following:



| |   |                                                                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | difficulties in integrating the operations,
    technologies, products and personnel of an acquired company;                                                         
|
| |  | diversion of managements attention from
    normal daily operations of the business;                                                                                
|
| |  | potential difficulties in completing projects
    associated with in-process research and development;                                                               
|
| |  | difficulties in entering markets in which we have
    no or limited direct prior experience and where competitors in
    such markets have stronger market positions;
|
| |  | initial dependence on unfamiliar supply chains or
    relatively small supply partners;                                                                              
|
| |  | insufficient revenues to offset increased
    expenses associated with acquisitions; and                                                                             
|
| |  | the potential loss of key employees of the
    acquired companies.                                                                                                   

Acquisitions may also cause us to:



| |   |                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------
| |  | issue common stock that would dilute our current
    stockholders percentage ownership;                                                           
|
| |  | assume liabilities;                                                                                                                                
|
| |  | record goodwill and non-amortizable intangible
    assets that will be subject to impairment testing and potential
    periodic impairment charges;
|
| |  | incur amortization expenses related to certain
    intangible assets;                                                                              
|
| |  | incur large and immediate write-offs; or                                                                                                           
|
| |  | become subject to litigation.                                                                                                                      

Mergers and acquisitions of high-technology
companies are inherently risky, and no assurance can be given
that our previous or future acquisitions will be successful and
will not materially adversely affect our business, operating
results or financial condition. Failure to manage and
successfully integrate acquisitions we make could harm our
business and operating results in a material way. Even when an
acquired company has already developed and marketed products,
there can be no assurance that product enhancements will be made
in a timely fashion or that all pre-acquisition due diligence
will have identified all possible issues that might arise with
respect to such products.

We made ten acquisitions during the period
between 1999 and 2000. Due to various economic conditions, none
of the products from our acquired businesses have achieved the
level of market acceptance that was forecasted at the time of
their acquisitions. Additionally, certain product groups have
not achieved the level of technological development needed to be
marketable or to expand the market. We recorded impairment
losses of approximately $4.0 million and
$572.8 million of intangible assets related to these
acquisitions in December 31, 2002 and 2001. As of
December 31, 2002, no intangible assets from these
acquisitions remain.

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| |                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We Have Adopted a Stockholder Rights Plan,
    Which, Together With Provisions in Our Charter Documents and
    Delaware Law, May Delay or Prevent an Acquisition of Us, Which
    Could Decrease the Value of Our Stock.

We adopted a stockholder rights plan pursuant to
which we distributed one right for each outstanding share of
common stock held by stockholders of record as of
February 20, 2001. Because the rights may substantially
dilute the stock ownership of a person or group attempting a
take-over of us, even if such a change in control is beneficial
to our stockholders, without the approval of our board of
directors, the plan could make it more difficult for a third
party to acquire us, or a significant percentage of our
outstanding capital stock, without first negotiating with our
board of directors. Additionally, provisions of our Certificate
of Incorporation and our Bylaws could make it more difficult for
a third party to acquire control of us in a transaction not
approved by our Board of Directors, and we have also opted out
of the anti-takeover provisions of Section 203 of the
Delaware General Corporation Law, which could also have the
effect of delaying or preventing our acquisition by a third
party.



| |                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Various Export Licensing Requirements Could
    Materially and Adversely Affect Our Business or Require Us to
    Significantly Modify Our Current Business
    Practices.

Various government export regulations may apply
to the encryption or other features of our products. We may have
to make certain filings with the government in order to obtain
permission to export certain of our products. In the past, we
may have inadvertently failed to file certain export
applications and notices, and we may have to make certain
filings and request permission to continue exportation of any
affected products without interruption while these applications
are pending. If we do have to make such filings, we cannot
assure you that we will obtain permission to continue exporting
the affected products or that we will obtain any required export
approvals now or in the future. If we do not receive the
required export approvals, we may be unable to ship those
products to certain customers located outside of the United
States. In addition, we may be subject to fines or other
penalties due to the failure to file certain export applications
and notices.




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 $136,000 decline (less than 1%)
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. A hypothetical adverse change of 10% in exchange
rates would result in a decline in income before taxes of
approximately $0.5 million. All of the potential changes
noted above are based on sensitivity analyses performed on our
financial positions at December 31, 2002. Actual results
may differ materially. See Note 1 of the Notes to
Consolidated Financial Statements.

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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 |  |      | 55 | 
|Consolidated Balance Sheets                           |  |      | 56 | 
|Consolidated Statements of Operations                 |  |      | 57 | 
|Consolidated Statements of Stockholders
    Equity   |  |      | 58 | 
|Consolidated Statements of Cash Flows                 |  |      | 61 | 
|Notes to Consolidated Financial Statements            |  |      | 63 | 

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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, 2002 and 2001, and the related consolidated
statements of operations, stockholders equity, and cash
flows for each of the three years in the period ended
December 31, 2002. Our audits also included the financial
statement schedule listed in the index at Item 15(a)(2).
These financial statements and schedule are the responsibility
of the Companys management. Our responsibility is to
express an opinion on these financial statements and schedule
based on our audits.

We conducted our audits in accordance with
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, 2002 and 2001,
and the consolidated results of its operations and its cash
flows for each of the three years in the period ended
December 31, 2002, 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.

As discussed in Note 1 to the consolidated
financial statements, effective January 1, 2002, the
company adopted Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets,
and effective April 1, 2002 the Company adopted Statement
of Financial Accounting Standards No. 145, Rescission
of FASB Statements No. 4, 44 and 64, Amendment of FASB
Statement No. 13, and Technical Corrections.



| |                      
| | ---------------------
| | /s/ Ernst & Young LLP

San Jose, California

January 24, 2003


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TERAYON COMMUNICATION SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

|                                               |                                                                                                    |                                                             |                           |           |    |         |         |           |    |         | 
|---------------------------------------------- | -------------------------------------------------------------------------------------------------- | ----------------------------------------------------------- | ------------------------- | --------- | -- | ------- | ------- | --------- | -- | ------- | 
|                                               |                                                                                                    |                                                            
|                                               |                                                                                                    | December 31,                                               
|                                               |                                                                                                    |                                                            
|                                               |                                                                                                    | 2002                                                        |                           | 2001     
|                                               |                                                                                                    |                                                             |                           |          
|                                               |                                                                                                    |                                                            
|                                               |                                                                                                    | (in thousands,                                             
|                                               |                                                                                                    | except share data)                                         
|ASSETS                                        
|Current assets:                                |                                                                                                    |                                                             |                           |           |    |         |         |          
|                                               | Cash and cash equivalents                                                                          |                                                             | $                         | 117,079   |    |         | $       | 100,274   |   
|                                               | Short-term investments                                                                             |                                                             |                           | 89,424    |    |         |         | 233,614   |   
|                                               | Accounts receivable, less allowance for doubtful
    accounts of $3,519 in 2002 and $7,207 in 2001 |                                                             |                           | 16,355    |    |         |         | 48,386    |   
|                                               | Accounts receivable from related parties                                                           |                                                             |                           | 842       |    |         |         | 4,006     |   
|                                               | Other current receivables                                                                          |                                                             |                           | 2,597     |    |         |         | 7,476     |   
|                                               | Inventory                                                                                          |                                                             |                           | 8,257     |    |         |         | 16,658    |   
|                                               | Other current assets                                                                               |                                                             |                           | 8,263     |    |         |         | 13,462    |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |         |          
|                                               |                                                                                                    |                                                             | Total current assets      |           |    | 242,817 |         |           |    | 423,876 | 
|Property and equipment, net                    |                                                                                                    |                                                             | 17,906                    |           |    |         | 25,279  |          
|Intangibles and other assets, net              |                                                                                                    |                                                             | 14,987                    |           |    |         | 17,491  |          
|                                               |                                                                                                    |                                                             |                           |           |    |         |         |          
|                                               |                                                                                                    |                                                             | Total assets              |           | $  | 275,710 |         |           | $  | 466,646 | 
|                                               |                                                                                                    |                                                             |                           |           |    |         |         |          
|LIABILITIES AND STOCKHOLDERS
    EQUITY      
|Current liabilities:                           |                                                                                                    |                                                             |                           |           |    |         |         |          
|                                               | Accounts payable                                                                                   |                                                             | $                         | 23,920    |    |         | $       | 42,821    |   
|                                               | Accrued payroll and related expenses                                                               |                                                             |                           | 6,227     |    |         |         | 9,441     |   
|                                               | Deferred revenues                                                                                  |                                                             |                           | 497       |    |         |         | 4,169     |   
|                                               | Warranty reserves                                                                                  |                                                             |                           | 8,607     |    |         |         | 8,368     |   
|                                               | Accrued restructuring charges                                                                      |                                                             |                           | 6,754     |    |         |         | 8,197     |   
|                                               | Accrued vendor cancellation charges                                                                |                                                             |                           | 13,865    |    |         |         | 17,291    |   
|                                               | Other accrued liabilities                                                                          |                                                             |                           | 8,609     |    |         |         | 14,015    |   
|                                               | Interest payable and current portion of long-term
    debt                                         |                                                             |                           | 1,355     |    |         |         | 3,273     |   
|                                               | Current portion of capital lease obligations                                                       |                                                             |                           | 154       |    |         |         | 126       |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |         |          
|                                               |                                                                                                    |                                                             | Total current liabilities |           |    | 69,988  |         |           |    | 107,701 | 
|Long-term obligations                          |                                                                                                    |                                                             | 3,421                     |           |    |         | 4,267   |          
|Long-term portion of capital lease obligations |                                                                                                    |                                                             | 78                        |           |    |         | 233     |          
|Convertible subordinated notes                 |                                                                                                    |                                                             | 65,081                    |           |    |         | 174,141 |          
|Commitments and contingencies                  |                                                                                                    |                                                             |                           |           |    |         |         |          
|Stockholders equity:                          |                                                                                                    |                                                             |                           |           |    |         |         |          
|                                               | Preferred stock, $0.001 par value:                                                                 |                                                             |                           |           |    |         |         |           |   
|                                               |                                                                                                    | Authorized shares  5,000,000                               |                           |           |    |         |         |           |    |        
|                                               |                                                                                                    | Issued and outstanding shares  none in
    2002 and 2001   |                           |           |   |         |         |           |   |        
|                                               | Common stock, $0.001 par value:                                                                    |                                                             |                           |           |    |         |         |           |   
|                                               |                                                                                                    | Authorized shares  200,000,000                             |                           |           |    |         |         |           |    |        
|                                               |                                                                                                    | Issued  73,240,054 in 2002 and
    72,071,769 in 2001      |                           |           |    |         |         |           |    |        
|                                               |                                                                                                    | Outstanding  73,084,045 in 2002 and
    71,943,930 in 2001 |                           |           | 73 |         |         |           | 73 |        
|                                               | Additional paid in capital                                                                         |                                                             |                           | 1,078,144 |    |         |         | 1,074,203 |   
|                                               | Accumulated deficit                                                                                |                                                             |                           | (937,207  | )  |         |         | (892,994  | ) 
|                                               | Deferred compensation                                                                              |                                                             |                           | (25       | )  |         |         | (458      | ) 
|                                               | Treasury Stock, at cost; 156,009 shares in 2002
    and 127,839 shares in 2001                     |                                                             |                           | (773      | )  |         |         | (768      | ) 
|                                               | Accumulated other comprehensive income (loss)                                                      |                                                             |                           | (3,070    | )  |         |         | 248       |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |         |          
|                                               | Total stockholders equity                                                                         |                                                             |                           | 137,142   |    |         |         | 180,304   |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |         |          
|                                               | Total liabilities and stockholders equity                                                         |                                                             | $                         | 275,710   |    |         | $       | 466,646   |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |         |          

See accompanying notes.

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TERAYON COMMUNICATION SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |         |         | 
|----------------------------------------------------------------- | ------------------------------------------------ | ------------------------------------- | ------- | ------- | ------- | ---- | -------- | ------- | ------- | - | -------- | ------- | ------- | 
|                                                                  |                                                  |                                      
|                                                                  |                                                  | Years Ended December 31,             
|                                                                  |                                                  |                                      
|                                                                  |                                                  | 2002                                  |         | 2001    |         | 2000
|                                                                  |                                                  |                                       |         |         |         |     
|                                                                  |                                                  |                                      
|                                                                  |                                                  | (in thousands, except per share data)
|Revenues:                                                         |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|                                                                  | Product revenues                                 |                                       | $       | 120,306 |         |      | $        | 227,036 |         |   | $        | 220,228 |        
|                                                                  | Related party product revenues                   |                                       |         | 9,097   |         |      |          | 52,445  |         |   |          | 119,321 |        
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|                                                                  |                                                  | Total revenues                        |         |         | 129,403 |      |          |         | 279,481 |   |          |         | 339,549 | 
|Cost of goods sold:                                               |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|                                                                  | Cost of product revenues                         |                                       |         | 93,640  |         |      |          | 229,936 |         |   |          | 224,787 |        
|                                                                  | Cost of related party product revenues           |                                       |         | 7,309   |         |      |          | 33,181  |         |   |          | 64,744  |        
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|                                                                  |                                                  | Total cost of goods sold              |         |         | 100,949 |      |          |         | 263,117 |   |          |         | 289,531 | 
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|Gross profit                                                      |                                                  |                                       | 28,454  |         |         |      | 16,364   |         |         |   | 50,018   |        
|Operating expenses:                                               |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|                                                                  | Research and development                         |                                       |         | 58,696  |         |      |          | 79,927  |         |   |          | 68,270  |        
|                                                                  | Cost of product development assistance agreement |                                       |         |        |         |      |          |        |         |   |          | 9,563   |        
|                                                                  | In-process research and development              |                                       |         |        |         |      |          |        |         |   |          | 30,535  |        
|                                                                  | Sales and marketing                              |                                       |         | 35,704  |         |      |          | 55,701  |         |   |          | 45,261  |        
|                                                                  | General and administrative                       |                                       |         | 14,715  |         |      |          | 31,309  |         |   |          | 24,809  |        
|                                                                  | Goodwill amortization                            |                                       |         |        |         |      |          | 25,410  |         |   |          | 59,057  |        
|                                                                  | Restructuring costs and asset write-offs         |                                       |         | 8,922   |         |      |          | 587,149 |         |   |          |        |        
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|                                                                  |                                                  | Total operating expenses              |         |         | 118,037 |      |          |         | 779,496 |   |          |         | 237,495 | 
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|Loss from operations                                              |                                                  |                                       | (89,583 | )       |         |      | (763,132 | )       |         |   | (187,477 | )      
|Interest income                                                   |                                                  |                                       | 6,838   |         |         |      | 18,132   |         |         |   | 19,794   |        
|Interest expense                                                  |                                                  |                                       | (6,174  | )       |         |      | (15,224  | )       |         |   | (11,265  | )      
|Other expense                                                     |                                                  |                                       | (4,145  | )       |         |      | (2,864   | )       |         |   | (1,819   | )      
|Gain on early retirement of debt                                  |                                                  |                                       | 49,089  |         |         |      | 185,327  |         |         |   |         |        
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|Loss before tax (expense) benefit                                 |                                                  |                                       | (43,975 | )       |         |      | (577,761 | )       |         |   | (180,767 | )      
|Income tax (expense) benefit                                      |                                                  |                                       | (238    | )       |         |      | 13,915   |         |         |   |         |        
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|Net loss                                                          |                                                  | $                                     | (44,213 | )       |         | $    | (563,846 | )       |         | $ | (180,767 | )      
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|Basic and diluted net loss per share                              |                                                  | $                                     | (0.61   | )       |         | $    | (8.25    | )       |         | $ | (2.95    | )      
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        
|Shares used in computing basic and diluted net
    loss per share |                                                  |                                       | 72,803  |         |         |      | 68,331   |         |         |   | 61,349   |        
|                                                                  |                                                  |                                       |         |         |         |      |          |         |         |   |          |        

See accompanying notes.

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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, 1999                                    |                                   |                                      | 48,870,334 |            |  | $           | 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:                                                   |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |    |   |  |   |      |       |  |  |        |  |  |   |     |   |  |   |        |         
|                                                                | Telegate                          |                                      |            | 4,400,000  |  |             |    | 4        |  |               |           | 95,969        |  |                |          |               |   |        |        |        |   |   |    |   |  |   |      |       |  |  |        |  |  |   |     |   |  |   |         | 95,973   |         
|                                                                | ANE                               |                                      |            | 1,404,552  |  |             |    | 2        |  |               |           | 83,475        |  |                |          |               |   |        |        |        |   |   |    |   |  |   |      |       |  |  |        |  |  |   |     |   |  |   |         | 83,477   |         
|                                                                | Internet Telecom                  |                                      |            | 376,251    |  |             |    | 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   |         
|                                                                | TrueChat                          |                                      |            | 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                                    |                                   |                                      | 67,266,986 |            |  |             | 68 |          |  |               | 1,037,964 |               |  |                | (329,148 | )             |   |        | (6,788 | )      |   |   | (3 | ) |  |   | 661  |       |  |  | 34,722 |  |  |   | (73 | ) |  |   | 702,681 |         
|                                                                |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |   |   |    |   |  |   |      |       |  |  |        |  |  |   |     |   |  |   |         |         

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|                                                                      |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |  |  |    |   |  |  |     |      |   |  |         |  |  |  |      |   |  |  |         |          |          |  
|--------------------------------------------------------------------- | --------------------------------- | ------------------------------------ | ---------- | ---------- |  | ----------- | -- | -------- |  | ------------- | --------- | ------------- |  | -------------- | -------- | ------------- | - | ------ | ------ | ------ |  |  | -- | - |  |  | --- | ---- | - |  | ------- |  |  |  | ---- | - |  |  | ------- | -------- | -------- | -
|                                                                      |                                   |                                      |            |            |  |             |    |          |  |               |           | 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, 2000
    (brought forward)                  |                                   |                                      | 67,266,986 |            |  |             | 68 |          |  |               | 1,037,964 |               |  |                | (329,148 | )             |   |        | (6,788 | )      |  |  | (3 | ) |  |  | 661 |      |   |  | 34,722  |  |  |  | (73  | ) |  |  | 702,681 |         
|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                                          |                                   |                                      | 71,943,930 |            |  |             | 73 |          |  |               | 1,074,203 |               |  |                | (892,994 | )             |   |        | (458   | )      |  |  |   |   |  |  | 248 |      |   |  | 127,839 |  |  |  | (768 | ) |  |  | 180,304 |         
|                                                                      |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |        |        |  |  |    |   |  |  |     |      |   |  |         |  |  |  |      |   |  |  |         |         

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|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         |         |  
|------------------------------------------------------------------------------------ | --------------------------------- | ------------------------------------ | ---------- | ---------- |  | ----------- | -- | -------- |  | ------------- | --------- | ------------- |  | -------------- | -------- | ------------- | - | ------ | ---- | ------ |  | - | - |  |  | - | ------ | ------ | - |  | ------- |  |  | - | ---- | - |  | - | ------- | ------- | ------- | -
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           | 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, 2001(brought forward)                                        |                                   |                                      | 71,943,930 |            |  |             | 73 |          |  |               | 1,074,203 |               |  |                | (892,994 | )             |   |        | (458 | )      |  |   |  |  |  |   | 248    |        |   |  | 127,839 |  |  |   | (768 | ) |  |   | 180,304 |        
|Exercise of option for cash to purchase common
    stock                             |                                   |                                      | 422,073    |            |  |             |    |          |  |               | 1,721     |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1,721   |        
|Repurchase or return of common stock                                                 |                                   |                                      | (1,068     | )          |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  | 28,170  |  |  |   | (5   | ) |  |   | (5      | )      
|Return of escrow shares from Telegate acquisition                                    |                                   |                                      | (25,077    | )          |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |        
|Issuance of options to non-employees                                                 |                                   |                                      |            |            |  |             |    |          |  |               | 38        |               |  |                |          |               |   |        | (38  | )      |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |        |        
|Amortization of deferred compensation                                                |                                   |                                      |            |            |  |             |    |          |  |               | 1         |               |  |                |          |               |   |        | 471  |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 472     |        
|Issuance of restricted common stock from stock
    option plan for services provided |                                   |                                      | 205,001    |            |  |             |    |          |  |               | 290       |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 290     |        
|Acceleration of vesting of employee stock options
    and stock protection payment   |                                   |                                      |            |            |  |             |    |          |  |               | 1         |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1       |        
|Issuance of common stock for Employee Stock
    Purchase Plan                        |                                   |                                      | 539,186    |            |  |             |    |          |  |               | 1,864     |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1,864   |        
|Issuance of warrant to purchase common stock                                         |                                   |                                      |            |            |  |             |    |          |  |               | 26        |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 26      |        
|Comprehensive income:                                                                |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |        
|Increase to unrealized gain on short-term
    investments                            |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   | (519   | )      |   |  |         |  |  |   |      |   |  |   | (519    | )      
|                                                                                     | Cumulative translation adjustment |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        | (2,799 | ) |  |         |  |  |   |      |   |  |   |         | (2,799  | )      
|                                                                                     | Net loss                          |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          | (44,213       | ) |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         | (44,213 | )      
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |        
|                                                                                     |                                   | Comprehensive loss                   |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         | (44,531 | )
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |        
|Balance at December 31, 2002                                                         |                                   |                                      | 73,084,045 |            |  | $           | 73 |          |  | $             | 1,078,144 |               |  | $              | (937,207 | )             |   | $      | (25  | )      |  | $ |  |  |  | $ | (3,070 | )      |   |  | 156,009 |  |  | $ | (773 | ) |  | $ | 137,142 |        
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |                |          |               |   |        |      |        |  |   |   |  |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |        

See accompanying notes

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TERAYON COMMUNICATION SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                              |                                                         |                          |         |         |   |      |          |          |   |    |         |         |  
|--------------------------------------------------------------------------------------------- | ------------------------------------------------------- | ------------------------ | ------- | ------- | - | ---- | -------- | -------- | - | -- | ------- | ------- | -
|                                                                                              |                                                         |                         
|                                                                                              |                                                         | Years Ended December 31,
|                                                                                              |                                                         |                         
|                                                                                              |                                                         | 2002                     |         | 2001    |   | 2000
|                                                                                              |                                                         |                          |         |         |   |     
|                                                                                              |                                                         |                         
|                                                                                              |                                                         | (in thousands)          
|Operating activities:                                                                         |                                                         |                          |         |         |   |      |          |          |   |    |         |        
|Net loss                                                                                      |                                                         | ($                       | 44,213  | )       |   | ($   | 563,846  | )        |   | ($ | 180,767 | )      
|Adjustments to reconcile net loss to net cash
    (used in) provided by operating activities: |                                                         |                          |         |         |   |      |          |          |   |    |         |        
|                                                                                              | Settlement of Net Servicos account receivable           |                          |         | 1,118   |   |      |          |         |   |    |         |        |  
|                                                                                              | Depreciation                                            |                          |         | 11,572  |   |      |          | 15,728   |   |    |         | 11,284  |  
|                                                                                              | Write-off and amortization of intangible assets         |                          |         | 3,972   |   |      |          | 619,157  |   |    |         | 106,305 |  
|                                                                                              | In-process research and development                     |                          |         |        |   |      |          |         |   |    |         | 30,535  |  
|                                                                                              | Amortization related to stock options                   |                          |         | 476     |   |      |          | 5,815    |   |    |         | 3,465   |  
|                                                                                              | Gain on early retirement of debt                        |                          |         | (49,089 | ) |      |          | (185,327 | ) |    |         |        |  
|                                                                                              | Lower of cost or market inventory provision             |                          |         | 6,109   |   |      |          |         |   |    |         |        |  
|                                                                                              | Impairment of investment                                |                          |         | 4,500   |   |      |          |         |   |    |         |        |  
|                                                                                              | Write-off of fixed assets                               |                          |         | 2,987   |   |      |          | 1,600    |   |    |         |        |  
|                                                                                              | Compensation expense for issuance of common stock       |                          |         |         |   |      |          | 3,238    |   |    |         |        |  
|                                                                                              | Value of common and preferred stock warrants
    issued |                          |         | 26      |   |      |          | 505      |   |    |         | 9,563   |  
|Changes in operating assets and liabilities:                                                  |                                                         |                          |         |         |   |      |          |          |   |    |         |        
|                                                                                              | Accounts receivable                                     |                          |         | 26,211  |   |      |          | (5,614   | ) |    |         | (28,757 | )
|                                                                                              | Accounts receivable from related parties                |                          |         | 3,164   |   |      |          | 13,448   |   |    |         | (10,173 | )
|                                                                                              | Inventory                                               |                          |         | 4,065   |   |      |          | 71,109   |   |    |         | (82,776 | )
|                                                                                              | Other assets                                            |                          |         | 443     |   |      |          | 16,606   |   |    |         | (18,876 | )
|                                                                                              | Accounts payable                                        |                          |         | (18,901 | ) |      |          | (81,173  | ) |    |         | 110,777 |  
|                                                                                              | Accrued payroll and related expenses                    |                          |         | (3,214  | ) |      |          | (3,664   | ) |    |         | 7,167   |  
|                                                                                              | Deferred revenues                                       |                          |         | (3,672  | ) |      |          | (829     | ) |    |         | 457     |  
|                                                                                              | Warranty reserves                                       |                          |         | 239     |   |      |          | 2,443    |   |    |         | 3,240   |  
|                                                                                              | Accrued restructuring charges                           |                          |         | (1,443  | ) |      |          | 8,197    |   |    |         |        |  
|                                                                                              | Accrued vendor cancellation charges                     |                          |         | (3,426  | ) |      |          | (1,709   | ) |    |         | 19,000  |  
|                                                                                              | Other accrued liabilities                               |                          |         | (6,725  | ) |      |          | 8,000    |   |    |         | 21,850  |  
|                                                                                              | Deferred taxes                                          |                          |         |        |   |      |          | (18,565  | ) |    |         | 7,567   |  
|                                                                                              | Current portion of long term debt                       |                          |         |        |   |      |          |         |   |    |         | 10,853  |  
|                                                                                              | Interest payable                                        |                          |         | (1,918  | ) |      |          | (7,580   | ) |    |         |        |  
|                                                                                              |                                                         |                          |         |         |   |      |          |          |   |    |         |        
|Net cash (used in) provided by operating
    activities                                       |                                                         |                          | (67,719 | )       |   |      | (102,461 | )        |   |    | 20,714  |        
|                                                                                              |                                                         |                          |         |         |   |      |          |          |   |    |         |        

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TERAYON COMMUNICATION SYSTEMS, INC.


CONSOLIDATED STATEMENTS OF CASH
FLOWS  (Continued)

|                                                                           |                                                         |                          |          |         |   |      |          |          |   |   |          |         | 
|-------------------------------------------------------------------------- | ------------------------------------------------------- | ------------------------ | -------- | ------- | - | ---- | -------- | -------- | - | - | -------- | ------- | 
|                                                                           |                                                         |                         
|                                                                           |                                                         | Years Ended December 31,
|                                                                           |                                                         |                         
|                                                                           |                                                         | 2002                     |          | 2001    |   | 2000
|                                                                           |                                                         |                          |          |         |   |     
|                                                                           |                                                         |                         
|                                                                           |                                                         | (in thousands)          
|Investing activities:                                                      |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Purchases of short-term investments                                        |                                                         |                          | (288,186 | )       |   |      | (402,653 | )        |   |   | (376,108 | )      
|Proceeds from sales and maturities of short-term
    investments           |                                                         |                          | 434,346  |         |   |      | 384,689  |          |   |   | 240,744  |        
|Purchases of property and equipment                                        |                                                         |                          | (7,186   | )       |   |      | (9,074   | )        |   |   | (38,534  | )      
|Purchase of other assets                                                   |                                                         |                          |         |         |   |      |         |          |   |   | (17,969  | )      
|Cash paid for acquisition of businesses                                    |                                                         |                          |         |         |   |      |         |          |   |   | (14,848  | )      
|                                                                           |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Net cash provided by (used in) investing
    activities                    |                                                         |                          | 138,974  |         |   |      | (27,038  | )        |   |   | (206,715 | )      
|                                                                           |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Financing activities:                                                      |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Principal payments on capital leases                                       |                                                         |                          | (127     | )       |   |      | (130     | )        |   |   | (12      | )      
|Principal payments on debt                                                 |                                                         |                          |         |         |   |      | (16,835  | )        |   |   |         |        
|Proceeds from long-term debt                                               |                                                         |                          |         |         |   |      |         |          |   |   | 484,429  |        
|Exercise of options and warrant to purchase
    common stock               |                                                         |                          | 1,667    |         |   |      | 12,498   |          |   |   | 14,183   |        
|Payments on repurchase of common stock                                     |                                                         |                          | (5       | )       |   |      | (695     | )        |   |   | (73      | )      
|Principal payments on stockholder notes receivable                         |                                                         |                          |         |         |   |      | 3        |          |   |   | 3        |        
|Repurchase of convertible notes                                            |                                                         |                          | (57,627  | )       |   |      | (113,428 | )        |   |   |         |        
|Proceeds from issuance of common stock                                     |                                                         |                          | 2,205    |         |   |      | 1,966    |          |   |   | 2,088    |        
|                                                                           |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|                                                                           | Net cash (used in) provided by financing
    activities |                          |          | (53,887 | ) |      |          | (116,621 | ) |   |          | 500,618 | 
|Effect of exchange rate changes                                            |                                                         |                          | (563     | )       |   |      | (620     | )        |   |   |         |        
|                                                                           |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Net increase (decrease) in cash and cash
    equivalents                   |                                                         |                          | 16,805   |         |   |      | (246,741 | )        |   |   | 314,617  |        
|Cash and cash equivalents at beginning of year                             |                                                         |                          | 100,274  |         |   |      | 347,015  |          |   |   | 32,398   |        
|                                                                           |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Cash and cash equivalents at end of year                                   |                                                         | $                        | 117,079  |         |   | $    | 100,274  |          |   | $ | 347,015  |        
|                                                                           |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Supplemental disclosures of cash flow information:                         |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Cash paid for income taxes                                                 |                                                         | $                        | 714      |         |   | $    | 31       |          |   | $ |         |        
|Cash paid for interest                                                     |                                                         | $                        | 8,387    |         |   | $    | 20,810   |          |   | $ | 365      |        
|Supplemental noncash investing and financing
    activities:               |                                                         |                          |          |         |   |      |          |          |   |   |          |        
|Common shares issued for settlement of
    convertible debt                |                                                         | $                        |         |         |   | $    | 17,900   |          |   | $ |         |        
|Acquisition of businesses                                                  |                                                         | $                        |         |         |   | $    |         |          |   | $ | 565,228  |        
|Deferred compensation relating to common stock
    issued to non-employees |                                                         | $                        | 38       |         |   | $    | 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.

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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.



| |                  
| | -----------------
| | Accounting Change

Effective the beginning of 2002, the Company
adopted Statement of Financial Accounting Standards (SFAS)
No. 141, Business Combinations, and SFAS
No. 142, Goodwill and Other Intangible Assets.
As required by SFAS No. 142, the Company discontinued
amortizing the remaining balances of goodwill as of the
beginning of fiscal 2002. See Note 5.

In April 2002, the Company adopted FASB issued
SFAS No. 145, Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement
No. 13, and Technical Corrections (SFAS
No. 145). SFAS No. 145 allows only those gains and
losses on the extinguishment of debt that meet the criteria of
extraordinary items to be treated as such in the consolidated
financial statements. Accordingly, the Company is now reporting
the gain from retirement of Convertible Notes in operating
results. As a result of adopting SFAS No. 145, the Company
reclassified the $185.3 million previously recorded in 2001
as extraordinary gain as a component of operating results.



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

The preparation of the consolidated financial
statements in conformity with generally accepted accounting
principles in the United States requires management to make
estimates and assumptions that affect the amounts reported in
the consolidated financial statements and accompanying notes.
Estimates are based on historical experience, input from sources
outside of the company, and other relevant facts and
circumstances. Actual results could differ from those estimates.
Areas that are particularly significant include the
Companys revenue recognition policy, the valuation of its
accounts receivable and inventory reserves, the assessment of
recoverability and the measurement of impairment of fixed
assets, and the recognition of restructuring reserves.



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

The Company records the effect of foreign
currency translation in accordance with SFAS No. 52,
Foreign Currency Translation. For operations outside
the United States 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, 2002, translation
gains and losses were not significant. Realized foreign currency
transaction gains and losses are included in results of
operations as incurred, and have not been significant to the
Companys operating results in any year presented.

63



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



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

The Company operates in two principal operating
segments: Cable Broadband Access Systems (Cable) and Telecom
Carrier Access Systems (Telecom). The Company sells primarily to
customers within the cable and telecommunications industries,
including related parties (see Note 12). The Company
performs ongoing credit evaluations of its customers and
generally requires no collateral. Credit losses have
historically been within managements expectations. The
Company maintains a reserve for potentially uncollectible
accounts receivable based on an assessment of collectibility.
The Company assesses collectibility based on a number of
factors, including past history, the number of days an amount is
past due (based on invoice due date), changes in credit ratings
of customers, current events and circumstances regarding the
business of the Companys clients customers and other
factors that the Company believes are relevant. Charges for
uncollectible accounts are included as a component of net
revenue in the consolidated statement of operations. At
December 31, 2002 and 2001, the reserve for potentially
uncollectible accounts was $3.5 million and
$7.2 million, respectively. A relatively small number of
customers account for a significant percentage of the
Companys revenues and accounts receivable. The Company
expects the sale of its products to a limited number of
customers and resellers to continue to account for a high
percentage of revenues. Cross Beam Networks, a subsidiary of
Sumitomo, accounted for more than 10% of the Companys
total revenues for the year ended December 31, 2002. Two
customers, both related to the Cable segment, accounted for 10%
or more of the total revenues (33% and 13%) for the year ended
December 31, 2001. Three customers, all of whom related to
the Cable segment, accounted for 10% or more of total revenues
(17%, 17%, and 11%) for the year ended December 31, 2000.

The Company relies on single source suppliers of
materials and labor for the significant majority of its product
inventory. 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.

The Company places its cash and cash equivalents
in a variety of financial institutions and limits the amount of
credit exposure through diversification and by investing in only
high-grade government and commercial issuers.

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 global service providers, and to a lesser
extent, resellers and integrators and recognizes revenue upon
shipment to the customer when title is transferred. Revenues
related to product sales are recognized in accordance with SEC
Staff Accounting Bulletin No. 101, Revenue
Recognition in Financial Statements (SAB 101):
(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.
A provision is made for estimated product returns under the
warranty terms.

64



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                      
| | -------------------------------------
| | 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, 2002, 2001 and
2000 were $0.4 million, $2.3 million, and
$1.0 million, respectively.

In December 2001, the Company entered into
co-marketing arrangements with Shaw Communications, Inc. (Shaw)
and Rogers Communications, Inc. (Rogers), a related party. The
Company paid $7.5 million to Shaw and $0.9 million to
Rogers, and recorded these amounts as other current assets. In
July 2002, the Company began amortizing these prepaid assets and
charging them against Cable revenues in accordance with Emerging
Issues Task Force (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. Amounts charged against revenues in 2002 totaled
approximately $2.8 million. The Company will continue to
charge the amortization of these assets against Cable revenues
in each of the next four quarters through December 31,
2003, the term of the related arrangement, at the rate of
$1.4 million per quarter (see Note 13).



| |                   
| | ------------------
| | Net Loss Per Share

Historical basic and diluted net loss per share
was computed using the weighted average number of common shares
outstanding. Options, warrants, restricted stock, preferred
stock, and convertible debt 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 basic and
diluted net loss per share follows (in thousands, except per
share data):

|                                                                  |  |                          |         |      |  |      |          |   |  |   |          |  
|----------------------------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | -------- | - |  | - | -------- | -
|                                                                  |  |                         
|                                                                  |  | Years Ended December 31,
|                                                                  |  |                         
|                                                                  |  | 2002                     |         | 2001 |  | 2000
|                                                                  |  |                          |         |      |  |     
|Net loss                                                          |  | $                        | (44,213 | )    |  | $    | (563,846 | ) |  | $ | (180,767 | )
|                                                                  |  |                          |         |      |  |      |          |   |  |   |          |  
|Shares used in computing basic and diluted net
    loss per share |  |                          | 72,803  |      |  |      | 68,331   |   |  |   | 61,349   |  
|                                                                  |  |                          |         |      |  |      |          |   |  |   |          |  
|Basic and diluted net loss per share                              |  | $                        | (0.61   | )    |  | $    | (8.25    | ) |  | $ | (2.95    | )
|                                                                  |  |                          |         |      |  |      |          |   |  |   |          |  

Options to purchase 14,635,025, 20,007,686, and
21,489,536 shares of common stock were outstanding at
December 31, 2002, 2001 and 2000, respectively, and
warrants to purchase 2,425,593, 2,408,300, and 2,072,318 shares
of common stock were outstanding at December 31, 2002, 2001
and 2000, respectively, but were not included in the computation
of diluted net loss per share, since the effect is antidilutive.



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

The Company recognizes 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 stockholders
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

65



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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.

The Company had no derivative financial
instruments outstanding as of December 31, 2002, 2001 or
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 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 short-term equity securities at December 31, 2002 or
2001.

During the third quarter of 2002, the Company
received approximately 35.9 million shares of Net Servicos
de Comunicacao SA (Net Servicos), a customer, valued at
approximately $2.5 million as settlement for all
outstanding accounts receivables due from Net Servicos. The
shares of Net Servicos are traded on the Sao Paulo Stock
Exchange. All revenue and the cost of sales relating to these
receivables had been deferred due to extended payment terms
offered in the original sales agreements. The Company recorded a
loss on the settlement of the Net Servicos receivables of
$0.9 million, which was charged to cost of goods sold in
the third quarter of 2002.

The Company liquidated 32.9 million of these
shares valued at $2.3 million in the fourth quarter of
2002. The Company recorded revenue and the related cost of sales
as the shares were sold and cash was received. The remaining
3.0 million shares are classified as available-for-sale and
are included in the consolidated balance sheet as short-term
investments of $0.35 million.

66



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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,
|                |  |             
|                |  | 2002         |       | 2001
|                |  |              |       |     
|Finished goods  |  | $            | 5,915 |      |  | $ | 6,433  | 
|Work-in process |  |              | 769   |      |  |   | 236    | 
|Raw materials   |  |              | 1,573 |      |  |   | 9,989  | 
|                |  |              |       |      |  |   |        | 
|                |  | $            | 8,257 |      |  | $ | 16,658 | 
|                |  |              |       |      |  |   |        | 

Gross inventory levels decreased during fiscal
2002 due to the transition of the Companys manufacturing
functions to contract manufacturers, and as a result, the
Company was able to significantly reduce its purchases of raw
materials.

The Company records losses on commitments to
purchase inventory in accordance with Statement 10 of
Chapter 4 of Accounting Release Bulletin No. 43. The
Companys policy for valuation of inventory and commitments
to purchase inventory, including the determination of obsolete
or excess inventory, requires it to perform a detailed
assessment of inventory at each balance sheet date which
includes a review of, among other factors, an estimate of future
demand for products within specific time horizons, generally six
months or less, as well as product lifecycle and product
development plans. The estimates of future demand that the
Company uses in the valuation of inventory are the basis for the
revenue forecast, which is also consistent with its short-term
manufacturing plan. Based on this analysis, the Company reduces
the cost of inventory that it specifically identifies and
considers obsolete or excessive to fulfill future sales
estimates. The Company defines obsolete inventory as inventory
that will no longer be used in the manufacturing process. Excess
inventory is generally defined as inventory in excess of
projected usage, and is determined using the Companys best
estimate of future demand at the time, based upon information
then available. The Company disposes of excess and obsolete
inventories in the normal course of business. See Note 3.

Cost of goods sold for the year ended
December 31, 2002 included a reversal of $15.3 million
of special charges taken in 2001 for vendor cancellation charges
and inventory considered to be excess and obsolete. The Company
was able to reverse the provision in 2002 as it was able to sell
inventory originally considered to be excess and obsolete. In
addition, the Company was able to negotiate downward certain
vendor cancellation claims to terms more favorable to the
Company.

Cost of goods sold for the year ended
December 31, 2001 and 2000 included $33.5 million and
$19.0 million of special charges for inventory considered
to be excess and obsolete. During 2002, the Company recorded a
charge to cost of sales of $6.1 million to reduce certain
inventories to the lower of cost or market as average selling
prices fell below the cost of these products.



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

As of December 31, 2002 and 2001, other
current receivables is primarily composed of interest, taxes,
and non-trade receivables, and included approximately
$1.4 million and $5.2 million, respectively, 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 seven years. Leasehold improvements are
amortized using the straight-line

67



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 $1.3 million in asset impairments primarily
related to the Companys restructuring in 2002, and
$1.6 million in asset impairments 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.

Property and equipment are as follows (in
thousands):

|                                          |  |              |         |      |  |   |         |  
|----------------------------------------- |  | ------------ | ------- | ---- |  | - | ------- | -
|                                          |  |             
|                                          |  | December 31,
|                                          |  |             
|                                          |  | 2002         |         | 2001
|                                          |  |              |         |     
|Software and computers                    |  | $            | 25,531  |      |  | $ | 25,328  |  
|Furniture and equipment                   |  |              | 31,092  |      |  |   | 29,754  |  
|Leasehold improvements                    |  |              | 5,018   |      |  |   | 3,573   |  
|Automobiles                               |  |              | 16      |      |  |   | 37      |  
|Construction in progress                  |  |              |        |      |  |   | 4,805   |  
|                                          |  |              |         |      |  |   |         |  
|Property and equipment                    |  |              | 61,657  |      |  |   | 63,497  |  
|Accumulated depreciation and amortization |  |              | (43,751 | )    |  |   | (38,218 | )
|                                          |  |              |         |      |  |   |         |  
|Property and equipment, net               |  | $            | 17,906  |      |  | $ | 25,279  |  
|                                          |  |              |         |      |  |   |         |  



| |            
| | -----------
| | Intangibles

Intangibles and other assets consisted of (in
thousands):

|                 |                                    |              |        |        |  |   |        |        | 
|---------------- | ---------------------------------- | ------------ | ------ | ------ |  | - | ------ | ------ | 
|                 |                                    |             
|                 |                                    | December 31,
|                 |                                    |             
|                 |                                    | 2002         |        | 2001  
|                 |                                    |              |        |       
|Intangibles, net |                                    | $            |       |        |  | $ | 3,767  |       
|Other assets     |                                    |              | 14,987 |        |  |   | 13,724 |       
|                 |                                    |              |        |        |  |   |        |       
|                 | Total intangibles and other assets |              | $      | 14,987 |  |   | $      | 17,491 | 
|                 |                                    |              |        |        |  |   |        |       

|                             |                     |            |   |              |        |     |   |        |        |  |   |   |   | 
|---------------------------- | ------------------- | ---------- | - | ------------ | ------ | --- | - | ------ | ------ |  | - | - | - | 
|                             |                     |           
|                             |                     | 12/31/2002
|                             |                     |           
|                             |                     |            |   | Accumulated  |        |    
|                             |                     | Gross      |   | Amortization |        | Net
|                             |                     |            |   |              |        |    
|Amortized intangible assets: |                     |            |   |              |        |     |   |        |        |  |   |  
|                             | Goodwill            |            | $ | 20,974       |        |     | $ | 20,974 |        |  | $ |  |  
|                             | Assembled workforce |            |   | 3,072        |        |     |   | 3,072  |        |  |   |  |  
|                             |                     |            |   |              |        |     |   |        |        |  |   |  
|                             |                     | Total      |   | $            | 24,046 |     |   | $      | 24,046 |  |   | $ |  | 
|                             |                     |            |   |              |        |     |   |        |        |  |   |  

|                             |                     |            |   |              |        |     |   |         |         |   |   |       |       | 
|---------------------------- | ------------------- | ---------- | - | ------------ | ------ | --- | - | ------- | ------- | - | - | ----- | ----- | 
|                             |                     |           
|                             |                     | 12/31/2001
|                             |                     |           
|                             |                     |            |   | Accumulated  |        |    
|                             |                     | Gross      |   | Amortization |        | Net
|                             |                     |            |   |              |        |    
|Amortized intangible assets: |                     |            |   |              |        |     |   |         |         |   |   |      
|                             | Goodwill            |            | $ | 20,769       |        |     | $ | (18,251 | )       |   | $ | 2,518 |      
|                             | Assembled workforce |            |   | 3,072        |        |     |   | (1,823  | )       |   |   | 1,249 |      
|                             |                     |            |   |              |        |     |   |         |         |   |   |      
|                             |                     | Total      |   | $            | 23,841 |     |   | $       | (20,074 | ) |   | $     | 3,767 | 
|                             |                     |            |   |              |        |     |   |         |         |   |   |      

68



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 2002,
$0.2 million was added to goodwill relating to a
reclassification of the original purchase price of Digitrans
(see Note 14). During 2001, $4.5 million was added to
assembled workforce relating to retention payments in
conjunction with the acquisition of ANE (see Note 14).
During 2002, the Company reclassified $1.3 million of
assembled workforce, net of accumulated amortization, with an
indefinite life, to goodwill at the date of adoption of SFAS
No. 142 see Note 14.

Other assets primarily consist of obligations
supported by letters of credit. See Note 3.



| |             
| | ------------
| | Other Assets

Included in Other Assets on the consolidated
Balance Sheet at December 31, 2002 is restricted cash of
approximately $9 million related to the Companys
aircraft lease. See Note 3.



| |                                                       
| | ------------------------------------------------------
| | 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 2002 and 2001, the Company recorded
impairment charges for goodwill, assembled workforce, and other
intangible assets, See Note 5.

The Company determines impairment related to its
equity investments in accordance with SFAS No. 115,
Accounting for Certain Investments in Debt and Equity
Securities, and Securities and Exchange Commission (SEC)
Staff Accounting Bulletin (SAB) 59, Accounting for
Noncurrent Marketable Equity Securities, which provide
guidance on determining when an investment is
other-than-temporarily impaired. Applying this guidance requires
judgment. In making this judgment, the Company evaluates, among
other factors, the duration and extent to which the fair value
of an investment is less than its cost; the financial health of
and business outlook for the investee, including factors such as
industry and sector performance, changes in technology, and
operational and financing cash flow, available financial
information, and the Companys intent and ability to hold
the investment, See Note 6.



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

The Company provides a standard warranty for most
of its products, generally lasting one to five years 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. See Note 16.



| |                         
| | ------------------------
| | 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 No. 123). The
Company provides additional pro forma disclosures as required
under SFAS No. 123 and SFAS No. 148, Accounting
for Stock-Based Compensation, Transition and Disclosure in
Note 10.

69



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Equity instruments granted to consultants are
accounted for under the fair value method, in accordance with
SFAS No. 123 and Emerging Issues Task Force No. 96-18,
Accounting for Equity Instruments That Are Issued to Other
Than Employees for Acquiring, or in Conjunction with Selling,
Goods or Services, using the Black-Scholes option pricing
model and are recorded in the equity section of the
Companys Consolidated Balance Sheet as deferred
compensation. These instruments are subject to periodic
revaluations over their vesting terms. The expense is recognized
as the instruments vest.

SFAS No. 148 amends SFAS No. 123 in
December 2002 to require that disclosures of the pro forma
effect of using the fair value method of accounting for
stock-based employee compensation be displayed more prominently
and in a tabular format. 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 SFAS No. 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) (See Note 9):

|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|---------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | -------- | - |  | - | -------- | -
|                                               |  |                         
|                                               |  | Years Ended December 31,
|                                               |  |                         
|                                               |  | 2002                     |         | 2001 |  | 2000
|                                               |  |                          |         |      |  |     
|Net loss                                       |  | $                        | (44,213 | )    |  | $    | (563,846 | ) |  | $ | (180,767 | )
|Stock option plans                             |  |                          | (33,747 | )    |  |      | (126,721 | ) |  |   | (118,909 | )
|Employee stock purchase plan                   |  |                          | (1,990  | )    |  |      | (2,212   | ) |  |   | (990     | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|Pro forma net loss                             |  | $                        | (79,950 | )    |  | $    | (692,779 | ) |  | $ | (300,666 | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|Pro forma basic and diluted net loss per share |  | $                        | (1.10   | )    |  | $    | (10.14   | ) |  | $ | (4.90    | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  



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

Accumulated other comprehensive income (loss)
presented in the accompanying consolidated balance sheets and
consolidated statements of stockholders 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) (in thousands):

|                         |                                                                        |                          |         |        |   |   |          |      |  
|------------------------ | ---------------------------------------------------------------------- | ------------------------ | ------- | ------ | - | - | -------- | ---- | -
|                         |                                                                        |                         
|                         |                                                                        | Years ended December 31,
|                         |                                                                        |                         
|                         |                                                                        | 2002                     |         | 2001  
|                         |                                                                        |                          |         |       
|Net loss                 |                                                                        | $                        | (44,213 | )      |   | $ | (563,846 | )   
|                         | Cumulative translation adjustments                                     |                          |         | (2,799 | ) |   |          | (621 | )
|                         | Change in unrealized gain (loss) on
    available-for-sale investments |                          |         | (519   | ) |   |          | 208  |  
|                         |                                                                        |                          |         |        |   |   |          |     
|Total comprehensive loss |                                                                        | $                        | (47,531 | )      |   | $ | (564,259 | )   
|                         |                                                                        |                          |         |        |   |   |          |     



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

Certain amounts reported in previous years have
been reclassified to conform to 2002 presentation. Such
reclassifications had no effect on previously reported results
of operations, total assets or accumulated deficit.



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

In December 2002, the Financial Accounting
Standards Board (FASB) issued Statement of Financial Accounting
Standards (SFAS) No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure 
an amendment of SFAS 123 (SFAS No. 148). This
statement amends SFAS No. 123,

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Accounting for Stock-Based
Compensation, to provide alternative methods of transition
for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition,
this statement amends the disclosure requirements of SFAS
No. 123 to require prominent disclosures in both annual and
interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method
used on reported results. The Company will adopt the annual
disclosure provisions of SFAS No. 148 in its quarterly
financial reports beginning in the first quarter of 2003. As the
adoption of this standard involves disclosures only, the Company
does not expect a material impact on its results of operations,
financial position or liquidity.

In November 2002, the FASB issued SFAS
Interpretation No. 45, Guarantors Accounting
and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (FIN 45).
FIN 45 requires that upon issuance of a guarantee, a
guarantor must recognize a liability for the fair value of an
obligation assumed under a guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual
financial statements about the obligations associated with
guarantees issued. The recognition provisions of FIN 45 are
effective for any guarantees issued or modified after
December 31, 2002. The disclosure requirements are
effective for financial statements of interim or annual periods
ending after December 15, 2002. The adoption of FIN 45
is not anticipated to have a material effect on the
Companys financial position, results of operations, or
cash flows.

In November 2002, the EITF reached a consensus on
Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables. EITF Issue No. 00-21 provides guidance
on how to account for arrangements that involve the delivery or
performance of multiple products, services and/or rights to use
assets. The provisions of EITF Issue No. 00-21 will
apply to revenue arrangements entered into in fiscal periods
beginning after June 15, 2003. The Company is currently
evaluating the effect that the adoption of EITF
Issue No. 00-21 will have on its results of operations
and financial condition.

In July 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities (SFAS No. 146), which requires the Company
to recognize costs associated with exit or disposal activities
when they are incurred rather than at the date of a commitment
to an exit or disposal plan. SFAS No. 146 replaces Emerging
Issues Task Force (EITF) Issue No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring). The provisions of SFAS No. 146 are to
be applied prospectively to exit or disposal activities
initiated after December 31, 2002. The effect of adoption
of SFAS No. 146 is dependent on the Companys related
activities subsequent to the date of adoption.

In April 2002, the FASB issued SFAS No. 145,
Rescission of FASB Statements No. 4, 44 and 64,
Amendment of FASB Statement No. 13, and Technical
Corrections (SFAS No. 145). SFAS No. 145 allows
only those gains and losses on the extinguishment of debt that
meet the criteria of extraordinary items to be treated as such
in the consolidated financial statements. SFAS No. 145 also
requires sales-leaseback accounting for certain lease
modifications that have economic effects that are similar to
lease-back transactions. The Company adopted the provisions of
SFAS No. 145 in the second quarter of 2002. In accordance
with its adoption of SFAS No. 145, all prior periods
reflect the adoption of SFAS No. 145 in the consolidated
financial statements.

In August 2001, the FASB issued SFAS
No. 144, Accounting for the Impairment or Disposal of
Long-lived Assets (SFAS No. 144). SFAS No. 144
supercedes SFAS 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 Transactions. SFAS
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 SFAS
No. 144 were adopted by the Company effective
January 1, 2002. In

71



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

accordance with SFAS No. 144, the Company
records impairment losses on long-lived assets used in
operations when events and circumstances indicate that
long-lived assets might be impaired and the undiscounted cash
flows estimated to be generated by those assets are less than
the carrying amounts of those assets. The Company recorded
impairment losses during the second quarter of 2002 associated
with the SFAS No. 144 impairment review as further
described in Note 5.

In June 2001, the FASB issued SFAS No. 141,
Business Combinations, and SFAS No. 142,
Goodwill and Other Intangible Assets (SFAS
No. 141 and SFAS No. 142). SFAS No. 141 requires
that the purchase method of accounting be used for all business
combinations initiated after June 30, 2001. SFAS
No. 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.
SFAS No. 142 prohibits the amortization of goodwill and
intangible assets with indefinite useful lives. SFAS
No. 142 requires that these assets be reviewed for
impairment at least annually. Intangible assets with definite
lives will continue to be amortized over their estimated useful
lives. Additionally, SFAS No. 142 requires that goodwill
included in the carrying value of equity method investments no
longer be amortized.

The Company adopted SFAS No. 142 on
January 1, 2002. Identifiable intangible assets with
indefinite lives were reclassified, as defined by SFAS
No. 142, to goodwill at the date of adoption. The Company
tested goodwill for impairment using the two-step process
prescribed in SFAS No. 142. The first step is a screen for
potential impairment, while the second step measures the amount
of the impairment, if any. See Note 5.

The following pro forma information reflects the
impact on net income (loss) and net income (loss) per share
assuming the adoption of SFAS No. 142 had occurred on
January 1, 2000 (in thousands):

|                                      |                                                                                                |                          |         |             |   |             |          |        |   |   |          |         |  
|------------------------------------- | ---------------------------------------------------------------------------------------------- | ------------------------ | ------- | ----------- | - | ----------- | -------- | ------ | - | - | -------- | ------- | -
|                                      |                                                                                                |                         
|                                      |                                                                                                | Years ended December 31,
|                                      |                                                                                                |                         
|                                      |                                                                                                |                          |         | 2001        |   | 2000       
|                                      |                                                                                                | 2002                     |         | (Pro forma) |   | (Pro forma)
|                                      |                                                                                                |                          |         |             |   |            
|Reported net loss                     |                                                                                                | $                        | (44,213 | )           |   | $           | (563,846 | )      |   | $ | (180,767 | )      
|                                      | Amortization of goodwill and intangible assets
    with indefinite lives                       |                          |         |            |   |             |          | 53,846 |   |   |          | 104,015 |  
|                                      |                                                                                                |                          |         |             |   |             |          |        |   |   |          |        
|Pro forma net loss                    |                                                                                                | $                        | (44,213 | )           |   | $           | (510,000 | )      |   | $ | (76,752  | )      
|                                      |                                                                                                |                          |         |             |   |             |          |        |   |   |          |        
|Basic and diluted net loss per share: |                                                                                                |                          |         |             |   |             |          |        |   |   |          |        
|                                      | Reported net loss                                                                              |                          | $       | (0.61       | ) |             | $        | (8.25  | ) |   | $        | (2.95   | )
|                                      | Adjustment related to amortization of goodwill
    and intangible assets with indefinite lives |                          |         |            |   |             |          | 0.79   |   |   |          | 1.70    |  
|                                      |                                                                                                |                          |         |             |   |             |          |        |   |   |          |        
|Pro forma net loss per share          |                                                                                                | $                        | (0.61   | )           |   | $           | (7.46    | )      |   | $ | (1.25    | )      
|                                      |                                                                                                |                          |         |             |   |             |          |        |   |   |          |        

2.     Fair Value of
Financial Instruments

The amounts reported as cash and cash
equivalents, accounts receivable, accounts payable and accrued
liabilities approximate fair value due to their short-term
maturities. The fair value for the Companys investments in
marketable debt and equity securities is estimated based on
quoted market prices.

The fair value of short-term and long-term
capital lease and debt obligations is estimated based on current
interest rates available to us for debt instruments with similar
terms, degrees of risk and remaining maturities. The carrying
values of these obligations, as of each period presented
approximate their respective fair values.

The following estimated fair value amounts have
been determined using available market information. However,
considerable judgment is required in interpreting market data to
develop the estimates of fair value.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Accordingly, the estimates presented herein are
not necessarily indicative of the amounts that the Company could
realize in a current market exchange.

|                                              |       |                   |        |            |        |            |     |            |       |   |     |     |     |   |        |        |        | 
|--------------------------------------------- | ----- | ----------------- | ------ | ---------- | ------ | ---------- | --- | ---------- | ----- | - | --- | --- | --- | - | ------ | ------ | ------ | 
|                                              |       |                  
|                                              |       | December 31, 2002
|                                              |       |                  
|                                              |       |                   |        | Gross      |        | Gross      |     |           
|                                              |       |                   |        | Unrealized |        | Unrealized |     | Estimated 
|                                              |       | Amortized Cost    |        | Gains      |        | Losses     |     | Fair Value
|                                              |       |                   |        |            |        |            |     |           
|                                              |       |                  
|                                              |       | (in thousands)   
|Short-term investments                        |       |                   |        |            |        |            |     |            |       |   |     |     |     |   |        |       
|Investments maturing in less than
    1 year: |       |                   |        |            |        |            |     |            |       |   |     |     |     |   |        |       
|Commercial paper                              |       | $                 | 16,000 |            |        | $          |    |            |       | $ | (26 | )   |     | $ | 15,974 |       
|Fixed income corporate securities             |       |                   | 12,920 |            |        |            | 196 |            |       |   |    |     |     |   | 13,116 |       
|Government agency obligations                 |       |                   | 18,300 |            |        |            | 260 |            |       |   |    |     |     |   | 18,560 |       
|Corporate equity securities                   |       |                   | 202    |            |        |            | 151 |            |       |   |    |     |     |   | 353    |       
|                                              |       |                   |        |            |        |            |     |            |       |   |     |     |     |   |        |       
|                                              | Total |                   |        | 47,422     |        |            |     | 607        |       |   |     | (26 | )   |   |        | 48,003 |       
|Investments maturing in
    1-2 years:        |       |                   |        |            |        |            |     |            |       |   |     |     |     |   |        |       
|Fixed income corporate securities             |       |                   | 2,000  |            |        |            | 145 |            |       |   |    |     |     |   | 2,145  |       
|Government agency obligations                 |       |                   | 39,000 |            |        |            | 276 |            |       |   |    |     |     |   | 39,276 |       
|                                              |       |                   |        |            |        |            |     |            |       |   |     |     |     |   |        |       
|                                              | Total |                   |        | 41,000     |        |            |     | 421        |       |   |     |    |     |   |        | 41,421 |       
|                                              |       |                   |        |            |        |            |     |            |       |   |     |     |     |   |        |       
|                                              |       | Total             |        | $          | 88,422 |            |     | $          | 1,028 |   |     | $   | (26 | ) |        | $      | 89,424 | 
|                                              |       |                   |        |            |        |            |     |            |       |   |     |     |     |   |        |       

|                                              |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |         |         | 
|--------------------------------------------- | ----- | ----------------- | ------ | ---------- | ------- | ---------- | --- | ---------- | ----- | - | - | - | - | - | ------ | ------- | ------- | 
|                                              |       |                  
|                                              |       | December 31, 2001
|                                              |       |                  
|                                              |       |                   |        | Gross      |         | Gross      |     |           
|                                              |       |                   |        | Unrealized |         | Unrealized |     | Estimated 
|                                              |       | Amortized Cost    |        | Gains      |         | Losses     |     | Fair Value
|                                              |       |                   |        |            |         |            |     |           
|                                              |       |                  
|                                              |       | (in thousands)   
|Short-term investments                        |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |        
|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 | 
|                                              |       |                   |        |            |         |            |     |            |       |   |   |   |   |   |        |        

Realized gains and losses were insignificant for
each of the years in the three year period ended
December 31, 2002.

3.     Commitments



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

The Company leases its facilities and certain
equipment under operating leases. The operating lease for the
Companys corporate headquarters expires in 2009. The
operating lease for the Companys Israel

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

headquarters expires in 2005. The Companys
other operating leases expire at various times through 2006.
Rent expense was approximately $7.9 million,
$7.2 million, and $4.2 million, for the years ended
December 31, 2002, 2001, and 2000, respectively. The
Company subleases a small portion of its facilities to third
parties. The Companys sublease rental income was
approximately $0.4 million, $0.1 million, and
$0.2 million for the years ended December 31, 2002,
2001, and 2000.

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 $0.7 million and
$1.2 million at December 31, 2002 and 2001,
respectively. Related accumulated amortization was
$0.6 million and $0.8 million at December 31,
2002 and 2001, 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.

In 2002, the Company entered into an operating
lease arrangement to lease a corporate aircraft. This lease
arrangement is secured by a $9.0 million letter of credit
at December 31, 2002. The Lease commitment for the aircraft
is included in the table below.

Future minimum lease payments under noncancelable
operating leases and capital leases as of December 31, 2002
are as follows (in thousands):

|                                  |  |                  |        |                |  |   |     | 
|--------------------------------- |  | ---------------- | ------ | -------------- |  | - | --- | 
|                                  |  | Operating Leases |        | Capital Leases
|                                  |  |                  |        |               
|2003                              |  | $                | 8,356  |                |  | $ | 169 | 
|2004                              |  |                  | 7,660  |                |  |   | 80  | 
|2005                              |  |                  | 6,723  |                |  |   |    | 
|2006                              |  |                  | 4,430  |                |  |   |    | 
|2007                              |  |                  | 3,107  |                |  |   |    | 
|Thereafter                        |  |                  | 5,582  |                |  |   |    | 
|                                  |  |                  |        |                |  |   |     | 
|Total minimum payments            |  | $                | 35,858 |                |  |   | 249 | 
|                                  |  |                  |        |                |  |   |     | 
|Less amount representing interest |  |                  |        |                |  |   | 17  | 
|                                  |  |                  |        |                |  |   |     | 
|                                  |  |                  |        |                |  |   | 232 | 
|Less current portion              |  |                  |        |                |  |   | 154 | 
|                                  |  |                  |        |                |  |   |     | 
|Long term portion                 |  |                  |        |                |  | $ | 78  | 
|                                  |  |                  |        |                |  |   |     | 

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



| |                                             
| | --------------------------------------------
| | Purchase Obligations and Special
    Charges

The Company has purchase obligations to certain
of its suppliers that support the Companys ability to
manufacture its products. The obligations consist of purchase
orders placed with vendors for goods and services and require
the Company to purchase minimum quantities of the
suppliers products at a specified price. As of
December 31, 2002, $45.5 million of purchase
obligations are outstanding. As a result of declines in
forecast, the Company has canceled certain purchase orders with
its contract manufacturers that had existing inventory on hand
or on order in anticipation of the Companys earlier
forecasts. Consequently, the Company accrued for vendor
cancellation charges representing managements estimate of
the Companys exposure to vendors for its inventory
commitments. At December 31, 2002, accrued vendor
cancellation charges were $13.9 million and are included on
the Consolidated Balance Sheet as accrued vendor

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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

cancellation charges, and the remaining $31.6 is
attributable to open purchase orders. The remaining obligations
are expected to become payable at various times throughout 2003.



| |                  
| | -----------------
| | Letters of Credit

As of December 31, 2002 the Company had
$10.4 million in unused outstanding letters of credit
primarily required to support operating leases, which expire at
various date through 2009.



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

The Company has purchased, through its
acquisition of Radwiz Ltd. (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.

Additionally, the Company has various royalty
arrangements, which require it to pay nominal amounts to various
suppliers for usage of licensed property primarily related to
DOCSIS modems.

The Companys total accrued obligation for
royalties, at December 31, 2002, was $0.6 million.



| |           
| | ----------
| | Guarantees

The Company from time to time enters into certain
types of contracts that contingently require the Company to
indemnify parties against third party claims. These obligations
primarily relate to certain agreements with the Companys
officers, directors and employees, under which the Company may
be required to indemnify such persons for liabilities arising
out of their employment relationship.

The terms of such obligations vary. Generally, a
maximum obligation is not explicitly stated. Because the
obligated amounts of these types of agreements often are not
explicitly stated, the overall maximum amount of the obligations
cannot be reasonably estimated. Historically, the Company has
not been obligated to make any payments for these obligations,
and no liabilities have been recorded for these obligations on
its balance sheets as of December 31, 2002.

4.     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,
2002, $1.6 million for accrued severance pay was included
in other long-term obligations. In accordance with EITF
No. 88-1, Determination of Vested Benefit Obligation
for a Defined Benefit Pension Plan, the Company included
$1.1 million relating to the amounts funded by the purchase
of insurance policies for the Israeli severance liability in its
consolidated balance sheets as other assets at December 31,
2002.

75



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

5.     Restructuring
Charges and Asset Write-offs



| |              
| | -------------
| | Restructuring

During the third quarter of 2002, the
Companys Board of Directors approved a restructuring plan
to conform the expense and revenue levels and to better position
the Company for future growth and eventual profitability. The
Company incurred restructuring charges in the amount of
$3.6 million of which $2.3 million related to employee
termination costs and the remaining $1.3 million related to
costs for excess leased facilities. At December 31, 2002,
restructuring charges of $1.5 million remain accrued. As of
December 31, 2002, the employment of 147 employees has
been terminated and the Company paid $2.1 million in
termination costs. The remaining employee severance costs
related to an additional 6 employees will be substantially
paid in 2003. The Company anticipates the remaining
restructuring accrual, primarily relating to excess leased
facilities, included in the lease commitment table in
Note 3, will be utilized for servicing operating lease
payments or negotiated buyout of operating lease commitments,
through 2005.

The Company reclassified $0.1 million, which
had originally been accrued for as employee termination costs to
accrued excess lease facility costs due to a revision in
estimate.

A summary of the 2002 accrued restructuring
charges is as follows (in millions):

|                             |  |              |      |                |  |       |     |  |  |   |      |  
|---------------------------- |  | ------------ | ---- | -------------- |  | ----- | --- |  |  | - | ---- | -
|                             |  |              |      | Excess Leased  |  |      
|                             |  |              |      | Facilities and |  |      
|                             |  | Involuntary  |      | Cancelled      |  |      
|                             |  | Terminations |      | Contracts      |  | Total
|                             |  |              |      |                |  |      
|Total Charge                 |  | $            | 2.3  |                |  | $     | 1.3 |  |  | $ | 3.6  |  
|Cash Payments                |  |              | (2.1 | )              |  |       |    |  |  |   | (2.1 | )
|Reclassification             |  |              | (0.1 | )              |  |       | 0.1 |  |  |   |     |  
|                             |  |              |      |                |  |       |     |  |  |   |      |  
|Balance at December 31, 2002 |  | $            | 0.1  |                |  | $     | 1.4 |  |  | $ | 1.5  |  
|                             |  |              |      |                |  |       |     |  |  |   |      |  

During 2001, the Companys Board of
Directors approved a restructuring plan to streamline the
Companys organizational structure worldwide. The Company
incurred restructuring charges in the amount of
$12.7 million in fiscal year 2001 of which
$8.2 million remained accrued at December 31, 2001. Of
the total restructuring charges recorded during fiscal year
2001, $3.2 million related to employee termination costs
covering 293 technical, production and administrative
employees. As of December 31, 2002, the Company had paid
approximately $2.0 million in termination costs. At
December 31, 2002, restructuring charges of
$5.3 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.

In 2002, the Company reclassified
$1.1 million, which had originally been accrued for as
employee termination costs to accrued excess lease facility
costs due to a revision in estimate.

76



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table summarizes the costs and
activities during 2002, related to the 2001 restructuring (in
millions):

|                             |  |              |      |                |  |       |      |   |  |   |      |  
|---------------------------- |  | ------------ | ---- | -------------- |  | ----- | ---- | - |  | - | ---- | -
|                             |  |              |      | Excess Leased  |  |      
|                             |  |              |      | Facilities and |  |      
|                             |  | Involuntary  |      | Cancelled      |  |      
|                             |  | Terminations |      | Contracts      |  | Total
|                             |  |              |      |                |  |      
|Balance at December 31, 2000 |  | $            |     |                |  | $     |     |   |  | $ |     |  
|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  |  
|Cash Payments                |  |              | (0.1 | )              |  |       | (2.8 | ) |  |   | (2.9 | )
|Reclassification             |  |              | (1.1 | )              |  |       | 1.1  |   |  |   |     |  
|                             |  |              |      |                |  |       |      |   |  |   |      |  
|Balance at December 31, 2002 |  | $            |     |                |  | $     | 5.3  |   |  | $ | 5.3  |  
|                             |  |              |      |                |  |       |      |   |  |   |      |  



| |                 
| | ----------------
| | Asset Write-offs

As a result of restructuring activities in 2002
and 2001, and a rapid decline in demand for ANE products,
certain property and equipment was determined to have no
remaining useful life. Accordingly, the assets were written down
to fair value, which was deemed to be zero.

During 2002, $1.3 million of fixed assets
became impaired and were written-off. The impaired fixed assets
represent the net book value of idle manufacturing equipment,
leasehold, and office equipment. During 2001, $1.6 million
related to fixed assets acquired from ANE were determined to
have no remaining useful life and were written-off.

In March 2001, the Company evaluated the carrying
value of certain long-lived assets and acquired intangibles,
consisting primarily of goodwill recorded on its consolidated
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,
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.

From September 1999 through December 2000, the
Company acquired ten companies. The intended result of these
acquisitions was to offer customers and potential customers a
robust family of product offerings that integrated many of the
acquired technologies. In order to achieve the expected
integration of the products and realize the synergies of
combined infrastructures, the technologies needed to be further
developed, and the products needed to obtain market acceptance.

None of the products from these acquired
businesses achieved the level of market acceptance that was
forecasted at the time of such acquisitions. Additionally,
certain product groups have not achieved the level of
technological development needed to be salable or to expand the
market. This resulted in significantly lower than expected
revenues. Additionally, the general economic slowdown, and the
high technology slowdown in particular, had a significant impact
on the Companys operating results, just as it had also
impacted the results of similar companies in its sector. Prior
to the fourth quarter of 2000, the Company had experienced
significant quarter-over-quarter growth and consistently met the
markets expectations.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Companys stock price dramatically
declined in the fourth quarter of 2000 with the decline in
expected operating results for the quarter. The principal reason
for the decline in operating results was a slowdown in orders
for traditional cable products.

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 the Companys decision
to suspend certain product lines and product development efforts
during the first quarter of 2001, intangible assets totaling
$163.1 million, related to certain acquisitions were deemed
to be impaired with no future value, were written-off and
included in asset write-offs in the Companys consolidated
statements of operations in 2001. 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 companies acquired
during fiscal 1999 and 2000. In accordance with the
Companys 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 the Cable and Telecom segments of
$409.7 million in the first nine months of 2001. This
amount was included in asset write-offs in the Companys
consolidated statements of operations in 2001.

The Company adopted SFAS No. 142 on
January 1, 2002. The Company reclassified $1.3 million
of assembled workforce, net of accumulated amortization, with an
indefinite life, to goodwill at the date of adoption. The
Company tests goodwill for impairment using the two-step process
prescribed in SFAS No. 142. The first step is a screen for
potential impairment, while the second step measures the amount
of the impairment, if any. The first step was completed during
the second quarter of 2002. The company completed the initial
goodwill impairment review as of the beginning of 2002, and
found no impairment. Due to a difficult economic environment and
heightened price competition in the modem and telecom businesses
during the three months ended June 30, 2002, the Company
experienced a significant drop in its market capitalization, and
therefore proceeded to perform an interim test to measure
goodwill and intangible assets for impairment at June 30,
2002. Based on the Companys forecast, the estimated
undiscounted future cash flows from the use of the goodwill
would be less than its carrying amount. The Company determined
that the outcome of this test reflected that the fair value of
the goodwill was zero. This resulted in a non-cash charge of
$4.0 million to write off the remaining goodwill of which
$3.0 million is related to the Cable segment and
$1.0 million is related to the Telecom segment. Subsequent
to this write-off, the Company has no intangible assets, which
are deemed to have indefinite useful lives.

The Company assigned goodwill to its reporting
entities based on the nature of the underlying business
acquired. The acquisitions made by the Company in 1999 and 2000
were designated to one of the Companys two reportable
segments at the time of the acquisition.

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.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Company did not write-off any intangible
assets in 2000. The following table describes the intangible
assets written off during 2001:

|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|----------------------- |  | -------------- | ----- | ---------- |  | --------- | ----- | --------- |  | -------- | --- | --------- |  | ----- | ---- |  |  | - | --- |  |  | - | --- |  |  | - | ----- | 
|                        |  |                |       | Developed  |  |           |       | Customer  |  | Customer |     | Assembled |  |      
|                        |  | Goodwill       |       | Technology |  | Trademark |       | Relations |  | Base     |     | Workforce |  | Total
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |      
|                        |  |               
|                        |  | (in thousands)
|Cable Segment:          |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Ultracom                |  | $              | 46.2  |            |  | $         | 0.9   |           |  | $        |    |           |  | $     |     |  |  | $ |    |  |  | $ | 0.3 |  |  | $ | 47.4  | 
|ComBox                  |  |                | 65.3  |            |  |           | 10.0  |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   | 0.2 |  |  |   | 75.5  | 
|Imedia                  |  |                | 47.2  |            |  |           | 20.0  |           |  |          | 2.9 |           |  |       |     |  |  |   |    |  |  |   | 0.3 |  |  |   | 70.4  | 
|Digitrans               |  |                | 8.2   |            |  |           | 0.5   |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   | 0.3 |  |  |   | 9.0   | 
|Telegate                |  |                | 52.8  |            |  |           | 17.0  |           |  |          |    |           |  |       | 20.2 |  |  |   |    |  |  |   | 0.8 |  |  |   | 90.8  | 
|Internet Telecom        |  |                | 39.1  |            |  |           | 5.0   |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   | 0.1 |  |  |   | 44.2  | 
|TrueChat                |  |                |      |            |  |           |      |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   |    |  |  |   |      | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Total Cable Segment     |  | $              | 258.8 |            |  | $         | 53.4  |           |  | $        | 2.9 |           |  | $     | 20.2 |  |  | $ | 0.0 |  |  | $ | 2.0 |  |  | $ | 337.3 | 
|Telecom Segment:        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|MainSail                |  |                | 97.0  |            |  |           | 44.1  |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   | 0.6 |  |  |   | 141.7 | 
|ANE                     |  |                | 33.5  |            |  |           | 10.3  |           |  |          | 0.5 |           |  |       |     |  |  |   | 2.0 |  |  |   | 4.5 |  |  |   | 50.8  | 
|Radwiz                  |  |                | 18.7  |            |  |           | 23.1  |           |  |          | 0.9 |           |  |       |     |  |  |   |    |  |  |   | 0.3 |  |  |   | 43.0  | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Total Telecom Segment   |  | $              | 149.2 |            |  | $         | 77.5  |           |  | $        | 1.4 |           |  | $     | 0.0  |  |  | $ | 2.0 |  |  | $ | 5.4 |  |  | $ | 235.5 | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Total Cable and Telecom |  | $              | 408.0 |            |  | $         | 130.9 |           |  | $        | 4.3 |           |  | $     | 20.2 |  |  | $ | 2.0 |  |  | $ | 7.4 |  |  | $ | 572.8 | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 

The following table describes the intangible
assets written off during 2002:

|                        |  |                |     |            |  |           |   |           |  |          |   |           |  |       |   |  |  |   |   |  |  |   |     |  |  |   |     | 
|----------------------- |  | -------------- | --- | ---------- |  | --------- | - | --------- |  | -------- | - | --------- |  | ----- | - |  |  | - | - |  |  | - | --- |  |  | - | --- | 
|                        |  |                |     | Developed  |  |           |   | Customer  |  | Customer |   | Assembled |  |      
|                        |  | Goodwill       |     | Technology |  | Trademark |   | Relations |  | Base     |   | Workforce |  | Total
|                        |  |                |     |            |  |           |   |           |  |          |   |           |  |      
|                        |  |               
|                        |  | (in thousands)
|Cable Segment:          |  |                |     |            |  |           |   |           |  |          |   |           |  |       |   |  |  |   |   |  |  |   |     |  |  |   |     | 
|Ultracom                |  | $              |    |            |  | $         |  |           |  | $        |  |           |  | $     |  |  |  | $ |  |  |  | $ | 0.1 |  |  | $ | 0.1 | 
|ComBox                  |  |                |    |            |  |           |  |           |  |          |  |           |  |       |  |  |  |   |  |  |  |   | 0.1 |  |  |   | 0.1 | 
|Digitrans               |  |                | 0.2 |            |  |           |  |           |  |          |  |           |  |       |  |  |  |   |  |  |  |   |    |  |  |   | 0.2 | 
|Internet Telecom        |  |                |    |            |  |           |  |           |  |          |  |           |  |       |  |  |  |   |  |  |  |   | 0.1 |  |  |   | 0.1 | 
|TrueChat                |  |                | 2.5 |            |  |           |  |           |  |          |  |           |  |       |  |  |  |   |  |  |  |   |    |  |  |   | 2.5 | 
|                        |  |                |     |            |  |           |   |           |  |          |   |           |  |       |   |  |  |   |   |  |  |   |     |  |  |   |     | 
|Total Cable Segment     |  | $              | 2.7 |            |  | $         |  |           |  | $        |  |           |  | $     |  |  |  | $ |  |  |  | $ | 0.3 |  |  | $ | 3.0 | 
|Telecom Segment:        |  |                |     |            |  |           |   |           |  |          |   |           |  |       |   |  |  |   |   |  |  |   |     |  |  |   |     | 
|MainSail                |  |                |    |            |  |           |  |           |  |          |  |           |  |       |  |  |  |   |  |  |  |   | 0.5 |  |  |   | 0.5 | 
|ANE                     |  |                |    |            |  |           |  |           |  |          |  |           |  |       |  |  |  |   |  |  |  |   | 0.5 |  |  |   | 0.5 | 
|                        |  |                |     |            |  |           |   |           |  |          |   |           |  |       |   |  |  |   |   |  |  |   |     |  |  |   |     | 
|Total Telecom Segment   |  | $              |    |            |  | $         |  |           |  | $        |  |           |  | $     |  |  |  | $ |  |  |  | $ | 1.0 |  |  | $ | 1.0 | 
|                        |  |                |     |            |  |           |   |           |  |          |   |           |  |       |   |  |  |   |   |  |  |   |     |  |  |   |     | 
|Total Cable and Telecom |  | $              | 2.7 |            |  | $         |  |           |  | $        |  |           |  | $     |  |  |  | $ |  |  |  | $ | 1.3 |  |  | $ | 4.0 | 
|                        |  |                |     |            |  |           |   |           |  |          |   |           |  |       |   |  |  |   |   |  |  |   |     |  |  |   |     | 

6.     Impairment of
Long-Term Investment

The Companys long-lived assets include
long-term equity investments. During 2002, the Company
determined that one such equity investment in a privately-held
company was impaired and recorded an impairment charge of
$4.5 million. In 2002, the investees forecasts were
not met and market conditions significantly deteriorated. The
Companys estimate of the fair value of the long-term
investment was dependent on the performance of the investment,
as well as the volatility inherent in the external markets for
this investment.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

7.     Convertible
Subordinated Notes

In July 2000, the Company issued
$500 million of 5% Convertible Subordinated Notes due in
August 2007 (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 Convertible Notes at
any time on or after August 7, 2003 at specified prices
plus accrued and unpaid interest. Interest is payable
semi-annually. Debt issuance costs related to the Convertible
Notes were approximately $15.6 million and are amortized
over seven years. At December 31, 2002 amortization of debt
issuance costs totaled $14.2 million.

In 2001, the Company repurchased approximately
$325.9 million of Convertible Notes for $113.4 million
in cash and $17.9 million in stock, resulting in a gain of
approximately $185.3 million, net of related unamortized
issuance costs of $9.3 million. In 2002, the Company
repurchased approximately $109.1 million of Convertible
Notes for $57.6 million in cash, resulting in a gain of
approximately $49.1 million, net of related unamortized
issuance costs of $2.4 million.

In April 2002, the Company adopted SFAS
No. 145 and determined that the extinguishment of its debt
did not meet the criteria of an extraordinary item as set forth
in SFAS No. 145. Accordingly, the Company is now reporting
the gain from retirement of Convertible Notes in operating
results. As a result of adopting SFAS No. 145, the Company
reclassified the $185.3 million previously recorded in 2001
as extraordinary gain as a component of operating results.

Approximately $65.1 million of Convertible
Notes were outstanding at December 31, 2002.

8.     Contingencies



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

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
the Companys 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 the Companys 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 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 the Companys 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

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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. On March 29, 2002, the court denied
the defendants motion to dismiss. The parties are now in
the discovery process. In addition, the court has certified the
plaintiffs proposed class and scheduled trial to begin on
November 4, 2003.

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 intends 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 California Superior Court,
San Luis Obispo County. 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. On
August 7, 2002, the court held another conference at which
it entered an order dismissing the Bertram case. The
courts order permits the individual plaintiffs in the
Bertram case to pursue any claims that they may have as
members of the purported class in the related, consolidated
class action discussed above. Plaintiffs have appealed this
order, and the Court of Appeals has set a briefing schedule for
the appeal.

The Company believes that the allegations in the
Bertram case, as with the allegations in the federal
securities case, are without merit and intends to contest the
matter vigorously.

On May 7, 2002, a shareholder filed a
derivative lawsuit purportedly on behalf of the Company against
five of its current directors, two former directors and two
former officers. This lawsuit is titled Campbell vs. Rakib,
et al., and is pending in the California Superior Court,
Santa Clara County. The Company is a nominal defendant in this
lawsuit, which alleges claims relating to essentially the same
purportedly misleading statements that are at issue in the
pending securities class action. In that litigation, the Company
disputes making any misleading statements. The derivative
complaint also alleges claims relating to stock sales by certain
of the director and officer defendants.

On July 12, 2002, a shareholder filed a
derivative lawsuit purportedly on behalf of the Company against
three of its current directors, one former officer and three
former investors. This lawsuit is titled OBrien vs.
Rakib, et al., and is pending in the California Superior
Court, San Francisco County. The Company is a nominal defendant
in this lawsuit, which alleges claims relating to essentially
the same purportedly misleading statements that are at issue in
the pending securities class action. In that litigation, the
Company disputes making any misleading statements. The
derivative complaint also alleges claims relating to stock sales
by

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

certain of the director and officer defendants.
The plaintiff in the OBrien case has dismissed the
investor defendants without prejudice.

Since the Campbell and OBrien
cases were filed, the parties have taken steps to have these
cases consolidated in the California Superior Court, County of
Santa Clara. On October 4, 2002, the California Superior
Court, County of San Francisco entered an order providing for
the transfer of the OBrien case. On
October 29, 2002, plaintiff in the OBrien case
submitted certain materials to the California Superior Court,
County of Santa Clara to effectuate that transfer, which is now
complete. The OBrien case is now consolidated with
the Campbell case.

The Company believes that there are many defects
in the Campbell and OBrien derivative
complaints.

On January 19, 2003, Omniband Group Limited,
a Russian company, (Omniband) filed a request for arbitration
with the Zurich Chamber of Commerce, claiming damages in an
amount of $2,094,970 allegedly caused by the Companys
breach of an agreement to sell to Omniband certain equipment
pursuant to an agreement between Omniband and Radwiz Ltd., the
Companys subsidiary, dated February 22, 2000. On
February 10, 2003,the President of the Zurich Chamber of
Commerce appointed the Chairman of a three member panel to
preside over the arbitration proceedings. The Company believes
that the allegations are without merit and intends to present a
vigorous defense in the arbitration proceedings.

On September 3, 2002, Uniscor Ltd. (an
Israeli company under voluntary liquidation) and Flextronics
(Israel) Ltd., an Israeli company, (Flextronics)filed a claim
with the Tel Aviv District Court in Israel against the Company
and Radwiz, the Companys subsidiary, alleging that damages
of NIS 25,000,000 (approximately) $5 million
US dollars) were caused to them by the Companys
alleged failure to comply with its contractual obligations to
accept and pay for components manufactured by Flextronics in the
first quarter of 2001 pursuant to projections it had received
from Radwiz. The Company filed a statement of defense denying
the allegations, after which the parties accepted the
Courts recommendation to transfer the case to non-binding
mediation.

The Company is currently a party to various other
legal proceedings, in addition to those noted above, and may
become involved from time to time in other legal proceedings in
the future. While the Company currently believes that the
ultimate outcome of these other proceedings, individually and in
the aggregate, will not have a material adverse effect on the
Companys financial position or overall trends in results
of operations, litigation is subject to inherent uncertainties.
Were an unfavorable ruling to occur in any of the Companys
legal proceedings, there exists the possibility of a material
adverse impact on the Companys results of operations for
the period in which the ruling occurs. The estimate of the
potential impact on the Companys financial position or
overall results of operations for any of the above legal
proceedings could change in the future.

9.     Stockholders
Equity



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

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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
$2.0 million, 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.



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

In conjunction with a 1998 preferred stock
financing, the Company issued Shaw a warrant (Anti-Dilution
Warrant) to purchase an indeterminate number of shares of common
stock. The Anti-Dilution Warrant is exercisable at the option of
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, 2002 and
2001, required the Company to issue an additional 17,293 and
35,982 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 $26,000 and $0.2 million
relating to the issuance of warrants pursuant to the
Anti-Dilution Warrant, in 2002 and 2001, respectively, and none
in 2000. The expense is calculated by multiplying the annualized
fair market value of the Companys stock by the share
dilution attributable to the Anti-Dilution Warrant. As of
December 31, 2002, the Anti-Dilution Warrant was
exercisable for an aggregate of 125,593 shares of the
Companys common stock.

On March 18, 1999, the Company entered into
a one-year Product Development Assistance Agreement (Development
Agreement) with 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
$45.0 million using the Black Scholes model, and resulted
in a noncash charge included in operations over the term of the
Development Agreement. As a result of the Development Agreement,
the Companys results of operations for the years ended
December 31, 2000 include noncash charges of
$9.6 million. 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. As of December 31, 2002, no
further shares of the Companys stock were exercisable
under this warrant.

In October 1999, a customer of the Company
entered into an agreement with Telegate Ltd., an Israeli company
(Telegate), which was negotiating with the Company to be
acquired by the Company, 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 did not close. 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 $34.6 million 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. In the first quarter of 2001, the Company wrote-off the
intangible assets relating to the purchase of Telegate (see

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 5). For the year ended December 2002,
the Company incurred no amortization expense related to the
warrant. For the years ended December 31, 2001 and 2000,
the Company incurred approximately $2.9 million and
$11.5 million in amortization expense related to the
warrant, respectively. As of December 31, 2002, the
Telegate warrant was exercisable for an aggregate of 2,000,000
shares of the Companys common stock. The Telegate warrant
expired in January 2003.

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. (TrueChat) 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 1/24th per
month, beginning January 31, 2001. The fair value of the
warrant of approximately $0.7 million was calculated using
the Black-Scholes method and was recorded as additional
consideration relating to the purchase of TrueChat. As of
December 31, 2002, the TrueChat warrant was exercisable for
an aggregate of 200,000 shares of the Companys common
stock.

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. (Philips) 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 $0.3 million was
recorded as cost of goods sold during 2001. As of
December 31, 2002, the Philips warrant was exercisable for
an aggregate of 100,000 shares of the Companys common
stock.



| |                        
| | -----------------------
| | 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 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 Reserved

Common stock reserved for issuance is as follows:

|                             |  |              |            | 
|---------------------------- |  | ------------ | ---------- | 
|                             |  | December 31,
|                             |  | 2002        
|                             |  |             
|Common stock options         |  |              | 43,547,831 | 
|Common stock warrants        |  |              | 2,425,593  | 
|Employee stock purchase plan |  |              | 3,000,000  | 
|                             |  |              |            | 
|                             |  |              | 48,973,424 | 
|                             |  |              |            | 



| |                                          
| | -----------------------------------------
| | Stock Option and Stock Purchase
    Plans

In March 1995, the Companys Board of
Directors approved a stock option plan (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, 2002 a total of 4,229,494 shares have been
authorized for issuance related to the 1995 Plan.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In March 1997, the Companys Board of
Directors approved an equity incentive plan (1997 Plan) that
authorized 1,600,000 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 (5,000,000 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 shares authorized for issuance by 3,770,000
additional shares and to provide for an increase in the number
of shares of common stock beginning January 1, 2000 through
January 1, 2007, by the lesser of five percent (5%) of the
common stock outstanding on such January 1 or 3,000,000
shares. As of December 31, 2002, a total of 18,754,528
shares have been authorized for issuance related to the 1997
Plan.

In June 1998, the Companys Board of
Directors authorized the adoption of the 1998 Non-Employee
Directors Stock Option Plan (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 2002, the Companys Board of Directors amended
the 1998 Plan to increase the shares authorized for issuance by
400,000 additional shares. As of December 31, 2002, a total
of 800,000 shares have been authorized for issuance related to
the 1998 Plan.

In September 1999, the Companys Board of
Directors authorized the adoption of the 1999 Non-Officers
Equity Incentive Plan (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 by 10,000,000.
As of December 31, 2002, a total of 28,500,000 shares have
been authorized for issuance related to the 1999 Plan.

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 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
generally 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 may not be
less than 85% of the fair market value of the common stock at
the date of the grant. Options generally 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.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

During the years ended December 31, 2002,
2001 and 2000, the Company recorded aggregate deferred
compensation of approximately $38,000, $35,000 and
$3.5 million, 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. In each subsequent
reporting period (through the vesting period) the remaining
deferred compensation will be remeasured. For the years ended
December 31, 2002, 2001, and 2000, the amortization expense
was approximately $0.5 million, $0.5 million, and
$0.6 million, respectively.

In June 2001, the Company issued 160,000 shares
of the Companys common stock to members of its Board of
Advisors and recorded $0.6 million 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 at $3.72 per share.

During 2001, the Company issued 115,250 shares of
common stock to its employees, and recorded $0.6 million 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 at $5.57 per share.

During 2002, the Company issued 20,000
nonqualified stock options of common stock to a member of its
Board of Advisors and recorded $38,000 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 $1.95 per share.

During 2002, the Company issued 200,000 shares of
common stock to a consultant and recorded $290,000 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 $1.45 per share.

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 the Company in conjunction with
its business acquisitions of (see Note 14) and option
grants made outside the Plans (if any):

|                             |                    |           |           |                     |   |           |            |             |   |   |       |       | 
|---------------------------- | ------------------ | --------- | --------- | ------------------- | - | --------- | ---------- | ----------- | - | - | ----- | ----- | 
|                             |                    |           |           |                    
|                             |                    |           |           | Options Outstanding
|                             |                    |           |           |                    
|                             |                    |           |           |                     |   | Weighted-
|                             |                    | Options   |           |                     |   | Average  
|                             |                    | Available |           | Number of           |   | Exercise 
|                             |                    | for Grant |           | Shares              |   | Price    
|                             |                    |           |           |                     |   |          
|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 | 
|                             |                    |           |           |                     |   |           |            |             |   |   |       |      

86



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                             |                    |           |            |                     |   |           |            |            |   |   |      |       | 
|---------------------------- | ------------------ | --------- | ---------- | ------------------- | - | --------- | ---------- | ---------- | - | - | ---- | ----- | 
|                             |                    |           |            |                    
|                             |                    |           |            | Options Outstanding
|                             |                    |           |            |                    
|                             |                    |           |            |                     |   | Weighted-
|                             |                    | Options   |            |                     |   | Average  
|                             |                    | Available |            | Number of           |   | Exercise 
|                             |                    | for Grant |            | Shares              |   | Price    
|                             |                    |           |            |                     |   |          
|Balance at December 31, 2001 |                    |           | 20,397,666 |                     |   |           | 20,007,686 |            |   | $ | 9.75 |      
|                             | Options authorized |           |            | 3,400,000           |   |           |            |           |   |   |      |       | 
|                             | Options granted    |           |            | (1,734,400          | ) |           |            | 1,734,400  |   |   | $    | 5.40  | 
|                             | Options exercised  |           |            |                    |   |           |            | (257,521   | ) |   | $    | 3.95  | 
|                             | Options canceled   |           |            | 6,849,540           |   |           |            | (6,849,540 | ) |   | $    | 12.66 | 
|                             |                    |           |            |                     |   |           |            |            |   |   |      |      
|Balance at December 31, 2002 |                    |           | 28,912,806 |                     |   |           | 14,635,025 |            |   | $ | 8.05 |      
|                             |                    |           |            |                     |   |           |            |            |   |   |      |      

In addition, the following table summarizes
information about stock options that were outstanding and
exercisable at December 31, 2002:

|                         |       |                     |           |                     |  |          |      |             |  |          |        |      |  |  |           |           |  |   |        |      | 
|------------------------ | ----- | ------------------- | --------- | ------------------- |  | -------- | ---- | ----------- |  | -------- | ------ | ---- |  |  | --------- | --------- |  | - | ------ | ---- | 
|                         |       |                     |           |                    
|                         |       | Options Outstanding |           | Options Exercisable
|                         |       |                     |           |                    
|                         |       |                     |           | Number of           |  | Weighted |      |             |  | Weighted
|                         |       | Weighted            |           | Average             |  | Average  |      |             |  | Average 
|                         |       | Number              |           | Remaining           |  | Exercise |      | Exercisable |  | Exercise
|Range of Exercise Prices |       | Outstanding         |           | Contractual Life    |  | Price    |      | Options     |  | Price   
|                         |       |                     |           |                     |  |          |      |             |  |         
|$0.01 - $5.53            |       |                     | 4,228,212 |                     |  |          | 7.89 |             |  | $        | 4.08   |      |  |  | 1,744,353 |           |  | $ | 4.03   |     
|$5.67 - $6.50            |       |                     | 944,357   |                     |  |          | 8.32 |             |  | $        | 6.12   |      |  |  | 262,658   |           |  | $ | 6.21   |     
|$6.50 - $6.81            |       |                     | 7,493,268 |                     |  |          | 8.15 |             |  | $        | 6.80   |      |  |  | 4,478,550 |           |  | $ | 6.80   |     
|$6.84 - $82.78           |       |                     | 1,933,188 |                     |  |          | 7.93 |             |  | $        | 20.35  |      |  |  | 877,926   |           |  | $ | 27.63  |     
|$123.50                  |       |                     | 36,000    |                     |  |          | 7.20 |             |  | $        | 123.50 |      |  |  | 19,800    |           |  | $ | 123.50 |     
|                         |       |                     |           |                     |  |          |      |             |  |          |        |      |  |  |           |           |  |   |        |     
|                         | Total |                     |           | 14,635,025          |  |          |      | 8.05        |  |          | $      | 8.05 |  |  |           | 7,383,287 |  |   | $      | 8.92 | 
|                         |       |                     |           |                     |  |          |      |             |  |          |        |      |  |  |           |           |  |   |        |     

At December 31, 2002, approximately 667
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
(ESPP), which is designed to allow eligible employees of the
Company to purchase shares of common stock at semi-annual
intervals through periodic payroll deductions. In 2002, the ESPP
was amended to add an additional 3,000,000 shares to the ESPP.
An aggregate of 4,400,000 shares of common stock has been
reserved for the ESPP, and 1,400,000 shares have been issued
through December 31, 2002. The ESPP 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
ESPP 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. In November 2002 the
Companys Board of Directors suspended the ESPP after the
current Offering Period expires (no later than July 31,
2004).

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 SFAS
No. 123 requires the use of valuation models that were not
developed for use in valuing employee stock

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 SFAS No. 123 and is calculated as if the
Company had accounted for its employee stock options granted
during the years ended December 31, 2002, 2001 and 2000 and
for its ESPP shares to be issued under the fair value method of
SFAS No. 123. The fair value for employee stock options
granted and ESPP shares was estimated at the date of grant based
on the Black-Scholes model using the following weighted average
assumptions:

|                             |  |               |      |               |  |               |      |   |  |  |      |  
|---------------------------- |  | ------------- | ---- | ------------- |  | ------------- | ---- | - |  |  | ---- | -
|                             |  | Risk Free     |      | Risk Free     |  | Risk Free    
|                             |  | Interest Rate |      | Interest Rate |  | Interest Rate
|                             |  | 2002          |      | 2001          |  | 2000         
|                             |  |               |      |               |  |              
|Stock option plans           |  |               | 4.22 | %             |  |               | 4.50 | % |  |  | 5.98 | %
|Employee stock purchase plan |  |               | 4.36 | %             |  |               | 4.14 | % |  |  | 6.35 | %

|                             |  |           |     |            |  |            |      |            |  |  |      |  |  |  |      | 
|---------------------------- |  | --------- | --- | ---------- |  | ---------- | ---- | ---------- |  |  | ---- |  |  |  | ---- | 
|                             |  | Dividend  |     | Volatility |  | Volatility |      | Volatility
|                             |  | Yield     |     | Factor     |  | Factor     |      | Factor    
|                             |  | All Years |     | 2002       |  | 2001       |      | 2000      
|                             |  |           |     |            |  |            |      |           
|Stock option plans           |  |           | 0.0 |            |  |            | 1.50 |            |  |  | 1.50 |  |  |  | 1.20 | 
|Employee stock purchase plan |  |           | 0.0 |            |  |            | 1.50 |            |  |  | 1.50 |  |  |  | 1.20 | 

|                             |  |               |     |               |  |               |     |  |  |  |     | 
|---------------------------- |  | ------------- | --- | ------------- |  | ------------- | --- |  |  |  | --- | 
|                             |  | Weighted      |     | Weighted      |  | Weighted     
|                             |  | Average       |     | Average       |  | Average      
|                             |  | Expected Life |     | Expected Life |  | Expected Life
|                             |  | 2002          |     | 2001          |  | 2000         
|                             |  |               |     |               |  |              
|Stock option plans           |  |               | 5.0 |               |  |               | 5.0 |  |  |  | 5.0 | 
|Employee stock purchase plan |  |               | 0.5 |               |  |               | 0.5 |  |  |  | 0.5 | 

As discussed above, the valuation models used
under SFAS No. 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.

SFAS No. 148 amends SFAS No. 123 in
December 2002 to require that disclosures of the pro forma
effect of using the fair value method of accounting for
stock-based employee compensation be displayed more prominently
and in a tabular format. 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 SFAS No. 123, the Companys net
loss applicable to common stockholders and net loss per share
applicable to common

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

stockholders would have been increased to the pro
forma amounts indicated below (in thousands, except per share
data):

|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|---------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | -------- | - |  | - | -------- | -
|                                               |  |                         
|                                               |  | Years Ended December 31,
|                                               |  |                         
|                                               |  | 2002                     |         | 2001 |  | 2000
|                                               |  |                          |         |      |  |     
|Net loss                                       |  | $                        | (44,213 | )    |  | $    | (563,846 | ) |  | $ | (180,767 | )
|Stock option plans                             |  |                          | (33,747 | )    |  |      | (126,721 | ) |  |   | (118,909 | )
|Employee stock purchase plan                   |  |                          | (1,990  | )    |  |      | (2,212   | ) |  |   | (990     | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|Pro forma net loss                             |  | $                        | (79,950 | )    |  | $    | (692,779 | ) |  | $ | (300,666 | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  
|Pro forma basic and diluted net loss per share |  | $                        | (1.10   | )    |  | $    | (10.14   | ) |  | $ | (4.90    | )
|                                               |  |                          |         |      |  |      |          |   |  |   |          |  

The pro forma impact of options granted and ESPP
shares to be issued for the years ended December 31, 2002,
2001 and 2000 is not representative of the effects on net income
(loss) for future years, as future years will include the
continued 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
SFAS No. 123, was $4.98, $5.83, and $43.81, for options
granted during 2002, 2001, and 2000, respectively. The weighted
average grant date fair value of ESPP shares to be issued was
$2.25, $3.99, and $9.30 for the years ended December 31,
2002, 2001 and 2000, respectively.

10. Income Taxes

For the years ended December 31, 2002 and
2001, the Company had an income tax expense of
$0.2 million, and an income tax benefit of
$13.9 million, respectively. Due to operating losses and
the inability to recognize the benefits, there is no provision
for income taxes for the year ended December 31, 2000.

|          |         |                          |                |      |     |      |         |         |     |         |   |   |   |   | 
|--------- | ------- | ------------------------ | -------------- | ---- | --- | ---- | ------- | ------- | --- | ------- | - | - | - | - | 
|          |         |                         
|          |         | Years Ended December 31,
|          |         |                         
|          |         | 2002                     |                | 2001 |     | 2000
|          |         |                          |                |      |     |     
|          |         |                         
|          |         | (in thousands)          
|Current:  |         |                          |                |      |     |      |         |         |     |         |   |  
|          | Federal |                          | $              |     |     |      | $       |        |     |         | $ |  |  
|          | State   |                          |                | 20   |     |      |         |        |     |         |   |  |  
|          | Foreign |                          |                | 218  |     |      |         | 831     |     |         |   |  |  
|          |         |                          |                |      |     |      |         |         |     |         |   |  
|          |         | Total current            |                | $    | 238 |      |         | $       | 831 |         |   | $ |  |  
|Deferred: |         | $                        |               |      |     | $    |        |         |     | $       |  |  
|          | Federal |                          |                |     |     |      |         |        |     |         |   |  |  
|          | State   |                          |                |     |     |      |         |        |     |         |   |  |  
|          | Foreign |                          |                |     |     |      | $       | (14,746 | )   |         |   |  |  
|          |         |                          |                |      |     |      |         |         |     |         |   |  
|          |         |                          | Total deferred |      | $   |     |         |         |     | (14,746 | ) |   | $ |  | 
|          |         |                          |                |      |     |      |         |         |     |         |   |  
|Total     |         | $                        | 238            |      |     | $    | (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.
In fiscal 1999 and 2000, the Company acquired ten companies. In
fiscal 2001, certain intangible assets from these acquisitions
were written off. As part of recording the write-offs the
related deferred tax liabilities were also written off. This
resulted in the recording of a deferred tax benefit of
$14.7 million in fiscal 2001. There were also foreign
income taxes of $0.8 million for fiscal 2001.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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,
|                                                            |  |                         
|                                                            |  | 2002                     |         | 2001 |  | 2000
|                                                            |  |                          |         |      |  |     
|Tax benefit at U.S. statutory rate                          |  | $                        | (15,391 | )    |  | $    | (197,346 | ) |  | $ | (63,268 | )
|Goodwill amortization                                       |  |                          |        |      |  |      | 2,849    |   |  |   | 19,405  |  
|In-process research and development                         |  |                          |        |      |  |      |         |   |  |   | 8,698   |  
|Loss for which no tax benefit is currently
    recognizable |  |                          | 15,391  |      |  |      | 179,338  |   |  |   | 34,529  |  
|Other, net                                                  |  |                          | 238     |      |  |      | 1,244    |   |  |   | 636     |  
|                                                            |  |                          |         |      |  |      |          |   |  |   |         |  
|                                                            |  | $                        | 238     |      |  | $    | (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. Significant components of the
Companys deferred tax assets and liabilities as of
December 31, 2002 and 2001 are as follows (in thousands):

|                          |                                      |              |   |          |   |   |   |          |  
|------------------------- | ------------------------------------ | ------------ | - | -------- | - | - | - | -------- | -
|                          |                                      |             
|                          |                                      | December 31,
|                          |                                      |             
|                          |                                      | 2002         |   | 2001    
|                          |                                      |              |   |         
|Deferred tax assets:      |                                      |              |   |          |   |   |   |         
|                          | Net operating loss carryforwards     |              | $ | 118,021  |   |   | $ | 130,321  |  
|                          | Tax credit carryforwards             |              |   | 14,936   |   |   |   | 13,047   |  
|                          | Reserves and accruals                |              |   | 96,428   |   |   |   | 58,418   |  
|                          | Capitalized research and development |              |   | 4,372    |   |   |   | 7,580    |  
|                          | Intangibles amortization             |              |   | 2,616    |   |   |   | 8,396    |  
|                          | Other, net                           |              |   | 8,430    |   |   |   | 610      |  
|                          |                                      |              |   |          |   |   |   |         
|                          | Gross deferred tax assets            |              |   | 244,803  |   |   |   | 218,372  |  
|                          | Valuation allowance                  |              |   | (244,803 | ) |   |   | (218,372 | )
|                          |                                      |              |   |          |   |   |   |         
|Total deferred tax assets |                                      | $            |  |          |   | $ |  |         
|                          |                                      |              |   |          |   |   |   |         

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,
2002 and 2001. The change in the valuation allowance was a net
increase of approximately $26.4 million,
$86.7 million, and $88.2 million for the years ended
December 31, 2002, 2001, and 2000, respectively.
Approximately $44.2 million of the valuation allowance will be
credited to equity when realized.

As of December 31, 2002, the Company had
federal, California and foreign net operating loss carryforwards
of approximately $244.5 million, $136.4 million and
$113.5 million, respectively. The Company also had federal
and California tax credit carryforwards of approximately
$8.7 million and $9.6 million, respectively. The federal
and California net operating loss and credit carryforwards will
expire at various dates beginning in the years 2003 through
2022, 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.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

11. 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, 2002, 2001, and 2000.

12.     Segments of
an Enterprise and Related Information

The Companys 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
does not allocate non-operating income or expenses to its
segments, as management does not use the information to measure
the performance of the operating segments.

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 its TeraComm System, TJ line of
DOCSIS cable modems, Bluewave line of DOCSIS Cable Modem
Termination Systems (CMTS), and the CherryPicker family of
Digital Video Management Systems that are sold primarily to
cable operators for the deployment of data, video and voice
services over the existing cable infrastructure. The Telecom
segment consists primarily of MiniPlex DSL Systems, IPTL
Converged Voice and Data Service System and MainSail products,
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,
|                                  |                        |                         
|                                  |                        | 2002                     |         | 2001    |        | 2000
|                                  |                        |                          |         |         |        |     
|Cable Broadband Access Segment:   |                        |                          |         |         |        |      |         |          |         |   |         |         
|                                  | Revenues:              |                          |         |         |        |      |         |          |         |   |         |          |        
|                                  |                        | TeraComm System          |         | $       | 68,753 |      |         | $        | 192,757 |   |         | $        | 238,358 | 
|                                  |                        | TJ DOCSIS cable modems   |         |         | 23,059 |      |         |          | 25,069  |   |         |          | 24,736  | 
|                                  |                        | Video products           |         |         | 20,833 |      |         |          | 16,363  |   |         |          | 19,714  | 
|                                  |                        | Other                    |         |         | 6,284  |      |         |          | 11,639  |   |         |          | 20,716  | 
|                                  |                        |                          |         |         |        |      |         |          |         |   |         |         
|                                  | Total Cable revenues   |                          | $       | 118,929 |        |      | $       | 245,828  |         |   | $       | 303,524  |        
|                                  | Depreciation expense   |                          | $       | 10,347  |        |      | $       | 12,028   |         |   | $       | 10,699   |        
|                                  | Operating loss         |                          | $       | (78,731 | )      |      | $       | (465,435 | )       |   | $       | (132,643 | )      
|Telecom Broadband Access Segment: |                        |                          |         |         |        |      |         |          |         |   |         |         
|                                  | Revenues:              |                          |         |         |        |      |         |          |         |   |         |          |        
|                                  |                        | MiniPlex DSL Systems     |         | $       | 8,366  |      |         | $        | 23,417  |   |         | $        | 33,363  | 
|                                  |                        | Other                    |         |         | 2,108  |      |         |          | 10,236  |   |         |          | 2,662   | 
|                                  |                        |                          |         |         |        |      |         |          |         |   |         |         
|                                  | Total Telecom revenues |                          | $       | 10,474  |        |      | $       | 33,653   |         |   | $       | 36,025   |        
|                                  | Depreciation expense   |                          | $       | 1,225   |        |      | $       | 3,700    |         |   | $       | 585      |        
|                                  | Operating loss         |                          | $       | (10,852 | )      |      | $       | (297,697 | )       |   | $       | (54,834  | )      
|Total revenues                    |                        | $                        | 129,403 |         |        | $    | 279,481 |          |         | $ | 339,549 |         
|Total depreciation expense        |                        | $                        | 11,572  |         |        | $    | 15,728  |          |         | $ | 11,284  |         

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                  |                                          |                          |        |          |        |       |         |          |         |        |          |          |         |        |          |  
|----------------- | ---------------------------------------- | ------------------------ | ------ | -------- | ------ | ----- | ------- | -------- | ------- | ------ | -------- | -------- | ------- | ------ | -------- | -
|                  |                                          |                         
|                  |                                          | Years Ended December 31,
|                  |                                          |                         
|                  |                                          | 2002                     |        | 2001     |        | 2000 
|                  |                                          |                          |        |          |        |      
|Operating loss:   |                                          |                          |        |          |        |       |         |          |         |        |          |         
|                  | Operating loss by reportable segments    |                          | $      | (89,583  | )      |       | $       | (763,132 | )       |        | $        | (187,477 | )      
|                  | Unallocated amounts:                     |                          |        |          |        |       |         |          |         |        |          |          |        
|                  | Interest and other income (expense), net |                          |        | (3,481   | )      |       |         | 44       |         |        |          | 6,710    |        
|                  | Gain on early retirement of debt         |                          |        | 49,089   |        |       |         | 185,327  |         |        |          |         |        
|                  | Income tax (expense) benefit             |                          |        | (238     | )      |       |         | 13,915   |         |        |          |         |        
|                  |                                          |                          |        |          |        |       |         |          |         |        |          |         
|                  |                                          |                          |        | Net loss |        | $     | (44,213 | )        |         | $      | (563,846 | )        |         | $      | (180,767 | )
|                  |                                          |                          |        |          |        |       |         |          |         |        |          |         
|Geographic areas: |                                          |                          |        |          |        |       |         |          |         |        |          |         
|                  | Revenues:                                |                          |        |          |        |       |         |          |         |        |          |          |        
|                  |                                          | United States            |        | $        | 41,150 |       |         | $        | 50,291  |        |          | $        | 83,974  |       
|                  |                                          | Canada                   |        |          | 17,247 |       |         |          | 113,300 |        |          |          | 118,491 |       
|                  |                                          | Europe                   |        |          | 11,381 |       |         |          | 34,952  |        |          |          | 37,880  |       
|                  |                                          |                          | Israel |          |        | 8,283 |         |          |         | 16,528 |          |          |         | 23,861 |         
|                  |                                          | Japan                    |        |          | 36,214 |       |         |          | 37,721  |        |          |          | 36,612  |       
|                  |                                          | Asia, excluding Japan    |        |          | 11,845 |       |         |          | 24,094  |        |          |          | 24,373  |       
|                  |                                          | South America            |        |          | 3,283  |       |         |          | 2,595   |        |          |          | 14,358  |       
|                  |                                          |                          |        |          |        |       |         |          |         |        |          |         
|                  |                                          |                          |        | Total    |        | $     | 129,403 |          |         | $      | 279,481  |          |         | $      | 339,549  |  
|                  |                                          |                          |        |          |        |       |         |          |         |        |          |         

|                                 |               |              |         |              |         |   |         |        |         |  |  |  |  | 
|-------------------------------- | ------------- | ------------ | ------- | ------------ | ------- | - | ------- | ------ | ------- |  |  |  |  | 
|                                 |               | December 31, |         | December 31, |         |  
|                                 |               | 2002         |         | 2001         |         |  
|                                 |               |              |         |              |         |  
|Assets:                          |               |              |         |              |         |   |         |        |         |  |  | 
|Cable Broadband Access Segment   |               | $            | 217,531 |              |         | $ | 455,836 |        |         |  |  | 
|Telecom Broadband Access Segment |               |              | 58,179  |              |         |   | 10,810  |        |         |  |  | 
|                                 |               |              |         |              |         |   |         |        |         |  |  | 
|                                 |               | Total assets |         | $            | 275,710 |   |         | $      | 466,646 |  |  |  |  | 
|                                 |               |              |         |              |         |   |         |        |         |  |  | 
|Long-lived assets:               |               |              |         |              |         |   |         |        |         |  |  | 
|                                 | United States |              | $       | 28,169       |         |   | $       | 36,106 |         |  |  |  | 
|                                 | Canada        |              |         | 787          |         |   |         | 256    |         |  |  |  | 
|                                 | Europe        |              |         | 170          |         |   |         | 388    |         |  |  |  | 
|                                 | Israel        |              |         | 3,442        |         |   |         | 3,757  |         |  |  |  | 
|                                 | Asia          |              |         | 207          |         |   |         | 243    |         |  |  |  | 
|                                 | South America |              |         | 118          |         |   |         | 2,020  |         |  |  |  | 
|                                 |               |              |         |              |         |   |         |        |         |  |  | 
|Total long-lived assets          |               |              | 32,893  |              |         |   | 42,770  |        |         |  |  | 
|Total current assets             |               |              | 242,817 |              |         |   | 423,876 |        |         |  |  | 
|                                 |               |              |         |              |         |   |         |        |         |  |  | 
|Total assets                     |               | $            | 275,710 |              |         | $ | 466,646 |        |         |  |  | 
|                                 |               |              |         |              |         |   |         |        |         |  |  | 

One customer, related to the Cable segment,
accounted for 10% or more of total revenues for the year ended
December 31, 2002 (28%). Two customers, both related to the
Cable segment, accounted for 10% or more of the total revenues
(33% and 13%) for the year ended December 31, 2001. Three
customers, all of whom related to the Cable segment, accounted
for 10% or more of total revenues (17%, 17%, and 11%) for the

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

year ended December 31, 2000. No other
customer accounted for more than 10% of revenues during these
years. One customer, related to the Cable segment, accounted for
10% or more of total accounts receivable for the year ended
December 31, 2002 (23%).

13.     Related Party
Transactions

During the years ended December 31, 2002,
2001 and 2000, the Company recognized revenue of
$9.1 million, $52.4 million, and $119.3 million,
respectively in connection with product shipments made to
related parties. Prior to the third quarter of 2001, both Shaw
and Rogers, each of which had one representative on the
Companys Board of Directors were significant stockholders
and were related parties. Beginning in the third quarter of
2001, Shaw was no longer a significant stockholder because Shaw
no longer exercised voting rights over its shares in the
Company, and the board member from Shaw resigned. Accordingly,
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.
Alek Krstajic, a member of the Companys board of
directors, was the Senior Vice President of Interactive
Services, Sales and Product Development for Rogers until January
2003. In May 2003, Rogers will no longer be a related party to
the Company.

Lewis Solomon, a member of the Companys
Board of Directors and chairman of the Companys Audit
Committee is also a member of the Board of Directors of
Harmonic, Inc. (Harmonic) a manufacturer and seller of broadband
products. In April 2002, the Company entered a reseller
agreement with Harmonic to sell certain of the Companys
products. The agreement appoints Harmonic as an authorized,
non-exclusive reseller of certain of the Companys video
products. In the year ended December 31, 2002, revenues
from Harmonic of $1.1 million are included as revenue from
related parties.

Cost of related party product revenues consist of
direct product costs in cost of goods sold in the Companys
consolidated statements of operations. No indirect costs are
applied to the cost of related party revenue. Accounts
receivable from Rogers and Harmonic totaled approximately
$0.8 million and $4.0 million at December 31,
2002 and 2001, respectively. None of the related parties is a
supplier to the Company.

In December 2001, the Company entered into
co-marketing arrangements with Shaw and Rogers. The Company paid
$7.5 million to Shaw and $0.9 million to Rogers, and
recorded these amounts as other current assets. The Company
entered into these arrangements with Shaw and Rogers to promote
the Companys brand and identify its products. The Company
will charge the amortization of these assets against Cable
revenues in each of the next four quarters through
December 31, 2003, the term of the related arrangement, at
the rate of $1.4 million per quarter. Amounts charged
against revenues in 2002 totaled approximately
$2.8 million. See Note 1.

Between April 1998 and March 1999, the Company
issued various warrants to Shaw and Rogers to purchase shares of
the Companys common stock. See Note 9.

In October 2002, the Company incurred a marketing
expense of $150,000 for Team Honor, an organization that
supports a professional sailing team. One of the Companys
Board members, Aleksander Krstajic is the founder and President
of Team Honor.

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 in accordance with Accounting
Principles Board Opinion No. 16 (APB 16). 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 in
accordance with Emerging Issues Task Forces No. 99-12

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(EITF 99-12). 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 acquired companies 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.

As discussed in Note 5, the Company recorded
losses due to the impairment of goodwill and intangible assets
of approximately $4.0 million and $572.8 million
relating to these acquisitions in December 31, 2002 and
2001, respectively. No intangible assets remained at
December 31, 2002.

In connection with the acquisitions of Imedia and
Telegate, in 1999, the Company gave one of its directors, Lewis
Solomon, a grant of 50,000 non-qualified stock options and an
additional grant of 20,000 shares of restricted common stock for
consulting services provided to the Company by Mr. Solomon
for his assistance with the Companys strategic
partnerships and acquisitions.

Imedia
Corporation

In July 1999, the Company entered into an
Agreement and Plan of Reorganization (Imedia 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
(Imedia Closing Date).

In accordance with the Imedia 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 option holders and warrant holders of Imedia on the
Imedia Closing Date. The approximate purchase price of
$91.0 million was determined as the value of the
Companys common stock issued at closing
($77.0 million) and the value of the options to purchase
the Companys shares issued to the unvested option holders
($14.0 million) based on the fair market value of the
Companys common stock on the days immediately preceding
and following the closing date of the acquisition.

Tangible assets acquired principally include
cash, accounts receivable and property and equipment.
Liabilities assumed principally include accounts payable and
accrued liabilities. At the Imedia Closing Date, the Company
forgave Imedias note payable obligation of
$1.0 million.

The analysis of the expected future cash flows
attributed to all existing technology resulted in a valuation of
approximately $27.0 million for developed technology that
had reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $11.0 million consisted primarily of major
additions to Imedias core technology, which was related to
Imedias planned development of new features.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The majority of the intended functionality of
these new features was not supported by Imedias
then-current 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 (Radwiz Agreement) to acquire Radwiz. Radwiz
produced communication access systems based on high-speed IP
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
(Radwiz Closing Date).

In accordance with the Radwiz Agreement, the
Company paid $0.3 million in cash and issued 1,992,306
shares of the Companys common stock to the former
shareholders of Radwiz and issued options to purchase 267,959
shares of the Companys common stock to the unvested
optionholders of Radwiz on the Radwiz 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 $52.7 million. This represents the minimum purchase
price, as specified in the Radwiz Agreement, to be issued to the
shareholders and vested option holders of Radwiz
($50.0 million) plus the value of the options issued to
unvested option holders of Radwiz ($2.7 million) 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 $29.9 million for developed technology that
had reached technological feasibility and therefore was
capitalizable.

In-process technology acquired in the
transaction, valued at approximately $3.0 million consisted
primarily of additions to Radwizs core technology, which
was related to Radwizs planned development of new
features. The majority of the intended functionality of these
new features was not supported by Radwizs then-current
technology. Intended new features included 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.
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 4.4 million shares of common stock and paid
approximately $2.5 million in cash on January 2, 2000.
The Company made an additional cash payment of approximately
$0.9 million during the third quarter of 2000. The
approximate purchase price of $100.0 million was determined
as the value of the Companys common stock issued at
closing based on the fair market value of the Companys
common stock on the days immediately preceding and following the
announcement date of the acquisition.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In addition, the Company issued a warrant to
purchase 2.0 million 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 classified as a 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.

The analysis of the expected future cash flow
attributed to all existing technology resulted in a valuation of
approximately $21.5 million for developed technology that
had reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $7.5 million, 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 then-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 (ANE Agreement) to acquire certain
assets and assume certain liabilities of ANE, a company that
provides 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 $83.5 million based on the fair market value
of the Companys common stock on the days immediately
preceding and following the announcement date of the
acquisition. 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 three annual payments to the identified employees in a
total amount of approximately $4.5 million 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
related 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 $12.6 million 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
$2.4 million.

In-process technology acquired in the
transaction, valued at approximately $0.8 million,
consisted primarily of additions to ANEs core technology,
which was related to ANEs planned development of new
features. A portion of the intended functionality of these new
features was not supported by ANEs then-

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 (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.

In accordance with the ComBox Agreement, the
Company issued 1,547,770 shares of common stock and made a cash
payment of approximately $0.3 million. 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 the
Companys common stock issued at closing
($92.0 million) and the value of the options to purchase
the Companys shares issued to the unvested option holders
($6.8 million) based on the fair market value of the
Companys common stock on the days immediately preceding
and following the date the acquisition was announced. In
addition, the cash payment of approximately $0.3 million
was included in the purchase price. Proceeds to be received from
the option holders and warrant holders upon exercise were 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 $12.5 million for developed technology, which
had reached technological feasibility and therefore was
capitalizable.

In-process technology acquired valued at
approximately $8.0 million consisted 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 then-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), an Israeli company. Internet Telecom is a
supplier of PacketCable and other standards-based, Voice-over-IP
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 $46.0 million 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 $2.0 million in cash. In
addition, as a result of certain conditions in the Internet
Telecom Agreement with regards to the price of the
Companys common stock, an additional accrued purchase
price payable of approximately $14.1 million was included
in the consolidated balance sheet as of December 31, 2000.
This amount was paid during 2001.

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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 $6.0 million for developed technology, which
had reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $2.6 million, consisted 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
then-current technology. During 2001, the Company decided to no
longer develop the new features from Internet Telecom.



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

In March 2000, the Company entered into a Share
Purchase Agreement to acquire Ultracom (Ultracom Agreement), 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 $0.2 million 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
the Companys common stock issued at the closing
($57.6 million) and the value of the options to purchase
the Companys shares issued to the unvested option holders
($0.6 million) based on the fair market value of the
Companys common stock on the days immediately preceding
and following the date the acquisition was announced. In
addition, the cash payment of approximately $0.2 million
was 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 $1.1 million for developed technology that
had reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $1.8 million, consisted primarily of
additions to Ultracoms core technology, which was 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 then-current technology. During
2001, the Company determined that it would no longer continue
development on the Ultracom technology.



| |                        
| | -----------------------
| | MainSail Networks, Inc.

In August 2000, the Company entered into an
Agreement and Plan of Merger and Reorganization (MainSail
Agreement) to acquire 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 the
Companys common stock on the days immediately preceding
and following the date the acquisition was announced
($171.3 million) less the intrinsic value of the unvested
options recorded as deferred compensation ($4.7 million).
Deferred compensation is amortized over the option holders
vesting period.

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 $49.0 million for developed technology that
had reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $5.0 million, consisted primarily of
additions to MainSails core technology, which was 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 then-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.



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

On September 27, 2000, the Company acquired
Digital Transmission Equipment (Digitrans) pursuant to the terms
of a Stock Purchase Agreement (Digitrans 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 $14.2 million based on the fair market
value of the Companys common stock on the days subsequent
to the closing date and immediately proceeding and following the
removal of all contingencies. In addition, a provision in the
Digitrans Agreement with Digitrans stipulated that if the value
of the acquisition shares fell below the purchase price on the
date the Registration Statement filed in connection with the
acquisition was declared effective, the Company would pay the
former shareholders of Digitrans, in the form of stock, the
difference between the purchase price of $22.45 per share and
the value of $43.13 per share of the acquisition shares, divided
by the purchase price, multiplied by the original share issuance
of 394,329 shares. As a result of this provision and an
additional issuance of 4,455 shares, the Company issued a
total of 367,804 additional shares of its common stock to the
former stockholders of Digitrans in September 2000.
Additionally, the Company forgave $2.0 million of
convertible promissory notes, which were originally issued to
Digitrans by the Company in June 2000.

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 $0.6 million for developed technology that
had reached technological feasibility and therefore was
capitalizable.

In-process technology acquired, valued at
approximately $5.0 million, 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 then-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, pursuant to the terms of an Agreement and Plan of
Merger and Reorganization (TrueChat Agreement). TrueChat
develops communication systems that enable multimedia
teleconferencing and provide increased control over
teleconference parameters.

99



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In accordance with the TrueChat Agreement, the
Company issued 534,487 shares of common stock and made a cash
payment of $0.2 million. In addition, the former option
holders of TrueChat received options to purchase 126,061 shares
of the Companys common stock. The approximate purchase
price was $2.9 million, based on the fair market value of
the Companys common stock on the days immediately
preceding and following the closing date of the acquisition
($2.2 million) and the value of the options to purchase the
Companys shares issued to the unvested option holders
($0.5 million). Deferred compensation relating to the
options is amortized over the option holders vesting
period. (see Note 9).

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):

|                                |                                                |          |         |         |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |        |  |   |       |       | 
|------------------------------- | ---------------------------------------------- | -------- | ------- | ------- | - | ------ | ------ | ------ |  | -------- | ------ | -------- | - | --------- | ------ | -------- |  | - | ------ | ------ | - | - | ------- | ------- | - | - | ------ | ------ |  | - | ----- | ----- | 
|                                |                                                | Telegate |         | ANE     |   | ComBox |        | IT     |  | Ultracom |        | MainSail |   | Digitrans |        | TrueChat
|                                |                                                |          |         |         |   |        |        |        |  |          |        |          |   |           |        |         
|2000 Acquisitions:              |                                                |          |         |         |   |        |        |        |  |          |        |          |   |           |        |          |  |   |        |        |   |   |         |         |   |   |        |        |  |   |       |      
|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   | 

100



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                |                                                |        |         |         |   |   |        |         |   |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|------------------------------- | ---------------------------------------------- | ------ | ------- | ------- | - | - | ------ | ------- | - |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|                                |                                                | Imedia |         | Radwiz  |   |   |        |         |   |  |  |  |  |  |  | 
|                                |                                                |        |         |         |   |   |        |         |   |  |  |  |  |  |  | 
|1999 Acquisitions:              |                                                |        |         |         |   |   |        |         |   |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|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       |   |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 

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 financial information is not
necessarily indicative of the results that would have occurred
had the acquisitions 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  
|                                                 |  | December 31,
|                                                 |  | 2000        
|                                                 |  |             
|Revenues                                         |  | $            | 358,559 |  
|Net loss(1)                                      |  | $            | (71,343 | )
|Net loss per share(1)                            |  | $            | (1.16   | )
|Shares used in calculation of net loss per share |  |              | 61,349  |  



---



|    |                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Net loss and net loss per share excludes
    approximately $30.5 million of in-process research and
    development charges for the year ended December 31, 2000.

101



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

15.     Product
Warranties

The Company provides for estimated product
warranty expenses when it sells the related products. Because
warranty estimates are forecasts that are based on the best
available information  mostly historical claims
experience  claims costs may differ from amounts
provided. An analysis of changes in the liability for product
warranties follows (in thousands):

|                             |                  |            |   |            |  |            |  |            |  |  |  |       |  |  |   |       | 
|---------------------------- | ---------------- | ---------- | - | ---------- |  | ---------- |  | ---------- |  |  |  | ----- |  |  | - | ----- | 
|                             |                  |            |   | Additions  |  |            |  |           
|                             |                  | Balance at |   | Charged to |  |            |  | Balance at
|                             |                  | Beginning  |   | Costs and  |  |            |  | End of    
|                             |                  | of Period  |   | Expenses   |  | Write-offs |  | Period    
|                             |                  |            |   |            |  |            |  |           
|Year ended December 31, 2000 |                  |            |   |            |  |            |  |            |  |  |  |       |  |  |   |      
|                             | Warranty reserve |            | $ | 2,685      |  |            |  | 5,991      |  |  |  | 2,751 |  |  | $ | 5,925 | 
|Year ended December 31, 2001 |                  |            |   |            |  |            |  |            |  |  |  |       |  |  |   |      
|                             | Warranty reserve |            | $ | 5,925      |  |            |  | 7,956      |  |  |  | 5,513 |  |  | $ | 8,368 | 
|Year ended December 31, 2002 |                  |            |   |            |  |            |  |            |  |  |  |       |  |  |   |      
|                             | Warranty reserve |            | $ | 8,368      |  |            |  | 2,730      |  |  |  | 2,491 |  |  | $ | 8,607 | 

16.     Subsequent
Events (Unaudited)

On February 26, 2003, the Company and
Solectron Corporation (Solectron) entered into an agreement to
settle all outstanding obligations under two manufacturing
agreements between the Company and Solectron. Under the terms of
the settlement agreement, the Company paid Solectron
approximately $3.9 million, and each party released any and
all claims that it may have had against the other party.
Additionally, Terayon received selected inventory from
Solectron. The Company previously accrued the $3.9 million
settlement as a vendor cancellation in the fourth quarter of
2000 and the second quarter of 2001.

On March 14, 2003, the Company initiated a
worldwide reduction in force of approximately 100 employees, or
20 percent of the workforce, and the closure of certain
remote facilities. The Company expects to record total charges
in the range of approximately $4 million to $5 million
associated with the realignment and the writedown of certain
related assets in the quarter ending March 31, 2003.

17.     Unaudited
Quarterly Financial Data

Summarized quarterly financial data for 2002 and
2001 is as follows (in thousands, except per share data):

|                                            |  |         |        |        |  |       |        |        |  |   |         |   |  |   |         |  
|------------------------------------------- |  | ------- | ------ | ------ |  | ----- | ------ | ------ |  | - | ------- | - |  | - | ------- | -
|                                            |  |        
|                                            |  | Quarter
|                                            |  |        
|2002                                        |  | First   |        | Second |  | Third |        | Fourth
|                                            |  |         |        |        |  |       |        |       
|Total revenues                              |  | $       | 57,218 |        |  | $     | 22,407 |        |  | $ | 24,475  |   |  | $ | 25,303  |  
|Gross profit (loss)                         |  |         | 25,491 |        |  |       | (27    | )      |  |   | 296     |   |  |   | 2,694   |  
|Restructuring costs and asset write-offs(2) |  |         |       |        |  |       | (3,972 | )      |  |   | (4,950  | ) |  |   |        |  
|Net loss(3)                                 |  |         | (4,090 | )      |  |       | (3,685 | )      |  |   | (15,972 | ) |  |   | (20,466 | )
|Basic and diluted net loss per share        |  | $       | (0.06  | )      |  | $     | (0.05  | )      |  | $ | (0.22   | ) |  | $ | (0.28   | )

102



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                            |  |         |          |        |  |       |         |        |  |   |        |   |  |   |        |  
|------------------------------------------- |  | ------- | -------- | ------ |  | ----- | ------- | ------ |  | - | ------ | - |  | - | ------ | -
|                                            |  |        
|                                            |  | Quarter
|                                            |  |        
|2001                                        |  | First   |          | Second |  | Third |         | Fourth
|                                            |  |         |          |        |  |       |         |       
|Total revenues                              |  | $       | 53,984   |        |  | $     | 65,733  |        |  | $ | 79,603 |   |  | $ | 80,161 |  
|Gross profit (loss)                         |  |         | (869     | )      |  |       | (15,731 | )      |  |   | 10,368 |   |  |   | 22,445 |  
|Restructuring costs and asset write-offs(2) |  |         | (574,744 | )      |  |       | (2,549  | )      |  |   | (5,301 | ) |  |   | (3,449 | )
|Net income (loss)(3)                        |  |         | (508,200 | )      |  |       | (62,504 | )      |  |   | 13,082 |   |  |   | (6,224 | )
|Basic and diluted income (loss) per share   |  | $       | (7.53    | )      |  | $     | (0.93   | )      |  | $ | 0.19   |   |  | $ | (0.09  | )



---



|    |                                                                                                                                                                                                                                                                 
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Earnings per share are computed independently for
    each of the quarters presented. The sum of the quarterly
    earnings per share in 2002 and 2001 does not equal the total
    computed for the year due to changes in shares outstanding and
    rounding.
|   
|(2) | See Note 5 for an explanation for
    restructuring and asset write-offs.                                                                                                                                                                                       
|   
|(3) | See Note 7 for an explanation of the
    repurchase of subordinated convertible notes.                                                                                                                                                                          

103



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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

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






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

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






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

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






|         |                                                  
|-------- | -------------------------------------------------
|Item 13. | Certain Relationship and Related
    Transactions

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






|         |                        
|-------- | -----------------------
|Item 14. | Controls and Procedures

(a) Evaluation of disclosure controls and
procedures.Our Chief Executive Officer and our Chief
Financial Officer, after evaluating the effectiveness of the
companys disclosure controls and procedures
(as defined in the Securities Exchange Act of 1934
Rules 13a-14(c) and 15-d-14(c)) as of a date (Evaluation
Date) within 90 days before the filing date of this annual
report, have concluded that as of the Evaluation Date, our
disclosure controls and procedures were adequate and designed to
ensure that material information relating to us and our
consolidated subsidiaries would be made known to them by others
within those entities.

(b) Changes in internal controls.There were no significant changes in our internal controls
or to our knowledge, in other factors that could significantly
affect our disclosure controls and procedures subsequent to the
Evaluation Date.

104



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PART IV






|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 15. | 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, 2002 and 2001.                                                                                                                                                                                                          
|
| |  | 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, 2002, 2001, and 2000.

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, 2002, 2001 and
    2000.

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.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. On November 14, 2002, the Company
    filed a report on Form 8-K announcing that the Chief
    Executive Officer, Zaki Rakib, and the Chief Financial Officer,
    Carol Lustenader, had executed a certification pursuant to 18
    U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002, which
    accompanied the Companys 10-Q filed with the
    Securities and Exchange Commission on November 14, 2002.
|
| | 2. On December 20, 2002, the Company
    filed a report on Form 8-K announcing that Cable Television
    Laboratories, Inc. (CableLabs) had informed Terayon that its
    Bluewave3500 CMTS and TJ 715 CM had received
    CableLabs DOCSIS 2.0 qualification and certification.
    The Company publicly announced the qualification and
    certification in a press release on December 19, 2002.                                                      

105



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EXHIBIT INDEX

|        |    |                     |  |                                                                                                                                                                                                
|------- | -- | ------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |                    
|Number  |    | Exhibit Description
|        |    |                    
|        | 3  | .1                  |  | Amended and Restated Certificate of Incorporation
    of Terayon Communication Systems, Inc.(1)                                                                                                
|        | 3  | .2                  |  | Bylaws of Terayon Communication Systems, Inc.(1)                                                                                                                                               
|        | 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.(7)                                                                                                            
|        | 4  | .1                  |  | Specimen Common Stock Certificate.(2)                                                                                                                                                          
|        | 4  | .2                  |  | Amended and Restated Information and Registration
    Rights Agreement dated April 6, 1998.(1)                                                                                                 
|        | 4  | .3                  |  | Form of Security for Terayon Communication
    Systems, Inc.s 5% Convertible Subordinated Notes due
    August 1, 2007.(5)                                                                    
|        | 4  | .4                  |  | Registration Rights Agreement by and among
    Terayon Communication Systems, Inc. and Deutsche Bank
    Securities, Inc. and Lehman Brothers, Inc.(5)                                         
|        | 4  | .5                  |  | Indenture between Terayon Communication Systems,
    Inc. and State Street Bank and Trust Company of California, N.A.
    dated July 26, 2000.(5)                                              
|        | 4  | .6                  |  | Rights Agreement between Terayon Communication
    Systems, Inc. and Fleet National Bank dated February 6,
    2001.(6)                                                                        
|        | 10 | .1                  |  | Form of Indemnity Agreement between Terayon
    Communication Systems, Inc. and each of its directors and
    officers.(1)                                                                     
|        | 10 | .2                  |  | 1995 Stock Option Plan, as amended on
    March 26, 1996.(1)                                                                                                                                   
|        | 10 | .3                  |  | 1997 Equity Incentive Plan, as amended on
    July 31, 2000.(9)                                                                                                                                
|        | 10 | .4                  |  | 1998 Employee Stock Purchase Plan, as amended on
    May 22, 2002.(7)                                                                                                                          
|        | 10 | .5                  |  | 1998 Non-Employee Directors Stock Option Plan as
    amended on May 22, 2002.(1)                                                                                                               
|        | 10 | .6                  |  | 1998 Employee Stock Purchase Plan Offering for
    Foreign Employees, adopted July 31, 2000.(7)                                                                                                
|        | 10 | .7                  |  | Anti-Dilution Warrant to Purchase Shares of
    Common Stock dated April 6, 1998 issued to Shaw
    Communications Inc.(1)                                                                     
|        | 10 | .8                  |  | Lease Agreement dated April 20, 1998 between
    Imedia Corporation and Martin CL Associate, L.P.(3)                                                                                           
|        | 10 | .9                  |  | Sublease Agreement dated November 15, 1999
    between Imedia Corporation and ISP Channel, Inc.(3)                                                                                             
|        | 10 | .10                 |  | 1999 Non-Officer Equity Incentive Plan, as
    amended February 14, 2001.(7)                                                                                                                   
|        | 10 | .11                 |  | Form of Non-Statutory Stock Option Agreement Used
    in Connection with the 1999 Non-Officer Equity Incentive Plan.(4)                                                                        
|        | 10 | .12                 |  | Azrieli Center Offices Lease Agreement, dated
    January 23, 2002, between Canit HaShalom Investments Ltd.
    and Terayon Communication Systems, Inc.(9)                                     
|        | 10 | .13                 |  | Azrieli Center Agreement to Transfer Lease Rights
    dated 23rd day of January, 2000                                                                                                          
|        | 10 | .14                 |  | Employment Agreement, between Terayon
    Communication Systems, Inc. and Zaki Rakib dated February
    1993.(1)                                                                               
|        | 10 | .15                 |  | Data Over Cable Service Interface Specifications
    License Agreement, dated December 21, 2001, between Terayon
    Communication Systems, Inc. and Cable Television Laboratories,
    Inc.(9)
|        | 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.(9)                 
|        | 10 | .17                 |  | Data Over Cable Service Interface Specifications
    License Agreement, dated December 21, 2001, between Imedia
    Semiconductor Corporation and Cable Television Laboratories,
    Inc.(9)   
|        | 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.(9)                    
|        | 10 | .19                 |  | Lease Agreement, dated September 18, 1996,
    between Sobrato Interests III and VeriFone.(10)                                                                                                 

106



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##### Table of Contents



|        |    |                     |  |                                                                                                                                                          
|------- | -- | ------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |                    
|Number  |    | Exhibit Description
|        |    |                    
|        | 10 | .20                 |  | Sublease, dated April 1, 2002, by and
    between Terayon Communication Systems, Inc. and Hewlett-Packard
    Company. (10)                              
|        | 10 | .21                 |  | Aircraft Lease Agreement, dated February 8,
    2002, between Terayon Communication Systems, Inc. and General
    Electric Capital Corporation.          
|        | 10 | .22                 |  | Letter of Credit Agreement, dated
    February 8, 2002, between Terayon Communication Systems,
    Inc. and General Electric Capital Corporation.        
|        | 10 | .23                 |  | Employment Agreement, dated January 24,
    2003, between Terayon Communication Systems, Inc. and
    Arthur T. Taylor.                                  
|        | 21 | .1                  |  | List of Subsidiaries.                                                                                                                                    
|        | 23 | .1                  |  | Consent of Ernst & Young LLP Independent
    Auditors.                                                                                                   
|        | 24 | .1                  |  | Power of Attorney (see page 106 of this
    Annual Report Form 10-K)                                                                                     
|        | 99 | .1                  |  | Chief Executive Officers Certification
    Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
    Section 906 of The Sarbanes-Oxley Act of 2002.
|        | 99 | .2                  |  | Chief Financial Officers Certification
    Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
    Section 906 of The Sarbanes-Oxley Act of 2002.



---



|    |                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference to exhibits to our
    Registration Statement on Form S-1 filed on June 16,
    1998 (File No. 333-56911).   
|   
|(2) | Incorporated by reference to exhibits to our
    Registration Statement on Form S-1/ A filed on
    July 31, 1998 (File No. 333-69699).
|   
|(3) | Incorporated by reference to our Report on
    Form 10-Q filed on November 15, 1999.                                                   
|   
|(4) | Incorporated by reference to our Registration
    Statement on Form S-8 filed on December 29, 1999.                                    
|   
|(5) | Incorporated by reference to our Registration
    Statement on Form S-3 filed on October 24, 2000 (File
    No. 333-48536).            
|   
|(6) | Incorporated by reference to our Report on
    Form 8-K filed on February 9, 2001.                                                     
|   
|(7) | Incorporated by reference to our Report on
    Form 10-K filed on April 2, 2001.                                                       
|   
|(8) | Incorporated by reference to our Report on
    Form 10-Q filed on May 15, 2001.                                                        
|   
|(9) | Incorporated by reference to our Report on
    Form 10-Q filed on April 1, 2002.                                                       



|     |                                                                                
|---- | -------------------------------------------------------------------------------
|(10) | Incorporated by reference to our Report on
    Form 10-Q filed on May 15, 2002.

107



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##### Table of Contents






SCHEDULE
II     VALUATION AND QUALIFYING
ACCOUNTS

|                             |                                                  |                |   |            |  |            |  |            |  |  |  |        |  |  |   |        | 
|---------------------------- | ------------------------------------------------ | -------------- | - | ---------- |  | ---------- |  | ---------- |  |  |  | ------ |  |  | - | ------ | 
|                             |                                                  |                |   | Additions  |  |            |  |           
|                             |                                                  | Balance at     |   | Charged to |  |            |  | Balance at
|                             |                                                  | Beginning      |   | Costs and  |  |            |  | End of    
|                             |                                                  | of Period      |   | Expenses   |  | Write-offs |  | Period    
|                             |                                                  |                |   |            |  |            |  |           
|                             |                                                  |               
|                             |                                                  | (in thousands)
|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 and lower of cost or market reserve |                | $ | 3,212      |  |            |  | 13,914     |  |  |  | 803    |  |  | $ | 16,323 | 
|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 and lower of cost or market reserve |                | $ | 16,323     |  |            |  | 24,670     |  |  |  | 3,812  |  |  | $ | 37,181 | 
|Year ended December 31, 2002 |                                                  |                |   |            |  |            |  |            |  |  |  |        |  |  |   |       
|                             | Allowance for doubtful accounts                  |                | $ | 7,207      |  |            |  | 1,090      |  |  |  | 4,778  |  |  | $ | 3,519  | 
|                             | Warranty reserve                                 |                | $ | 8,368      |  |            |  | 2,730      |  |  |  | 2,491  |  |  | $ | 8,607  | 
|                             | Obsolescence and lower of cost or market reserve |                | $ | 37,181     |  |            |  | 4,336      |  |  |  | 16,044 |  |  | $ | 25,473 | 

108



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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 27th day of March, 2003.



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



| |     |                   
| | --- | ------------------
| | BY: | /s/ DR. ZAKI RAKIB

| |                        
| | -----------------------
| |                        
| | Dr. Zaki Rakib         
| | Chief Executive Officer

Each person whose signature appears below
constitutes Dr. Zaki Rakib, Shlomo Rakib and Arthur Taylor
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 27, 2003
|                                                
|/s/ ARTHUR T. TAYLORArthur T. Taylor             |  | Chief Financial Officer (Principal Financial and
    Accounting Officer) |  | March 27, 2003
|                                                
|/s/ SHLOMO RAKIBShlomo Rakib                     |  | President and Chairman of the Board of Directors                         |  | March 27, 2003
|                                                
|/s/ CHRISTOPHER J. SCHAEPEChristopher J. Schaepe |  | Director                                                                 |  | March 27, 2003
|                                                
|/s/ LEWIS SOLOMONLewis Solomon                   |  | Director                                                                 |  | March 27, 2003
|                                                
|/s/ ALEK KRSTAJICAlek Krstajic                   |  | Director                                                                 |  | March 27, 2003
|                                                
|/s/ DAVID WOODROWDavid Woodrow                   |  | Director                                                                 |  | March 27, 2003

109



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##### Table of Contents



Terayon Communication Systems, Inc.

Certification:

I, Zaki Rakib, Chief Executive Officer, certify
that:



| |                                                                                                                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. I have reviewed this annual report on
    Form 10-K of Terayon Communication Systems, Inc.;                                                                                                                                                                                                                                                 
|
| | 2. Based on my knowledge, this annual report
    does not contain any untrue statement of a material fact or omit
    to state a material fact necessary to make the statements made,
    in light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|
| | 3. Based on my knowledge, the financial
    statements, and other financial information included in this
    annual report, fairly present in all material respects the
    financial condition, results of operations and cash flows of the
    registrant as of, and for, the periods presented in this annual
    report;                   
|
| | 4. The registrants other certifying
    officers and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and we have:                                                                                                       



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



| |                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5. The registrants other certifying
    officers and I have disclosed, based on our most recent
    evaluation, to the registrants auditors and the audit
    committee of registrants board of directors (or persons
    performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    



| |                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6. The registrants other certifying
    officers and I have indicated in this annual report whether or
    not there were significant changes in internal controls or in
    other factors that could significantly affect internal controls
    subsequent to the date of our most recent evaluation, including
    any corrective actions with regard to significant deficiencies
    and material weaknesses.



| |     |               
| | --- | --------------
| | By: | /s/ ZAKI RAKIB

| |                        
| | -----------------------
| |                        
| | Zaki Rakib             
| | Chief Executive Officer

Date: March 27, 2003

110



---



##### Table of Contents



Terayon Communication Systems, Inc.

Certification:

I, Arthur T. Taylor, Chief Financial Officer,
certify that:



| |                                                                                                                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. I have reviewed this annual report on
    Form 10-K of Terayon Communication Systems, Inc.;                                                                                                                                                                                                                                                 
|
| | 2. Based on my knowledge, this annual report
    does not contain any untrue statement of a material fact or omit
    to state a material fact necessary to make the statements made,
    in light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|
| | 3. Based on my knowledge, the financial
    statements, and other financial information included in this
    annual report, fairly present in all material respects the
    financial condition, results of operations and cash flows of the
    registrant as of, and for, the periods presented in this annual
    report;                   
|
| | 4. The registrants other certifying
    officers and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and we have:                                                                                                       



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | d) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | e) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | f) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



| |                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5. The registrants other certifying
    officers and I have disclosed, based on our most recent
    evaluation, to the registrants auditors and the audit
    committee of registrants board of directors (or persons
    performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    



| |                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6. The registrants other certifying
    officers and I have indicated in this annual report whether or
    not there were significant changes in internal controls or in
    other factors that could significantly affect internal controls
    subsequent to the date of our most recent evaluation, including
    any corrective actions with regard to significant deficiencies
    and material weaknesses.



| |     |                     
| | --- | --------------------
| | By: | /s/ ARTHUR T. TAYLOR

| |                        
| | -----------------------
| |                        
| | Arthur T. Taylor       
| | Chief Financial Officer

Date: March 27, 2003

111



---



##### Table of Contents






EXHIBIT INDEX

|        |    |                     |  |                                                                                                                                                                                                
|------- | -- | ------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |                    
|Number  |    | Exhibit Description
|        |    |                    
|        | 3  | .1                  |  | Amended and Restated Certificate of Incorporation
    of Terayon Communication Systems, Inc.(1)                                                                                                
|        | 3  | .2                  |  | Bylaws of Terayon Communication Systems, Inc.(1)                                                                                                                                               
|        | 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.(7)                                                                                                            
|        | 4  | .1                  |  | Specimen Common Stock Certificate.(2)                                                                                                                                                          
|        | 4  | .2                  |  | Amended and Restated Information and Registration
    Rights Agreement dated April 6, 1998.(1)                                                                                                 
|        | 4  | .3                  |  | Form of Security for Terayon Communication
    Systems, Inc.s 5% Convertible Subordinated Notes due
    August 1, 2007.(5)                                                                    
|        | 4  | .4                  |  | Registration Rights Agreement by and among
    Terayon Communication Systems, Inc. and Deutsche Bank
    Securities, Inc. and Lehman Brothers, Inc.(5)                                         
|        | 4  | .5                  |  | Indenture between Terayon Communication Systems,
    Inc. and State Street Bank and Trust Company of California, N.A.
    dated July 26, 2000.(5)                                              
|        | 4  | .6                  |  | Rights Agreement between Terayon Communication
    Systems, Inc. and Fleet National Bank dated February 6,
    2001.(6)                                                                        
|        | 10 | .1                  |  | Form of Indemnity Agreement between Terayon
    Communication Systems, Inc. and each of its directors and
    officers.(1)                                                                     
|        | 10 | .2                  |  | 1995 Stock Option Plan, as amended on
    March 26, 1996.(1)                                                                                                                                   
|        | 10 | .3                  |  | 1997 Equity Incentive Plan, as amended on
    July 31, 2000.(9)                                                                                                                                
|        | 10 | .4                  |  | 1998 Employee Stock Purchase Plan, as amended on
    May 22, 2002.(7)                                                                                                                          
|        | 10 | .5                  |  | 1998 Non-Employee Directors Stock Option Plan as
    amended on May 22, 2002. (1)                                                                                                              
|        | 10 | .6                  |  | 1998 Employee Stock Purchase Plan Offering for
    Foreign Employees, adopted July 31, 2000.(7)                                                                                                
|        | 10 | .7                  |  | Anti-Dilution Warrant to Purchase Shares of
    Common Stock dated April 6, 1998 issued to Shaw
    Communications Inc.(1)                                                                     
|        | 10 | .8                  |  | Lease Agreement dated April 20, 1998 between
    Imedia Corporation and Martin CL Associate, L.P.(3)                                                                                           
|        | 10 | .9                  |  | Sublease Agreement dated November 15, 1999
    between Imedia Corporation and ISP Channel, Inc.(3)                                                                                             
|        | 10 | .10                 |  | 1999 Non-Officer Equity Incentive Plan, as
    amended February 14, 2001.(7)                                                                                                                   
|        | 10 | .11                 |  | Form of Non-Statutory Stock Option Agreement Used
    in Connection with the 1999 Non-Officer Equity Incentive Plan.(4)                                                                        
|        | 10 | .12                 |  | Azrieli Center Offices Lease Agreement, dated
    January 23, 2002, between Canit HaShalom Investments Ltd.
    and Terayon Communication Systems, Inc.(9)                                     
|        | 10 | .13                 |  | Azrieli Center Agreement to Transfer Lease Rights
    dated 23rd day of January, 2000                                                                                                          
|        | 10 | .14                 |  | Employment Agreement, between Terayon
    Communication Systems, Inc. and Zaki Rakib dated February
    1993.(1)                                                                               
|        | 10 | .15                 |  | Data Over Cable Service Interface Specifications
    License Agreement, dated December 21, 2001, between Terayon
    Communication Systems, Inc. and Cable Television Laboratories,
    Inc.(9)
|        | 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.(9)                 
|        | 10 | .17                 |  | Data Over Cable Service Interface Specifications
    License Agreement, dated December 21, 2001, between Imedia
    Semiconductor Corporation and Cable Television Laboratories,
    Inc.(9)   
|        | 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.(9)                    
|        | 10 | .19                 |  | Lease Agreement, dated September 18, 1996,
    between Sobrato Interests III and VeriFone.(10)                                                                                                 
|        | 10 | .20                 |  | Sublease, dated April 1, 2002, by and
    between Terayon Communication Systems, Inc. and Hewlett-Packard
    Company.(10)                                                                     



---



##### Table of Contents



|        |    |                     |  |                                                                                                                                                          
|------- | -- | ------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |                    
|Number  |    | Exhibit Description
|        |    |                    
|        | 10 | .21                 |  | Aircraft Lease Agreement, dated February 8,
    2002, between Terayon Communication Systems, Inc. and General
    Electric Capital Corporation.          
|        | 10 | .22                 |  | Letter of Credit Agreement, dated
    February 8, 2002, between Terayon Communication Systems,
    Inc. and General Electric Capital Corporation.        
|        | 10 | .23                 |  | Employment Agreement, dated January 24,
    2003, between Terayon Communication Systems, Inc. and
    Arthur T. Taylor.                                  
|        | 21 | .1                  |  | List of Subsidiaries.                                                                                                                                    
|        | 23 | .1                  |  | Consent of Ernst & Young LLP Independent
    Auditors.                                                                                                   
|        | 24 | .1                  |  | Power of Attorney (see page 106 of this
    Annual Report Form 10-K)                                                                                     
|        | 99 | .1                  |  | Chief Executive Officers Certification
    Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
    Section 906 of The Sarbanes-Oxley Act of 2002.
|        | 99 | .2                  |  | Chief Financial Officers Certification
    Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
    Section 906 of The Sarbanes-Oxley Act of 2002.



---



|    |                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference to exhibits to our
    Registration Statement on Form S-1 filed on June 16,
    1998 (File No. 333-56911).  
|   
|(2) | Incorporated by reference to exhibits to our
    Registration Statement on Form S-1/A filed on July 31,
    1998 (File No. 333-69699).
|   
|(3) | Incorporated by reference to our Report on
    Form 10-Q filed on November 15, 1999.                                                  
|   
|(4) | Incorporated by reference to our Registration
    Statement on Form S-8 filed on December 29, 1999.                                   
|   
|(5) | Incorporated by reference to our Registration
    Statement on Form S-3 filed on October 24, 2000 (File
    No. 333-48536).           
|   
|(6) | Incorporated by reference to our Report on
    Form 8-K filed on February 9, 2001.                                                    
|   
|(7) | Incorporated by reference to our Report on
    Form 10-K filed on April 2, 2001.                                                      
|   
|(8) | Incorporated by reference to our Report on
    Form 10-Q filed on May 15, 2001.                                                       
|   
|(9) | Incorporated by reference to our Report on
    Form 10-Q filed on April 1, 2002.                                                      



|     |                                                                                
|---- | -------------------------------------------------------------------------------
|(10) | Incorporated by reference to our Report on
    Form 10-Q filed on May 15, 2002.