**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **WASHINGTON,
        D.C. 20549**
  
  FORM
        10-Q
  x**QUARTERLY
        REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
        1934**
  FOR
        THE QUARTERLY PERIOD ENDED DECEMBER 31,
        2005
  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 000-27427**
 **ALTIGEN
        COMMUNICATIONS, INC.**
 (Exact
        name of Registrant as specified in its charter)
 
 **DELAWARE**
              
              **94-3204299**(State
                  or other jurisdiction of
                incorporation
                  or organization)
              
              (I.R.S.
                  Employer
                Identification
                  Number)**4555
                  Cushing Parkway**
                **Fremont,
                  CA**
              
              **94538**(Address
                  of principal executive offices)
              
              (Zip
                  Code)Registrant’s
                  telephone number, including area code:**(510)
                  252-9712**
 Former
        name, former address and former fiscal year, if changed since last report:
        N/A
  Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days.   YES x NO o
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange
        Act.  Large accelerated filer o Accelerated filer o Non-accelerated filer x
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act).    Yes  ̈ No x
 
 The
        number of shares of our common stock outstanding as of February 14, 2006
        was:
        14,935,587 shares
  
 
 
 **Table
        of Contents**
 
 **PART
                  I. FINANCIAL INFORMATION**Item
                  1.
              Financial
                  Statements:Balance
                  Sheets as of December 31, 2005 and September 30, 2005
              3Statements
                  of Operations for the Three Months Ended December 31, 2005 and
                  2004
              4Statements
                  of Cash Flows for the Three Months Ended December 31, 2005 and
                  2004
              5Notes
                  to Financial Statements
              6Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              13Item
                  3.
              Quantitative
                  and Qualitative Disclosures about Market Risk
              25Item
                  4.
              Controls
                  and Procedures
              25**PART
                  II. OTHER INFORMATION**Item
                  1.
              Legal
                  Proceedings
              26Item
                  1A.
              Risk
                  Factors
              19Item
                  2.
              Unregistered
                  Sales of Equity Securities and Use of Proceeds
              26Item
                  3.
              Defaults
                  Upon Senior Securities
              26Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              26Item
                  5
              Other
                  Information
              26Item
                  6.
              Exhibits
              26**SIGNATURE**
              27**EXHIBIT
                  INDEX**
              28
 2
  **PART
        I. FINANCIAL INFORMATION**
  **Item
                  1.**
              **Financial
                  Statements**
 
 **ALTIGEN
        COMMUNICATIONS, INC. AND SUBSIDIARY**
 **UNAUDITED
        CONDENSED CONSOLIDATED BALANCE SHEETS**
 **(in
        thousands, except share and per share amounts)**
 
 **December
                  31,**
                **2005**
              
              **September
                  30,**
                **2005****ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              $
              4,896
              
              $
              3,963Short-term
                  investments
              
              
              4,364
              
              
              5,459Accounts
                  receivable, net of allowances of $74 and $40 at December 31, 2005
                  and
                September
                  30, 2005, respectively
              
              
              2,196
              
              
              1,957Inventories
              
              
              1,303
              
              
              965Prepaid
                  expenses and other current assets
              
              
              178
              
              
              148Total
                  current assets
              
              
              12,937
              
              
              12,492Property
                  and equipment:Furniture
                  and equipment
              
              
              1,533
              
              
              1,405Computer
                  software
              
              
              920
              
              
              9202,453
              
              
              2,325Less:
                  Accumulated depreciation and amortization
              
              
              (1,853
              )
              
              (1,803
              )Net
                  property and equipment
              
              
              600
              
              
              522Other
                  non-current assets:Long-term
                  investments
              
              
              238
              
              
              247Long-term
                  deposit
              
              
              74
              
              
              74Total
                  other non-current assets
              
              
              312
              
              
              321Total
                  assets
              
              $
              13,849
              
              $
              13,335**LIABILITIES
                  AND STOCKHOLDERS’ EQUITY**Current
                  liabilities:Accounts
                  payable
              
              $
              1,067
              
              $
              653Accrued
                  liabilities:Payroll
                  and related benefits
              
              
              360
              
              
              317Warranty
                  (Note 2)
              
              
              252
              
              
              264Marketing
              
              
              64
              
              
              58Accrued
                  expense
              
              
              261
              
              
              272Other
              
              
              328
              
              
              288Deferred
                  revenue
              
              
              403
              
              
              507Total
                  current liabilities
              
              
              2,735
              
              
              2,359Deferred
                  Rent
              
              
              239
              
              
              258Stockholders’
                  equity:Convertible
                  preferred stock, $0.001 par value; Authorized - 5,000,000 shares;
                Outstanding
                  - none at December 31, 2005 and September 30, 2005
              
              
              —
              
              
              —Common
                  stock, $0.001 par value; Authorized - 50,000,000 shares; Outstanding
                  -
                  15,968,146
                shares
                  at December 31, 2005 and 15,782,071 shares at September 30,
                  2005
              
              
              16
              
              
              16Treasury
                  stock at cost - 1,063,895 shares at December 31, 2005 and September
                  30,
                  2005
              
              
              (1,014
              )
              
              (1,014
              )Additional
                  paid-in capital
              
              
              63,240
              
              
              62,863Accumulated
                  other comprehensive loss
              
              
              (3
              )
              
              (1
              )Accumulated
                  deficit
              
              
              (51,364
              )
              
              (51,146
              )Total
                  stockholders’ equity
              
              
              10,875
              
              
              10,718Total
                  liabilities and stockholders’ equity
              
              $
              13,849
              
              $
              13,335
 
 The
        accompanying notes are an integral part of these unaudited condensed
        consolidated financial statements.
  3
 
 **ALTIGEN
        COMMUNICATIONS, INC. AND SUBSIDIARY**
 **UNAUDITED
        CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**
 **(in
        thousands, except per share amounts)**
 
 **Three
                  Months Ended**
                **December
                  31,****2005**
              
              **2004**Net
                  revenue:Hardware
              
              $
              4,109
              
              $
              3,564Software
              
              
              294
              
              
              711Total
                  net revenue
              
              
              4,403
              
              
              4,275Cost
                  of revenue:Hardware
              
              
              1,997
              
              
              1,615Software
              
              
              21
              
              
              52Total
                  cost of revenue
              
              
              2,018
              
              
              1,667Gross
                  profit
              
              
              2,385
              
              
              2,608Operating
                  expenses:Research
                  and development*
              
              
              1,027
              
              
              822Sales
                  and marketing*
              
              
              1,091
              
              
              1,001General
                  and administrative*
              
              
              558
              
              
              475Total
                  operating expenses
              
              
              2,676
              
              
              2,298Income
                  (loss) from operations
              
              
              (291
              )
              
              310Equity
                  in net loss of investee
              
              
              (10
              )
              
              —Interest
                  and other income, net
              
              
              83
              
              
              42Net
                  income (loss) before tax
              
              
              (218
              )
              
              352Income
                  taxes
              
              
              —
              
              
              10Net
                  income (loss)
              
              $
              (218
              )
              $
              342Basic
                  and diluted net (loss) income per share
              
              $
              (0.01
              )
              $
              0.02Weighted
                  average shares used in computing basic net income (loss) per
                  share
              
              
              14,842
              
              
              14,459Weighted
                  average shares used in computing diluted net income (loss) per
                  share
              
              
              14,842
              
              
              15,797
 **________**
 
 *  Commencing
        October 1, 2005 we adopted the provisions of Statement of Financial Accounting
        Standard (“SFAS”) No. 123(R), “Share Based Payment” (“SFAS No. 123(R)”), which
        requires all share-based payments, including grants of stock options, to
        be
        recognized in the income statement as an operating expense, based on their
        fair
        values. For the three months ended December 31, 2005, stock compensation
        was
        accounted under SFAS No. 123(R) while for the three months ended December
        31,
        2004, stock compensation was accounted under Accounting Principles Board
        (APB),
        opinion No. 25 APB (25).
 
 The
        following table summarizes the total stock-based compensation expense for
        the
        three months ended December 31, 2005 and is included in the Unaudited Condensed
        Consolidated Statements of Operations:
 
 **Three
                  Months Ended**
                **December
                  31,****2005**Cost
                  of goods sold
              
              $
              12Research
                  and development
              
              
              100Selling,
                  general and administrative
              
              
              148Pre-tax
                  stock-based compensation expense
              
              
              260Income
                  tax
              
              
              —Net
                  stock-based compensation expense
              
              $
              260
 
 The
        accompanying notes are an integral part of these unaudited condensed
        consolidated financial statements.
  4
  **ALTIGEN
        COMMUNICATIONS, INC. AND SUBSIDIARY**
 **UNAUDITED
        CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(in
        thousands)**
 
 **Three
                  Months Ended December 31,****2005**
              
              **2004**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  income (loss)
              
              $
              (218
              )
              $
              342Adjustments
                  to reconcile net income (loss) to net cash used in operating
                  activities:Depreciation
              
              
              49
              
              
              22Stock based compensation
              
              
              260
              
              
              —Equity in net loss of investee
              
              
              9
              
              
              —Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              (239
              )
              
              (158
              )Inventories
              
              
              (338
              )
              
              168Prepaid
                  expenses and other current assets
              
              
              (30
              )
              
              (101
              )Accounts
                  payable
              
              
              414
              
              
              (74
              )Accrued
                  liabilities
              
              
              66
              
              
              (156
              )Deferred
                  revenue
              
              
              (104
              )
              
              (223
              )Deferred rent
              
              
              (19
              )
              
              (11
              )Net
                  cash used in operating activities
              
              
              (150
              )
              
              (191
              )CASH
                  FLOWS FROM INVESTING ACTIVITIES:Purchases
                  of short-term investments
              
              
              (5,369
              )
              
              (1,594
              )Proceeds
                  from sale of short-term investments
              
              
              6,462
              
              
              3,000Changes
                  in long-term investments
              
              
              —
              
              
              19Purchases
                  of property and equipment
              
              
              (127
              )
              
              (22
              )Net
                  cash provided by investing activities
              
              
              966
              
              
              1,403CASH
                  FLOWS FROM FINANCING ACTIVITIES:Proceeds
                  from issuances of common stock, net of issuance costs
              
              
              117
              
              
              174Net
                  cash provided by financing activities
              
              
              117
              
              
              174NET
                  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
              
              
              933
              
              
              1,386CASH
                  AND CASH EQUIVALENTS, BEGINNING OF PERIOD
              
              
              3,963
              
              
              5,367CASH
                  AND CASH EQUIVALENTS, END OF PERIOD
              
              $
              4,896
              
              $
              6,753SUPPLEMENTAL
                  DISCLOSURE OF CASH FLOW INFORMATION:Cash paid during the period for:Income
                  taxes
              
              $
              —
              
              $
              10
 
 The
        accompanying notes are an integral part of these unaudited condensed
        consolidated financial statements.
  5
  **ALTIGEN
        COMMUNICATIONS, INC. AND SUBSIDIARY**
 **NOTES
        TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
        STATEMENTS**
 
 **1.  SUMMARY
        OF SIGNIFICANT ACCOUNTING POLICIES**
 
 **BASIS
        OF PRESENTATION**
 
 AltiGen
        Communications, Inc. (“we or the Company”) is a pioneer and market leader in
        Internet protocol telephony systems for small-to-medium sized businesses.
        We
        design, manufacture and market next generation, Internet protocol phone systems
        and contact centers that use both the Internet and the public telephone network
        to take advantage of the convergence of voice and data communications. Unlike
        traditional proprietary phone systems, our systems are designed with open
        architecture and are built on an industry standard platform.  This
        adherence to industry standards allows our products to play an important
        role in
        the small-to-medium sized business market by delivering phone systems that
        can
        integrate with other technologies and provide integrated voice and data
        solutions.  We believe this enables our customers to implement
        communication systems that have an increased return versus past technology
        investments.
 
 The
        accompanying unaudited condensed consolidated financial statements have been
        prepared in conformity with generally accepted accounting principles for
        interim
        financial information and with the instructions for Form 10-Q and Article
        10 of
        Regulation S-X. Accordingly, certain information and footnote disclosures
        normally included in financial statements prepared in accordance with generally
        accepted accounting principles have been condensed, or omitted, pursuant
        to the
        rules and regulations of the Securities and Exchange Commission (SEC). These
        unaudited condensed consolidated financial statements reflect the operations
        of
        the Company and its wholly-owned subsidiary. All significant intercompany
        transactions and balances have been eliminated. In our opinion, these unaudited
        condensed consolidated financial statements include all adjustments necessary
        (which are of a normal and recurring nature) for a fair presentation of the
        Company’s financial position, results of operations and cash flows for the
        periods presented.
 
 These
        financial statements should be read in conjunction with our audited consolidated
        financial statements for the fiscal year ended September 30, 2005, included
        in
        the Company’s 2005 Annual Report on Form 10-K filed with the SEC on December 28,
        2005. AltiGen’s results of operations for any interim period are not necessarily
        indicative of the results of operations for any other interim period or for
        a
        full fiscal year.
 
 **CASH
        AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS**
 
 We
        consider all highly liquid investments with an original maturity of three
        months
        or less from the date of purchase to be cash equivalents. Short-term investments
        are in highly liquid financial instruments with original maturities greater
        than
        three-months but less than one year and are classified as “available-for-sale”
investments. Investments are reported at their fair value, with unrealized
        gains
        and losses excluded from earnings and reported as a separate component of
        stockholders’ equity.  As of December 31, 2005, our cash and cash
        equivalents consisted of commercial paper and cash deposited in checking
        and
        money market accounts. For the three months ended December 31, 2005 and 2004,
        we
        did not make any cash payments for interest or income taxes.
 
 Unrealized
        loss from short-term investments was $3,000 at December 31, 2005 and $1,000
        at
        September 30, 2005, respectively.
 
 **INVENTORIES**
 
 Inventories
        (which include costs associated with components assembled by third-party
        assembly manufacturers, as well as internal labor and allocable overhead)
        are
        stated at the lower of cost (which approximates actual cost on first-in,
        first-out method) or market. Provisions, when required, are made to reduce
        excess and obsolete inventories to their estimated net realizable values.
        We
        regularly monitor inventory quantities on hand and record a provision for
        excess
        and obsolete inventories based primarily on our estimated forecast of product
        demand and production requirements for the next six months. We did not record
        any provision for excess and obsolete inventories for the three months ended
        December 31, 2005 and 2004. The components of inventories include (in
        thousands):
 
 **December
                  31,**
                **2005**
              
              **September
                  30,**
                **2005**Raw
                  materials
              
              $
              261
              
              $
              144Work-in-progress
              
              
              122
              
              
              84Finished
                  goods
              
              
              920
              
              
              737$
              1,303
              
              $
              965
  6
  **LONG-TERM
        INVESTMENTS**
 
 As
        of
        December 31, 2005, we held an investment of common stock in a private Taiwanese
        telecommunication company valued at approximately $195,000 accounted for
        using
        the cost method.  Our interest in the company is approximately 2%,
        which interest does not allow us to exercise significant influence.
 
 In
        July
        2004, we purchased common stock of a private Korean telecommunications company
        for **** $ 79,000.
        As a result of this investment, we acquired approximately 23% of the voting
        power of the company and have the right to nominate and have elected one
        of the
        three members of the company's current board of directors.  We are
        accounting for this investment using the equity method and record our minority
        interest of their results in our results of operations. As of December 31,
        2005,
        our investment in the Korean company had a remaining book value of approximately
        $43,000.
 
 We
        perform a periodic review of our investments for impairment. Our investments
        are
        considered impaired when a review of the corporate operations and other
        indicators of impairment indicate that the carrying value of the investment
        is
        not likely to be recoverable. Such indicators include, but are not limited
        to,
        limited capital resources, limited prospects of receiving additional financing,
        and limited prospects for liquidity of the related securities. No write-downs
        were recorded as of December 31, 2005.
 
 **SOFTWARE
        DEVELOPMENT COST**
 
 In
        accordance with Statement of Financial Accounting Standards (“SFAS”)
        No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased,
        or Otherwise Marketed,” the Company capitalizes eligible computer software
        development costs upon the establishment of technological feasibility, which
        it
        has defined as completion of a working model. The amount of costs eligible
        for
        capitalization, after consideration of factors such as realizable value,
        were
        not material and, accordingly, all software development costs have been charged
        to research and development expense in the accompanying consolidated statements
        of operations.
 
 **REVENUE
        RECOGNITION**
 
 We
        account for the recognition of software license revenue in accordance with
        Statement of Position ("SOP") 97-2, "Software Revenue Recognition.” Revenue
        consist of sales to end-users, including resellers, and to distributors.
        Revenue
        from sales to end-users are recognized upon shipment, when risk of loss has
        passed to the customer, collection of the receivable is reasonably assured,
        persuasive evidence of an arrangement exits, and the price is fixed and
        determinable. Sales to distributors are made under terms allowing certain
        rights
        of return and protection against subsequent price declines on the Company's
        products held by its distributors. Upon termination, any unsold products
        may be
        returned by the distributor for a full refund. These agreements may be canceled
        by either party based on a specified notice. As a result of the above
        provisions, we defer recognition of distributor revenue until such distributors
        resell our products to their customers. The amounts deferred as a result
        of this
        policy are reflected as "deferred revenue" in the accompanying consolidated
        balance sheets. The related cost of revenue is also deferred and reported
        in the
        consolidated balance sheets as inventory.
 
 Software
        components are generally not sold separately from our hardware components.
        Software revenue consist of license revenue that are recognized upon the
        delivery of application products. We provide limited post-contract customer
        support ("PCS"), consisting primarily of technical support and "bug" fixes.
        In
        accordance with SOP 97-2, revenue earned on software arrangements involving
        multiple elements is allocated to each element based upon the relative fair
        values of the elements. Although we provide PCS, the revenue allocated to
        this
        element is recognized together with the initial licensing fee on delivery
        of the
        software because: (1) the PCS fee is included with the initial licensing
        fee; (2) the PCS included with the initial license fee is for one year or
        less; (3) the estimated cost of providing PCS during the arrangement is
        insignificant; and (4) unspecified upgrades/enhancements offered for
        minimal or no cost during PCS arrangements historically have been and are
        expected to continue to be minimal and infrequent. All estimated costs of
        providing the services, including upgrades and enhancements, are accrued
        for at
        the time of delivery.
 
 **STOCK-BASED
        COMPENSATION**
 
 Commencing
        October 1, 2005, we adopted the provisions of Statement of Financial Accounting
        Standard (“SFAS”) No. 123(R), “Share Based Payment” (“SFAS No. 123(R)”), which
        requires all share-based payments, including grants of stock options, to
        be
        recognized in the income statement as an operating expense, based on their
        fair
        values.
 
 Prior
        to
        adopting SFAS No. 123(R), we accounted for stock-based employee compensation
        under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock
        Issued to Employees,” and
        comply with the disclosure provisions of SFAS No. 123, as amended by SFAS
        No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosures.”
The Company has applied
        the modified prospective method in adopting SFAS No. 123(R). Accordingly,
        periods prior to adoption have not been restated.
 
 For
        the
        three months ended October 1, 2005, the adoption of SFAS No. 123(R) 1.31
        million
        of unvested stock options were outstanding.
  7
 
 The
        following table summarizes the total stock-based compensation expense for
        the
        three months ended December 31, 2005 and is included in the Unaudited Condensed
        Consolidated Statements of Operations:
 
 **Three
                  Months Ended**
                **December
                  31,****2005**Cost
                  of goods sold
              
              $
              12Research
                  and development
              
              
              100Selling,
                  general and administrative
              
              
              148Pre-tax
                  stock-based compensation expense
              
              
              260Income
                  tax
              
              
              —Net
                  stock-based compensation expense
              
              $
              260
 
 
 The
        following table illustrates the effect on net income and earnings per share
        if
        the fair value based method had been applied to the prior period.
 
 **Three
                  Months Ended**
                **December
                  31,****2004**Reported
                  net income
              
              $
              342Add:
                  stock-based employee compensation expense included in reported
                  net income
                  (loss) under APB No. 25
              
              
              —Deduct:
                  Total stock-based compensation determined under fair value based
                  method
                  prior to adoption of SFAS No. 123R , net of related tax
                  effects
              
              
              (396
              )Pro
                  forma net income (loss)
              
              
              (54
              )Basic
                  and diluted net (loss) per share:As
                  reported
              
              $
              0.02Pro
                  forma
              
              $
              (0.00
              )
 
 The
        fair
        value of each option grant during the three months ended December 31, 2005
        and
        December 31, 2004 was estimated at the date of grant using the Black-Scholes
        option pricing model, and is not subject to revaluation as a result of
        subsequent stock price fluctuations. The following weighted-average assumptions
        are used:
 **Employee
                  Stock Option Plan**
                **for
                  Three Months**
                **Ended
                  December 31,****2005**
              
              **2004**Expected
                  Life (in years)
              
              
              5
              
              
              5Risk-free
                  interest rate
              
              
              4.4
              %
              
              3.5
              %Volatility
              
              
              97
              %
              
              103
              %Expected
                  dividend
              
              
              0.0
              %
              
              0.0
              %
 
 The
        fair
        value of each purchase rights granted under the Company’s Employee Stock
        Purchase Plan during the three months ended December 31, 2005 and December
        31,
        2004 was estimated at the date of grant using the Black-Scholes option pricing
        model, and is not subject to revaluation as a result of subsequent stock
        price
        fluctuations. The following weighted-average assumptions are used:
 
 **Employee
                  Stock Purchase Plan**
                **for
                  Three Months**
                **Ended
                  December 31,****2005**
              
              **2004**Expected
                  Life (in years)
              
              
              0.5
              
              
              0.5Risk-free
                  interest rate
              
              
              4.3
              %
              
              2.5
              %Volatility
              
              
              98
              %
              
              102
              %Expected
                  dividend
              
              
              0.0
              %
              
              0.0
              %
 
 8
  The
        following table summarizes the Company’s stock option plan as of December 31,
        2005, and changes during the three months ended December 31, 2005:
 **Number
                    of**
                  **Shares**
                
                **Weighted-**
                  **average**
                  **Exercise Price**
                
                **Weighted-**
                  **average**
                  **Remaining**
                  **Contractual**
                  **Term**Outstanding
                    at October 1, 2005
                
                
                4,084,490
                
                $
                3.75Granted
                
                
                8,000
                
                
                1.93Exercised
                
                
                (141,809
                )
                
                0.81Forfeitures
                    and cancellations
                
                
                (169,365
                )
                
                5.36Outstanding
                    at December 31, 2005
                
                
                381,316
                
                $
                3.77
                
                
                6.23Vested
                    and expected to vest at December 31, 2005
                
                
                2,910,105
                
                $
                4.06Exercisable
                    at December 31, 2005
                
                
                2,910,105
                
                $
                4.06
  During
        the three months ended December 31, 2005, 2.9 million shares of options are
        exercisable with a weighted-average exercise price of $4.06. The
        weighted-average remaining contractual term for outstanding options at December
        31, 2005 was 6.2 years.
 
 As
        of
        December 31, 2005, approximately $831,000 represents the estimated forfeitures
        cost. This cost is to be recognized over a weighted average period of
        approximately 4 years.
 
 Under
        the
        1999 Employee Stock Purchase Plan (the “1999 Purchase Plan”), 875,038 shares of
        common stock are reserved for issuance at September 30, 2005 to eligible
        employees at a price of 85% of the lower of the fair market value of the
        common
        stock on the first day of the offering period or a specified exercise date
        (last
        trading day in April or October). During
        the three months ended December 31, 2005, 48,913 shares were purchased by
        and
        distributed to employees at a price of $1.31 per share.
 
 The
        Black-Scholes option pricing model was developed for use in estimating the
        fair
        value of traded options that have no vesting restrictions and are fully
        transferable. In addition, option pricing models require the input of highly
        subjective assumptions, including the expected stock price volatility. We
        use
        projected volatility rates, which are based upon historical volatility rates
        since our initial public offering, trended into future years. We also use
        historical data to estimate option forfeitures. Because our 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 our
        options.
  9
 
 **COMPUTATION
        OF BASIC AND DILUTED NET INCOME (LOSS) PER SHARE**
 
 Historical
        net income (loss) per share has been calculated under SFAS No. 128,
“Earnings per Share.” SFAS No. 128 requires companies to compute earnings
        per share under two methods (basic and diluted). Basic net income (loss)
        per
        share is calculated by dividing net income (loss) by the weighted average
        shares
        of common stock outstanding during the period. Diluted
        earnings per share reflects the potential dilution that could occur if
        securities or other contracts to issue common stock were exercised or converted
        into common stock. For
        the
        three months ended December 31, 2005, basic and diluted net loss per share
        numbers were identical as potential common shares resulting from the exercise
        of
        stock options were antidilutive.
 
 Basic
        and
        diluted income (loss) per share for each of the two quarters in the period
        ended
        December 31, 2005 are as follows (in thousands):
 
 **Three
                  Months**
                **Ended
                  December 31****,****2005**
              
              **2004**Reported
                  net income (loss)
              
              $
              (218
              )
              $
              342Computation
                  of common shares outstanding - basic (loss) income per share:
                Weighted average common stock
              
              
              14,842
              
              
              14,459Weighted
                  average dilutive potential shares
              
              
              —
              
              
              1,338Weighted
                  average shares used in computation of dilutive EPS
              
              
              14,842
              
              
              15,797Basic
                  net income (loss) per share
              
              $
              (0.01
              )
              $
              0.02Diluted
                  net income (loss) per share
              
              $
              (0.01
              )
              $
              0.02
   **COMPREHENSIVE
        INCOME**
 
 Comprehensive
        loss for the three months ended December 31, 2005 and 2004 was as follows,
        in
        thousands:
 
 **Three
                  Months Ended**
                **December
                  31,****2005**
              
              **2004**Net
                  income (loss)
              
              $
              (218
              )
              $
              342Unrealized
                  (loss ) gain
              
              
              (
                  3
              )
              
              —$
              (221
              )
              $
              342
  
 **SEGMENT
        REPORTING**
 
 We
        are
        organized and operate as one operating segment. We operate primarily in one
        geographic area, the Americas.
 
 Net
        revenue by geographic region based on customer location for the three months
        ended December 31, 2005 and 2004, respectively, were as follows:
 
 International
        is comprised of revenue primarily from China, the United Kingdom and Norway.
        All
        significant long-lived assets are located in the United States for all periods
        presented.
 
 Net
        Revenue by Geographic Area:
 
 **Three
                  Months Ended**
                **December
                  31,****2005**
              
              **2004**Americas
              
              
              91
              %
              
              85
              %International
              
              
              9
              %
              
              15
              %
  10
 
 Net
        revenue by customers that individually accounted for more than 10% of our
        revenue for the three months ended December 31, 2005 and 2004, respectively,
        were as follows:
 
 Net
        Revenue by Customers:
 
 **Three
                  Months Ended**
                **December
                  31,****2005**
              
              **2004**AltiSys
              
              
              17
              %
              
              10
              %Ingram
                  Micro*
              
              
              —
              
              
              7
              %Synnex
              
              
              56
              %
              
              49
              %Graybar
              
              
              13
              %
              
              10
              %
 
 * On
        July
        20, 2005, we terminated our distribution agreement with Ingram
        Micro.
 
 
 **2.
        WARRANTY**
 
 The
        Company provides a one year warranty for hardware products starting upon
        shipment to end users. We historically have experienced minimal warranty
        costs.
        Factors that affect our warranty liability include the number of installed
        units, historical experience and management's judgment regarding anticipated
        rates of warranty claims and cost per claim. We assess the adequacy of our
        recorded warranty liability every quarter and make adjustments to the liability
        if necessary.
  Changes
        in our warranty liability for the three months ended December 31, 2005 and
        2004,
        respectively, are as follows (in thousands):
 
 **Three
                  Months Ended December 31,****2005**
              
              **2004**Beginning
                  balance
              
              $
              264
              
              $
              424Provisions
                  for warranty liability
              
              
              23
              
              
              23Warranty
                  cost including labor, components and scrap
              
              
              (35
              )
              
              (40
              )Ending
                  balance
              
              $
              252
              
              $
              407
 11
  **3.  COMMITMENTS
        AND CONTINGENCIES**
 
 *Commitments*
 
 We
        lease
        our facilities under various operating lease agreements expiring on various
        dates through February 2009. In December 2003, we leased approximately
        32,000 square feet to serve as our headquarters for corporate administration,
        research and development, manufacturing, and sales and marketing facility
        in
        Fremont, California. The lease for our headquarters expires on February 21,
        2009. Rent expense for all operating leases totaled approximately $126,000
        for
        the three months ended December 31, 2005 and 2004. In addition, we lease
        certain
        equipment under capital lease arrangements. Minimum future lease payments
        under
        all noncancellable capital and operating leases as of December 31, 2005 are
        as
        follows (in thousands):
 
 Capital
              
              OperatingFiscal
                  Year Ending September 30,
              
              Leases
              
              LeasesRemainder
                  of 2006
              
              $
              40
              
              $
              2982007
              
              
              52
              
              
              3612008
              
              
              47
              
              
              2712009
              
              
              44
              
              
              922010
              
              
              33
              
              
              —Total
                  minimum lease payment
              
              $
              216
              
              $
              1,022Amount
                  representing interest
              
              $
              38Present
                  value of minimum lease payment
              
              
              178Total
                  minimum lease payment
              
              $
              216Current
                  portion plus current portion of interest
              
              $
              52Long-term
                  portion plus long-term portion of interest
              
              
              164Total
                  capital lease commitments
              
              $
              216
 
 
 *Contingencies*
 
 We
        may
        become party to litigation in the normal course of our business. Litigation
        in
        general, and intellectual property and securities litigation in particular,
        can
        be expensive and disruptive to normal business operations. Moreover, the
        results
        of complex litigation are difficult to predict.
  On
        September 6, 2002, Vertical Networks, Inc. filed suit against us in
        the United States District Court for the Northern District of California,
        alleging infringement of Vertical Networks’ U.S. Patents Nos. 6,266,341;
        6,289,025; 6,292,482; 6,389,009; and 6,396,849. On October 28, 2002,
        Vertical Networks amended its complaint to add allegations of infringement
        of
        U.S. Patents Nos. 5,617,418 and 5,687,174. Vertical Networks filed a second
        amended complaint on November 20, 2002 to identify our products and/or
        activities that allegedly infringe the seven patents-in-suit. Vertical Networks
        seeks a judgment of patent infringement and an award of damages, including
        treble damages for alleged willful infringement, and attorneys’ fees and costs.
        We filed an answer and counterclaims for declaratory relief on December 9,
        2002. On December 26, 2002, Vertical Networks filed its answer to our
        counterclaims. Vertical Networks served its preliminary infringement contentions
        on us on April 9, 2003 and we served Vertical Networks our preliminary
        invalidity contentions on June 3, 2003 and July 14, 2003. To date, the
        parties have exchanged some discovery, but no depositions have been taken,
        and
        no motions are currently pending. On October 7, 2003, the parties filed a
        stipulation to stay this action, pending the outcome of the reissue of some
        of
        the subject patents before the U.S. Patent and Trademark Office. We believe
        we
        have strong defenses and arguments in this dispute and intend to vigorously
        litigate our position. Management’s view is that any loss from this litigation
        is not probable or estimable. Therefore, we have not established a reserve
        on
        our balance sheets as to any liability related to the outcome of this
        action.
 12
  **Item
        2. Management’s Discussion and Analysis of Financial Condition and Results of
        Operations**
 
 **FORWARD-LOOKING
        INFORMATION**
 
 This
        report contains certain forward-looking statements (within the meaning of
        Section 27A of the Securities Act of 1933, as amended, and Section 21E
        of the Securities Exchange Act of 1934, as amended) and information relating
        to
        us that are based on the beliefs of our management as well as assumptions
        made
        by and information currently available to our management. Additional forward
        looking statements may be identified by the words "anticipate," "believe,"
        "expect," "intend," "plan," or the negative of such terms, or similar
        expressions, as they relate to us or our management.
 
 The
        forward-looking statements contained herein reflect our judgment as of the
        date
        of this report with respect to future events, the outcome of which is subject
        to
        certain risks that may have a significant impact on our business, operating
        results or financial condition. You are cautioned that these forward-looking
        statements are inherently uncertain. Should one or more of these risks or
        uncertainties materialize, or should underlying assumptions prove incorrect,
        actual results or outcomes may vary materially from those described herein.
        Although we believe that the expectations reflected in these forward-looking
        statements are reasonable, we cannot guarantee future results, levels of
        activity, performance or achievements. You should carefully review the
        cautionary statements contained in this Form 10-Q, including those found in
        "Certain Factors Affecting Business, Operating Results, and Financial Condition"
        below.
 
 **OVERVIEW**
 
 We
        are a
        pioneer and market leader in Internet protocol telephony systems for
        small-to-medium sized businesses. We design, manufacture and market next
        generation, Internet protocol phone systems and contact centers that use
        both
        the Internet and the public telephone network to take advantage of the
        convergence of voice and data communications. Unlike traditional proprietary
        phone systems, our systems are designed with open architecture and are built
        on
        an industry standard platform.  This adherence to industry standards
        allows our products to play an important role in the small-to-medium sized
        business market by delivering phone systems that can integrate with other
        technologies and provide integrated voice and data solutions.  We
        believe this enables our customers to implement communication systems that
        have
        an increased return versus past technology investments.  We generated
        net revenue of $4.4 million and $4.3 million for the three months ended December
        31, 2005 and 2004. As of December 31, 2005 we had an accumulated deficit
        of
        $51.4 million. Net cash used in operating activities was $150,000 for the
        three month ended December 31, 2005.
 
 We
        derive
        our revenue from sales of our AltiServ telephone systems. Product revenue
        consists of sales to end-users (including dealers) and to distributors. Revenue
        from product sales to end users and resellers are recognized upon shipment.
        We
        defer recognition of revenue for sales to distributors until they resell
        our
        products to their customers. Upon shipment, we also provide a reserve for
        the
        estimated cost that may be incurred for product warranty. Under our distribution
        contracts, a distributor has the right, in certain circumstances, to return
        products it determines are overstocked, so long as it provides an offsetting
        purchase order for products in an amount equal to or greater than the dollar
        value of the returned products. In addition, we provide distributors protection
        from subsequent price reductions.
 
 Our
        cost
        of revenue consists of component and material costs, direct labor costs,
        provisions for excess and obsolete inventory, warranty costs and overhead
        related to the manufacturing of our products. Several factors that have affected
        and will continue to affect our revenue growth are the state of economy,
        the
        market acceptance of our products, our ability to add new resellers and our
        ability to design, develop, and release new products. We engage third-party
        assemblers, which in fiscal year 2005 were All Quality Services and Bestronics
        in San Jose, to insert the hardware components into the printed circuit board.
        We selected our manufacturing partners with the goals of ensuring a reliable
        supply of high-quality finished products and lowering per unit product costs
        as
        a result of manufacturing economies of scale. We cannot assure you that we
        will
        maintain the volumes required realizing these economies of scale or when
        or if
        such cost reductions will occur. The failure to obtain such cost reductions
        could materially adversely affect our gross margins and operating results.
 
 We
        continue to focus on developing enhancements to our current products to provide
        greater functionality and increased capabilities, based on our market research,
        customer feedback and our competitors' product offerings and creating new
        product offerings. In particular, we focus (i) on developing products that
        allow
        us to enhance our position in our target market segment and (ii) entering
        new
        geographical markets. Additionally, we intend to continue to focus on selling
        our products to small-to-medium sized businesses and branch offices of larger
        corporations. Also, we plan to continue to recruit additional resellers and
        distributors that focus on selling phone systems to our target customers.
        We
        believe that the adoption rate for this Internet telephony  is
        much
        faster with small-to-medium sized businesses because they have no significant
        investment on their books for traditional phone systems. Also we believe
        that
        small-to-medium sized businesses are looking for call center-type administration
        to increase the productivity and efficiency of their contacts with customers.
        Assuming that current  market trends, including  the
        continuing acceptance of the call center products, continuing growth in the
        marketplaces of Asia, Latin America, Caribbean, and the status quo of the
        North
        American economy continues and that we are successful in enhancing our products,
        we expect to see continued revenue growth rate of at least 20% for fiscal
        year
        2006.
  13
  **CRITICAL
        ACCOUNTING POLICIES**
 
 *Revenue
        recognition.* Revenue
        consist of sales to end-users, including resellers, and to distributors.
        Revenue
        from sales to end-users are recognized upon shipment, when risk of loss has
        passed to the customer, collection of the receivable is reasonably assured,
        persuasive evidence of an arrangement exists, and the price is fixed and
        determinable. We provide for estimated sales returns and allowances and warranty
        costs related to such sales at the time of shipment. Net revenue consist
        of
        product revenue reduced by estimated sales returns and allowances. Sales
        to
        distributors are made under terms allowing certain rights of return and
        protection against subsequent price declines on our products held by its
        distributors. Upon termination, any unsold products may be returned by the
        distributor for a full refund. These agreements may be canceled without cause
        by
        either party following a specified notice period. As a result of the above
        provisions, we defer recognition of distributor revenue until such distributors
        resell our products to their customers. The amounts deferred as a result
        of this
        policy are reflected as “deferred revenue” in the accompanying consolidated
        balance sheets. The related cost of revenue is also deferred and reported
        in the
        consolidated balance sheets as inventory. Our total deferred revenue was
        $403,000 and $295,000 as of December 31, 2005 and December 31, 2004,
        respectively.
 
 Software
        components are generally not sold separately from our hardware components.
        Software revenues consist of license revenues that are recognized upon the
        delivery of application products. We provide limited post-contract customer
        support (“PCS”), consisting primarily of technical support and “bug” fixes. In
        accordance with SOP 97-2, revenue earned on software arrangements involving
        multiple elements is allocated to each element based upon the relative fair
        values of the elements. Although we provide PCS, the revenue allocated to
        this
        element is recognized together with the initial licensing fee on delivery
        of the
        software because: (1) the PCS fee is included with the initial licensing
        fee; (2) the PCS included with the initial license fee is for one year or
        less; (3) the estimated cost of providing PCS during the arrangement is
        insignificant; and (4) unspecified upgrades/enhancements offered for
        minimal or no cost during PCS arrangements historically have been and are
        expected to continue to be minimal and infrequent. All estimated costs of
        providing the services, including upgrades and enhancements are accrued for
        at
        the time of delivery.
 
 *Allowance
        for Doubtful Accounts.* The
        allowance for doubtful accounts is based on our assessment of the collectibility
        of specific customer accounts and the aging of the accounts receivable. If
        there
        were a deterioration of a major customer’s creditworthiness, or actual defaults
        were higher than our historical experience, we could be required to increase
        our
        allowance and our earnings could be adversely affected. Our allowance for
        doubtful accounts was $74,000 and $30,000 as of December 31, 2005 and 2004,
        respectively.
 
 *Inventory* .  Inventory
        is stated at the lower of cost (first-in, first-out method) or market. Our
        inventory balance was $1.3 million and $890,000 as of December 31, 2005 and
        December 31, 2004. We regularly review value of inventory in detail, with
        consideration given to future customer demand for our products, obsolescence
        from rapidly changing technology, and other factors. If actual market conditions
        are less favorable than those projected by management, and our estimates
        prove
        to be inaccurate, we could be required to increase our inventory provision
        and
        our gross margins could be adversely affected. As of December 2001, AltiGen
        had
        established a reserve to write off $3.5 million of excess inventory which
        management believed would not be sold.  During 2002 through 2005,
        AltiGen reversed a portion of the reserve related to inventory which was
        sold.  The amount of such reversals were $167,000, $293,000 and
        $401,000 in fiscal years ending 2005, 2004 and 2003, respectively.  Our
        inventory allowance was $2.4 million as of December 31, 2005.
 
 *Warranty.* We
        accrue for warranty costs based on estimated product return rates and the
        expected material and labor costs to provide warranty services. If actual
        return
        rates and repair and replacement costs differ significantly from our estimates,
        our gross margin could be adversely affected. The liability for product
        warranties was $252,000 and 407,000 as of December 31, 2005 and December
        31,
        2004, respectively.
  14
  **Results
        of Operations**
 
 The
        following table sets forth consolidated statements of operations data for
        the
        periods indicated as a percentage of net revenue.
 
 
 **Three
                  Months Ended**
                **December
                  31****2005**
              
              **2004**Consolidated
                  Statements of Operations Data:Net
                  revenue:Hardware
              
              
              93.3
              %
              
              83.4
              %Software
              
              
              6.7
              
              
              16.6Total
                  net revenue
              
              
              100.0
              
              
              100.0Cost
                  of revenue:Hardware
              
              
              45.3
              
              
              37.8Software
              
              
              0.5
              
              
              1.2Total
                  cost of revenue
              
              
              45.8
              
              
              39.0Gross
                  profit
              
              
              54.2
              
              
              61.0Operating
                  expenses:Research
                  and development
              
              
              23.3
              
              
              19.2Sales
                  and marketing
              
              
              24.8
              
              
              23.4General
                  and administrative
              
              
              12.7
              
              
              11.1Total
                  operating expenses
              
              
              60.8
              
              
              53.7Income
                  (loss) from operations
              
              
              (6.6
              )
              
              7.3Equity
                  in net loss of investee
              
              
              (0.2
              )
              
              —Interest
                  and other income, net
              
              
              1.9
              
              
              0.9Net
                  income (loss) before taxes
              
              
              (4.9
              )
              
              8.2Provision
                  for income taxes
              
              
              —
              
              
              0.2Net
                  income (loss)
              
              
              (4.9
              )%
              
              8.0
              %
 
 
 **Revenue,
        net** .
        Revenue
        consist of sales to end users (including resellers) and
        distributors.
 
 International
        is comprised of revenue primarily from China, the United Kingdom and Norway.
        All
        significant long-lived assets are located in the United States for all periods
        presented.
  Net
        Revenue by Geographic Area:
 
 **Three
                  Months Ended**
                **December
                  31,****2005**
              
              **2004**Americas
              
              
              91
              %
              
              85
              %International
              
              
              9
              %
              
              15
              %
  15
 
 Net
        revenue by customers that individually accounted for more than 10% of our
        revenue for the three months ended December 31, 2005 and 2004, respectively,
        were as follows:
 
 Net
        Revenue by Customers:
 
 **Three
                  Months Ended**
                **December
                  31,****2005**
              
              **2004**AltiSys
              
              
              17
              %
              
              10
              %Ingram
                  Micro*
              
              
              —
              
              
              7
              %Synnex
              
              
              56
              %
              
              49
              %Graybar
              
              
              13
              %
              
              10
              %
 
 * On
        July
        20, 2005, we terminated our distribution agreement with Ingram
        Micro.
 
 Revenue
        generated in the Americas accounted for $4.0 million or 91% of revenue for
        the three months ended December 31, 2005 and $3.6 million or 85% of revenue
        for the three months ended December 31, 2004, however this increase was offset
        by a 35% or $221,000 drop in International revenue in that same period. Net
        revenue increased 3% to $4.4 million for the three months ended December
        31, 2005 from $4.3 million for the three months ended December 31, 2004.
        This was largely attributable to increased sales in telephone systems in
        the
        Americas as a result of increasing our market presence through better performing
        resellers, and selling more products into the call center market space.
 
 Although
        a net profit was generated in the first quarter of fiscal 2006, due to the
        adoption of SFAS No. 123(R) we recognized $260,000 of non-cash stock based
        compensation and as a result we incurred a net loss of $218,000 for the three
        months ended December 31, 2005.
 
 **Cost
        of revenue.** Cost
        of revenue for the three months ended December 31, 2005 increased $351,000
        or
        21% to $2.0 million from approximately $1.7 million for the three
        months ended December 31, 2004 primarily due to an increase in overall sale
        of
        products and the requisite increase in product costs. Cost of revenues as
        a
        percentage of net revenue increased from 39% in the three months ended December
        31, 2004 to 46% in the three months ended December 31, 2005. This increase
        was
        attributable to lower profit margin as a result of a price reduction on our
        low-end product bundles in the second quarter of fiscal year 2005. No additional
        provision for excess or obsolete inventory was necessary in the three months
        ended December 31, 2005.
 
 **Research
        and development expenses.** Research
        and development expenses consist principally of costs related to salaries
        and
        related personnel expenses, consultant fees and prototype expenses related
        to
        the design, development and testing of our products and enhancement of our
        converged telephone system software. Research and development expenses increased
        by approximately $205,000 or 25% from $0.8 million in the three month ended
        December 31, 2004 to $1.0 million in the three month ended December 31, 2005.
        Research and development expenses as a percentage of revenue increased from
        19%
        in the three months ended December 31, 2004 to 23% in the three month ended
        December 31, 2005. The increase in research and development was a result
        of
        increases in equipment expenses of approximately $10,000; depreciation expense
        of approximately $12,000; consultant fees of approximately $8,000; project
        material expenses of approximately $45,000 and legal expenses of approximately
        $8,000. Additionally, we recognized $100,000 of non-cash stock based
        compensation expense required by SFAS No. 123(R). Management intends
        to continue to monitor and focus on cost control in order to keep expenses
        in
        line with revenue opportunities.
  **Sales
        and marketing expenses.** Sales
        and marketing expenses consist primarily of salaries, commissions and related
        expenses for personnel engaged in marketing, sales and customer support
        functions, as well as trade shows, advertising, and promotional expenses.
        Sales
        and marketing expenses for the three months ended December 31, 2005 were
        $1.1
        million compared to $1.0 million for the three months ended December 31,
        2004.
        Sales and marketing expenses as a percentage of revenue were 25% and 23%
        for the
        three month ended December 31, 2005 and 2004, respectively. This increase
        was
        primarily attributable to non-cash stock based compensation recorded due
        to the
        adoption of SFAS No. 123(R) of approximately $63,000 as well as a $22,000
        increase due a national partner conference. We expect sales and marketing
        expenses to remain relatively flat due to the uncertainty about customers'
        spending patterns in the current economic environment; however, some expenses
        vary with revenue, such as commissions, which move with sales of our products.
 
 **General
        and administrative expenses.** General
        and administrative expenses consist of salaries and related expenses for
        executive, finance and administrative personnel, facilities, allowance for
        doubtful accounts, legal, and other general corporate expenses. General and
        administrative expenses were $558,000 for the three months ended December
        31,
        2005 and $0.4 million for the three months ended December 31, 2004. This
        increase was mainly the result of a $85,000 non-cash stock based compensation
        expense required by SFAS No. 123(R). General and administrative expenses
        as a
        percentage of revenue were 13% and 11% for the three months ended December
        31,
        2005 and 2004, respectively. We expect general and administrative expenses
        to
        increase due to the cost associated with compliance with Section 404 of the
        Sarbanes-Oxley Act during fiscal year 2007.
  16
  **Equity
        in net loss of investee** .  In
        July
        2004, we purchased common stock of a private Korean telecommunications company
        for **$** 79,000.
        As a result of this investment, we acquired approximately 23% of the voting
        power of the company and have the right to nominate and have elected one
        of the
        three members of the company's current board of directors.  We are
        accounting for this investment using the equity method. The
        total
        equity in net losses of Korea investee was approximately $43,000 of which
        23%,
        or $9,000, is recognized in the three months ended December 31,
        2005.
  **Interest
        and other income, net.** Net
        interest and other income increased to $83,000 for the three months ended
        December 31, 2005 from $42,000 for the three months ended December 31, 2004. The
        increase in net interest and other income for the three months ended December
        31, 2005 was primarily a result of higher interest rates .
        We
        expect net interest and other income to remain relatively flat with little
        change in cash available to invest.
 
 **Liquidity
        and Capital Resources**
 
 Since
        inception, we have financed our operations primarily through the sale of
        equity
        securities. As of December 31, 2005, we had cash and short-term investments
        totaling $9.3 million consisting of cash and cash equivalents of
        $4.9 million and $4.4 million of short-term investment with a maturity
        of greater than 90 days.
 
 **Three
                  Months Ended**
                **December
                  31,****2005**
              
              **2004****(dollars
                  in thousands)**Cash
                  and cash equivalents
              
              $
                  4,896
              
              $
                  6,753Short-term
                  investments
              
              
              4,364
              
              
              3,261Total
                  cash, cash equivalents and short-term investments
              
              $
              9,260
              
              $
              10,014Cash
                  used in operating activities
              
              $
              (150
              )
              $
              (191
              )Cash
                  provided by (used in) investing activities
              
              $
              966
              
              $
              1,403Cash
                  provided by financing activities
              
              $
              117
              
              $
              174Net
                  increase in cash and cash equivalents
              
              $
              933
              
              $
              1,386
 
 *Changes
        in Cash Flows*
 
 During
        the three months ended December 31, 2005, net cash used in operating activities
        was $150,000, which was approximately $41,000 lower than the cash used in
        operating activities during the same period of fiscal 2005. The decrease
        was
        primarily attributable to a net profit (prior to “SFAS
        No.
        123(R) allocation) being generated in the
        first quarter of fiscal 2006. For the three months ended December 31, 2005,
        net
        cash provided by non-operating activities was $966,000, which was primarily
        attributable to proceeds from maturities of short-term investments.
 
 Net
        accounts receivable increased to $2.2 million at December 31, 2005 from
        $2.0 million at September 30, 2005. The increase in net accounts receivable
        was primarily due to increases in revenue and an increase in days sales
        outstanding (DSO) at 45 days as of December 31, 2005 from 42 as of September
        30,
        2005.
 
 We
        ended
        the first quarter of fiscal 2006 with a cash conversion cycle of 55 days
        as
        compared to 51 days for the first quarter of fiscal 2005. The cash conversion
        cycle is the duration between purchase of inventories and services and the
        collection of the cash from the sale of our products and services and is
        a
        metric on which we have focused as we continue to try to efficiently manage
        our
        assets. The cash conversion cycle results from the calculation of days of
        sales
        outstanding (DSO) added to days of supply in inventories (DOS), reduced by
        days
        of payable outstanding (DPO).
  Inventories
        increased to $1.3 million at December 31, 2005 from $965,000 at
        September 30, 2005 and our inventory turn rate increased to 6.2 at December
        31, 2005 from 7.3 at September 30, 2005. Our annualized inventory turn rate
        represents the number of times inventory is replenished during the year.
        Inventory management will continue to be an area of focus as we balance the
        need
        to maintain strategic inventory levels to help ensure competitive lead times
        with the risk of inventory obsolescence due to rapidly changing technology
        and
        customer requirements.
  17
  Accounts
        payable increased to $1.1 million at December 31, 2005 from $653,000 at
        September 30, 2005. This
        increase to accounts payable during this period was primarily attributable
        to an
        increase of products purchased in the first quarter of fiscal 2006. Accrued
        pa yroll-related
        liabilities increased to $360,000 at December 31, 2005 from $317,000 at
        September 30, 2005, primarily as a result of an increase of $17,000 in
        commissions and $25,000 increase in employee stock purchase plan
        contribution.
 
 During
        the three months ended December 31, 2005, our net cash provided by financing
        activities was $117,000 which was related to the proceeds from the exercise
        of
        employee stock option and stock purchases through our employee stock purchase
        plan.
  *Liquidity
        and Capital Resources*
 
 We
        intend
        to invest our cash in excess of current operating requirements in short-term,
        interest bearing investment-grade securities.
 
 Our
        cash
        needs depend on numerous factors, including market acceptance of and demand
        for
        our products, our ability to develop and introduce new products and enhancements
        to existing products, the prices at which we can sell our products, the
        resources we devote to developing, marketing, selling and supporting our
        products, the timing and expense associated with expanding our distribution
        channels, increases in manufacturing costs and the prices of the components
        we
        purchase, as well as other factors. If we need and are unable to raise
        additional capital or if sales from our new products or enhancements are
        lower
        than expected, we will be required to make additional reductions in operating
        expenses and capital expenditures to ensure that we will have adequate cash
        reserves to fund operations.
 
 Additional
        financing, if required, may not be available on acceptable terms, or at all.
        We
        also may require additional capital to acquire or invest in complementary
        businesses or products, or obtain the right to use complementary technologies.
        If we cannot raise needed funds in the future if needed, on acceptable terms,
        we
        may not be able to further develop or enhance our products, take advantage
        of
        opportunities, or respond to competitive pressures or unanticipated
        requirements, which could seriously harm our business. Even if additional
        financing is available, we may be required to obtain the consent of our
        stockholders, which we may or may not be able to obtain. In addition, the
        issuance of equity or equity-related securities will dilute the ownership
        interest of our stockholders and the issuance of debt securities could increase
        the risk or perceived risk of investing in our securities.
 
 We
        do not
        have any material commitments for capital expenditures as of December 31,
        2005.
        We have a commitment under our noncancellable capital and operating lease
        in the
        amount of $1.2 million as of December 31, 2005. We believe, we have
        sufficient cash reserves to allow us to continue operations for more than
        a year
        assuming our quarterly cash usage rate does not deteriorate over that period.
        Our cash and short-term investments totaled $9.3 million as of December 31,
        2005. The following table represents our future commitments as of December
        31,
        2005 (in thousands):
 
 Payment
                  Due by PeriodContractual
                  Obligations
              
              Total
              
              Less
                  than
                1
                  Year
              
              1
                  -
                  3 Years
              
              3
                  -
                  5 Years
              
              More
                  than
                5
                  YearsOperating
                  leases obligation
              
              $
              1,022
              
              $
              298
              
              $
              632
              
              $
              92
              
              $
              --Capital
                  leases obligation
              
              
              216
              
              
              40
              
              
              99
              
              
              77
              
              
              --Total
              
              $
              1,238
              
              $
              338
              
              $
              731
              
              $
              169
              
              $
              --
 
 We
        believe we have sufficient cash reserves to allow us to continue operations
        for
        more than a year.
 
 18
 
 **Item
        1A. Risk Factors**
 
 **CERTAIN
        FACTORS AFFECTING BUSINESS, OPERATING RESULTS, AND FINANCIAL
        CONDITION**
 
 You
        should carefully consider the risks described below and all of the information
        contained in this Form 10-Q. If any of the following risks occur, our
        business, financial condition and result of operations could be harmed, the
        trading price of our common stock could decline and you may lose all or part
        of
        your investment in our common stock.
 
 *Risks
        Related to Our Business*
 
 *We
        have had a history of losses and may incur future losses, which may prevent
        us
        from maintaining profitability.*
 
 We
        have
        had a history of operating losses since our inception, and as of December
        31,
        2005, we had an accumulated deficit of $51.3 million. We may incur operating
        losses in the future, and these losses could be substantial and impact our
        ability to maintain profitability. We do not expect to increase expenditures
        for
        product development, general and administrative expenses, and sales and
        marketing expenses; however, if we cannot maintain current revenue or revenue
        growth, we will not achieve or sustain profitability or positive operating
        cash
        flows. Even if we achieve profitability and positive operating cash flows,
        we
        may not be able to sustain or increase profitability or positive operating
        cash
        flows on a quarterly or annual basis.
 
 *Our
        operating results vary, making future operating results difficult to
        predict.*
 
 Our
        quarterly and annual operating results have varied significantly in the past
        and
        likely will vary significantly in the future. A number of factors, many of
        which
        are beyond our control, have caused and may cause our operating results to
        vary,
        including:
 
 our
        ability to respond effectively to competitive pricing pressures;
  •
                our
                      ability to respond effectively to competitive pricing
                      pressures;
 •
              our
                  ability to establish or increase market acceptance of our technology,
                  products and systems;
 
 •
              our
                  success in expanding our network of distributors, dealers and companies
                  that buy our products in bulk, customize them for particular applications
                  or customers, and resell them under their own
                  names;
 
 •
              market
                  acceptance of products and systems incorporating our technology
                  and
                  enhancements to our product applications on a timely
                  basis;
 
 •
              our
                  ability to respond effectively to competitive pressures;
 
 •
              our
                  success in supporting our products and
                  systems;
 
 •
              our
                  sales cycle, which may vary substantially from customer to
                  customer;
 
 •
              unfavorable
                  changes in the prices and delivery of the components we
                  purchase;
 
 •
              the
                  size and timing of orders for our products, which may vary depending
                  on
                  the season, and the contractual terms of the
                  orders;
 
 •
              the
                  size and timing of our expenses, including operating expenses and
                  expenses
                  of developing new products and product
                  enhancements;
 
 •
              deferrals
                  of customer orders in anticipation of new products, services or
                  product
                  enhancements introduced by us or by our competitors;
                  and
 
 •
              our
                  ability to attain and maintain production volumes and quality levels
                  for
                  our products.
 
 
 Our
        future projected budgets and commitments are based in part on our expectations
        of future sales. If our sales do not meet expectations, it will be difficult
        for
        us to reduce our expenses quickly and, consequently, our operating results
        may
        suffer.
 
 Our
        dealers often require immediate shipment and installation of our products.
        As a
        result, we have historically operated with limited backlog, and our sales
        and
        operating results in any quarter primarily depend on orders booked and shipped
        during that quarter.
 
 19
  Any
        of
        the above factors could harm our business, financial condition and results
        of
        operations. We believe that period-to-period comparisons of our results of
        operations are not meaningful, and you should not rely upon them as indicators
        of our future performance.
 
 *Our
        market is highly competitive and we may not have the resources to adequately
        compete.*
 
 The
        market for our integrated, multifunction telecommunications systems is new,
        rapidly evolving and highly competitive. We expect competition to intensify
        in
        the future as existing competitors develop new products and new competitors
        enter the market. We believe that a critical component to success in this
        market
        is the ability to establish and maintain strong partner and customer
        relationships with a wide variety of domestic and international providers.
        If we
        fail to establish or maintain these relationships, we will be at a serious
        competitive disadvantage.
 
 We
        face
        competition from companies providing traditional private telephone systems.
        Our
        principal competitors that produce these telephone systems are Avaya
        Communications, NEC and Nortel Networks. We also compete against providers
        of
        multi-function telecommunications systems, including 3Com Corporation, and
        Cisco
        Systems, Inc., as well as any number of future competitors. Many of our
        competitors are substantially larger than we are and have significantly greater
        name recognition, financial resources, sales and marketing teams, technical
        and
        customer support, manufacturing capabilities and other resources. These
        competitors also may have more established distribution channels and stronger
        relationships with service providers. These competitors may be able to respond
        more rapidly to new or emerging technologies and changes in customer
        requirements or to devote greater resources to the development, promotion
        and
        sale of their products. These competitors may enter our existing or future
        markets with products that may be less expensive, provide higher performance
        or
        additional features or be introduced earlier than our phone systems. We also
        expect that other companies may enter our market with better products and
        technologies. If any technology that is competing with ours is more reliable,
        faster, less expensive or has other advantages over our technology, then
        the
        demand for our products and services could decrease and harm our
        business.
 
 We
        expect
        our competitors to continue to improve the performance of their current products
        and introduce new products or new technologies. If our competitors successfully
        introduce new products or enhance their existing products, our sales or market
        acceptance of our products and services could be reduced, price competition
        could be increased or make our products could become obsolete. To remain
        competitive, therefore, we must continue to invest significant resources
        in
        research and development, sales and marketing and customer support. We may
        not
        have sufficient resources to make these investments or to make the technological
        advances necessary to be competitive, which in turn will cause our business
        to
        suffer.
 
 *We
        sell our products through dealers and distributors, which limits our ability
        to
        control the timing of our sales, and which makes it more difficult to predict
        our revenue.*
 
 We
        do not
        recognize revenue from the sale of our products to our distributors until
        these
        products are sold to either resellers or end-users. We have little control
        over
        the timing of product sales to dealers and end users. Our lack of control
        over
        the revenue that we recognize from our distributors’ sales to resellers and
        end-users limits our ability to predict revenue for any given period. Our
        future
        projected budgets and commitments are based in part on our expectations of
        future sales. If our sales do not meet expectations, it will be difficult
        for us
        to reduce our expenses quickly, and consequently our operating results may
        suffer.
   *We
        rely on resellers to promote, sell, install and support our products, and
        their
        failure to do so may substantially reduce our sales and thus seriously harm
        our
        business.*
 
 We
        rely
        on resellers who can provide high quality sales and support services. As
        with
        our distributors, we compete with other telecommunications systems providers
        for
        our resellers’ business as our resellers generally market competing products. If
        a reseller promotes a competitor’s products to the detriment of our products or
        otherwise fails to market our products and services effectively, we could
        lose
        market share. In addition, the loss of a key reseller or the failure of
        resellers to provide adequate customer service could cause our business to
        suffer. If we do not properly train our resellers to sell, install and service
        our products, our business will suffer. On July 20, 2005, we terminated our
        distribution agreement with Ingram Micro with no impact to our business. *Software
        or hardware errors may seriously harm our business and damage our reputation,
        causing loss of customers and revenue.*
 
 Users
        expect telephone systems to provide a high level of reliability. Our products
        are inherently complex and may have undetected software or hardware errors.
        We
        have detected and may continue to detect errors and product defects in our
        installed base of products, new product releases and product upgrades. End
        users
        may install, maintain and use our products improperly or for purposes for
        which
        they were not designed. These problems may degrade or terminate the operation
        of
        our products, which could cause end users to lose telephone service, cause
        us to
        incur significant warranty and repair costs, damage our reputation and cause
        significant customer relations problems. Any significant delay in the commercial
        introduction of our products due to errors or defects, any design modifications
        required to correct these errors or defects or any negative effect on customer
        satisfaction as a result of errors or defects could seriously harm our business,
        financial condition and results of operations.
 
 20
 
 Any
        claims brought because of problems with our products or services could seriously
        harm our business, financial condition and results of operations. We currently
        offer a one-year hardware guarantee to end-users. If our products fail within
        the first year, we face replacement costs. Our insurance policies may not
        provide sufficient or any coverage should a claim be asserted. In addition,
        our
        introduction of products and systems with reliability, quality or compatibility
        problems could result in reduced revenue, uncollectible accounts receivable,
        delays in collecting accounts receivable, warranties and additional costs.
        Our
        customers, end users or employees could find errors in our products and systems
        after we have begun to sell them, resulting in product redevelopment costs
        and
        loss of, or delay in, their acceptance by the markets in which we compete.
        Further, we may experience significant product returns in the future. Any
        of
        these events could have a material adverse effect on our business, financial
        condition and results of operations.
 
 *Our
        market is subject to changing preferences; failure to keep up with these
        changes
        would result in our losing market share, thus seriously harming our business,
        financial condition and results of operations.*
 
 Our
        customers and end users expect frequent product introductions and have changing
        requirements for new products and features. In order to be competitive,
        therefore, we need to develop and market new products and product enhancements
        that respond to these changing requirements on a timely and cost-effective
        basis. Our failure to do so promptly and cost effectively would seriously
        harm
        our business, financial condition and results of operations. Also, introducing
        new products could require us to write-off existing inventory as obsolete,
        which
        could harm our results of operations.
 
 *We
        depend on attracting and retaining qualified personnel to maintain and expand
        our business; our failure to promptly attract and retain qualified personnel
        may
        seriously harm our business, financial condition and results of
        operations.*
 
 We
        depend, in large part, on our ability to attract and retain highly skilled
        personnel, particularly engineers and sales and marketing personnel. We need
        highly trained technical personnel to design and support our server-based
        telecommunications systems. In addition, we need highly trained sales and
        marketing personnel to expand our marketing and sales operations in order
        to
        increase market awareness of our products and generate increased revenue.
        Competition for highly trained personnel is intense, especially in the San
        Francisco Bay Area where most of our operations are located. We cannot be
        certain that we will be successful in our recruitment and retention efforts.
        If
        we fail to attract or retain qualified personnel or suffer from delays in
        hiring
        required personnel, our business, financial condition and results of operations
        may be seriously harmed.
 
 *FASB’s
        adoption of SFAS No. 123(R) will cause, and changes to existing accounting
        pronouncements or taxation rules or practices may cause, adverse revenue
        fluctuations, affect our reported results of operations or how we conduct
        our
        business.*
 
 In
        December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, which
        establishes standards for transactions in which an entity exchanges its equity
        instruments for goods or services. In March 2005, the SEC issued Staff
        Accounting Bulletin No. 107 - Share-Based Payment, which provides interpretive
        guidance related to SFAS No. 123(R). SFAS No. 123(R) requires a public entity
        to
        measure the cost of employee services received in exchange for an award of
        equity instruments based on the grant-date fair value of the award. This
        eliminates the exception to account for such awards using the intrinsic method
        previously allowable under APB Opinion No. 25. SFAS No. 123(R). We have adopted
        this standard starting October 1, 2005. We expect that the new standard will
        have a material effect on our results of operations.
 
 Also,
        a
        change in accounting pronouncements or taxation rules or practices can have
        a
        significant effect on our reported results and may even affect our reporting
        of
        transactions completed before the change is effective. Other new accounting
        pronouncements or taxation rules and varying interpretations of accounting
        pronouncements or taxation practice have occurred and may occur in the future.
        This change to existing rules, future changes, if any, or the questioning
        of
        current practices may adversely affect our reported financial results or
        the way
        we conduct our business.
 
 *If,
        as of the end of our 2007 fiscal year, we are unable to assert that our internal
        control over financial reporting is effective, or if our auditors are unable
        to
        confirm our assessment, investors could lose confidence in our reported
        financial information, and the trading price of our stock price and our business
        could be adversely affected.*
  We
        are in
        the process of documenting, and plan to test during the current fiscal year,
        our
        internal control procedures in order to satisfy the requirements of Section
        404
        of the Sarbanes-Oxley Act. Commencing on September 30, 2007, the end of our
        2007
        fiscal year, the Sarbanes-Oxley Act will require annual management assessments
        of the effectiveness of our internal controls over financial reporting and
        a
        report by our independent registered public accounting firm addressing these
        assessments. During the course of our testing we may identify deficiencies
        which
        we may not be able to remediate in time to meet the deadline imposed by the
        Sarbanes-Oxley Act for compliance with the requirements of Section 404. In
        addition, if we fail to achieve and maintain the adequacy of our internal
        controls, as such standards are modified, supplemented, or amended from time
        to
        time, we may not be able to ensure that we can conclude on an ongoing basis
        that
        we have effective internal controls over financial reporting in accordance
        with
        Section 404 of the Sarbanes-Oxley Act. Effective internal controls are important
        to help produce reliable financial reports and to prevent financial fraud.
        If we
        are unable to assert that our internal control over financial reporting is
        effective as of the end of our 2007 fiscal year, or if our auditors are unable
        to attest that our management’s report is fairly stated or they are unable to
        express an opinion on our management’s evaluation or on the effectiveness of the
        internal controls, we could lose investor confidence in the accuracy and
        completeness of our financial reports, investors could lose confidence in
        our
        reported financial information, and the trading price of our stock and our
        business could be adversely affected.
 
 21
  *If
        we
        do not manage our growth effectively, our business will
        suffer.*
 
 We
        may
        not be successful in managing our future growth. We have expanded our operations
        rapidly since our inception. In order to manage this expansion and grow in
        the
        future, we will need to expand or enhance our management, manufacturing,
        research and development and sales and marketing capabilities. We may not
        be
        able to hire the management, staff or other personnel required to do
        so.
 
 We
        may
        not be able to install adequate control systems in an efficient and timely
        manner, and our current or planned operational systems, procedures and controls
        may not be adequate to support our future operations. Difficulties in installing
        and implementing new systems, procedures and controls may significantly burden
        our management and our internal resources. Delays in the implementation of
        new
        systems or operational disruptions when we transition to new systems would
        impair our ability to accurately forecast sales demand, manage our product
        inventory and record and report financial and management information on a
        timely
        and accurate basis.
 
 Lead
        times for materials and components used in the assembly of our products vary
        significantly, and depend on factors such as the supplier, contract terms
        and
        demand for a component at a given time. If orders do not match forecasts,
        we may
        have excess or inadequate inventory of certain materials and components,
        which
        may seriously harm our business, financial condition and results of
        operations.
 
 *Losing
        any of our key distributors would harm our business. We also need to establish
        and maintain relationships with additional distributors and original equipment
        manufacturers.*
 
 Sales
        through our three key distributors, Altisys, Graybar and Synnex, accounted
        for
        86% of our net revenue in the three months ended December 31,
        2005.  Our business and operating results will suffer if any one of
        these distributors does not continue distributing our products, fails to
        distribute the volume of our products that it currently distributes or fails
        to
        expand our customer base. We also need to establish and maintain relationships
        with additional distributors and original equipment manufacturers. We may
        not be
        able to establish, or successfully manage, relationships with additional
        distribution partners. In addition, our agreements with distributors typically
        provide for termination by either party upon written notice to the other
        party.
        For example, our agreement with Synnex provides for termination, with or
        without
        cause, by either party upon 30 days’ written notice to the other party, or
        upon insolvency or bankruptcy. Generally, these agreements are non-exclusive
        and
        distributors sell products that compete with ours. If we fail to establish
        or
        maintain relationships with distributors and original equipment manufacturers,
        our ability to increase or maintain our sales and our customer base will
        be
        substantially harmed.
 
 *We
        rely on sole-sourced components and third party technology and products;
        if
        these components are not available, our business may suffer.*
 
 We
        purchase technology from third parties that is incorporated into many of
        our
        products, including virtually all of our hardware products. We order
        sole-sourced components using purchase orders and do not have supply contracts
        for them. One sole-sourced component, a TI DSP chip, is particularly important
        to our business because it is included in virtually all of our hardware
        products. If we were unable to purchase an adequate supply of these sole-sourced
        components on a timely basis, we would be required to develop alternative
        products, which could entail qualifying an alternative source or redesigning
        our
        products based on different components. Our inability to obtain these
        sole-sourced components, especially the TI DSP chip, could significantly
        delay
        shipment of our products, which could have a negative effect on our business,
        financial condition and results of operations
 
 *Compliance
        with changing regulations of corporate governance and public disclosure may
        result in additional expenses.*
  Changing
        laws, regulations and standards relating to corporate governance and public
        disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations
        and
        Nasdaq National Market rules, are creating uncertainty for companies such
        as
        ours. These new or changed laws, regulations and standards are subject to
        varying interpretations in many cases due to their lack of specificity, and
        as a
        result, their application in practice may evolve over time as new guidance
        is
        provided by regulatory and governing bodies, which could result in continuing
        uncertainty regarding compliance matters and higher costs necessitated by
        ongoing revisions to disclosure and governance practices. As a result, our
        efforts to comply with evolving laws, regulations and standards have resulted
        in, and are likely to continue to result in, increased general and
        administrative expenses and a diversion of management time and attention
        from
        revenue-generating activities to compliance activities. In particular, our
        efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and
        the
        related regulations regarding our required assessment of our internal controls
        over financial reporting and our external auditors’ audit of that assessment has
        required the commitment of significant financial and managerial resources.
        We
        expect these efforts to require the continued commitment of significant
        resources. Further, our board members, chief executive officer, and chief
        financial officer could face an increased risk of personal liability in
        connection with the performance of their duties. As a result, we may have
        difficulty attracting and retaining qualified board members and executive
        officers, which could harm our business. If our efforts to comply with new
        or
        changed laws, regulations and standards differ from the activities intended
        by
        regulatory or governing bodies due to ambiguities related to practice, our
        reputation may be harmed.
 
 22
 
 *Our
        facility is vulnerable to damage from earthquakes and other natural disasters
        and other business interruptions; any such damage could seriously or completely
        impair our business.*
 
 We
        perform final assembly, software installation and testing of our products
        at our
        facility in Fremont, California. Our facility is located on or near known
        earthquake fault zones and may be subject to rolling electrical blackouts
        and is
        vulnerable to damage or interruption from fire, floods, earthquakes, power
        loss,
        telecommunications failures and similar events. If such a disaster or
        interruption occurs, our ability to perform final assembly, software
        installation and testing of our products at our facility would be seriously,
        if
        not completely, impaired. If we were unable to obtain an alternative place
        or
        way to perform these functions, our business, financial condition and results
        of
        operations would suffer. The insurance we maintain may not be adequate to
        cover
        our losses against fires, floods, earthquakes and general business
        interruptions. We
        engage
        third-party assemblers, which in fiscal year 2005 were All Quality Services
        and
        Bestronics in San Jose, to insert the hardware components into the printed
        circuit board. We selected our manufacturing partners with the goals of ensuring
        a reliable supply of high-quality finished products and lowering per unit
        product costs as a result of manufacturing economies of scale.
 
 *Our
        strategy to outsource assembly and test functions in the future could delay
        delivery of products, decrease quality or increase costs.*
 
 Based
        on
        volume or customer requirements, we may begin outsourcing some assembly and
        test
        functions. In addition, we may determine that we need to establish assembly
        and
        test operations overseas to better serve our international customers.
        Establishing overseas assembly and test operations may be more difficult
        or take
        longer than we anticipate. This outsourcing strategy involves certain risks,
        including the potential lack of adequate capacity and reduced control over
        delivery schedules, manufacturing yield, quality and costs. In the event
        that
        any significant subcontractors were to become unable or unwilling to continue
        to
        manufacture or test our products in the required volumes, we would have to
        identify and qualify acceptable replacements. Finding replacements could
        take
        time and we cannot be sure that additional sources would be available to
        us on a
        timely basis. Any delay or increase in costs in the assembly and testing
        of
        products by third-party subcontractors could seriously harm our business,
        financial condition and results of operations.
 
 *Our
        planned expansion in international markets will involve new risks that our
        previous domestic operations have not prepared us to address; our failure
        to
        address these risks could harm our business, financial condition and results
        of
        operations.*
 
 For
        the
        three months ended December 31, 2005, approximately 9% of our net revenue
        came
        from customers outside of the Americas. We intend to expand our international
        sales and marketing efforts. Our efforts are subject to a variety of risks
        associated with conducting business internationally, any of which could
        seriously harm our business, financial condition and results of operations.
        These risks include:
 
 •
              tariffs,
                  duties, price controls or other restrictions on foreign currencies
                  or
                  trade barriers, such as import or export licensing imposed by foreign
                  countries, especially on
                  technology;
 
 •
              potential
                  adverse tax consequences, including restrictions on repatriation
                  of
                  earnings;
 
 •
              fluctuations
                  in foreign currency exchange rates, which could make our products
                  relatively more expensive in foreign markets;
                  and
 
 •
              conflicting
                  regulatory requirements in different countries that may require
                  us to
                  invest significant resources customizing our products for each
                  country.
 
 *Any
        failure by us to protect our intellectual property could harm our business
        and
        competitive position.*
 
 Our
        success depends, to a certain extent, upon our proprietary technology. We
        currently rely on a combination of patent, trade secret, copyright and trademark
        law, together with non-disclosure and invention assignment agreements, to
        establish and protect the proprietary rights in the technology used in our
        products.
 
 Although
        we have filed patent applications, we are not certain that our patent
        applications will result in the issuance of patents, or that any patents
        issued
        will provide commercially significant protection of our technology. In addition,
        other individuals or companies may independently develop substantially
        equivalent proprietary information not covered by patents to which we own
        rights, may obtain access to our know-how or may claim to have issued patents
        that prevent the sale of one or more of our products. Also, it may be possible
        for third parties to obtain and use our proprietary information without our
        authorization. Further, the laws of some countries, such as those in Japan,
        one
        of our target markets, may not adequately protect our intellectual property
        or
        such protection may be uncertain. Our success also depends on trade secrets
        that
        cannot be patented and are difficult to protect. If we fail to protect our
        proprietary information effectively, or if third parties use our proprietary
        technology without authorization, our competitive position and business will
        suffer.
 
 23
  *If
        we
        are unable to raise additional capital when needed, we may be unable to develop
        or enhance our products and services.*
 
 We
        may
        seek additional funding in the future. If we cannot raise funds on acceptable
        terms, we may be unable to develop or enhance our products and services,
        take
        advantage of future opportunities or respond to competitive pressures or
        unanticipated requirements. We also may be required to reduce operating costs
        through lay-offs or reduce our sales and marketing or research and development
        efforts. If we issue equity securities, stockholders may experience additional
        dilution or the new equity securities may have rights, preferences or privileges
        senior to those of our common stock.
 
 *We
        may face infringement issues that could harm our business by requiring us
        to
        license technology on unfavorable terms or temporarily or permanently cease
        sales of key products.*
 
 We
        may
        become parties to litigation in the normal course of our business. Litigation
        in
        general, and intellectual property and securities litigation in particular,
        can
        be expensive and disruptive to normal business operations. Moreover, the
        results
        of complex litigation are difficult to predict.
 
 On
        September 6, 2002, Vertical Networks, Inc. filed suit against us in
        the United States District Court for the Northern District of California,
        alleging infringement of Vertical Networks’ U.S. Patents Nos. 6,266,341;
        6,289,025; 6,292,482; 6,389,009; and 6,396,849. On October 28, 2002,
        Vertical Networks amended its complaint to add allegations of infringement
        of
        U.S. Patents Nos. 5,617,418 and 5,687,174. Vertical Networks filed a second
        amended complaint on November 20, 2002 to identify our products and/or
        activities that allegedly infringe the seven patents-in-suit. Vertical Networks
        seeks a judgment of patent infringement and an award of damages, including
        treble damages for alleged willful infringement, and attorneys’ fees and costs.
        We filed an answer and counterclaims for declaratory relief on December 9,
        2002. On December 26, 2002, Vertical Networks filed its answer to our
        counterclaims. Vertical Networks served its preliminary infringement contentions
        on us on April 9, 2003 and we served Vertical Networks our preliminary
        invalidity contentions on June 3, 2003 and July 14, 2003. To date, the
        parties have exchanged some discovery, but no depositions have been taken,
        and
        no motions are currently pending. On October 7, 2003, the parties filed a
        stipulation to stay this action, pending the outcome of the reissue of some
        of
        the subject patents before the U.S. Patent and Trademark Office. We believe
        we
        have strong defenses and arguments in this dispute and intend to vigorously
        defend our position. Management’s view is that any loss from this litigation is
        currently not probable or estimable. Therefore, we have not established a
        reserve on our balance sheets as to any liability related to the outcome
        of this
        action.
 
 More
        generally, litigation related to these types of claims may require us to
        acquire
        licenses under third party patents that may not be available on acceptable
        terms, if at all. We believe that an increasing portion of our revenue in
        the
        future will come from sales of software applications for our hardware products.
        The software market traditionally has experienced widespread unauthorized
        reproduction of products in violation of developers’ intellectual property
        rights. This activity is difficult to detect, and legal proceedings to enforce
        developers’ intellectual property rights are often burdensome and involve a high
        degree of uncertainty and substantial costs.
 
 *Our
        products may not meet the legal standards required for their sale in some
        countries; if we cannot sell our products in these countries, our results
        of
        operations may be seriously harmed.*
 
 The
        United States and other countries in which we intend to sell our products
        have
        standards for safety and other certifications that must be met for our products
        to be legally sold in those countries. We have tried to design our products
        to
        meet the requirements of the countries where we sell or plan to sell them.
        We
        also have obtained or are trying to obtain the certifications that we believe
        are required to sell our products in these countries. We cannot, however,
        guarantee that our products meet all of these standards or that we will be
        able
        to obtain any certifications required. In addition, there is, and will likely
        continue to be, an increasing number of laws and regulations pertaining to
        the
        products we offer and may offer in the future. These laws or regulations
        may
        include, for example, more stringent safety standards, requirements for
        additional or more burdensome certifications or more stringent consumer
        protection laws.
 
 If
        our
        products do not meet a country’s standards or we do not receive the
        certifications required by a country’s laws or regulations, then we may not be
        able to sell our products in that country. This inability to sell our products
        may seriously harm our results of operation by reducing our sales or requiring
        us to invest significant resources to conform our products to these
        standards.
 
 *Risks
        Related to the Industry*
 
 *Integrated,
        multifunction telecommunications systems may not achieve widespread
        acceptance.*
 
 The
        market for integrated, multifunction telecommunications systems is relatively
        new and rapidly evolving. Businesses have invested substantial resources
        in the
        existing telecommunications infrastructure, including traditional private
        telephone systems, and may be unwilling to replace these systems in the near
        term or at all. Businesses also may be reluctant to adopt integrated,
        multifunction telecommunications systems because of their concern about the
        current limitations of data networks, including the Internet. For example,
        end
        users sometimes experience delays in receiving calls and reduced voice quality
        during calls when routing calls over data networks. Moreover, businesses
        that
        begin to route calls over the same networks that currently carry only their
        data
        also may experience these problems if the networks do not have sufficient
        capacity to carry all of these communications at the same time.
 
 24
  *Evolving
        standards may delay our product introductions, increase our product development
        costs or cause end users to defer or cancel plans to purchase our products,
        any
        of which could adversely affect our business.*
  The
        standards in our market are still evolving. These standards are designed
        to
        ensure that integrated, multifunction telecommunications products from different
        manufacturers can operate together. Some of these standards are proposed
        by
        other participants in our market, including some of our competitors, and
        include
        proprietary technology. In recent years, these standards have changed, and
        new
        standards have been proposed, in response to developments in our market.
        Our
        failure to conform our products to existing or future standards may limit
        their
        acceptance by market participants. We may not anticipate which standards
        will
        achieve the broadest acceptance in our market in the future, and we may take
        a
        significant amount of time and expense to adapt our products to these standards.
        We also may have to pay additional royalties to developers of proprietary
        technologies that become standards in our market. These delays and expenses
        may
        seriously harm our results of operations. In addition, customers and users
        may
        defer or cancel plans to purchase our products due to concerns about the
        ability
        of our products to conform to existing standards or to adapt to new or changed
        standards, and this could seriously harm our results of operations.
 
 *Future
        regulation or legislation could harm our business or increase our cost of
        doing
        business.*
 
 The
        Federal Communications Commission (FCC) has submitted a report to Congress
        stating that it may regulate certain Internet services if it determines that
        such Internet services are functionally equivalent to conventional
        telecommunications services. The increasing growth of the voice over data
        network market and the popularity of supporting products and services, heighten
        the risk that national governments will seek to regulate the transmission
        of
        voice communications over networks such as the Internet. In addition, large
        telecommunications companies may devote substantial lobbying efforts to
        influence the regulation of this market so as to benefit their interests,
        which
        may be contrary to our interests. These regulations may include, for example,
        assessing access or settlement charges, imposing tariffs or imposing regulations
        based on encryption concerns or the characteristics and quality of products
        and
        services. In February 2004, the FCC found that an entirely Internet based
        voice
        over Internet protocol service was an unregulated information service. At
        the
        same time, the FCC began a broader proceeding to examine what its role should
        be
        in this new environment of increased consumer choice and what can be done
        to
        meet its role of safeguarding the public interest. Future laws, legal decisions
        or regulations, as well as changes in interpretations of existing laws and
        regulations, could require us to expend significant resources to comply with
        them. In addition, these future events or changes may create uncertainty
        in our
        market that could reduce demand for our products.
 
 **Item
        3. Quantitative and Qualitative Disclosures About Market
        Risk.**
 
 *Interest
        Rate Risk.* Our
        interest income is sensitive to changes in the general level of U.S. interest
        rates, particularly since the majority of our investments are in cash
        equivalents and short-term instruments. Due to the short-term nature of our
        cash
        equivalents and investments, we have concluded that a change in interest
        rates
        does not pose a material market risk to us.
 
 *Foreign
        Currency Exchange Risk.* We
        face
        foreign exchange currency fluctuations with our subsidiary in China, however,
        due to the strength in China’s economy, we do not foresee foreign exchange
        currency fluctuations to pose a material market risk to us.
 
 **Item
        4. Controls and Procedures****.**
 
 *(a)*  *Evaluation
        of disclosure controls and procedures* .
        Our
        management evaluated, with the participation of our Chief Executive Officer
        and
        our Chief Financial Officer, the effectiveness of our disclosure controls
        and
        procedures as of the end of the period covered by this Quarterly Report on
        Form 10-Q. Based on this evaluation, our Chief Executive Officer and our
        Chief Financial Officer have concluded that our disclosure controls and
        procedures are effective to ensure that information we are required to disclose
        in reports that we file or submit under the Securities Exchange Act of 1934
        is
        accumulated and communicated to our management, including our principal
        executive and principal financial officers, as appropriate to allow timely
        decisions regarding required disclosure, and that such information is recorded,
        processed, summarized and reported within the time periods specified in
        Securities and Exchange Commission rules and forms.
 
 *(b)*  *Changes
        in internal control over financial reporting* .
        There
        was no change in our internal control over financial reporting that occurred
        during the period covered by this Quarterly Report on Form 10-Q that has
        materially affected, or is reasonably likely to materially affect, our internal
        control over financial reporting.
  25
  **PART
        II. OTHER INFORMATION**
 
 **Item
        1.  Legal Proceedings****.**
 
 On
        September 6, 2002, Vertical Networks, Inc. filed suit against us in
        the United States District Court for the Northern District of California,
        alleging infringement of Vertical Networks’ U.S. Patents Nos. 6,266,341;
        6,289,025; 6,292,482; 6,389,009; and 6,396,849. On October 28, 2002,
        Vertical Networks amended its complaint to add allegations of infringement
        of
        U.S. Patents Nos. 5,617,418 and 5,687,174. Vertical Networks filed a second
        amended complaint on November 20, 2002 to identify our products and/or
        activities that allegedly infringe the seven patents-in-suit. Vertical Networks
        seeks a judgment of patent infringement and an award of damages, including
        treble damages for alleged willful infringement, and attorneys’ fees and costs.
        We filed an answer and counterclaims for declaratory relief on December 9,
        2002. On December 26, 2002, Vertical Networks filed its answer to our
        counterclaims. Vertical Networks served its preliminary infringement contentions
        on us on April 9, 2003 and we served Vertical Networks our preliminary
        invalidity contentions on June 3, 2003 and July 14, 2003. To date, the
        parties have exchanged some discovery, but no depositions have been taken,
        and
        no motions are currently pending. On October 7, 2003, the parties filed a
        stipulation to stay this action, pending the outcome of the reissue of some
        of
        the subject patents before the U.S. Patent and Trademark Office. We believe
        we
        have strong defenses and arguments in this dispute and intend to vigorously
        defend our position. Management’s view is that any loss from this litigation is
        currently not probable or estimable; therefore, the Company has not established
        a reserve on its balance sheets as to any liability related to the outcome
        of
        this action.
 
 From
        time
        to time, we may become party to litigation and subject to claims arising
        in the
        ordinary course of our business. To date, these actions have not had a material
        adverse effect on our financial position, result of operations or cash flows.
        Although the results of litigation and claims cannot be predicted with
        certainty, we believe that the final outcome of such matters would not have
        a
        material adverse effect on our business, financial position, results of
        operation and cash flows.
 
 
 **Item
        2. Unregistered Sales of Equity Securities and Use of
        Proceeds.**
 
 None
 
 **Item
        3. Defaults Upon Senior Securities****.**
 
 None
 
 **Item
        4. Submission of Matters to a Vote of Security Holders****.**
 
 None
  **Item
        5.  Other Information** **.**
 
 None
 
 **Item
        6. Exhibits****.**
 
 
 Please
        refer to the Exhibit Index of this report on Form 10-Q.
  26
  
 **SIGNATURE**
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, the registrant
        has
        duly caused this report to be signed on its behalf by the undersigned thereunto
        duly authorized.
  ALTIGEN
                  COMMUNICATIONS, INC.Date:
                  February 16, 2006
              By:
              /s/
                  Philip M. McDermottPhilip
                  M. McDermott,Chief
                  Financial Officer(Principal
                  Financial and Accounting Officer)
  27
  **EXHIBIT
        INDEX**
 
 **Exhibit**
                **Number**
              
              **Description**3.1
                  (1)
              
              Amended
                  and Restated Certificate of Incorporation.3.2
                  (2)
              
              Second
                  Amended and Restated Bylaws.31.1
              
              Certification
                  of Principal Executive Officer, filed herewith.31.2
              
              Certification
                  of Principal Financial Officer, filed herewith.32.1
              
              Certification
                  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350,
                  as Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, file
                  herewith.32.2
              
              Certification
                  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350,
                  as Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, file
                  herewith.
 ___________________________________________
 
 (1)
              Incorporated
                  by reference to exhibit filed with the Registrant's Registration
                  Statement
                  on Form S-1 (No. 333-80037) declared effective on
                  October 4, 1999.(2)
              Incorporated
                  by reference to exhibit filed with the Registrant's Quarterly Report
                  on
                  Form 10-Q for the quarter ended March 31,
                  2004.
  28