**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe quarterly period ended June 30, 2006**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**CommissionFile Number 000-30229**

**SONUS NETWORKS, INC.**

(Exact name of Registrantas specified in its charter)

| **DELAWARE**                                                     |   | **04-3387074**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction  of incorporation or organization) |   | (I.R.S. employer  identification no.) |

 

**7 Technology Park Drive,Westford, Massachusetts 01886**

(Address of principalexecutive offices, including zip code)

**(978) 614-8100**

(Registrant’s telephonenumber, including area code)

**250 Apollo Drive,Chelmsford, Massachusetts 01824**

(Former name, formeraddress and former fiscal year, if changed since last report)

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

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x        Accelerated filer  o       Non-accelerated filer  o

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes  o  No  x.

Asof July 27, 2007, there were 257,465,110 shares of the registrant’s commonstock, $0.001 par value, outstanding.

 

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**Explanatory Note**

In this Form 10-Q (“Form 10-Q”), we arerestating our consolidated financial statements as of December 31, 2005and for the three and six months ended June 30, 2005. Immediatelyfollowing the filing of this Form 10-Q, we will file a Quarterly Report onForm 10-Q for the quarter ended September 30, 2006, an Annual Reporton Form 10-K for the year ended December 31, 2006 (“Form 10-K”)and a Quarterly Report on Form 10-Q for the quarter ended March 31,2007. In our Form 10-K, we are restating our consolidated financialstatements as of December 31, 2005 and for each of the years ended December 31,2005 and 2004 and each of the quarters in 2005 and the three months ended March 31,2006, which are included in “Financial Statements and Supplementary Data” inItem 8. This Form 10-K also reflects the restatement of selected financialdata as of and for each of the years ended December 31, 2002 through 2005,which is included in “Selected Financial Data” in Item 6, and the fiscal yearsended December 31, 2005 and 2004, which is included in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” inItem 7.

Previously filed annual reports on Form 10-K andquarterly reports on Form 10-Q affected by the restatements have not beenamended and should not be relied on.

The restatement ofour consolidated financial statements reflects:

1.                stock-basedcompensation expense not previously recorded for certain stock option grantsfor which we used an incorrect measurement date for accounting purposes;

2.                stock-basedcompensation expense for certain grants that should have been recorded usingvariable accounting;

3.                tax-relatedadjustments resulting from the above errors in stock option accounting; and

4.                the recording ofpreviously unrecorded adjustments not related to accounting for stock optionsthat were previously deemed to be immaterial to our consolidated financialstatements.

On May 25, 2006, in response to the recent focuson public company employee stock option granting practices and accounting, theCompany in conjunction with the Audit Committee of its Board of Directors (the “AuditCommittee”) voluntarily commenced a review of our stock option grantingpractices and accounting (the “Internal Review”). The Internal Review focusedon several grants in the years 2000 through 2002 for which the grant datesappeared to have been on dates when our share price was trading near six monthlows. As a result of the findings of the Internal Review, on August 3,2006, our Board of Directors authorized the Board’s Audit Committee to conductan expanded investigation (the “Audit Committee Investigation”) of our stockoption granting practices from our initial public offering on May 25, 2000(the “IPO”) through August 2006. The Audit Committee retained and wasassisted by outside legal counsel and forensic accountants in conducting itsinvestigation.

On October 23,2006, the Audit Committee issued a report on its findings (the “InvestigationReport”) that was presented to our Board of Directors. The following is asummary of the key findings:

·       Ourstock granting and administration practices lacked adequate controls, processesand documentation during the period from May 2000, the date of our initialpublic offering, through December 2003;

·       Theprocess by which members of the Compensation Committee formally approved stockoption grants often involved the signing of a unanimous written consent (“UWC”).We used the date set forth in the UWC as the grant date and measurement datefor accounting purposes. However, during the period from May 2000 to December 2003,there often was no clear documentation as to when the UWC was signed andreturned to the Company. For certain grants, a UWC was signed weeks or evenmonths after the grant date;

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·       Themeasurement dates used for accounting purposes for a number of stock optiongrants, particularly during the period from May 2000 through December 2003,were not accurate because all the required granting actions were not completedas of the grant date;

·       Evidencesuggests the probability that grant dates for several option grants from May 2000through 2003 were selected by two former members of management with hindsight. Therewas no evidence from late 2004 forward, suggesting the probability that anydates for stock option grants were selected after the stated date of the grantwith hindsight;

·       Nocurrent employee or director engaged in any willful or intentional misconduct;and

·       Beginningin August 2004, and continuing into 2005 and 2006, we implemented numerouspolicies and internal controls regarding option grants and significantlyimproved the practices and controls.

Responding to the findings of the Audit CommitteeInvestigation, we performed a review of stock option grant measurement datesrecorded for financial reporting purposes. We reassessed the measurement datesfor all of our historical stock option grants and reviewed all availableevidence for each option grant during the period from the IPO through December 31,2005.

Our historical stockoption grants fall under two broad categories: (a) major, company-widegrants made annually (“Annual Grants”) and (b) grants made throughout theyear for new hires and employee recognition (“Batched Grants”). Prior to ourIPO in May 2000, the Board of Directors or its Compensation Committee (“CompensationCommittee”) approved option grants at meetings documented in meeting minutes. Subsequentto the IPO, the Compensation Committee would either approve stock option grantsat meetings documented by meeting minutes or through a signed UWC, which weredated “as of” the date coinciding with the recorded stock option grant date. Thefollowing summarizes our historical practices for granting stock options:

*May 2000 IPOThrough Late 2004*

It was our historical practice through late 2004 thatour Former Chief Financial Officer (“Former CFO”) would select the stock optiongrant dates. The Former CFO along with the Company’s Chief Executive Officer (“CEO”)would present recommendations to the Compensation Committee regarding totalpools of stock options for Annual Grants for executives and non-executiveemployees. There was no consistency in the Former CFO’s method for selection ofthe grant dates. The Compensation Committee then decided on the amount of stockoptions to be granted to each executive and a total pool of stock options to beallocated to non-executive employees by Company management. The Former CFOwould submit a final list to the Compensation Committee for approval at a laterdate.

With the exception of stock options granted to newhires through 2000 (and certain new hires in 2001), Batched Grants had noconsistent process or timing and were initiated by the Former CFO as the needarose. Our Former CFO selected the grant dates for the Batched Grants andpresented the stock option grants to the Compensation Committee for approval ata later date. Again, there was no consistency in the method for selection ofthe grant dates. Stock option grants to new hires through 2000 (and certain newhires in 2001), were granted on the employment start dates. This practicechanged in 2001 so that new hire stock options were granted in batches.

There was no regular practice and, in many cases, nosupporting documentation regarding the actual signing dates of the UWCs by themembers of the Compensation Committee. We lacked a documented set of proceduresand controls for stock option grants through late 2004, including proceduresregarding who had authority and responsibility to select dates for stock optiongrants, how the Compensation Committee would approve stock option grants, howgrant dates were to be selected, and when lists containing recipients andamounts of options were to be considered final.

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We also lacked aconsistent or documented practice for entering grant information into theaccounting and equity records and how and when such stock option grants werecommunicated to employees.

*Late 2004 ThroughCurrent*

In response to a restatement of our consolidatedfinancial statements completed in July 2004, material weaknesses identifiedin our internal control over financial reporting and the hiring of new membersof senior management, including a new CFO in January 2005, we commenced inlate 2004 and continuing into 2006 implementing a number of improvements to ourstock option granting practices and controls. Notwithstandingthese improvements, we continued to have issues with inadequate documentationand processes resulting in revised measurement dates for certain grants through2005.

We began limiting the use of UWCs to grant stock optionscommencing in 2004 and eliminated the use fully in 2006. Annual Grants areprovided to the Compensation Committee in advance of the grant date andapproved in meetings supported by meeting minutes. In March 2005, theCompensation Committee formally delegated the approval for certain BatchedGrants to the CEO, who in turn formally delegated approval of certain stockoptions to other senior management. For all other Batched Grants, through June 2006,the Company presented UWCs with final lists for approval to the CompensationCommittee in advance of the date when the grants were to be approved. TheCompensation Committee retained the authority to grant options to executivesand all other grants not subject to the delegated authority.

In June 2006, the Compensation Committee modifiedthe March 2005 policy by requiring all New Hire Grants be effective on the15th day of the month following a new employee’sstart date. In addition to the delegation of authority for the aforementionedBatched Grants, the Compensation Committee has occasionally delegated authorityto our CEO to make other grants with specific limitations.

All stock optionsrequiring approval by the Compensation Committee are provided to theCompensation Committee in advance of the grant date and at meetings documentedby approved minutes.

*Measurement DateMethodology*

Based on the available facts and circumstancessurrounding our stock option granting practices, we adopted a methodology fordetermining the most likely measurement dates. We believe the application ofthis methodology indicated the date where the number of options granted to eachemployee and the exercise price were known with finality.

The Company adoptedthe following framework based on the facts and circumstances of each grant.

(1)         If the stock option grantwas approved at a Board-level meeting, the date reflected in meeting minutes ofthe Company’s Board of Directors or Compensation Committee of the Board ofDirectors where the number of options for each recipient and the exercise pricefor the grant has been clearly approved was determined to be the most likelymeasurement date. Measurement dates for approximately 35% of the total numberof grants were determined based on this method.

(2)         If the stock option grantwas approved by UWC, the date of communication of the principal terms of thegrant to the recipients if prior to the signature date on the UWC wasdetermined to be the most likely measurement date. Measurement dates forapproximately 42% of the total number of grants were determined based on thismethod.

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(3)         If the stock option grantwas approved by UWC and the Company did not have clear prior evidence of thedate the principal terms of the grant were communicated to the recipients, thedate of receipt of the last signature for the UWC provided there was clearevidence of the date the last signature was received was determined to be themost likely measurement date. Measurement dates for approximately 2% of thetotal number of grants were determined based on this method.

(4)         If the stock option grantwas approved by UWC and the Company did not have clear evidence of the date theprincipal terms of the grant were communicated to the recipients or the date ofreceipt of the last signature on the UWC, the Company reviewed all otheravailable evidence and used its judgment to determine the most likelymeasurement date. The additional available evidence included, but was notlimited to:

a.                  the next datethat the two Compensation Committee members were physically present at a Board-levelmeeting where the UWC may have been signed and the meeting occurred within areasonable time period; and

b.                 the date by whichat least 90% of the stock option grant was entered into the Company’s stockoption administration system.

Measurement dates for approximately 6% of the totalnumber of grants were determined based on the next date that the twoCompensation Committee members were physically present at a Board-level meetingand approximately 15% when at least 90% of the stock option grant was enteredinto the Company’s stock option administration system.

After selecting a measurement date through one of thefour steps in the above framework, the Company then determined if there wereany changes to the individual grant recipients or amount of options grantedafter the selected measurement date. If there were no changes following theselected measurement date, then the measurement date would remain unchanged. Ifthe Company identified changes following the selected measurement date, thenthe Company would evaluate whether the changes should delay the measurementdate for the entire list of grants until the list became final or whether thechanges should result in separate accounting for specific grants. Factorsconsidered in evaluating whether it would be appropriate to delay themeasurement date until the list was final included: 1) the frequency of anychanges as well as the reason for any changes; 2) whether the changes wereadministrative in nature (corrections of errors for grants to which recipientswould have been otherwise entitled); and 3) whether the changes reflectedre-allocation of options among a broader range of recipients.

In applying the methodology, we revised themeasurement dates for many grants which resulted in exercise prices that wereless than the fair market value of the stock on the revised measurement dates.During our review we also identified errors in accounting for stock optionawards where we did not appropriately account for modifications andcircumstances in which we did not appropriately account for awards as variable.The correction of all these errors related to stock option accounting resultedin additional cumulative stock-based compensation charges of approximately$54.1 million from 2000 through 2005. In addition, additional stock-basedcompensation of approximately $11,000 was recorded in the three months ended March 31,2006.

We acknowledge that many of our measurement dateconclusions are dependent on the facts and circumstances of each stock optiongrant and involved the application of significant management judgment. Becausethe revised measurement date may not be the actual measurement date, weperformed several analyses to compare the results of selecting measurementdates based upon the above described methodology to what would have resultedunder different methodologies. In the first analysis, we considered that themeasurement dates for all the stock option grants would be the last date thelast required action for grants had taken place. In this analysis, themeasurement date would be the date 

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approved at the Board orCompensation Committee meeting, the date of last receipt of the unanimouswritten consent or, if there was no evidence as to the receipt of the lastsignature, the date of the next board-level meeting at which the two members ofthe Compensation Committee were present following the preparation of a finallist of grantees. Had we applied this alternate approach, the new measurementdates would have resulted in approximately $0.2 million less in cumulativestock-based compensation charges being recorded from 2000 through 2005.

For anadditional analysis, we also considered what the results would have been had weselected measurement dates based upon the low, average and high closing pricesof our stock within the periods from the originally recorded grant dates to therevised measurement dates. Using this approach, we would have recordedadditional (less) cumulative stock-based compensation from 2000 through 2005 of$(52.3)million, $1.4 million, and $55.1 million by selecting measurement datesbased upon the low, average and high closing prices during those periods,respectively. The additional (less) cumulative stock-based compensation from2000 through 2005 under each category of our framework based upon the low,average and high closing prices during those periods is as follows (inmillions):

| **Category** | ** ** | ** ** | ** ** | **Low** | ** ** | **Average** | ** ** | **High** | ** ** |
|--------------|------------|------------|------------|---------|------------|-------------|------------|----------|------------|
| (1)          |       | $          | —     |    |       | $           | —     |     |       | $ | — |   |
| (2)          |       | (43.2      | )          |    | 4.4        |        |       | 50.0     |       |
| (3)          |       | (1.3       | )          |    | (0.3       | )           |       | 0.8      |       |
| (4)          |       | (7.8       | )          |    | (2.7       | )           |       | 4.3      |       |
|         |       | $          | (52.3      | )       |       | $           | 1.4        |     |       | $ | 55.1 |   |

 

Theadditional (less) cumulative stock-based compensation by year from 2000 through2005 under categories two, three and four of our framework based upon the low,average and high closing prices during those periods is as follows (in millions):

| ** ** | ** ** | **Category 2** | ** ** |
|------------|------------|---------------------|------------|
| ** ** | ** ** | **2000**            | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **Total** | ** ** |
| Low        |       |                | $          | — |   |   | $ | (13.4 | ) | $ | (19.9 | ) | $ | (5.4 | ) | $ | (2.6 | ) | $ | (1.9 | ) | $ | (43.2 | ) |
| Average    |       |                | $          | — |   |   | $ | 6.5 |   | $ | 2.0 |   | $ | (2.3 | ) | $ | (1.0 | ) | $ | (0.8 | ) | $ | 4.4 |   |
| High       |       |                | $          | — |   |   | $ | 33.1 |   | $ | 15.5 |   | $ | 0.2 |   | $ | 0.6 |   | $ | 0.6 |   | $ | 50.0 |   |

 

| ** ** | ** ** | **Category 3** | ** ** |
|------------|------------|---------------------|------------|
| ** ** | ** ** | **2000**            | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **Total** | ** ** |
| Low        |       |                | $          | — |   |   | $ | (0.1 | ) | $ | (0.7 | ) | $ | (0.4 | ) | $ | (0.1 | ) |   | $ | — |   |   | $ | (1.3 | ) |
| Average    |       |                | $          | — |   |   | $ | — |   | $ | (0.1 | ) | $ | (0.2 | ) | $ | — |   |   | $ | — |   |   | $ | (0.3 | ) |
| High       |       |                | $          | — |   |   | $ | 0.1 |   | $ | 0.6 |   | $ | 0.1 |   | $ | — |   |   | $ | — |   |   | $ | 0.8 |   |

 

| ** ** | ** ** | **Category 4** | ** ** |
|------------|------------|---------------------|------------|
| ** ** | ** ** | **2000**            | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **Total** | ** ** |
| Low        |       | $                   | —     |   | $ | (1.7 | ) | $ | (0.8 | ) | $ | (1.4 | ) | $ | (2.2 | ) | $ | (1.7 | ) | $ | (7.8 | ) |
| Average    |       | $                   | —     |   | $ | (0.6 | ) | $ | (0.1 | ) | $ | (0.6 | ) | $ | (0.9 | ) | $ | (0.5 | ) | $ | (2.7 | ) |
| High       |       | $                   | 4.1        |   | $ | (2.9 | ) | $ | 1.3 |   | $ | 0.3 |   | $ | 0.7 |   | $ | 0.8 |   | $ | 4.3 |   |

 

We believe our methodologybased on the best evidence available results in the most likely measurementdates for our stock option grants.

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*Tax-RelatedAdjustments*

*Withholding Taxes*

In addition to thestock-based compensation charges, we also have recorded tax-related expenserelated to our stock option grants. We have determined that numerous stockoptions previously classified as incentive stock options (“ISO”) no longer meetthe criteria for ISO tax status since they were issued in the money on therevised measurement date. The disqualification of ISO status resulted in thefailure to withhold certain employee income and payroll taxes and,consequently, we have recorded additional expense, along with penalties andinterest, in the periods of exercise. Tax-related adjustments related to thedisqualification of the ISO status of stock options totaled approximately $1.0million from 2001 through 2005 and approximately $0.2 million in the threemonths ended March 31, 2006.

*Section 409A*

Under Section 409A of the Internal Revenue Code (“Section 409A”),individuals who received option grants with an exercise price below the fairmarket value of the underlying stock at the revised measurement date will besubject to additional taxes and interest with respect to options that vestafter December 31, 2004. Holders of these stock options will be requiredto recognize ordinary income at vesting. Pursuant to the interim InternalRevenue Service guidance, the income is calculated as the difference betweenthe fair market value of the underlying stock and the exercise price as of December 31of the year of vesting. The individual must also recognize, in each subsequentyear until the option is fully exercised or expires, ordinary income equal tothe excess of the fair market value of the underlying stock over the sum of theexercise price and any previously recorded income. In addition to ordinaryincome and employment taxes, an additional 20% penalty tax on the resultingordinary income is levied on the individual, plus interest on any tax to bepaid.

In the fourth quarter of 2006, we decided to reimburseour employees and former employees the additional taxes arising under Section409A due to the exercise of certain discounted stock options in 2006.  As a result, we recorded expenses ofapproximately $0.9 million in 2006. Of this amount, $0.4 million relates toemployees and former employees who are subject to the disclosure requirementsunder Section 16 of the Securities Exchange Act of 1934 and $0.5 millionrelates to all other employees and former employees (the “qualifyingemployees”). In February 2007, the Internal Revenue Service (“IRS”) publishedguidance allowing companies to voluntarily pay the IRS directly on theiremployees’ behalf any Section 409A taxes and interest by June 30, 2007. Wenotified the IRS of our intention to participate in this program and,accordingly, in June 2007 we paid $0.5 million to the applicable federal andstate tax agencies on behalf of the qualifying employees.

In order to remedy the unfavorable personal taxconsequences for those who have not exercised stock options subject to Section 409A,we intend to provide holders of these options the opportunity to amend theiraffected options. In December 2006, we entered into agreements with ourdirectors and executive officers under which we will amend any affected stockoptions to increase the exercise price to the quoted market price on therevised measurement date and either provide cash payment in 2008 or issuerestricted stock in 2007, at our discretion, to the option holder based on thedifference in exercise price between the revised measurement date and originalgrant date. In February 2007, we determined we would provide a cashpayment or restricted stock for the change in exercise price for the directorsand officers with affected stock options. In addition, certain directors andofficers agreed to waive such cash payment or restricted stock from us for thedifference in exercise price of certain affected stock options. The agreements withour directors and executives resulted in additional stock-based compensationexpense of approximately $16,000 in our consolidated financial statements inthe fourth quarter of 2006 and will result in additional stock-basedcompensation expense of approximately $1.2 million to be recognized in thethree months ended March 31, 2007.

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For all other current employees, we are working on aprogram that we expect to announce following the filing of this Form 10-Qthat will make the employees whole and should eliminate the Section 409Ataxes associated with the affected stock options that have not yet beenexercised. The modification of the stock options held by other currentemployees will result in additional stock-based compensation being recorded,commencing when the program is completed. We estimate the maximum aggregatecash payments to option holders under the program to be approximately $3.7million.

For former employees whomay exercise stock options in 2007 that are subject to Section 409A, wedetermined in the second quarter of 2007 to reimburse the option holders fortaxes incurred and will record an expense in 2007 when and if the exercisesoccur.

*Income Taxes*

As a result of changes inthe tax law in the UK in 2003, we should have recorded a deferred income taxbenefit related to the stock-based compensation for options issued to our UKemployees. As part of this restatement, we have recorded income tax benefits of$10,000 and $5,000 for fiscal 2004 and 2005, respectively. In addition, werecorded $693,000 as an adjustment to our January 1, 2004 openingAccumulated Deficit balance related to fiscal 2003. In addition to the changerelated to the UK, the components of the Company’s deferred income tax assetsand valuation allowance have changed, but resulted in no significant net impactto the carrying value of the assets.

*Other Adjustments*

The restatement of prior year financial statementsincludes adjustments for other errors identified in subsequent periods. Sucherrors were not previously recorded as we concluded the amount of any sucherrors, both individually and in the aggregate, were not material to theconsolidated financial statements of any period. These errors related to thetiming of revenue recognition, the recording of cost of goods sold and certainoperating expenses.

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**SONUS NETWORKS,INC.FORM 10-QQUARTER ENDED JUNE 30, 2006TABLE OF CONTENTS**

|                                       | ** ** | ** **                                                                                                                                      | ** ** | **Page** |
|---------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I FINANCIAL INFORMATION** |       |                                                                                                                                            |       |
| Item 1.                               |       | Financial Statements                                                                                                                            |       |     |   |
|                                  |       | Condensed Consolidated Balance Sheets as of  June 30, 2006 and December 31, 2005 (as restated) (unaudited)                       |       | 10       |   |
|                                  |       | Condensed Consolidated Statements of Operations for  the Three and Six Months Ended June 30, 2006 and 2005 (as restated)  (unaudited) |       | 11       |   |
|                                  |       | Condensed Consolidated Statements of Cash Flows for  the Six Months Ended June 30, 2006 and 2005 (as restated) (unaudited)                 |       | 12       |   |
|                                  |       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                                               |       | 13       |   |
| Item 2.                               |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                                     |       | 39       |   |
| Item 3.                               |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                                     |       | 53       |   |
| Item 4.                               |       | Controls and Procedures                                                                                                                         |       | 53       |   |
| **PART II  OTHER INFORMATION**   |       |                                                                                                                                            |       |
| Item 1.                               |       | Legal Proceedings                                                                                                                               |       | 58       |   |
| Item 1A.                              |       | Risk Factors                                                                                                                                    |       | 61       |   |
| Item 4.                               |       | Submission of Matters to a Vote of Security Holders                                                                                             |       | 76       |   |
| Item 6.                               |       | Exhibits                                                                                                                                        |       | 76       |   |
|                                  |       | Signatures                                                                                                                                      |       | 77       |   |
|                                  |       | Exhibit Index                                                                                                                              |       | 78       |   |

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**PART I—FINANCIALINFORMATION**

**Item 1.**                        FinancialStatements

**SONUS NETWORKS, INC.Condensed Consolidated Balance Sheets(in thousands, except share data)(unaudited)**

| ** **                                                                                                                                                                                                                    | ** ** | **June 30,** | ** ** | **December 31,**                         | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                                                                                                                    | ** ** | **2006**          | ** ** | **2005**                                      | ** ** |
| ** **                                                                                                                                                                                                                    | ** ** | ** **        | ** ** | **(As Restated,  See Note 2)** | ** ** |
| **Assets**                                                                                                                                                                                                                    |       |              |       |                                          |       |   |   |
| Current assets:                                                                                                                                                                                                               |       |              |       |                                          |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                     |       | $                 | 30,383     |                                          |       | $ | 155,679 |   |   |
| Marketable debt  securities                                                                                                                                                                                                   |       | 239,717           |       |                                          | 140,569    |   |   |
| Accounts receivable, net                                                                                                                                                                                                      |       | 77,472            |       |                                          | 72,261     |   |   |
| Inventory, net                                                                                                                                                                                                                |       | 33,871            |       |                                          | 37,700     |   |   |
| Deferred income taxes                                                                                                                                                                                                         |       | 519               |       |                                          | 519        |   |   |
| Other current assets                                                                                                                                                                                                          |       | 17,298            |       |                                          | 14,411     |   |   |
| Total current assets                                                                                                                                                                                                          |       | 399,260           |       |                                          | 421,139    |   |   |
| Property and  equipment, net                                                                                                                                                                                                  |       | 15,605            |       |                                          | 15,331     |   |   |
| Long-term  investments                                                                                                                                                                                                        |       | 48,246            |       |                                          | 17,993     |   |   |
| Deferred income  taxes                                                                                                                                                                                                        |       | 802               |       |                                          | 802        |   |   |
| Other assets                                                                                                                                                                                                                  |       | 6,683             |       |                                          | 1,941      |   |   |
|                                                                                                                                                                                                                          |       | $                 | 470,596    |                                          |       | $ | 457,206 |   |   |
| **Liabilities  and stockholders’ equity**                                                                                                                                                                                |       |              |       |                                          |       |   |   |
| Current liabilities:                                                                                                                                                                                                          |       |              |       |                                          |       |   |   |
| Accounts payable                                                                                                                                                                                                              |       | $                 | 16,488     |                                          |       | $ | 20,375 |   |   |
| Accrued expenses                                                                                                                                                                                                              |       | 24,250            |       |                                          | 24,081     |   |   |
| Accrued restructuring  expenses                                                                                                                                                                                               |       | 200               |       |                                          | 195        |   |   |
| Current portion of  deferred revenue                                                                                                                                                                                          |       | 89,466            |       |                                          | 88,336     |   |   |
| Convertible subordinated  note                                                                                                                                                                                                |       | —            |       |                                          | 10,000     |   |   |
| Current portion of  long-term liabilities                                                                                                                                                                                     |       | 240               |       |                                          | 105        |   |   |
| Total current liabilities                                                                                                                                                                                                     |       | 130,644           |       |                                          | 143,092    |   |   |
| Long-term deferred  revenue                                                                                                                                                                                                   |       | 26,437            |       |                                          | 33,853     |   |   |
| Long-term liabilities,  net of current portion                                                                                                                                                                                |       | 1,230             |       |                                          | 1,449      |   |   |
| Total liabilities                                                                                                                                                                                                             |       | 158,311           |       |                                          | 178,394    |   |   |
| Commitments and contingencies (Note 5)                                                                                                                                                                                        |       |              |       |                                          |       |   |   |
| Stockholders equity:                                                                                                                                                                                                          |       |              |       |                                          |       |   |   |
| Preferred stock, $0.01  par value; 5,000,000 shares authorized, none issued and outstanding                                                                                                                                   |       | —            |       |                                          | —     |   |   |
| Common stock, $0.001 par  value; 600,000,000 shares authorized, 255,450,095 and 251,730,706 shares  issued and 253,153,185 and 249,433,796 shares outstanding at June 30,  2006 and December 31, 2005, respectively |       | 255               |       |                                          | 252        |   |   |
| Additional paid-in  capital                                                                                                                                                                                                   |       | 1,128,719         |       |                                          | 1,110,057  |   |   |
| Deferred compensation                                                                                                                                                                                                         |       | —            |       |                                          | (99        | ) |   |
| Accumulated deficit                                                                                                                                                                                                           |       | (816,357          | )          |                                          | (831,087   | ) |   |
| Accumulated other  comprehensive loss                                                                                                                                                                                         |       | (65               | )          |                                          | (44        | ) |   |
| Treasury stock, at cost;  2,296,910 common shares at June 30, 2006 and December 31, 2005                                                                                                                            |       | (267              | )          |                                          | (267       | ) |   |
| Total stockholders’  equity                                                                                                                                                                                              |       | 312,285           |       |                                          | 278,812    |   |   |
|                                                                                                                                                                                                                          |       | $                 | 470,596    |                                          |       | $ | 457,206 |   |   |

 

See notes to the condensed consolidated financial statements.

10

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**SONUS NETWORKS, INC.Condensed Consolidated Statements of Operations(in thousands, except per share data)(unaudited)**

| ** **                                      | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                      | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | **(As Restated,**         | ** ** | ** ** | ** ** | **(As Restated,** | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | **See Note 2)**      | ** ** | ** ** | ** ** | **See Note 2)** | ** ** |
| Revenue:                                        |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Product                                         |       | $                                | 48,853     |                           |       | $ | 40,993 |   |   | $ | 93,395 |   |   | $ | 63,750 |   |   |
| Service                                         |       | 15,627                           |       |                           | 16,372     |   |   | 31,080 |   |   | 27,561 |   |   |
| Total revenue                                   |       | 64,480                           |       |                           | 57,365     |   |   | 124,475 |   |   | 91,311 |   |   |
| Cost of revenue:                                |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Product                                         |       | 16,199                           |       |                           | 14,179     |   |   | 32,082 |   |   | 21,691 |   |   |
| Service                                         |       | 6,987                            |       |                           | 5,706      |   |   | 13,716 |   |   | 11,025 |   |   |
| Total cost of revenue                           |       | 23,186                           |       |                           | 19,885     |   |   | 45,798 |   |   | 32,716 |   |   |
| Gross profit                                    |       | 41,294                           |       |                           | 37,480     |   |   | 78,677 |   |   | 58,595 |   |   |
| Operating  expenses:                            |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Research and development                        |       | 12,900                           |       |                           | 11,421     |   |   | 25,976 |   |   | 22,611 |   |   |
| Sales and marketing                             |       | 15,646                           |       |                           | 11,543     |   |   | 29,671 |   |   | 21,219 |   |   |
| General and administrative                      |       | 7,248                            |       |                           | 6,751      |   |   | 14,228 |   |   | 13,737 |   |   |
| Total operating expenses                        |       | 35,794                           |       |                           | 29,715     |   |   | 69,875 |   |   | 57,567 |   |   |
| Income from operations                          |       | 5,500                            |       |                           | 7,765      |   |   | 8,802 |   |   | 1,028 |   |   |
| Interest expense                                |       | (81                              | )          |                           | (121       | ) |   | (218 | ) |   | (257 | ) |   |
| Interest income                                 |       | 3,899                            |       |                           | 2,222      |   |   | 7,341 |   |   | 4,097 |   |   |
| Income before income taxes                      |       | 9,318                            |       |                           | 9,866      |   |   | 15,925 |   |   | 4,868 |   |   |
| Income tax  provision                           |       | (404                             | )          |                           | (311       | ) |   | (1,195 | ) |   | (407 | ) |   |
| Net income                                      |       | $                                | 8,914      |                           |       | $ | 9,555 |   |   | $ | 14,730 |   |   | $ | 4,461 |   |   |
| Net income per  share:                          |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Basic                                           |       | $                                | 0.04       |                           |       | $ | 0.04 |   |   | $ | 0.06 |   |   | $ | 0.02 |   |   |
| Diluted                                         |       | $                                | 0.03       |                           |       | $ | 0.04 |   |   | $ | 0.06 |   |   | $ | 0.02 |   |   |
| Shares used in  computing net income per share: |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Basic                                           |       | 252,664                          |       |                           | 248,249    |   |   | 251,371 |   |   | 248,064 |   |   |
| Diluted                                         |       | 256,326                          |       |                           | 250,578    |   |   | 255,454 |   |   | 252,366 |   |   |

s

See notes to the condensed consolidated financial statements.

11

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**SONUS NETWORKS, INC.Condensed Consolidated Statements of Cash Flows(in thousands)(unaudited)**

| ** **                                                                           | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                           | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| ** **                                                                           | ** ** | ** **                                    | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Cash flows from operating activities:                                                |       |                                          |       |   |   |   |   |
| Net income                                                                           |       | $                                             | 14,730     |   |   | $ | 4,461 |   |   |
| Adjustments to reconcile  net income to cash flows provided by operating activities: |       |                                          |       |   |   |   |   |
| Depreciation and  amortization of property and equipment                             |       | 4,732                                         |       |   | 3,081 |   |   |
| Stock-based  compensation                                                            |       | 5,042                                         |       |   | 1,379 |   |   |
| Loss on disposal  of property and equipment                                          |       | 6                                             |       |   | — |   |   |
| Changes in operating  assets and liabilities:                                        |       |                                          |       |   |   |   |   |
| Accounts  receivable                                                                 |       | (5,162                                        | )          |   | (26,973 | ) |   |
| Inventory                                                                            |       | 4,170                                         |       |   | (2,105 | ) |   |
| Other operating  assets                                                              |       | (7,812                                        | )          |   | (1,958 | ) |   |
| Accounts payable                                                                     |       | (3,712                                        | )          |   | 3,328 |   |   |
| Accrued expenses,  deferred rent and accrued restructuring expenses                  |       | 52                                            |       |   | (428 | ) |   |
| Deferred revenue                                                                     |       | (6,661                                        | )          |   | 21,676 |   |   |
| Net cash provided  by operating activities                                           |       | 5,385                                         |       |   | 2,461 |   |   |
| Cash flows from investing activities:                                                |       |                                          |       |   |   |   |   |
| Purchases of  property and equipment                                                 |       | (5,163                                        | )          |   | (7,373 | ) |   |
| Maturities of  available-for-sale marketable debt securities                         |       | 68,775                                        |       |   | 106,900 |   |   |
| Purchases of  available-for-sale marketable debt securities                          |       | (31,175                                       | )          |   | (112,479 | ) |   |
| Maturities of  held-to-maturity marketable debt securities and long-term investments |       | 58,006                                        |       |   | 15,846 |   |   |
| Purchases of  held-to-maturity marketable debt securities and long-term investments  |       | (225,007                                      | )          |   | (10,207 | ) |   |
| Decrease in  restricted cash                                                         |       | 250                                           |       |   | 500 |   |   |
| Decrease in other  assets                                                            |       | —                                        |       |   | 84 |   |   |
| Net cash used in  investing activities                                               |       | (134,314                                      | )          |   | (6,729 | ) |   |
| Cash flows from financing activities:                                                |       |                                          |       |   |   |   |   |
| Sale of common  stock in connection with employee stock purchase plan                |       | 2,310                                         |       |   | 2,313 |   |   |
| Proceeds from  exercise of stock options                                             |       | 11,386                                        |       |   | 881 |   |   |
| Repayment of  convertible subordinated note                                          |       | (10,000                                       | )          |   | — |   |   |
| Principal payments  of capital lease obligations                                     |       | (23                                           | )          |   | (66 | ) |   |
| Net cash provided  by financing activities                                           |       | 3,673                                         |       |   | 3,128 |   |   |
| Effect of exchange  rate changes on cash and cash equivalents                        |       | (40                                           | )          |   | — |   |   |
| Net decrease in  cash and cash equivalents                                           |       | (125,296                                      | )          |   | (1,140 | ) |   |
| Cash and cash  equivalents, beginning of period                                      |       | 155,679                                       |       |   | 120,839 |   |   |
| Cash and cash  equivalents, end of period                                            |       | $                                             | 30,383     |   |   | $ | 119,699 |   |   |
| Supplemental disclosure of cash flow information:                                    |       |                                          |       |   |   |   |   |
| Interest paid                                                                        |       | $                                             | 211        |   |   | $ | 241 |   |   |
| Income taxes paid                                                                    |       | $                                             | 1,649      |   |   | $ | 619 |   |   |
| Supplemental disclosure of non-cash investing  activities:                           |       |                                          |       |   |   |   |   |
| Non-cash purchases  of property and equipment                                        |       | $                                             | 872        |   |   | $ | 1,211 |   |   |
| Property and  equipment acquired as part of a facility lease                         |       | $                                             | 50         |   |   | $ | — |   |   |
| Property and  equipment acquired under capital lease                                 |       | $                                             | —     |   |   | $ | 163 |   |   |

 

See notes to the condensed consolidated financial statements.

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**SONUS NETWORKS, INC.Notes to Condensed Consolidated Financial Statements(Unaudited)**

**(1)**          Descriptionof Business

Sonus Networks, Inc.(“Sonus” or the “Company”) was incorporated in 1997 and is a leading providerof voice infrastructure solutions for wireline and wireless service providers. Sonusoffers a new generation of carrier-class infrastructure equipment and softwarethat enables voice services to be delivered over packet-based networks.

**(2)**          Restatementof Consolidated Financial Statements

On May 25, 2006, in response to the recent focuson public company employee stock option granting practices and accounting, theCompany in conjunction with the Audit Committee of its Board of Directors (the “AuditCommittee”) voluntarily commenced a review of its historical stock optiongranting practices (the “Internal Review”) and accounting. The Internal Reviewinitially focused on several grants in the 2000 to 2002 time period for whichthe grant dates appear to have been set on dates where the Company’s share pricewas trading near six month lows. As a result of the findings of the InternalReview, on August 3, 2006, the Company’s Board of Directors authorized theAudit Committee to conduct an expanded, independent investigation of theCompany’s stock option granting practices from the Company’s initial publicoffering in May 2000 through August 2006 (the “Audit CommitteeInvestigation” or “Investigation”).

As a result of the Audit Committee Investigation, theCompany performed a review of stock option grant measurement dates recorded forfinancial reporting purposes. The Company determined that during the periodfrom May 2000 through December 31, 2005, the Company i) appliedincorrect measurement dates in the accounting for certain stock options and ii)incorrectly accounted for certain stock options that should have been recordedusing variable accounting. Accordingly, the Company has restated itsaccumulated deficit as of January 1, 2005 and its consolidated financialstatements for the three and six months ended June 30, 2005 to recordadditional stock-based compensation to correctly account for its stock optionsand related tax adjustments. The cumulative amount of these stock-basedcompensation adjustments aggregate to $54.1 million for fiscal years 2000through 2005. The Company has also corrected other previously unrecordedmisstatements not related to the accounting for stock options previously deemedto be immaterial.

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Thefollowing table reconciles net income and accumulated deficit as previouslyreported to the restated amounts (in thousands):

| ** **                                                                              | ** ** | **Net Income**                                   | ** ** | **Accumulated**                                     | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                              | ** ** | **Three Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2005** | ** ** | **Deficit as of  January 1,  2005** | ** ** |
| As previously  reported                                                                 |       |                                                  | $          | 9,745                                               |       |   |   | $ | 6,050 |   |   |   | $ | (784,085 | ) |   |
| Changes in net  income and accumulated deficit                                          |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |
| Stock-based compensation adjustments related to  revised measurement dates              |       |                                                  | (671       | )                                                   |       |   | (1,470 | ) |   |   | (49,156 | ) |   |
| Stock-based compensation adjustments related to the  application of variable accounting |       |                                                  | (45        | )                                                   |       |   | 95 |   |   |   | (1,370 | ) |   |
| Withholding tax adjustments                                                             |       |                                                  | (79        | )                                                   |       |   | (126 | ) |   |   | (755 | ) |   |
| Other adjustments                                                                       |       |                                                  | 605        |                                                |       |   | (88 | ) |   |   | (1,389 | ) |   |
| Income taxes                                                                            |       |                                                  | —     |                                                |       |   | — |   |   |   | 883 |   |   |
| Total change in  net income and accumulated deficit                                     |       |                                                  | (190       | )                                                   |       |   | (1,589 | ) |   |   | (51,787 | ) |   |
| As restated                                                                             |       |                                                  | $          | 9,555                                               |       |   |   | $ | 4,461 |   |   |   | $ | (835,872 | ) |   |

 

*Stock-BasedCompensation Adjustments Related to Revised Measurement Dates*

In light of the findings of the Audit CommitteeInvestigation, the Company assessed the measurement dates for all of the Company’shistorical stock option grants and reviewed all available evidence for eachoption grant. Based on the available facts and circumstances surrounding theCompany’s stock option granting practices, the Company adopted a methodologyfor determining the most likely measurement dates. The Company believes theapplication of this methodology indicated the date where the number of optionsgranted to each recipient and the exercise price are known with finality. Indetermining the most likely measurement date, the Company considered evidencesuch as the date of the completion of the granting process, clear communicationto the recipients of the principal terms of the award, and the date by whichthe grant was substantially entered into the Company’s stock administrationsystem.

The completion of the granting process involvingunanimous written consents (“UWCs”) was determined to be receipt of the lastsignature on the UWC approving the grant. There often was evidence throughemails or cover memos as to when the Company intended to forward UWCs to theCompensation Committee for signature, but rarely evidence as to the date theUWCs were signed and returned. If there is no clear evidence of receipt of thelast signature of the UWC, then the Company reviewed all other availableevidence and used its judgment to determine the most likely measurement date. Theadditional available evidence included, but was not limited to, the next datethat the two members of the Compensation Committee were physically present at aBoard-level meeting where the UWC may have been signed based on the Company’spast practice and the date by which at least 90% of the stock option grant wasentered into the Company’s stock option administration system.

Evidence of clear communication between the Companyand the recipients regarding a grant prior to the final granting actionincludes email or oral communication of the grant date and exercise price tothe entire recipient population followed thereafter by individualcommunications regarding the principal terms of the grant, offer lettersstating the principal terms of the grant or a Form 3 or Form 4 filedwith the SEC. The Company believes it is appropriate to rely on clearcommunication as evidence of finality because the Company’s past practice wasto communicate terms of grants to employees only when they were final andapproved by those with authority. The Company viewed the communication asgiving rise to a legal obligation to honor the grants.

14

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Based on theCompany’s analysis summarized above, the Company adopted the followingframework for determining the measurement dates of its stock option grants, andapplied this framework based on the facts and circumstances of each grant.

(1)         If the stock option grantwas approved at a Board-level meeting, the date reflected in meeting minutes ofthe Company’s Board of Directors or Compensation Committee of the Board ofDirectors where the number of options for each recipient and the exercise pricefor the grant has been clearly approved was determined to be the most likelymeasurement date. Measurement dates for approximately 35% of the total numberof grants were determined based on this method.

(2)         If the stock option grantwas approved by UWC, the date of communication of the principal terms of the grantto the recipients if prior to the signature date on the UWC was determined tobe the most likely measurement date. Measurement dates for approximately 42% ofthe total number of grants were determined based on this method.

(3)         If the stock option grantwas approved by UWC and the Company did not have clear prior evidence of thedate the principal terms of the grant were communicated to the recipients, thedate of receipt of the last signature for the UWC provided there was clearevidence of the date the last signature was received was determined to be themost likely measurement date. Measurement dates for approximately 2% of thetotal number of grants were determined based on this method.

(4)         If the stock option grantwas approved by UWC and the Company did not have clear evidence of the date theprincipal terms of the grant were communicated to the recipients or the date ofreceipt of the last signature on the UWC, the Company reviewed all otheravailable evidence and used its judgment to determine the most likelymeasurement date. The additional available evidence included, but was notlimited to:

a.                  the next datethat the two Compensation Committee members were physically present at aBoard-level meeting where the UWC may have been signed and the meeting occurredwithin a reasonable time period; and

b.                 the date by whichat least 90% of the stock option grant was entered into the Company’s stockoption administration system.

Measurement dates for approximately 6% of the totalnumber of grants were determined based on the next date that the twoCompensation Committee members were physically present at a Board-level meetingand approximately 15% when at least 90% of the stock option grant was enteredinto the Company’s stock option administration system.

After selecting a measurement date through one of thefour steps in the above framework, the Company then determined if there wereany changes to the individual grant recipients or amount of options grantedafter the selected measurement date. If there were no changes following theselected measurement date, then the measurement date would remain unchanged. Ifthe Company identified changes following the selected measurement date, thenthe Company would evaluate whether the changes should delay the measurementdate for the entire list of grants until the list became final or whether thechanges should result in separate accounting for specific grants. Factorsconsidered in evaluating whether it would be appropriate to delay themeasurement date until the list was final included: 1) the frequency of anychanges as well as the reason for any changes; 2) whether the changes wereadministrative in nature (corrections of errors for grants to which recipientswould have been otherwise entitled); and 3) whether the changes reflectedre-allocation of options among a broader range of recipients.

15

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In applying thisframework, the Company revised the measurement dates for many grants whichresulted in exercise prices that were less than the fair market value of thestock on the revised measurement dates. This outcome results in a stock-basedcompensation charge in accordance with APB 25. Adjustments related torevised measurement dates resulted in the Company recognizing additionalstock-based compensation expense from 2000 through 2005 of approximately $52.9million. The additional stock-based compensation for the three and six monthsended June 30, 2005 was $0.7 million and $1.5 million, respectively.

*Stock-BasedCompensation Adjustment Related to the Application of Variable Accounting*

In 1999, tax regulations became effective in theUnited Kingdom (“UK”) that required employers to remit a 12% UK NationalInsurance Contribution (“NIC”) tax on gains resulting from the exercise ofstock options held by UK citizens. In 2000, the UK passed regulations thatallowed an employer to either (a) transfer its NIC tax liability to anemployee or (b) be reimbursed by an employee for NIC payments incurred byan employer for options granted after April 1999. If a company decided totransfer its NIC tax liability to an employee, a company was required to obtainapproval of the use of a standard election form from UK Inland Revenue, whichwould then be signed by each employee.

Subsequent to theenactment of the new NIC regulations in 1999, the Company granted stock optionsto its UK employees. The Company entered into agreements whereby the employeewould be required to reimburse the Company for the taxes. Under the guidance ofIssue 15 of Emerging Issues Task Force (“EITF”) Issue No. 00-23, *Issues Related to the Accounting for Stock Compensation under APBOpinion No. 25 and FASB Interpretation No. 44,* variableaccounting is required for stock option grants when a cash payment contingentupon exercise is not fixed. Accordingly, an employee obligation to reimbursethe employer for the amount of NIC taxes triggered by an exercise causes avariable exercise price for the grant, and thus, the options issued to UKemployees resulted in the Company recording additional stock-based compensationexpense from 2000 through 2005 totaling approximately $1.2 million. The effecton stock-based compensation for the three months ended June 30, 2005 was anincrease in stock-based compensation of $45,000 and the effect on stock-basedcompensation for the six months ended June 30, 2005 was a decrease of $0.1million.

*Tax-RelatedAdjustments*

*Withholding Taxes*

In addition to the abovestock-based compensation charges, the Company has also recorded tax-relatedexpense related to the Company’s stock option grants. The Company hasdetermined that stock options previously classified as incentive stock options(“ISO”) no longer meet the criteria for ISO status since they were issued inthe money on the revised measurement date. The disqualification of ISO statusresulted in the failure to withhold certain employee income and payroll taxesand, consequently, the Company has recorded an additional expense, along withpenalties and interest, in the periods of exercise. Withholding tax adjustmentsrelated to the disqualification of the ISO status of stock options totaledapproximately $1.0 million from 2001 through 2005 and approximately $0.1 millionfor both the three and six months ended June 30, 2006.

*Section 409A*

Under Section 409A of the Internal Revenue Code (“Section 409A”)individuals who received option grants with an exercise price below the fairmarket value of the underlying stock at the revised measurement date will besubject to additional taxes and interest with respect to options that vestafter December 31, 2004. Holders of these stock options will be requiredto recognize ordinary income at vesting. Pursuant to the interim InternalRevenue Service guidance, the income is calculated as the 

16

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difference between thefair market value of the underlying stock and the exercise price as of December 31of the year of vesting. The individual must also recognize, in each subsequentyear until the option is fully exercised or expires, ordinary income equal tothe excess of the fair market value of the underlying stock over the sum of theexercise price and any previously recorded income. In addition to ordinaryincome and employment taxes, an additional 20% tax on the resulting ordinaryincome is levied on the individual, plus interest on any tax to be paid.

In the fourth quarter of 2006, the Company decided toreimburse its employees and former employees the additional taxes arising underSection 409A due to the exercise of certain discounted stock options in 2006.As a result, the Company recorded expenses of approximately $0.9 million in2006. Of this amount, $0.4 million relates to employees and former employeeswho are subject to the disclosure requirements under Section 16 of theSecurities Exchange Act of 1934 and $0.5 million relates to all other employeesand former employees (the “qualifying employees”).  In February 2007, the Internal RevenueService (“IRS”) published guidance allowing companies to voluntarily pay theIRS directly on their employees’ behalf any Section 409A taxes and interest byJune 30, 2007. Sonus notified the IRS of its intention to participate in thisprogram and, accordingly, in June 2007 the Company paid $0.5 million to theapplicable federal and state tax agencies on behalf of the qualifyingemployees.

In order to remedy the unfavorable personal taxconsequences for those who have not exercised stock options subject to Section 409A,the Company intends to provide holders of these options the opportunity toamend their affected options. In December 2006, the Company entered intoagreements with its directors and executive officers under which the Companywill amend any affected stock options to increase the exercise price to thequoted market price on the revised measurement date and either provide cashpayment in 2008 or issue restricted stock in 2007, at the Company’s discretion,to the option holder based on the difference in exercise price between therevised measurement date and original grant date. In February 2007, theCompany determined it would provide a cash payment or restricted stock for thechange in exercise price for the directors and officers. Certain director andofficers agreed to waive such cash payment or restricted stock from the Companyfor the difference in exercise price of certain affected stock options. TheCompany’s agreement with its directors and executives resulted in additionalstock-based compensation expense of approximately $16,000 in the Company’sconsolidated financial statements in the fourth quarter of 2006 and will resultin additional stock-based compensation expense of approximately $1.2 million inthe three months ended March 31, 2007.

For all other currentemployees, the Company is working on a program that it expects to announcefollowing the filing of this Form 10-Q that will make the employeeswhole and should eliminate the Section 409A taxes associated with theaffected stock options that have not yet been exercised. The modification ofthe stock options held by other current employees will result in additionalstock-based compensation being recorded, commencing when the program iscompleted. The Company estimates the maximum aggregate cash payments to optionholders under the program to be approximately $3.7 million.

*Income Taxes*

As a result of the changesin the tax law in the UK in 2003, the Company should have recorded a deferredincome tax benefit related to the stock-based compensation for options issuedto its UK employees. As part of this restatement, the Company has recordedincome tax benefits of $10,000 and $5,000 for fiscal 2004 and 2005,respectively. In addition, the Company recorded $693,000 as an adjustment toits January 1, 2004 beginning Accumulated Deficit balance related tofiscal 2003. In addition to the change related to the UK, the components of theCompany’s deferred income tax assets and valuation allowance have changed, butresulted in no significant net impact to the carrying value of the assets.

17

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*Other Adjustments*

The restatement of prioryear financial statements includes adjustments for other errors identified insubsequent periods. Such errors were not previously recorded as the Companyconcluded the amount of any such errors, both individually and in theaggregate, were not material to the consolidated financial statements of anyperiod. These errors related to the timing of revenue recognition, therecording of cost of goods sold and certain operating expenses.

*Adjustment toStatement of Cash Flows*

The statement of cashflows for the six months ended June 30, 2005 reflects the effects of theadjustments noted above as well as the presentation of purchases and maturitiesof marketable debt securities available-for-sale and held-to-maturity.

***Statement of Operations Adjustments***

The following tablesreconcile the amounts previously reported in the Company’s consolidatedstatements of operations for the three and six months ended June 30, 2005to the corresponding restated amounts, which reflect the restatementadjustments previously described (in thousands, except per share data):

| **Three Months Ended June 30, 2005** | ** ** | ** ** | ** ** | **As Previously  Reported** | ** ** | **Stock-Based  Compensation and  Tax-Related  Adjustments** | ** ** | **Other  Adjustments** | ** ** | **As Restated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|----------------------------------|------------|------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| Revenue:                                                      |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Product                                                       |       |       | $          | 41,339                           |       |                                                             |       | $                      | —     |                 |       |   | $ | (346 | ) |   |   | $ | 40,993 |   |   |
| Service                                                       |       |       | 16,754     |                             |       |                                                             | —     |                   |       |                 | (382       | ) |   |   | 16,372 |   |   |
| Total revenue                                                 |       |       | 58,093     |                             |       |                                                             | —     |                   |       |                 | (728       | ) |   |   | 57,365 |   |   |
| Cost of revenue:                                              |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Product                                                       |       |       | 15,404     |                             |       |                                                             | 5          |                   |       |                 | (1,230     | ) |   |   | 14,179 |   |   |
| Service                                                       |       |       | 5,651      |                             |       |                                                             | 81         |                   |       |                 | (26        | ) |   |   | 5,706 |   |   |
| Total cost of revenue                                         |       |       | 21,055     |                             |       |                                                             | 86         |                   |       |                 | (1,256     | ) |   |   | 19,885 |   |   |
| Gross profit                                                  |       |       | 37,038     |                             |       |                                                             | (86        | )                      |       |                 | 528        |   |   |   | 37,480 |   |   |
| Operating  expenses:                                          |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Research and development                                      |       |       | 11,098     |                             |       |                                                             | 230        |                   |       |                 | 93         |   |   |   | 11,421 |   |   |
| Sales and marketing                                           |       |       | 11,508     |                             |       |                                                             | 326        |                   |       |                 | (291       | ) |   |   | 11,543 |   |   |
| General and administrative                                    |       |       | 6,477      |                             |       |                                                             | 153        |                   |       |                 | 121        |   |   |   | 6,751 |   |   |
| Total operating expenses                                      |       |       | 29,083     |                             |       |                                                             | 709        |                   |       |                 | (77        | ) |   |   | 29,715 |   |   |
| Income from operations                                        |       |       | 7,955      |                             |       |                                                             | (795       | )                      |       |                 | 605        |   |   |   | 7,765 |   |   |
| Interest expense                                              |       |       | (121       | )                                |       |                                                             | —     |                   |       |                 | —     |   |   |   | (121 | ) |   |
| Interest income                                               |       |       | 2,222      |                             |       |                                                             | —     |                   |       |                 | —     |   |   |   | 2,222 |   |   |
| Income before income taxes                                    |       |       | 10,056     |                             |       |                                                             | (795       | )                      |       |                 | 605        |   |   |   | 9,866 |   |   |
| Income tax  provision                                         |       |       | (311       | )                                |       |                                                             | —     |                   |       |                 | —     |   |   |   | (311 | ) |   |
| Net income                                                    |       |       | $          | 9,745                            |       |                                                             |       | $                      | (795       | )                    |       |   | $ | 605 |   |   |   | $ | 9,555 |   |   |
| Net income per  share:                                        |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Basic and diluted                                             |       |       | $          | 0.04                             |       |                                                             |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 0.04 |   |   |
| Shares used in  computing net income per share:               |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Basic                                                         |       |       | 248,249    |                             |       |                                                             | —     |                   |       |                 | —     |   |   |   | 248,249 |   |   |
| Diluted                                                       |       |       | 250,651    |                             |       |                                                             | (73        | )                      |       |                 | —     |   |   |   | 250,578 |   |   |

 

18

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| **Six Months Ended June 30, 2005** | ** ** | ** ** | ** ** | **As Previously  Reported** | ** ** | **Stock-Based  Compensation and  Tax-Related  Adjustments** | ** ** | **Other  Adjustments** | ** ** | **As Restated** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|----------------------------------|------------|------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| Revenue:                                                    |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Product                                                     |       |       | $          | 63,797                           |       |                                                             |       | $                      | —     |                 |       |   | $ | (47 | ) |   |   | $ | 63,750 |   |   |
| Service                                                     |       |       | 27,906     |                             |       |                                                             | —     |                   |       |                 | (345       | ) |   |   | 27,561 |   |   |
| Total revenue                                               |       |       | 91,703     |                             |       |                                                             | —     |                   |       |                 | (392       | ) |   |   | 91,311 |   |   |
| Cost of revenue:                                            |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Product                                                     |       |       | 22,247     |                             |       |                                                             | 16         |                   |       |                 | (572       | ) |   |   | 21,691 |   |   |
| Service                                                     |       |       | 10,920     |                             |       |                                                             | 154        |                   |       |                 | (49        | ) |   |   | 11,025 |   |   |
| Total cost of revenue                                       |       |       | 33,167     |                             |       |                                                             | 170        |                   |       |                 | (621       | ) |   |   | 32,716 |   |   |
| Gross profit                                                |       |       | 58,536     |                             |       |                                                             | (170       | )                      |       |                 | 229        |   |   |   | 58,595 |   |   |
| Operating  expenses:                                        |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Research and development                                    |       |       | 22,115     |                             |       |                                                             | 442        |                   |       |                 | 54         |   |   |   | 22,611 |   |   |
| Sales and marketing                                         |       |       | 20,535     |                             |       |                                                             | 556        |                   |       |                 | 128        |   |   |   | 21,219 |   |   |
| General and administrative                                  |       |       | 13,277     |                             |       |                                                             | 333        |                   |       |                 | 127        |   |   |   | 13,737 |   |   |
| Total operating expenses                                    |       |       | 55,927     |                             |       |                                                             | 1,331      |                   |       |                 | 309        |   |   |   | 57,567 |   |   |
| Income from operations                                      |       |       | 2,609      |                             |       |                                                             | (1,501     | )                      |       |                 | (80        | ) |   |   | 1,028 |   |   |
| Interest expense                                            |       |       | (249       | )                                |       |                                                             | —     |                   |       |                 | (8         | ) |   |   | (257 | ) |   |
| Interest income                                             |       |       | 4,097      |                             |       |                                                             | —     |                   |       |                 | —     |   |   |   | 4,097 |   |   |
| Income before income taxes                                  |       |       | 6,457      |                             |       |                                                             | (1,501     | )                      |       |                 | (88        | ) |   |   | 4,868 |   |   |
| Income tax  provision                                       |       |       | (407       | )                                |       |                                                             | —     |                   |       |                 | —     |   |   |   | (407 | ) |   |
| Net income                                                  |       |       | $          | 6,050                            |       |                                                             |       | $                      | (1,501     | )                    |       |   | $ | (88 | ) |   |   | $ | 4,461 |   |   |
| Net income per  share:                                      |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Basic and diluted                                           |       |       | $          | 0.02                             |       |                                                             |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 0.02 |   |   |
| Shares used in  computing net income per share:             |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Basic                                                       |       |       | 248,064    |                             |       |                                                             | —     |                   |       |                 | —     |   |   |   | 248,064 |   |   |
| Diluted                                                     |       |       | 252,709    |                             |       |                                                             | (343       | )                      |       |                 | —     |   |   |   | 252,366 |   |   |

 

19

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***Balance SheetAdjustments***

Thefollowing tables reconcile the amounts previously reported in the Company’sconsolidated balance sheet as of December 31, 2005 to the correspondingrestated amounts, which reflect the restatement adjustments previously described(in thousands):

| **December 31, 2005**                | ** ** | ** ** | ** ** | **As Previously  Reported** | ** ** | **Stock-based  Compensation  and Tax-Related  Adjustments** | ** ** | **Other  Adjustments** | ** ** | **As Restated** | ** ** |
|------------------------------------------------|------------|------------|------------|----------------------------------|------------|------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| *Assets*                                       |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |
| Current assets:                                |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |
| Cash and cash equivalents                      |       |       | $          | 155,679                          |       |                                                             |       | $                      | —     |                 |       |   | $ | — |   |   | $ | 155,679 |   |
| Marketable debt securities                     |       |       | 140,569    |                             |       |                                                             | —     |                   |       |                 | —     |   |   | 140,569 |   |
| Accounts receivable, net                       |       |       | 72,321     |                             |       |                                                             | —     |                   |       |                 | (60        | ) |   | 72,261 |   |
| Inventory, net                                 |       |       | 37,831     |                             |       |                                                             | —     |                   |       |                 | (131       | ) |   | 37,700 |   |
| Deferred income taxes                          |       |       | 519        |                             |       |                                                             | —     |                   |       |                 | —     |   |   | 519 |   |
| Other current assets                           |       |       | 15,833     |                             |       |                                                             | —     |                   |       |                 | (1,422     | ) |   | 14,411 |   |
| Total current assets                           |       |       | 422,752    |                             |       |                                                             | —     |                   |       |                 | (1,613     | ) |   | 421,139 |   |
| Property and  equipment, net                   |       |       | 15,181     |                             |       |                                                             | —     |                   |       |                 | 150        |   |   | 15,331 |   |
| Long-term  investments                         |       |       | 17,993     |                             |       |                                                             | —     |                   |       |                 | —     |   |   | 17,993 |   |
| Deferred income  taxes                         |       |       | —     |                             |       |                                                             | 708        |                   |       |                 | 94         |   |   | 802 |   |
| Other assets                                   |       |       | 631        |                             |       |                                                             | —     |                   |       |                 | 1,310      |   |   | 1,941 |   |
|                                           |       |       | $          | 456,557                          |       |                                                             |       | $                      | 708        |                 |       |   | $ | (59 | ) |   | $ | 457,206 |   |
| *Liabilities and stockholders’  equity*   |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |
| Current  liabilities:                          |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |
| Accounts payable                               |       |       | $          | 20,408                           |       |                                                             |       | $                      | —     |                 |       |   | $ | (33 | ) |   | $ | 20,375 |   |
| Accrued expenses                               |       |       | 23,204     |                             |       |                                                             | 1,029      |                   |       |                 | (152       | ) |   | 24,081 |   |
| Accrued restructuring expenses                 |       |       | 195        |                             |       |                                                             | —     |                   |       |                 | —     |   |   | 195 |   |
| Current portion of deferred revenue            |       |       | 88,199     |                             |       |                                                             | —     |                   |       |                 | 137        |   |   | 88,336 |   |
| Convertible subordinated note                  |       |       | 10,000     |                             |       |                                                             | —     |                   |       |                 | —     |   |   | 10,000 |   |
| Current portion of long-term liabilities       |       |       | 48         |                             |       |                                                             | —     |                   |       |                 | 57         |   |   | 105 |   |
| Total current liabilities                      |       |       | 142,054    |                             |       |                                                             | 1,029      |                   |       |                 | 9          |   |   | 143,092 |   |
| Long-term  deferred revenue                    |       |       | 33,853     |                             |       |                                                             | —     |                   |       |                 | —     |   |   | 33,853 |   |
| Long-term  liabilities, net of current portion |       |       | 485        |                             |       |                                                             | —     |                   |       |                 | 964        |   |   | 1,449 |   |
| Total liabilities                              |       |       | 176,392    |                             |       |                                                             | 1,029      |                   |       |                 | 973        |   |   | 178,394 |   |
| Stockholders’  equity:                    |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |
| Preferred stock                                |       |       | —     |                             |       |                                                             | —     |                   |       |                 | —     |   |   | — |   |
| Common stock                                   |       |       | 252        |                             |       |                                                             | —     |                   |       |                 | —     |   |   | 252 |   |
| Additional paid-in capital                     |       |       | 1,055,941  |                             |       |                                                             | 54,183     |                   |       |                 | (67        | ) |   | 1,110,057 |   |
| Deferred compensation                          |       |       | —     |                             |       |                                                             | (99        | )                      |       |                 | —     |   |   | (99 | ) |
| Accumulated deficit                            |       |       | (775,717   | )                                |       |                                                             | (54,405    | )                      |       |                 | (965       | ) |   | (831,087 | ) |
| Accumulated other comprehensive loss           |       |       | (44        | )                                |       |                                                             | —     |                   |       |                 | —     |   |   | (44 | ) |
| Treasury stock                                 |       |       | (267       | )                                |       |                                                             | —     |                   |       |                 | —     |   |   | (267 | ) |
| Total stockholders’ equity                |       |       | 280,165    |                             |       |                                                             | (321       | )                      |       |                 | (1,032     | ) |   | 278,812 |   |
|                                           |       |       | $          | 456,557                          |       |                                                             |       | $                      | 708        |                 |       |   | $ | (59 | ) |   | $ | 457,206 |   |

 

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***Statement of CashFlows Adjustments***

Thefollowing tables reconcile the amounts previously reported in the Company’sconsolidated statements of cash flows for the six months ended June 30,2005 to the corresponding restated amounts, which reflect the restatementadjustments previously described (in thousands):

| ** **                                                                               | ** ** | **As Previously  Reported** | ** ** | **Stock-based  Compensation  and Tax-Related  Adjustments** | ** ** | **Other  Adjustments** | ** ** | **As Restated** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| Cash flows from  operating activities:                                                   |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |   |   |
| Net income                                                                               |       |                             | $          | 6,050                                                            |       |                   |       | $                    | (1,501     | ) |   |   | $ | (88 | ) |   |   | $ | 4,461 |   |   |
| Adjustments to reconcile net income to cash flows  from operating activities:       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |   |   |
| Depreciation and amortization of property and  equipment                                 |       |                             | 3,102      |                                                             |       |                   | —     |                 |       |   | (21 | ) |   |   | 3,081 |   |   |
| Tax benefit of stock options exercised                                                   |       |                             | 225        |                                                             |       |                   |       |                 |       |   | (225 | ) |   |   | — |   |   |
| Stock-based compensation                                                                 |       |                             | 4          |                                                             |       |                   | 1,375      |                 |       |   | — |   |   |   | 1,379 |   |   |
| Accounts receivable                                                                      |       |                             | (29,576    | )                                                                |       |                   | —     |                 |       |   | 2,603 |   |   |   | (26,973 | ) |   |
| Inventory                                                                                |       |                             | (2,200     | )                                                                |       |                   | —     |                 |       |   | 95 |   |   |   | (2,105 | ) |   |
| Other current assets                                                                     |       |                             | (1,129     | )                                                                |       |                   | —     |                 |       |   | (829 | ) |   |   | (1,958 | ) |   |
| Accounts payable                                                                         |       |                             | 3,328      |                                                             |       |                   | —     |                 |       |   | — |   |   |   | 3,328 |   |   |
| Accrued expenses, deferred rent and accrued  restructuring expenses                      |       |                             | (1,016     | )                                                                |       |                   | 126        |                 |       |   | 462 |   |   |   | (428 | ) |   |
| Deferred revenue                                                                         |       |                             | 23,796     |                                                             |       |                   | —     |                 |       |   | (2,120 | ) |   |   | 21,676 |   |   |
| Cash flows provided by operating activities                                              |       |                             | 2,584      |                                                             |       |                   | —     |                 |       |   | (123 | ) |   |   | 2,461 |   |   |
| Cash flows from investing activities:                                                    |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |   |   |
| Purchases of property and equipment                                                      |       |                             | (7,373     | )                                                                |       |                   | —     |                 |       |   | — |   |   |   | (7,373 | ) |   |
| Maturities of available-for-sale marketable  debt securities                             |       |                             | 122,746    |                                                             |       |                   | —     |                 |       |   | (15,846 | ) |   |   | 106,900 |   |   |
| Purchases of available-for-sale marketable  debt securities                              |       |                             | (122,686   | )                                                                |       |                   | —     |                 |       |   | 10,207 |   |   |   | (112,479 | ) |   |
| Maturities of held-to-maturity marketable  debt securities and long-term investments     |       |                             | —     |                                                             |       |                   | —     |                 |       |   | 15,846 |   |   |   | 15,846 |   |   |
| Purchases of held-to-maturity marketable debt  securities and long-term investments |       |                             | —     |                                                             |       |                   | —     |                 |       |   | (10,207 | ) |   |   | (10,207 | ) |   |
| Decrease in restricted cash                                                              |       |                             | —     |                                                             |       |                   | —     |                 |       |   | 500 |   |   |   | 500 |   |   |
| Changes in other assets                                                                  |       |                             | (39        | )                                                                |       |                   | —     |                 |       |   | 123 |   |   |   | 84 |   |   |
| Cash flows used in investing activities                                                  |       |                             | (7,352     | )                                                                |       |                   | —     |                 |       |   | 623 |   |   |   | (6,729 | ) |   |
| Cash flows from financing activities:                                                    |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |   |   |
| Sale of common stock in connection with employee  stock purchase plan               |       |                             | 2,313      |                                                             |       |                   | —     |                 |       |   | — |   |   |   | 2,313 |   |   |
| Proceeds from exercise of stock options                                                  |       |                             | 881        |                                                             |       |                   | —     |                 |       |   | — |   |   |   | 881 |   |   |
| Principal payments of capital lease obligations                                          |       |                             | (66        | )                                                                |       |                   | —     |                 |       |   | — |   |   |   | (66 | ) |   |
| Cash flows provided by financing activities                                              |       |                             | 3,128      |                                                             |       |                   | —     |                 |       |   | — |   |   |   | 3,128 |   |   |
| Net decrease in cash and cash equivalents                                                |       |                             | (1,640     | )                                                                |       |                   | —     |                 |       |   | 500 |   |   |   | (1,140 | ) |   |
| Cash and cash equivalents, beginning of period                                           |       |                             | 121,931    |                                                             |       |                   | —     |                 |       |   | (1,092 | ) |   |   | 120,839 |   |   |
| Cash and cash  equivalents, end of period                                                |       |                             | $          | 120,291                                                          |       |                   |       | $                    | —     |   |   |   | $ | (592 | ) |   |   | $ | 119,699 |   |   |
| Supplemental disclosure of cash flow information:                                        |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |   |   |
| Interest paid                                                                            |       |                             | $          | 241                                                              |       |                   |       | $                    | —     |   |   |   | $ | — |   |   |   | $ | 241 |   |   |
| Income taxes paid                                                                        |       |                             | $          | 619                                                              |       |                   |       | $                    | —     |   |   |   | $ | — |   |   |   | $ | 619 |   |   |
| Non-cash purchases of property and equipment                                             |       |                             | $          | —                                                           |       |                   |       | $                    | —     |   |   |   | $ | 1,211 |   |   |   | $ | 1,211 |   |   |
| Property and  equipment acquired under capital lease                                     |       |                             | $          | —                                                           |       |                   |       | $                    | —     |   |   |   | $ | 163 |   |   |   | $ | 163 |   |   |

 

21

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**(3)   Summaryof Significant Accounting Policies**

The accompanying condensedconsolidated financial statements reflect the application of certainsignificant accounting policies as described in this note and elsewhere in theaccompanying condensed consolidated financial statements and notes.

***(a) Basis of Presentation and Principles ofConsolidation***

The accompanying unaudited condensed consolidatedfinancial statements have been prepared by Sonus pursuant to the rules andregulations of the United States Securities and Exchange Commission (“SEC”)regarding interim financial reporting. Accordingly, they do not include all ofthe information and notes required by accounting principles generally acceptedin the United States of America (“U.S. GAAP”) for complete financial statementsand should be read in conjunction with the audited financial statementsincluded in Sonus’ Annual Report on Form 10-K for the year ended December 31,2006.

In the opinion of management, the accompanyingunaudited condensed consolidated financial statements have been prepared on thesame basis as the audited financial statements, and include all adjustments,consisting only of normal recurring adjustments, necessary for a fairpresentation of the results of the interim periods presented. The operatingresults for the interim periods presented are not necessarily indicative of theresults expected for the full fiscal year.

The accompanying condensedconsolidated financial statements include the accounts of Sonus and itswholly-owned subsidiaries. All intercompany transactions and balances have beeneliminated in consolidation.

***(b) Use of Estimates and Judgments***

The preparation offinancial statements in conformity with U.S. GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting periods. Significant estimates and judgments relied uponin preparing these financial statements include revenue recognition formultiple element arrangements, allowances for doubtful accounts, estimated fairvalue of investments, inventory reserves, expected future cash flows used toevaluate the recoverability of long-lived assets, restructuring and otherrelated charges, contingencies associated with revenue contracts, assumptionsused to determine the fair value of stock-based compensation, contingentliabilities and recoverability of Sonus’ net deferred tax assets and relatedvaluation allowance. Sonus regularly assesses these estimates and recordschanges in estimates in the period in which they become known. Sonus bases itsestimates on historical experience and various other assumptions that it believesto be reasonable under the circumstances. Actual results could differ fromthose estimates.

***(c) Cash Equivalents, Marketable Debt Securitiesand Long-Term Investments***

Cash equivalents are stated at cost, whichapproximates fair value, and have remaining maturities of three months or lessat the date of purchase.

Cash equivalents and marketable debt securities areinvested in high-quality debt instruments, primarily U.S. Government, municipaland corporate obligations. Investments in U.S. Government and corporateobligations are classified as held-to-maturity, as Sonus has the intent andability to hold them to maturity. Held-to-maturity marketable debt securitiesare reported at amortized cost. Investmentsin municipal obligations are classified as available-for-sale and are reportedat fair value. Unrealized gains and losses from available-for-sale marketabledebt securities were not material for the periods presented. The unrealizedlosses related to these securities at June 30, 2006 are not considered tobe a permanent decline in 

22

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thefair value of such securities. There have been no material realized gains orlosses to date. Current marketable debt securities include held-to-maturityinvestments with remaining maturities of less than one year as of the balancesheet date and available-for-sale investments that are expected to be sold inthe current period or to be used in current operations. Long-term investmentsinclude held-to-maturity investments with remaining maturities of one to fiveyears as of the balance sheet date.

At June 30,2006 and December 31, 2005, marketable debt securities and long-terminvestments consisted of the following (in thousands):

| ** **                      | ** ** | **June 30, 2006** | ** ** |
|---------------------------------|------------|-----------------------------|------------|
| ** **                      | ** ** | **Amortized   Cost**   | ** ** | **Unrealized   Gains** | ** ** | **Unrealized   Losses** | ** ** | **Fair   Value** | ** ** |
| *Marketable debt securities*    |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| State and municipal obligations |       |                        | $          | 60,275 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 60,275 |   |
| Held-to-maturity:               |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       |                        | 61,821     |   |   |   | — |   |   |   | (248 | ) |   | 61,573 |   |
| Corporate debt securities       |       |                        | 25,648     |   |   |   | — |   |   |   | (107 | ) |   | 25,541 |   |
| Commercial paper                |       |                        | 89,749     |   |   |   | — |   |   |   | (547 | ) |   | 89,202 |   |
| Certificates of deposit         |       |                        | 2,224      |   |   |   | — |   |   |   | (2 | ) |   | 2,222 |   |
|                            |       |                        | $          | 239,717 |   |   |   | $ | — |   |   |   | $ | (904 | ) |   | $ | 238,813 |   |
| *Long-term investments*         |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:               |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       |                        | $          | 39,375 |   |   |   | $ | — |   |   |   | $ | (274 | ) |   | $ | 39,101 |   |
| Corporate debt securities       |       |                        | 8,871      |   |   |   | — |   |   |   | (65 | ) |   | 8,806 |   |
|                            |       |                        | $          | 48,246 |   |   |   | $ | — |   |   |   | $ | (339 | ) |   | $ | 47,907 |   |

 

| ** **                      | ** ** | **December 31, 2005** | ** ** |
|---------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**             | ** ** | **Unrealized  Gains** | ** ** | **Unrealized   Losses** | ** ** | **Fair  Value** | ** ** |
| *Marketable debt securities*    |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:             |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| State and municipal obligations |       | $                               | 97,875     |   |   | $ | — |   |   |   | $ | — |   |   | $ | 97,875 |   |
| Held-to-maturity:               |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       | 16,643                          |       |   | — |   |   |   | (88 | ) |   | 16,555 |   |
| Corporate debt securities       |       | 18,503                          |       |   | — |   |   |   | (79 | ) |   | 18,424 |   |
| Commercial paper                |       | 5,950                           |       |   | — |   |   |   | (13 | ) |   | 5,937 |   |
| Certificates of deposit         |       | 1,598                           |       |   |   |   |   |   | (4 | ) |   | 1,594 |   |
| * *                        |       | $                               | 140,569    |   |   | $ | — |   |   |   | $ | (184 | ) |   | $ | 140,385 |   |
| *Long-term investments*         |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:               |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government  agency notes   |       | $                               | 17,993     |   |   | $ | — |   |   |   | $ | (48 | ) |   | $ | 17,945 |   |

 

At June 30, 2006 and December 31,2005, Sonus had $341,000 and $591,000, respectively, in restricted cash, whichis used to collateralize standby letters of credit. Restricted cash is includedin Other current assets in the Condensed Consolidated Balance Sheets.

In connection with themove to Westford, Massachusetts in January 2007, the Company issued a $500,000standby letter of credit. The standby letter of credit may be drawn upon in theevent of the Company’s noncompliance with the terms and conditions of thesublease for the Westford headquarters facility.

23

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***(d) Concentrationsof Credit and Off-Balance Sheet Risk, Significant Customers and LimitedSuppliers***

The financial instruments that potentially subjectSonus to concentrations of credit risk are cash, cash equivalents, marketabledebt securities, accounts receivable and long-term investments. Sonus’ cash,cash equivalents and investment portfolioholdings were diversified among five financial institutions at June 30, 2006.

Beginning in the third quarter of 2005, Sonus enteredinto foreign exchange contracts to hedge against currency fluctuations relatedto a particular account receivable and orders denominated in Japanese Yen. Sonusrecorded losses on the changes in the fair value of such foreign exchangecontracts of $81,000 and $71,000 during the three and six months ended June 30,2006, respectively. These amounts are included in General and administrativeexpense in the Condensed Consolidated Statements of Operations for thoseperiods.

Thefollowing customers each contributed at least 10% of Sonus’ revenue in at leastone of the three and six month periods ended June 30, 2006 and 2005:

| ** **   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,**            | ** ** |
|--------------|------------|-------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Customer** | ** ** | ** **                                      | ** ** | **    2006    ** | ** ** | **   2005   ** | ** ** | **  2006  ** | ** ** | **  2005  ** | ** ** |
| A       |       |                                            | 61         | %                                                        |       |   | 42 | % |   |   | 36 | % |   |   | 27 | % |   |
| B       |       |                                            | *          |                                                     |       |   | * |   |   |   | * |   |   |   | 12 | % |   |
|              |            |                                                 |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

*                    Representsless than 10% of revenue.

At June 30, 2006 and December 31, 2005, onecustomer and two customers, respectively, accounted for at least 10% of Sonus’accounts receivable balance, representing a total of approximately 58% and 43%,respectively, of the Company’s total account receivable balances. Sonusperforms ongoing credit evaluations of its customers and generally does notrequire collateral on accounts receivable. Sonus maintains an allowance fordoubtful accounts and such losses have been within management’s expectations.

Thefollowing table shows the percentage of revenue by geographic region for thethree and six months ended June 30, 2006 and 2005:

| ** **                      | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended   June 30,** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                        | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States                   |       |                                            | 95         | %                                                   |       |   | 82 | % |   |   | 86 | % |   |   | 81 | % |   |
| Japan                           |       |                                            | 2          |                                                |       |   | 7 |   |   |   | 6 |   |   |   | 8 |   |   |
| Other Asia  Pacific             |       |                                            | *          |                                                |       |   | 10 |   |   |   | 5 |   |   |   | 8 |   |   |
| Europe, Middle  East and Africa |       |                                            | 3          |                                                |       |   | 1 |   |   |   | 3 |   |   |   | 2 |   |   |
| Other                           |       |                                            | *          |                                                |       |   | * |   |   |   | * |   |   |   | 1 |   |   |
|                            |       |                                            | 100        | %                                                   |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

----

*                    Representsless than 1% of revenue.

Certain components and software licenses from thirdparties used in Sonus’ products are procured from single sources of supply. Thefailure of a supplier, including a subcontractor, to deliver on schedule coulddelay or interrupt Sonus’ delivery of products and thereby materially adverselyaffect Sonus’ revenues and operating results.

In 2006, Sonus consolidated its manufacturing to asingle manufacturer. Failure to manage these consolidation activities couldresult in a disruption in the supply of its products and in delays in thefulfillment of the Company’s customer orders.

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***(e) Accounts Receivable***

Accounts receivable consist of the following (inthousands):

| ** **                       | ** ** | **June 30,  2006** | ** ** | **December 31,  2005**                   | ** ** |
|----------------------------------|------------|-------------------------|------------|-----------------------------------------------|------------|
| ** **                       | ** ** | ** **              | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Earned accounts  receivable      |       | $                       | 60,511     |                                          |       | $ | 48,804 |   |   |
| Unearned accounts  receivable    |       | 17,580                  |       |                                          | 23,883     |   |   |
| Accounts receivable, gross       |       | 78,091                  |       |                                          | 72,687     |   |   |
| Allowance for  doubtful accounts |       | (619                    | )          |                                          | (426       | ) |   |
| Accounts  receivable, net        |       | $                       | 77,472     |                                          |       | $ | 72,261 |   |   |

 

Unearned accountsreceivable represent products shipped to customers where Sonus has acontractual right to bill the customer and collectibility is probable underordinary collection terms prior to satisfying Sonus’ revenue recognitioncriteria. The allowance for doubtful accounts is based on Sonus’ detailedassessment of the collectibility of specific customer accounts.

***(f) Inventory***

Inventoryconsists of the following (in thousands):

| ** **                                             | ** ** | **June 30,  2006** | ** ** | **December 31,  2005**                   | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------|------------|
| ** **                                             | ** ** | ** **              | ** ** | **(As Restated,  See Note 2)** | ** ** |
| On-hand final  assemblies and finished goods inventory |       | $                       | 18,668     |                                          |       | $ | 19,457 |   |   |
| Unearned  inventory                                    |       | 21,707                  |       |                                          | 20,979     |   |   |
| Evaluation  inventory                                  |       | 5,613                   |       |                                          | 4,615      |   |   |
| Inventory, gross                                       |       | 45,988                  |       |                                          | 45,051     |   |   |
| Excess, obsolete  and evaluation reserve               |       | (7,800                  | )          |                                          | (7,351     | ) |   |
| Inventory, net                                         |       | 38,188                  |       |                                          | 37,700     |   |   |
| Less current  portion                                  |       | (33,871                 | )          |                                          | (37,700    | ) |   |
| Long-term portion (included  in Other assets)          |       | $                       | 4,317      |                                          |       | $ | — |   |   |

 

Inventory is stated at the lower of cost (first-in,first-out basis) or market and consists of final assembly materials andfinished goods.

Unearned inventory represents deferred cost of revenuefor product shipments to customers prior to satisfaction of Sonus’ revenuerecognition criteria. Unearned inventory amounts related to revenue which theCompany does not expect to recognize within one year of the balance sheet dateare recorded as long-term assets and included as a component of Other assets inthe Condensed Consolidated Balance Sheets.

Sonus provides inventoryreserves based on excess and obsolete inventory determined primarily by futuredemand forecasts, recording any adjustments to such reserves through charges tocost of revenue. Sonus also records a full inventory reserve for evaluationequipment at the time of shipment to its customers as a charge to sales andmarketing expense as it is probable that the inventory will not be realizable. Ifthese evaluation shipments are later purchased by Sonus’ customers, Sonusreclassifies amounts previously charged to sales and marketing expense to costof revenue in the period when all revenue recognition criteria are met.

25

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***(g) Property and Equipment***

Property and equipment arestated at cost, net of accumulated depreciation. Expenditures for maintenanceand repairs are charged to expense as incurred. Depreciation is computed usingthe straight-line method over the estimated useful lives of the related assets,which range from two to five years. Leasehold improvements are amortized overthe lesser of the lease term or five years. When an item is sold or retired,the cost and related accumulated depreciation or amortization is eliminated,and the resulting gain or loss, if any, is recognized in income (loss) fromoperations in the Condensed Consolidated Statements of Operations.

***(h) Other Assets***

Otherassets consist of the following (in thousands):

| ** **           | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------|------------|-------------------------|------------|-----------------------------|------------|
| Prepaid  commissions |       |                    | $          | 1,189                       |       |   |   | $ | 1,310 |   |   |
| Prepaid royalties    |       |                    | 519        |                        |       |   | — |   |   |
| Deposits             |       |                    | 658        |                        |       |   | 631 |   |   |
| Unearned inventory   |       |                    | 4,317      |                        |       |   | — |   |   |
|                 |       |                    | $          | 6,683                       |       |   |   | $ | 1,941 |   |   |

 

***(i) Revenue Recognition***

Sonus’ products are primarily marketed based on thesoftware elements contained therein. In addition, hardware sold generally cannot be used apart from the software. Therefore, Sonus considers its principalproducts to be software-related. Sonus recognizes revenue from product saleswhen persuasive evidence of an arrangement exists, delivery has occurred, thesale price is fixed or determinable, and collectibility of the relatedreceivable is probable under ordinary payment terms. When Sonus has futureobligations, including a requirement to deliver additional elements which areessential to the functionality of the delivered elements or for whichvendor-specific objective evidence of fair value (“VSOE”) does not exist orcustomer acceptance is required, Sonus defers revenue recognition and relatedcosts until those obligations are satisfied. The ordering patterns and saleslead times associated with customer orders may vary significantly from periodto period.

Many of Sonus’ sales involve complex contractual,multiple-element arrangements. When a sale includes multiple elements, such asproducts, maintenance and/or professional services, Sonus recognizes revenueusing the residual method. Revenue associated with undelivered elements thatare not considered essential to the functionality of the product and for whichVSOE has been established is deferred based on the VSOE value, and anyremaining arrangement fee is then allocated to, and recognized as, productrevenue. VSOE is determined based upon the price charged when the same elementis sold separately or established by the relevant pricing authority. If Sonuscannot establish VSOE for each undelivered element, including specifiedupgrades, it defers revenue on the entire arrangement until VSOE for allundelivered elements is known or all elements are delivered and all otherrevenue recognition criteria are met.

Revenue from maintenance and support services isrecognized ratably over the life of the service period, ranging from one tofive years. Earned maintenance revenue is typically deferred until theassociated product is accepted by the customer and all other revenuerecognition criteria are met. Maintenance and support services includetelephone support, return and repair support and unspecified rights to productupgrades and enhancements.

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Revenue from installation services that are consideredto be perfunctory is generally recognized when the service is complete. Revenuefrom other professional services for which VSOE has been established istypically recognized based on the proportional performance method as theservices are delivered.

Revenue from consulting, custom development and otherprofessional service-only engagements is recognized as services are rendered.

Sonus sells the majority of its products directly toend users. For products sold to resellers and distributors, Sonus typicallyrecognizes revenue on a sell-through basis utilizing information provided toSonus from its resellers and distributors. ThroughDecember 31, 2005, no revenue had been recognized on a sell-in basis dueto the limited return history associated with shipments to resellers anddistributors. During the first quarter of 2006, Sonus began reportingrevenue from its original equipment manufacturer (“OEM”) relationship withMotorola, Inc. (“Motorola”) on a sell-in basis, where revenue isrecognized upon the shipment of products to Motorola, assuming all otherrequirements for revenue recognition have been met. Sonus had previouslyrecognized revenue for sales to Motorola when products had been sold byMotorola to its customers. This change reflects two years of history with Motoroladuring which Sonus has experienced no returns, no price concessions and anexcellent payment history. As a result of this history, Sonus has determinedthat the risk of a potential price concession has been eliminated andtherefore, the price for products sold to Motorola is now fixed or determinableupon sale to Motorola. In the three and six months ended June 30, 2006,Sonus recognized revenue totaling approximately $0.6 million and $3.5 million,respectively, in connection with sales of products to Motorola through June 30,2006 that had not yet sold through to Motorola’s customers. This revenue wouldhave been recognized in subsequent periods if the Company had not changed to asell-in basis for Motorola during the first quarter. This additional revenuefrom Motorola negatively affected product gross margins, as revenue from OEMrelationships typically has lower margin profiles than revenue from directsales to customers. This additional revenue resulted in approximately $0.3million and $1.4 million, respectively, of additional net income for the threeand six months ended June 30, 2006, respectively, but did not changereported basic and diluted net income per share for the three months endedJune 30, 2006. However, these transactions increased basic and diluted netincome per share by $0.01 for the six months ended June 30, 2006.

Sonus records deferred revenue for product deliveredor services performed for which collection of the amount billed is eitherprobable or has been collected before all other revenue recognition criteriahave been satisfied. Deferred revenue includes customer deposits and amountsassociated with maintenance contracts. Deferred revenue expected to berecognized as revenue more than one year subsequent to the balance sheet dateis classified as long-term deferred revenue.

Sonus defers recognitionof incremental direct costs, such as cost of goods, royalties, commissions andthird-party installation costs, until satisfaction of the criteria forrecognition of the related revenue.

***(j) Deferred Revenue***

Deferredrevenue consists of the following (in thousands):

| ** **                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005**                   | ** ** |
|------------------------------------|------------|-------------------------|------------|-----------------------------------------------|------------|
| ** **                         | ** ** | ** **              | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Maintenance and  support contracts |       | $                       | 60,408     |                                          |       | $ | 67,354 |   |   |
| Customer deposits                  |       | 37,915                  |       |                                          | 30,952     |   |   |
| Unearned revenue                   |       | 17,580                  |       |                                          | 23,883     |   |   |
| Total deferred revenue             |       | 115,903                 |       |                                          | 122,189    |   |   |
| Less current  portion              |       | (89,466                 | )          |                                          | (88,336    | ) |   |
| Long-term  portion                 |       | $                       | 26,437     |                                          |       | $ | 33,853 |   |   |

 

27

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Revenue from maintenance and support contracts isrecognized ratably over the life of the maintenance and support period. Customerdeposits represent payments received in advance of revenue recognition. Unearnedrevenue represents billings for which payment has not been received and revenuerecognition criteria have not been met. At June 30, 2006 and December 31,2005, both Deferred revenue and Accounts receivable excluded $10.1 millionand $5.3 million, respectively, related to products shipped and billed tocustomers for which revenue is recognized as cash is collected, or for whichtitle had not passed to the customer.

***(k) Stock-based Compensation***

Sonus issues stock options and restricted stockpursuant to the 1997 Stock Incentive Plan (“Stock Plan”) and provides employeesthe right to purchase stock pursuant to the 2000 Employee Stock Purchase Plan (“ESPP”).Prior to January 1, 2006, we accounted for all employee and non-employeedirector stock-based compensation awards using the intrinsic value method underAccounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB 25”)*,*and provided the required disclosures in accordance with SFAS No. 123, *Accounting for Stock-Based Compensation*(“SFAS 123”). On January 1,2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R,*Share-Based Payment* (“SFAS 123R”). Forstock-based compensation related to the ESPP, Sonus follows SFAS 123R, asinterpreted by FASB Technical Bulletin No. 97-1, *Accounting under Statement 123 for Certain Employee Stock PurchasePlans with a Look-Back Option*. Sonus accounts for all stock-basedcompensation awards to consultants and other non-employees in accordance withthe EITF Issue No. 96-18, *Accounting for EquityInstruments that are Issued to Other than Employees for Acquiring or inConjunction with Selling Goods or Services,* and SFAS 123, as amendedby SFAS No. 148, *Accounting for Stock BasedCompensation—Transition and Disclosure*  (prior to January 1, 2006) or inaccordance with SFAS 123R (subsequent to December 31, 2005). Modificationsto non-employee stock-based awards are accounted for in accordance with EITFIssue No. 00-19, *Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock*.  Sonus followed FASBInterpretation No. 28, *Accounting for StockAppreciation Rights and Other Variable Stock Option or Award Plans,*inthe recognition of stock-based compensation expense measured under APB 25(prior to January 1, 2006) and the straight-line method in the recognitionof stock-based compensation expense under SFAS 123 (prior to January 1,2006) and SFAS 123R (subsequent to December 31, 2005). Under both APB 25and SFAS 123R, the requisite service period over which stock-based compensationis expensed generally equals the vesting periods of the awards.

Stock options are generally issued with an exerciseprice equal to the current market price on the date of grant with a four-yearvesting period and contractual term of ten years. Restricted stock is generallyissued with no purchase price, with fair value based on the market price on thedate of grant. Sonus includes as part of its inventory a portion of the fairvalue of stock compensation, which is expensed as inventory is relieved,generally over six months. All of Sonus’ stock-based compensation is accountedfor as an equity instrument and there have been no liability awards granted. Sonus’policy is to issue new shares upon exercise of stock options.

Sonus has elected themodified prospective transition method for adopting SFAS 123R. Accordingly,periods prior to adoption have not been restated to conform to SFAS 123R andare not directly comparable to periods after adoption. Under this method, theprovisions of SFAS 123R apply to all awards granted or modified after the dateof adoption. The unrecognized expense of awards not yet vested at the date ofadoption shall be recognized in net income in the periods after the date ofadoption using the same valuation method, Black-Scholes, and assumptionsdetermined under the original provisions of SFAS 123.

28

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Sonus recorded $2.7million and $5.0 million of stock-based compensation for the three and sixmonths ended June 30, 2006, respectively, and $0.7 million and $1.4million of stock-based compensation for the three and six months ended June 30,2005, respectively. These amounts are included as components in the followingexpense categories in the Condensed Consolidated Statements of Operations (inthousands):

| ** **                 | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                 | ** ** | ** **                                      | ** ** | **(As Restated,  See Note 2)** | ** ** | ** ** | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Product cost of  revenues  |       | $                                               | 10         |                                          |       | $ | 4 |   |   | $ | 25 |   |   | $ | 16 |   |   |
| Service cost of  revenues  |       | 199                                             |       |                                          | 75         |   |   | 483 |   |   | 148 |   |   |
| Research and  development  |       | 633                                             |       |                                          | 225        |   |   | 1,420 |   |   | 430 |   |   |
| Sales and  marketing       |       | 1,166                                           |       |                                          | 327        |   |   | 1,676 |   |   | 549 |   |   |
| General and administrative |       | 735                                             |       |                                          | 89         |   |   | 1,438 |   |   | 236 |   |   |
|                       |       | $                                               | 2,743      |                                          |       | $ | 720 |   |   | $ | 5,042 |   |   | $ | 1,379 |   |   |

 

In addition, Sonus included in inventory approximately$26,000 of stock-based compensation at June 30, 2006.

At June 30, 2006, there was $15.3 million ofunrecognized compensation cost related to share-based awards, which is expectedto be recognized over a weighted average period of approximately three years.

Sonusused the Black-Scholes valuation model for estimating the grant-date fair valueof employee stock options granted after the adoption of SFAS 123R using thefollowing assumptions for the three and six months ended June 30, 2006:

| ** **                   | ** ** | **Three months  ended  June 30, 2006** | ** ** | **Six months  ended  June 30, 2006** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Risk-free  interest rate     |       |                                                  | 5.0        | %                                                   |       |   | 4.7 | % |   |
| Expected dividend  yield     |       |                                                  | —     |                                                |       |   | — |   |   |
| Expected  volatility         |       |                                                  | 70         | %                                                   |       |   | 70%-78 | % |   |
| Weighted average  volatility |       |                                                  | 70         | %                                                   |       |   | 78 | % |   |
| Expected life (years)        |       |                                                  | 4.5        |                                                |       |   | 4.5 |   |   |

 

The risk-free interest rate is the average U.S.Treasury Constant Maturities Rate for the expected term. The expected dividendyield of zero is based on the fact that Sonus has never paid dividends and hasno present intention to pay cash dividends. Prior to January 1, 2006,Sonus used historical volatility to estimate the grant-date fair value of stockoptions. Effective January 1, 2006, Sonus changed its method to acombination of historical and implied volatility. Sonus believes that acombination of historical and implied volatility results in a more accurateestimate of the grant-date fair value of employee stock options because it moreappropriately reflects the market’s expectations of future volatility. Historicalvolatility during the period associated with the expected term of its stockoptions over the past few years included a period of time during or subsequentto Sonus’ initial public offering when its stock price experienced abnormallyhigh volatility levels, which Sonus believes is unlikely to be indicative offuture stock price behavior. However, Sonus has not placed sole reliance onimplied volatility as options in its common stock that are actively traded onthe open market generally have a term of less than one year—substantiallyshorter than Sonus stock option’s expected term. The expected life is based ona combination of exercise patterns of the option holder over the option’s lifeand exercise patterns within similar industries. Sonus estimates forfeitures tooccur at a rate of 5% per year.

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Thefollowing table summarizes information relating to Stock Plan activity duringthe six months ended June 30, 2006:

| **Stock Options**                            | ** ** | ** ** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual Life  (Years)** | ** ** | **Aggregate  Intrinsic Value  (in thousands)** | ** ** |
|---------------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Outstanding at  January 1, 2006              |       | 45,333,532 |       |                       | $          | 4.74                                   |       |                                                                 |       |                                                     |       |   |   |   |   |   |
| Granted                                           |       | 3,464,150  |       |                       | $          | 4.85                                   |       |                                                                 |       |                                                     |       |   |   |   |   |   |
| Exercised                                         |       | (3,139,859 | )          |                       | $          | 3.63                                   |       |                                                                 |       |                                                     |       |   |   |   |   |   |
| Canceled                                          |       | (176,766   | )          |                       | $          | 4.11                                   |       |                                                                 |       |                                                     |       |   |   |   |   |   |
| Expired                                           |       | (807,967   | )          |                       | $          | 9.11                                   |       |                                                                 |       |                                                     |       |   |   |   |   |   |
| Outstanding at  June 30, 2006                |       | 44,673,090 |       |                       | $          | 4.75                                   |       |                                                                 |       | 6.06                                                     |       |   |   | $ | 25,796 |   |   |
| Vested or expected to  vest at June 30, 2006 |       | 44,189,402 |       |                       | $          | 4.76                                   |       |                                                                 |       | 6.03                                                     |       |   |   | $ | 25,600 |   |   |
| Exercisable at June 30, 2006                 |       | 39,187,671 |       |                       | $          | 4.79                                   |       |                                                                 |       | 5.68                                                     |       |   |   | $ | 22,972 |   |   |

 

The weighted average fairvalue of stock options granted during the three and six months endedJune 30, 2006 was $2.90 and $3.13, respectively. The total intrinsic valueof options exercised during the three and six months ended June 30, 2006was $2.4 million and $4.5 million, respectively. The total intrinsic value ofoptions exercised during the three and six months ended June 30, 2005 was$0.5 million and $0.7 million, respectively. The total fair value of optionsvested during the three and six months ended June 30, 2006 was $1.6million and $3.2 million, respectively. The total fair value of options vestedduring the three and six months ended June 30, 2005 was $10.7 million and$19.5 million, respectively.

During the three monthsended June 30, 2006, Sonus awarded 200,000 restricted shares of commonstock to an officer under the Stock Plan. The award vests over approximatelytwo years and was unvested at June 30, 2006. The fair value as of the dateof the restricted stock award was $4.82 per share.

The Company used the Black-Scholesvaluation model to value shares of common stock issued under the ESPP. Invaluing the shares to be purchased under the ESPP, Sonus assumed a  risk-free interest rate range of 2.7% to4.8%, expected volatility range of 55% to 117%, an expected life of six monthsto two years and no expected dividend yield for the three months endedJune 30, 2006  For the six monthsended June 30, 2006, Sonus assumed a risk-free interest rate range of 1.8%to 4.8%, expected volatility range of 55% to 126%, an expected life of sixmonths to two years and no expected dividend yield.

SFAS 123R requires thepresentation of pro forma information for the comparative period prior to theadoption as if Sonus had accounted for stock-based compensation expense underthe fair value method under SFAS 123. The following table shows Sonus’ proforma net loss and net loss per share as if accounted for under SFAS 123 forthe three and six months ended June 30, 2005 (in thousands, except pershare data):

| ** **                                                                                                               | ** ** | **Three months  ended  June 30, 2005** | ** ** | **Six months  ended  June 30, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **(As Restated,  See Note 2)**         | ** ** | **(As Restated,  See Note 2)**       | ** ** |
| Net income as reported                                                                                                   |       |                                                  | $          | 9,555                                               |       |   |   | $ | 4,461 |   |   |
| Plus: Employee  stock-based compensation expense included in net income under intrinsic value  method related to options |       |                                                  | 720        |                                                |       |   | 1,379 |   |   |
| Less: Employee  stock-based compensation under fair value method(1)                                                      |       |                                                  | (10,539    | )                                                   |       |   | (25,190 | ) |   |
| Pro forma net loss                                                                                                       |       |                                                  | $          | (264                                                | )          |   |   | $ | (19,350 | ) |   |
| Basic and diluted net income (loss) per share:                                                                           |       |                                                  |       |                                                |       |   |   |   |   |
| As reported                                                                                                              |       |                                                  | $          | 0.04                                                |       |   |   | $ | 0.02 |   |   |
| Pro forma                                                                                                                |       |                                                  | $          | 0.00                                                |       |   |   | $ | (0.08 | ) |   |

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(1)           As discussed in Note 2, stock-based compensation hasbeen restated as a result of the Company applying incorrect measurement datesin the accounting for certain stock options and incorrectly accounting forcertain 

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stock options that shouldhave been recorded using variable accounting. In addition, the historicalaccounting for the Company’s ESPP was also accounted for incorrectly under thefair value method.

Sonusused the Black-Scholes valuation model to estimate the fair value of employeestock options granted during the three and six months ended June 30, 2005with the following assumptions:

| ** **                   | ** ** | **Three months ended  June 30, 2005** | ** ** | **Six months ended  June 30, 2005** | ** ** |
|------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| Risk-free  interest rate     |       |                                                      | 3.9        | %                                                       |       |   | 3.9 | % |   |
| Expected dividend  yield     |       |                                                      | —     |                                                    |       |   | — |   |   |
| Expected  volatility         |       |                                                      | 118-122    | %                                                       |       |   | 118-124 | % |   |
| Weighted average  volatility |       |                                                      | 118        | %                                                       |       |   | 120 | % |   |
| Expected life (years)        |       |                                                      | 4.0-7.0    |                                                    |       |   | 4.0 |   |   |

 

The weighted average fair value of stock optionsgranted during the three and six months ended June 30, 2005 was $3.24 and$3.63, respectively.

For shares purchased underthe ESPP during the three months ended June 30, 2005, Sonus used theBlack-Scholes model, with an assumed risk-free interest rate of 3.9%, anexpected volatility of 118%, an expected life of six months to two years and noexpected dividend yield. During the six months ended June 30, 2005, Sonusused an assumed risk-free interest rate of 3.0%, an expected volatility of118%, an expected life of six months to two years and no expected dividendyield.

***(l) Comprehensive Income***

Sonus’comprehensive income for the three and six months ended June 30, 2006 and2005 is as follows (in thousands):

| ** **                                | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | ** **                                      | ** ** | **(As Restated,  See Note 2)** | ** ** | ** ** | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Net income                                |       | $                                               | 8,914      |                                          |       | $ | 9,555 |   |   | $ | 14,730 |   |   | $4,461 |   |   |
| Foreign currency  translation adjustments |       | (27                                             | )          |                                          | —     |   |   | (21 | ) |   | — |   |   |
| Comprehensive income                      |       | $                                               | 8,887      |                                          |       | $ | 9,555 |   |   | $ | 14,709 |   |   | $ | 4,461 |   |   |
|                                           |            |                                                 |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

***(m) Disclosures about Segments of an Enterprise***

Operating segments areidentified as components of an enterprise about which separate discretefinancial information is available for evaluation by the chief operatingdecision maker in making decisions regarding resource allocation and assessingperformance. To date, the chief operating decision maker has made suchdecisions and assessed performance at the company level, as one segment. TheCompany’s chief operating decision maker is its Chief Executive Officer.

***(n) Net Income per Share***

Net income per share is computed in accordance withSFAS No. 128, *Earnings per Share*.Basic net income (loss) per share is computed by dividing net income by theweighted average number of shares of common stock outstanding during the period.Diluted net income per share is determined by using the weighted average numberof common and dilutive common equivalent shares outstanding during the periodunless the effect is antidilutive. Potential dilutive common shares consist ofcommon stock issuable upon the exercise of stock options and purchases ofcommon shares under the Company’s ESPP using the treasury stock method.

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Thecalculation of shares used to compute basic and diluted net income per share isas follows (in thousands):

| ** **                                        | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | ** **                                      | ** ** | **(As Restated,  See Note 2)** | ** ** | ** ** | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Weighted average  shares outstanding—basic   |       | 252,664                                         |       |                                          | 248,249    |   |   | 251,371 |   |   | 248,064 |   |   |
| Potential  dilutive common shares                 |       | 3,662                                           |       |                                          | 2,329      |   |   | 4,083 |   |   | 4,302 |   |   |
| Weighted average shares  outstanding—diluted |       | 256,326                                         |       |                                          | 250,578    |   |   | 255,454 |   |   | 252,366 |   |   |

 

The calculations above forthe three and six months ended June 30, 2006 exclude options to purchase sharesof common stock and share of common stock issuable upon conversion of aconvertible subordinated note aggregating 21,425,549 shares and 20,714,362shares, respectively, as their effect would be antidilutive. The calculationsabove for the three and six months ended June 30, 2005 exclude options topurchase shares of common stock and shares of common stock issuable uponconversion of a convertible subordinated note aggregating 24,054,100 shares and10,686,499 shares, respectively, as their effect would be antidilutive.

***(o) Warranty Reserve***

Sonus’ products are covered by a standard warranty of90 days for software and one year for hardware or a warranty of longer periodsunder certain customer contracts. In addition, certain customer contractsinclude warranty-type provisions for epidemic or similar product failures,generally for the contractual period or the life of the product in accordancewith published telecommunications standards.Sonus accrues for warranty obligations when the occurrence of such obligationis probable and the amount of such obligation is reasonably estimable. Sonushas not incurred significant costs related to such obligations. Sonus’customers typically purchase maintenance and support contracts, which encompassits warranty obligations. Sonus’ estimates of anticipated rates of warrantyclaims and costs are primarily based on historical information and futureforecasts.

In addition, certain ofSonus’ customer contracts include provisions under which Sonus may be obligatedto pay penalties generally for the contractual period or for the life of theproduct if Sonus’ products fail or do not perform in accordance withspecifications. Sonus accrues for such contingent obligations when theoccurrence of such obligation is probable and the amount of such obligation isreasonably estimable. Sonus has not incurred significant costs related to suchprovisions. Sonus periodically assesses the adequacy of its recorded warrantyliabilities and adjusts the amounts as necessary. At June 30, 2006 and December 31,2005, Sonus had $45,000 and $84,000, respectively, of warranty reservesrecorded.

***(p) Income Taxes***

Sonus provides for income taxes during interim periodsbased on the estimated effective tax rate for the full fiscal year. Sonusrecords cumulative adjustments to the tax provision in an interim period inwhich a change in the estimated annual effective rate is determined.

The Company and itssubsidiaries file income tax returns in the U.S. federal jurisdiction, as wellas various states and foreign jurisdictions. Generally, the tax years 2003through 2006 remain open to examination by the major taxing jurisdictions towhich we are subject. In 2006, the Massachusetts Department of Revenue (“Mass.DOR”) commenced an examination of the Company’s Massachusetts state income taxreturns for 2002 and 2003. Sonus extended the statute for the 2002 tax year toallow for additional time to complete this audit. As of March 31, 2007,the Mass. DOR had not proposed any significant adjustments to the Company’s taxpositions.

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***(q) Reclassification***

The presentation ofstock-based compensation for the three and six months ended June 30, 2005,which historically has been presented separately in the Condensed ConsolidatedStatements of Operations, has been reclassified into the applicable cost andexpense categories to conform to the presentation for the three and six monthsended June 30, 2006.

***(r) Recent Accounting Pronouncements***

In February 2007, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities* (“SFAS159”). SFAS 159 permits an entity to measure certain financial assets andfinancial liabilities at fair value. Under SFAS 159, entities that elect thefair value option will report unrealized gains and losses in earnings at eachsubsequent reporting date. The fair value option may be elected on aninstrument-by-instrument basis, with a few exceptions, as long as it is appliedto the instrument in its entirety. SFAS 159 establishes presentation anddisclosure requirements, but does not eliminate disclosure requirements ofother accounting standards. Assets and liabilities that are measured at fairvalue must be displayed on the face of the balance sheet. SFAS 159 is effectivein fiscal years beginning after November 15, 2007, although its provisionsmay be applied earlier if certain conditions are met. The Company is currentlyevaluating the impact of SFAS 159 on its consolidated results of operations andfinancial condition.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements* (“SFAS 157”). SFAS 157provides a single definition of fair value, along with a framework formeasuring it, and requires additional disclosure about using fair value tomeasure assets and liabilities. SFAS 157 emphasizes that fair value measurementis market-based, not entity-specific, and establishes a fair value hierarchy inwhich the highest priority is quoted prices in active markets. Under SFAS 157,fair value measurements are disclosed according to their level within thishierarchy. While SFAS 157 does not add any new fair value measurements, it doeschange current practice in certain ways, including requiring entities toinclude their own credit standing when measuring their liabilities. SFAS 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years. The Company is currentlyevaluating the impact of SFAS 157 on its consolidated results of operations andfinancial condition.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements* (“SAB 108”). SAB 108 providesspecific guidance on disclosures for companies who elect not to restate priorperiods for misstatements and instead elect to record a cumulative-effectadjustment. Sonus applied the provisions of SAB 108 in the quarter ended March 31,2007. The application of SAB 108 had no impact on the Company’s consolidatedresults of operations or financial condition.

In June 2006, theFASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109*(“FIN 48”), which clarifies the accounting for uncertainty in income taxesrecognized in a company’s financial statements in accordance with FASBStatement No. 109, *Accounting for IncomeTaxes.*FIN 48 prescribes a two-step process to determine the amountof tax benefit to be recognized. First, the tax position must be evaluated todetermine the likelihood that it will be sustained upon external examination. Ifthe tax position is deemed more-likely-than-not to be sustained, the taxposition is then assessed to determine the amount of benefit to recognize inthe financial statements. The amount of the benefit that may be recognized isthe largest amount that has a greater than 50% likelihood of being realizedupon ultimate settlement. The Company adopted FIN 48 on January 1,2007. The adoption of FIN 48 did not have a material impact on the Company’sconsolidated results of operations or financial condition.

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**(4)   AccruedRestructuring Expenses**

Commencing in the thirdquarter of fiscal 2001 and extending through fiscal 2002, in response tounfavorable business conditions primarily caused by significant declines incapital spending by telecommunications service providers, Sonus implementedrestructuring plans designed to reduce expenses and align its cost structurewith its revised business outlook. The restructuring plans included worldwideworkforce reductions, consolidation of excess facilities and the write-off ofexcess inventory and purchase commitments.

***2002 Restructuring Accrual***

Thefollowing table summarizes the activity during the six months ended June 30,2006 relating to Sonus’ accrual for fiscal 2002 restructuring actions (inthousands):

| ** **                   | ** ** | **Balance  December 31,  2005** | ** ** | **Cash  Payments** | ** ** | **Balance  June 30,  2006** | ** ** | **Current  Portion** | ** ** | **Long-term  Portion** | ** ** |
|------------------------------|------------|--------------------------------------|------------|--------------------|------------|----------------------------------|------------|----------------------|------------|------------------------|------------|
| Consolidation of  facilities |       |                                 | $          | 613                |       |                             |       | $                    | (96        | )                      |       |   | $ | 517 |   |   |   | $ | 200 |   |   |   | $ | 317 |   |   |
|                              |            |                                      |            |                    |            |                                  |            |                      |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The remaining cashpayments relating to the consolidation of excess facilities are expected to bepaid through 2008.

**(5)   Contingencies**

In November 2001, a purchaser of the Company’scommon stock filed a complaint in the United States District Court for theSouthern District of New York against Sonus, two of its officers and the leadunderwriters alleging violations of the federal securities laws in connectionwith Sonus’ initial public offering (“IPO”) and seeking unspecified monetarydamages. The purchaser seeks to represent a class of persons who purchased theCompany’s common stock between the IPO on May 24, 2000 and December 6,2000. An amended complaint was filed in April 2002. The amended complaintalleges that our registration statement contained false or misleadinginformation or omitted to state material facts concerning the alleged receiptof undisclosed compensation by the underwriters and the existence ofundisclosed arrangements between the underwriters and certain purchasers tomake additional purchases in the after market. The claims against Sonus areasserted under Section 10(b) of the Securities Exchange Act of 1934(the “Exchange Act”) and Section 11 of the Securities Act of 1933 andagainst the individual defendants under Sections 11 and 15 of the SecuritiesAct and Sections 10(b) and 20(a) of the Exchange Act. Otherplaintiffs have filed substantially similar class action cases againstapproximately 300 other publicly traded companies and their IPO underwriterswhich, along with the actions against Sonus, have been transferred to a singlefederal judge for purposes of coordinated case management. On July 15, 2002,Sonus, together with the other issuers named as defendants in these coordinatedproceedings, filed a collective motion to dismiss the consolidated amendedcomplaints on various legal grounds common to all or most of the issuerdefendants. The plaintiffs voluntarily dismissed the claims against many of theindividual defendants, including Sonus’officers named in the complaint. On February 19, 2003, the court granted aportion of the motion to dismiss by dismissing the Section 10(b) claimsagainst certain defendants including Sonus, but denied the remainder of themotion as to the defendants. In June 2003, a special committee of ourBoard of Directors authorized Sonus to enter into a proposed settlement withthe plaintiffs on terms substantially consistent with the terms of a Memorandumof Understanding negotiated among representatives of the plaintiffs, the issuerdefendants and the insurers for the issuer defendants. In October 2004,the court certified the class in a case against certain defendants. On February 15,2005, the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. On August 31,2005, the court approved the terms of the proposed settlement, as modified. On April 24,2006, the court held a hearing on a motion to approve the final settlement andtook 

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thematter under advisement. On December 5, 2006, the Court of Appeals for theSecond Circuit reversed the court’s October 2004 order certifying a class.On June 25, 2007, the Court entered an order terminating the settlement. Accordingly,the Company is unable to determine the ultimate outcome or potential range ofloss, if any.

Beginning in July 2002, several purchasers of theCompany’s common stock filed complaints in the United States District Court forthe District of Massachusetts against Sonus, certain officers and directors anda former officer under Sections 10(b) and 20(a) and Rule 10b-5of the Exchange Act (the “Class Action Complaints”). The purchasers seekto represent a class of persons who purchased the Company’s common stockbetween December 11, 2000 and January 16, 2002, and seek unspecifiedmonetary damages. The Class Action Complaints were essentially identicaland alleged that Sonus made false and misleading statements about its productsand business. On March 3, 2003, the plaintiffs filed a ConsolidatedAmended Complaint. On April 22, 2003, Sonus filed a motion to dismiss theConsolidated Amended Complaint on various grounds. On May 11, 2004, thecourt held oral argument on the motion, at the conclusion of which the courtdenied Sonus’ motion to dismiss. The plaintiffs filed a motion for classcertification on July 30, 2004. On February 16, 2005, the courtcertified the class and appointed a class representative. On March 9,2005, the court appointed the law firm of Moulton & Gans as leadcounsel. After the court requested additional briefing on the adequacy of theclass representative, the class representative withdrew. Lead counsel thenfiled a motion to substitute a new plaintiff as the class representative. On May 19,2005, the court held a hearing on the motion and took the matter underadvisement. On August 15, 2005, the court issued an order decertifying theclass and requiring the parties to submit a joint report informing the courtwhether the cases have been settled and whether defendants would be seeking torecover attorney’s fees from the plaintiffs. On September 30, 2005, theplaintiffs filed motions to voluntarily dismiss their complaints with prejudice.On October 5, 2005, the court entered an order dismissing the cases. On June 26,2006, the court issued an order denying Sonus’ motion for recovery of attorneys’fees.

On January 6, 2006, a purchaser of the Company’scommon stock filed a complaint in the United States District Court for theDistrict of Massachusetts that is essentially identical to the ConsolidatedAmended Complaint previously filed against the defendants. The Court hasappointed the Public Employees’ Retirement System of Mississippi as leadplaintiff. The lead plaintiff has filed an Amended Consolidated Complaint. Thedefendants filed on April 19, 2007 a motion to dismiss the AmendedConsolidated Complaint. There is no assurance Sonus will prevail in such amotion or defending this action. A judgment or a settlement of the claimsagainst the defendants could have a material impact on the Company’s financialresults. It is too early to determine the ultimate outcome or potential rangeof loss, if any.

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against Sonus and certain of itscurrent officers and directors. On June 28, 2004, the court consolidatedthe claims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the Exchange Act andSections 11, 12(a), and 15 of the Securities Act, relating to the restatementof Sonus’ financial results for 2001, 2002, and the first three quarters of2003. Specifically, the complaint alleges that Sonus issued a series of falseor misleading statements to the market concerning its revenues, earnings andfinancial condition. Plaintiffs contend that such statements caused the Company’sstock price to be artificially inflated. The complaint seeks unspecifieddamages on behalf of a purported class of purchasers of the Company’s commonstock during the period from March 28, 2002 through March 26, 2004. OnJanuary 28, 2005, Sonus filed a motion to dismiss the Section 10(b) and12(a) claims and joined the motion to dismiss the Section 11 claimfiled by the individual defendants. On June 1, 2005, the court held ahearing on the motion and allowed the plaintiff to file an amended complaint. Theplaintiff filed an amended complaint that included the same 

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claims and substantiallysimilar allegations as set forth in the initial complaint. On September 12,2005, the defendants filed motions to dismiss this amended complaint. On December 10,2005, the court held a hearing on the motions and took the matter underadvisement. On May 10, 2006, the court issued an order granting thedefendants’ motions in part and denying the motions in part. The courtdismissed the Section 12(a)(2) claims against all the defendants andthe Section 10(b) and Section 11 claims against the individualdefendants. The court denied the motions as to the Section 10(b) and Section 11claims against Sonus and Section 15 claims against the individualdefendants. The plaintiff has filed a motionfor class certification, which the defendants have opposed. The court held ahearing on February 28, 2007 on plaintiff’s motion for class certificationand took the matter under advisement. The Company believes that it hassubstantial legal and factual defenses to the claims, which it intends topursue vigorously. Sonus expects to incur significant legal fees in defendingthis action. At this time, Sonus is unable to determine the ultimate outcome orpotential range of loss, if any.

In February 2004, three purported shareholderderivative lawsuits were filed in the United States District Court for theDistrict of Massachusetts against Sonus and certain of its officers anddirectors, naming Sonus as a nominal defendant. Also in February 2004, twopurported shareholder derivative lawsuits were filed in the business litigationsession of the superior court of Suffolk County of Massachusetts against Sonusand certain of its directors and officers, also naming Sonus as a nominaldefendant. The suits claim that certain of Sonus’ officers and directorsbreached their fiduciary duties to the Company’s stockholders and to theCompany. The complaints are derivative in nature and do not seek relief fromSonus. However, Sonus has entered into indemnification agreements in theordinary course of business with certain of the defendant officers anddirectors and may be obligated throughout the pendency of these actions toadvance payment of legal fees and costs incurred by the defendants pursuant tothe Company’s obligations under the indemnification agreements or applicableDelaware law. On September 27, 2004, the state court granted Sonus’ motionto dismiss. On October 26, 2004, the plaintiffs filed a notice appealingthe state court’s dismissal of the actions. On June 24, 2005, theplaintiffs withdrew the appeal and dismissed the case with prejudice. In thefederal actions, on June 28, 2004, the court consolidated and stayed the threeactions. On October 12, 2004, the lead plaintiff filed a consolidatedamended complaint. On June 1, 2005, the court held a hearing on the motionand allowed the plaintiff to file an amended complaint. On July 1, 2005,the plaintiff filed an amended complaint. The defendants renewed their motions todismiss. On December 10, 2005, the court held a hearing on the motions andtook the matter under advisement. On March 31, 2006, the court entered anorder granting the defendants’ motions to dismiss the amended complaint. On April 26,2006, the plaintiffs filed a notice of appeal of the dismissal order. On February 6,2007, the First Circuit Court of Appeals held a hearing on the appeal. Sonusdoes not expect that this claim will have a material impact on its financialstatements.

In December 2004, a purchaser of Sonus’ commonstock filed a complaint in the circuit court in Will County, Illinois, againstSonus, one of its officers, and a former officer alleging misrepresentation andfraud in connection with the plaintiff’s purchase of Sonus’ stock. Thecomplaint seeks unspecified damages. Sonus filed a motion to dismiss thecomplaint. On May 5, 2005, the plaintiff filed an amended complaint. On October 26,2005, the court held a hearing on the motion during which it dismissed thefederal claims without prejudice and dismissed the state claims withoutprejudice. On November 23, 2005, the plaintiff filed a second amendedcomplaint with essentially the same allegations as in the prior complaints. Thedefendants renewed their motions to dismiss with respect to the second amendedcomplaint. On March 9, 2006, the court held a hearing on the defendants’motions during which the court entered an order dismissing the second amendedcomplaint with prejudice. On April 17, 2006, the plaintiff filed a noticeof appeal of the dismissal order. In order to avoid the costs of an appeal,Sonus agreed to settle the matter for a de minimus amount. On June 23,2006, the court entered an order dismissing the case.

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On June 14, 2006, C2 Communications sued AT&T, Inc.,Verizon Communications, Inc., Qwest, Bellsouth, Sprint Nextel Corporation,Global Crossing and Level 3 in the Eastern District of Texas, Marshall Division.C2 Communications has alleged that each of the defendants infringe U.S. Patent No. 6,243,373entitled “Method and Apparatus for Implementing a Computer Network InternetTelephone System.”  Sonus has agreed,subject to certain conditions, to assume the defense of Qwest, Global Crossingand Level 3 in this litigation to the extent the claim results from their useof products purchased from Sonus. There can be no assurance that otherdefendants who have purchased Sonus products will not seek indemnification fromSonus. The court issued a scheduling order with a trial date of August 4,2008. Sonus believes that the defendants have substantial legal and factualdefenses to the infringement claim, which the Company intends to pursuevigorously on behalf of the defendants for whom Sonus agrees or is required toassume defense of the litigation. However, there is no assurance any of thedefendants will prevail in defending this action. There also can be noassurance that Sonus will not be required to indemnify any of the defendantsfrom any judgment of infringement rendered against them. Sonus may be requiredto devote significant time and resources in connection with assuming thedefense of the claim of infringement on behalf of the defendants for whom Sonushas agreed to assume defense of the litigation. An adverse outcome with respectto the claim and Sonus’ indemnification could have a material adverse impact onSonus’ business, operating results and financial condition. Sonus cannotpredict the ultimate outcome of this litigation or any potential impact on itsoperating results or financial position.

On November 14, 2006, a purported shareholderderivative lawsuit was filed in the United District Court for the District ofMassachusetts against Sonus and certain of its officers and directors, namingSonus as a nominal defendant. Other purported shareholders filed virtuallyidentical complaints. The suits claim that certain of Sonus’ officers anddirectors breached their fiduciary duties to its stockholders and to Sonus inconnection with its announced stock option review. The complaints arederivative in nature and do not seek relief from Sonus. However, Sonus hasentered into indemnification agreements in the ordinary course of business withcertain of the defendant officers and directors and may be obligated throughoutthe pendency of these actions to advance payment of legal fees and costsincurred by the defendants pursuant to the Company’s obligations under theindemnification agreements or applicable Delaware law. By order dated December 18,2006, the Court consolidated the actions. The plaintiffs have filed aconsolidated complaint. The defendants filed on March 19, 2007 a motion todismiss the consolidated complaint. The Court held a hearing on July 11,2007, and took the motion under advisement. Sonus believes that it hassubstantial legal and factual defenses to the derivative claims, which itintends to pursue vigorously. There is no assurance Sonus will prevail indefending these actions. Sonus cannot predict the ultimate outcome of thislitigation or any potential impact on its operating results or financialposition.

On January 19, 2007, a purported shareholderderivative lawsuit was filed in the Superior Court Department of MiddlesexCounty of Massachusetts against certain of the Sonus’ directors and officers,also naming Sonus as a nominal defendant. Another purported shareholder filed avirtually identical complaint. The suits assert similar claims and seek reliefsimilar to the derivative suits filed in federal court. On May 7, 2007,the plaintiffs filed a consolidated complaint. On June 6, 2007, thedefendants moved to dismiss the consolidated complaint. The Court scheduled ahearing on the motion for August 14, 2007. Sonus believes that it hassubstantial legal and factual defenses to the derivative claims, which itintends to pursue vigorously. There is no assurance Sonus will prevail indefending these actions. Sonus cannot predict the ultimate outcome of thislitigation or any potential impact on its operating results or financialposition.

As announced on March 19, 2007, the SEC isconducting a formal private investigation into Sonus’ stock option grantingpractices. If the Company is subject to adverse findings, it could be requiredto pay damages or penalties or have other remedies imposed, including criminalpenalties, which could adversely Sonus’ business, financial position or resultsof operations.

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Sonus includes standard intellectual propertyindemnification provisions in its product agreements in the ordinary course ofbusiness. Pursuant to its product agreements, Sonus will indemnify, holdharmless, and reimburse the indemnified party for losses suffered or incurredby the indemnified party, generally business partners or customers, inconnection with certain patent, copyright or other intellectual propertyinfringement claims by third parties with respect to Sonus products. Otheragreements with Sonus’ customers provide indemnification for claims relating toproperty damage or personal injury resulting from the performance of servicesby Sonus or its subcontractors. Historically, Sonus’ costs to defend lawsuitsor settle claims relating to such indemnity agreements have been insignificant.Accordingly, the estimated fair value of these indemnification provisions isimmaterial.

The Internal Revenue Servicehas notified Sonus that its payroll tax returns for the years ended December 31,2004, 2005 and 2006 have been selected for audit in connection with the Company’sstock option review. In connection with the restatement of its financial statementsincluded in this Form 10-Q, the Company has recorded approximately$1.6 million of accruals for additional tax, penalties and interest related toadjustments resulting from errors in stock option accounting. For moreinformation about stock-based compensation, including the financial statementimpact from the restatement, see Note 2, “Restatement of Consolidated FinancialStatements” of the Notes to the Condensed Consolidated Financial Statements. Sonuscould be required to pay additional tax, penalties or interest, or have otherremedies imposed, which could adversely impact its business, financial positionor results of operations.

**(6)   ConvertibleSubordinated Note**

In May 2001, Sonuscompleted a private placement of an aggregate principal amount of $10.0 millionof a 4.75% convertible subordinated note with a customer. Repayment on theconvertible subordinated note was due and made in May 2006**.**

**(7)   SubsequentEvents**

On April 13, 2007, Sonus completed theacquisition of Zynetix Limited (“Zynetix”), a privately-held designer ofinnovative Global System for Mobile Communications (“GSM”) infrastructuresolutions located in the United Kingdom. In consideration, Sonus paid theselling shareholders £3,000,000 on the acquisition date (U.S. $5.9 million asof the acquisition date) and £1,330,583 on June 11, 2007 (U.S. $2.6million as of June 11, 2007). The Share Purchase Agreement also includes two additional potential payments to the sellingshareholders: (1) £1,500,000 (U.S. $3.0 million as of the acquisitiondate) payable on May 1, 2008; and (2) 175,000 shares of Sonus commonstock deliverable on April 30, 2009, contingent upon the businessachieving certain predetermined financial and business metrics.

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**Item 2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

*This Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontains forward-looking statements, which are subject to a number of risks anduncertainties. These forward-looking statements are based on our currentexpectations, assumptions, estimates and projections about our industry andourselves, and we do not undertake an obligation to update our forward-lookingstatements to reflect future events or circumstances. Our actual results coulddiffer materially from those anticipated in these forward-looking statements asa result of various factors, including the factors set forth in Item 1A. “RiskFactors” in this Quarterly Report on Form 10-Q. This discussionshould be read in conjunction with the unaudited condensed consolidatedfinancial statements and related notes for the periods specified. Furtherreference should be made to our Annual Report on Form 10-K for theyear ended December 31, 2006 to be filed immediately after the filing ofthis Quarterly Report on Form 10-Q.*

The following informationhas been adjusted to reflect the restatement of the our financial results,which is more fully described in the “Explanatory Note” preceding Part I,Item 1 and in Note 2, “Restatement of Consolidated Financial Statements” in theNotes to Condensed Consolidated Financial Statements of this Form 10-Q.The impact of the restatement on our results of operations decreased net incomeby $190,000 and $1.6 million for the three and six months ended June 30,2005, respectively.

**Overview**

We are a leading provider of voice infrastructuresolutions for wireline and wireless service providers. Our products are a newgeneration of carrier-class infrastructure equipment and software that enablesvoice services to be delivered over Internet Protocol (“IP”) packet-basednetworks. Our target customers include both traditional and emergingcommunications service providers, including long distance carriers, localexchange carriers, Internet service providers, wireless operators, cableoperators, international telephone companies and carriers that provide servicesto other carriers. IP packet-based networks, which transport traffic in smallbundles, or “packets,” offer a significantly more flexible, cost-effective andefficient means for providing communications services than existingcircuit-based networks, designed years ago to primarily deliver telephonecalls.

Our suite of voice infrastructure solutions allowswireline and wireless operators to build converged voice over IP (“VoIP”)networks. Our products are built on the same distributed, IP-based principlesembraced by the IP Multimedia Subsystem (“IMS”) architecture, as defined by theThird Generation Partnership (“3GPP”) program. This IMS architecture is beingaccepted by network operators globally as the common approach for buildingconverged voice, data, wireline and wireless networks. The IMS architecture isbased primarily on IP packets and the SIP protocol, which has been thefoundation of our products since our formation.

Following a period of restricted spending bycommunications providers, the telecommunications industry witnessed growth in2006 with the investment in new IP-based and wireless infrastructuretechnologies. Over the last few years, VoIP has been widely accepted as theprotocol on which next generation networks will be built. While the speed andextent of the adoption of carrier packet voice infrastructure products by largecarriers remains uncertain, we believe that over time the market opportunityfor packet voice solutions is substantial. Synergy Research Group projects thatthe market for service provider VoIP equipment and software will approximate $4billion in 2008. Our objective is to capitalize on our early technology andmarket lead and build a premier franchise in packet-based voice infrastructuresolutions.

Starting in 2004 and continuing into 2006, there wasincreased interest and activity in the market for packet-based voiceinfrastructure products. This trend has been reflected in our order activity aswe achieved record orders in the fourth quarter of fiscal 2004 and on an annualbasis in fiscal 2005. Customer orders were greater than revenue for the threemonths ended June 30, 2006. For the six months ended 

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June 30, 2006 orderswere slightly less than revenue due to the seasonally slower period forcustomer order activity during the first fiscal quarter and the strong revenuefor the six months ended June 30, 2006. While it remains uncertain as tothe speed and extent of the adoption of carrier packet voice infrastructureproducts by large carriers, we believe that over time the market opportunityfor packet voice solutions is substantial. For the three and six months ended June 30,2006, revenues were $64.5 and $124.5 million, respectively, compared to $57.4million and $91.3 million for the three and six months ended June 30,2005, respectively, reflecting continuing improvements in the market forpacket-based voice infrastructure products, as well as increased servicerevenues resulting from the growing installed base of our products.

We sell our products primarily through a direct salesforce and, in some markets, through or with the assistance of resellers anddistributors. Customers’ decisions to purchase our products to deploy incommercial networks involve a significant commitment of resources and a lengthyevaluation, testing and product qualification process. We believe our revenuesand results of operations may vary significantly and unexpectedly from quarterto quarter as a result of long sales cycles, our expectation that customerswill tend to sporadically place large orders with short lead times, and theapplication of complex revenue recognition rules to certain transactions,which may result in customer shipments and orders from multiple quarters beingrecognized as revenue in one quarter. We expect to recognize revenues from alimited number of customers for the foreseeable future.

Since our inception throughDecember 31, 2003, we have incurred significant losses. At June 30,2006, we had an accumulated deficit of $816.4 million. Although we achievedprofitability in the first two quarters of 2006 and on an annual basis infiscal years 2005 and 2004, we incurred net losses in the first and thirdquarters of fiscal 2005 and may incur additional losses in future quarters andyears. We have a lengthy sales cycle for our products and, accordingly, weexpect to incur sales and other expenses before we realize the related revenues.We expect to continue to incur significant sales and marketing, research anddevelopment and general and administrative expenses, many of which are fixedprior to the beginning of any particular fiscal period and, as a result, wewill need to generate significant revenues to maintain profitability.

**Recent Developments**

On April 13, 2007,Sonus completed the acquisition of Zynetix Limited (“Zynetix”), aprivately-held designer of innovative Global System for Mobile Communications (“GSM”)infrastructure solutions located in the United Kingdom. In consideration, Sonuspaid the selling shareholders £3,000,000 on the acquisition date (U.S. $5.9million as of the acquisition date) and £1,330,583 on June 11, 2007 (U.S.$2.6 million as of June 11, 2007). The Share Purchase Agreement alsoincludes two additional potential payments to the selling shareholders: (1) £1,500,000(U.S. $3.0 million as of the acquisition date) payable on May 1, 2008; and(2) 175,000 shares of Sonus common stock deliverable on April 30,2009, contingent upon the business achieving certain predetermined financialand business metrics.

**Stock-basedCompensation**

On January 1, 2006, we adopted Statement ofFinancial Accounting Standards (“SFAS”) No. 123R, *Share-BasedPayment* (“SFAS 123R”). SFAS 123R supersedes Accounting PrinciplesBoard Opinion No. 25 (“APB 25”), *Accountingfor Stock Issued to Employees,* and provided the required disclosuresin accordance with SFAS No. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”). In transitioning to SFAS 123R, weused the proscribed modified prospective transition method. Accordingly,periods prior to adoption have not been restated to conform to SFAS 123R andare not directly comparable to periods after adoption.

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Under the modifiedprospective transition method, the unrecognized expense of awards not yetvested at the date of adoption shall be recognized in net income in the periodsafter the date of adoption using the same valuation method, Black-Scholes, andassumptions determined under the original provisions of SFAS 123. We recorded $2.7 million and $5.0million of stock-based compensation in the consolidated statement of operationsfor the three and six months ended June 30, 2006, included in thefollowing expense categories (in thousands):

| ** **                  | ** ** | **Three Months  Ended  June 30, 2006** | ** ** | **Six Months  Ended  June 30, 2006** | ** ** |
|-----------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Product cost of  revenue    |       |                                                  | $          | 10                                                  |       |   |   | $ | 25 |   |   |
| Service cost of  revenue    |       |                                                  | 199        |                                                |       |   | 483 |   |   |
| Research and  development   |       |                                                  | 633        |                                                |       |   | 1,420 |   |   |
| Sales and  marketing        |       |                                                  | 1,166      |                                                |       |   | 1,676 |   |   |
| General and  administrative |       |                                                  | 735        |                                                |       |   | 1,438 |   |   |
|                        |       |                                                  | $          | 2,743                                               |       |   |   | $ | 5,042 |   |   |

 

In addition, we included in inventory approximately$26,000 of stock-based compensation at June 30, 2006.

The recording of stock-based compensation expense forthe three and six months ended June 30, 2006 resulted in a decrease in netincome of $2.7 million and $5.0 million, respectively and a decrease in basicand diluted earnings per share of $0.01 and $0.02, respectively. As of June 30,2006, there was $15.3 million of unrecognized compensation cost related tooptions, which is expected to be recognized over a weighted average period of 3years.

Under the provisions of APB 25, we recorded $0.7million and $1.4 million for the three and six months ended June 30, 2005,respectively, of stock-based compensation in the consolidated statements ofoperations, included in the following expense categories (in thousands):

| ** **                  | ** ** | **Three Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|-----------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Product cost of  revenue    |       |                                                  | $          | 4                                                   |       |   |   | $ | 16 |   |   |
| Service cost of  revenue    |       |                                                  | 75         |                                                |       |   | 148 |   |   |
| Research and  development   |       |                                                  | 225        |                                                |       |   | 430 |   |   |
| Sales and  marketing        |       |                                                  | 327        |                                                |       |   | 549 |   |   |
| General and  administrative |       |                                                  | 89         |                                                |       |   | 236 |   |   |
|                        |       |                                                  | $          | 720                                                 |       |   |   | $ | 1,379 |   |   |

 

On December 21, 2005, our Board of Directorsapproved accelerating the vesting of out-of-the-money, unvested stock optionsheld by all current employees, subject to employee approval to the extentaccelerating of vesting would create a change in classification of any grantfrom an incentive stock option to a non-qualified incentive stock option. Non-employeemembers of the Board of Directors were excluded from the acceleration. Unvestedoptions having an exercise price of $4.00 per share or greater at that time,representing the right to purchase a total of approximately 18.9 millionshares, became exercisable as a result of the vesting acceleration. All otherterms and conditions in the original grants remained unchanged. Theacceleration of vesting did not result in the recognition of compensationexpense in fiscal 2005 as the exercise price of the accelerated stock optionsexceeded the fair market value of the underlying common stock on the date ofmodification. The decision to accelerate vesting of these stock options wasmade primarily to reduce compensation expense that would otherwise berecognized after the adoption of SFAS 123R.

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For more information aboutstock-based compensation, including the financial statement impact from therestatement, see “Explanatory Note” preceding Part I, Item 1, Note 2, “Restatementof Consolidated Financial Statements” and Note 3, “Significant AccountingPolicies” Item (k), “Stock-based Compensation” in the Notes to the Condensed ConsolidatedFinancial Statements of this Form 10-Q and “Critical AccountingPolicies and Estimates” below.

**Critical AccountingPolicies and Estimates**

Management’sdiscussion and analysis of financial condition and results of operations isbased upon our condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. We base our estimates and judgments onhistorical experience, knowledge of current conditions and beliefs of whatcould occur in the future given available information. We consider thefollowing accounting policies to be both those most important to the portrayalof our financial condition and those that require the most subjective judgment.If actual results differ significantly from management’s estimates and projections,there could be a material effect on our financial statements. The significantaccounting policies that we believe are the most critical include thefollowing:

·       Revenuerecognition;

·       Deferredrevenue;

·       Allowancefor doubtful accounts;

·       Inventoryreserves;

·       Warranty,royalty, litigation and other loss contingency reserves;

·       Stock-basedcompensation; and

·       Accountingfor income taxes.

***Revenue Recognition.******  ***We recognizerevenue from product sales when persuasive evidence of an arrangement exists,delivery has occurred, the sales price is fixed or determinable, andcollectibility of the related receivable is probable under ordinary paymentterms. When we have future obligations, including a requirement to deliveradditional elements which are essential to the functionality of the deliveredelements or for which vendor specific objective evidence of fair value (“VSOE”)does not exist or customer acceptance isrequired, we defer revenue recognition and related costs until thoseobligations are satisfied. The ordering patterns and sales lead timesassociated with customer orders may vary significantly from period to period.

Many of our sales involve complex contractual,multiple-element arrangements. When a sale includes multiple elements, such asproducts, maintenance and/or professional services, we recognize revenue usingthe residual method as we have not established VSOE of fair value for ourproducts or specified features/upgrades. Revenue associated with undeliveredelements that are not considered essential to the functionality of the productand for which VSOE of fair value has been established, is deferred based on theVSOE of fair value and any remaining arrangement fee is then allocated to, andrecognized as, product revenue. We have established VSOE of fair value formaintenance arrangements (post-contract support) and some professional services.VSOE of fair value for maintenance and professional services is determined byeither the price charged when the same element is sold separately orestablished by management having the relevant pricing authority. The Company’sPricing Committee has the relevant authority for establishing pricing forproducts and services. If we cannot establish VSOE of fair value for anyundelivered element, including specified features and upgrades, we deferrevenue on the entire 

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arrangement until VSOE offair value for all undelivered elements is known or all elements are deliveredand all other revenue recognition criteria are met.

Revenue from maintenance and support services isrecognized ratably over the service period, ranging from one to five years. Earnedmaintenance revenue is typically deferred until the associated product isaccepted by the customer and all other revenue recognition criteria are met. Maintenanceand support services include telephone support, return and repair support andunspecified rights to product upgrades and enhancements.

Revenue from installation services is generallyrecognized when the service is complete. Revenue from other professionalservices for which VSOE has been established is typically recognized based onproportional performance as the services are delivered.

Revenue from consulting, custom development and otherprofessional services-only engagements are recognized as services arecompleted.

We sell the majority of our products directly to ourservice provider customers. For products sold to resellers and distributors, wetypically recognize revenue on a sell-through basis utilizing informationprovided to us from our resellers and distributors. Through December 31,2005, no revenue had been recognized on a sell-in basis due to the limitedreturn history associated with shipments to resellers and distributors. Duringthe first quarter of 2006, we began reporting revenue from our originalequipment manufacturer (“OEM”) relationship with Motorola, Inc. (“Motorola”)on a sell-in basis, where revenue is recognized upon the shipment of productsto Motorola, assuming all other requirements for revenue recognition have beenmet. We had previously recognized revenue for sales to Motorola when productshad been sold by Motorola to its customers. This change reflects the two yearsof history with Motorola during which we have experienced no returns, no priceconcessions and an excellent payment history. As a result of this history, wehave determined that the risk of a potential price concession has beeneliminated and therefore the price for products sold to Motorola is now fixedor determinable upon sale to Motorola. In the three and six months ended June 30,2006, we recognized revenue totaling approximately $0.6 million and $3.5million, respectively, in connection with sales of products to Motorola throughJune 30, 2006 that had not yet sold through to Motorola’s customers. Thisrevenue would have been recognized in subsequent quarters if we had not changedto a sell-in basis for Motorola during the first quarter. This additionalrevenue from Motorola negatively affected product gross margins, as revenuefrom OEM relationships typically have lower margin profiles than revenue fromdirect sales to customers. This additional revenue resulted in approximately$0.3 million and $1.4 million, respectively, of additional net income and didnot change reported basic and diluted net income per share for the three monthsended June 30, 2006. However, these transactions increased basic anddiluted net income per share by $0.01 for the six months ended June 30,2006.

***Deferred Revenue.******  ***We record deferred revenuefor product delivered or services performed for which collection of the amountbilled is either probable or has been collected but other revenue recognitioncriteria have not been satisfied. Deferred revenue includes customer depositsand amounts associated with maintenance contracts. Deferred revenue expected tobe recognized as revenue more than one year subsequent to the balance sheetdate is classified as long-term deferred revenue.

We defer recognition of incremental direct costs, suchas cost of goods, royalties, commissions and third-party installation costs,until satisfaction of the criteria for recognition of the related revenue.

***Allowance forDoubtful Accounts.******  ***We establish billing terms at thetime we negotiate purchase agreements with our customers. We continuallymonitor for timely payments and potential collection issues. The allowance fordoubtful accounts is estimated based on our detailed assessment of thecollectibility of specific customer accounts.

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***Inventory Reserves.******  ***Inventorypurchases and commitments are based upon estimated future demand for ourproducts. We value inventory at the lower of cost on a first-in, first-outbasis or net realizable value. We provide inventory reserves based on excessand obsolete inventory determined primarily by future demand forecasts andestimated returns of defective product, and record charges to cost of revenue. Weassess such demand forecasts and return history on at least a quarterly basis. Ifwe record a charge to reduce inventory to its estimated net realizable value,we do not increase its carrying value due to subsequent changes in demandforecasts or product repairs. Accordingly, if inventory previously reserved foris subsequently sold, we may realize improved gross profit margins on thosetransactions in the period the related revenue is recognized.

We record a full inventory reserve for evaluationequipment at the time of shipment to our customers as a charge to sales andmarketing expense, as it is not probable that the inventory value will berealizable. If these evaluation shipments are later purchased by our customers,we reclassify amounts previously charged to sales and marketing expenses tocost of revenue in the period that all revenue recognition criteria are met.

***Warranty Reserve.******  ***Our productsare covered by a standard warranty of 90 days for software and one year forhardware or a warranty for longer periods under certain customer contracts. Inaddition, certain customer contracts include warranty-type provisions forepidemic or similar product failures, generally for the contractual period orthe life of the product in accordance with published telecommunicationsstandards. We accrue for warranty obligations when the occurrence of suchobligation is probable and the amount of such obligation is reasonablyestimable. We have not incurred significant costs related to such obligations. Ourcustomers typically purchase maintenance and support contracts, which encompassour warranty obligations. Our estimates of warranty obligations are primarilybased on historical information and future forecasts.

In addition, certain of our customer contracts includeprovisions under which we may be obligated to pay penalties, generally for thecontractual period or for the life of the product, if our products fail or donot perform in accordance with specifications. We accrue for such contingentobligations when the occurrence of such obligation is probable and the amountof such obligation is reasonably estimable. We have not incurred significantcosts related to such provisions. We periodically assess the adequacy of ourrecorded warranty liabilities and adjust the amounts as necessary.

***Royalty Accrual.******  ***We accrue forroyalties for technology we license from vendors based on established royaltyrates and usage. In certain cases, we have been contacted by third parties whoclaim that our products infringe on certain intellectual property of the thirdparty. We evaluate these claims and accrue for royalties when the amounts areprobable and reasonably estimable.

***Reserve forLitigation and Legal Fees.******  ***We are subjectto various legal claims, including securities litigation. We reserve for legalcontingencies and legal fees when the amounts are probable and reasonablyestimable. Our director and officer liability insurance policies provide onlylimited liability protection relating to the securities class action andderivative lawsuits against us and certain of our officers and directors.

***Loss Contingenciesand Reserves.******  ***We are subject to ongoing businessrisks arising in the ordinary course of business that affect the estimationprocess of the carrying value of assets, the recording of liabilities and thepossibility of various loss contingencies. Under SFAS No. 5, *Accounting for Contingencies*(“SFAS 5”), an estimated losscontingency is accrued when it is probable that a liability has been incurredor an asset has been impaired and the amount of loss can be reasonablyestimated. We regularly evaluate current information available to determinewhether such amounts should be adjusted and record changes in estimates in theperiod they become known.

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***Stock-basedCompensation.*****  **Prior toJanuary 1, 2006, we accounted for all of employee and non-employeedirector stock-based compensation awards using the intrinsic value method underAPB 25, and provided the required disclosures in accordance with SFAS 123. On January 1,2006, we adopted SFAS 123R, using the modified prospective transitionmethod. We account for all stock-based compensation awards to consultants andother non-employees in accordance with the FASB Emerging Issues Task ForceIssue No. 96-18, *Accounting for EquityInstruments that are Issued to Other than Employees for Acquiring or inConjunction with Selling Goods or Services,* and SFAS 123, as amendedby SFAS No. 148, *Accounting for Stock BasedCompensation—Transition and Disclosure*(prior to January 1,2006), or in accordance with  SFAS 123R (subsequentto December 31, 2005). We followed FASB Interpretation (“FIN”) 28, *Accounting for Stock Appreciation Rights and Other Variable StockOption or Award Plans—an Interpretation of APB Opinions No. 15 and 25,*inthe recognition of stock-based compensation expense measured under APB 25(prior to January 1, 2006) and the straight-line method in the recognitionof stock-based compensation expense under SFAS 123 (prior to January 1,2006) and SFAS 123R (subsequent to December 31, 2005). Under both APB 25and SFAS 123R, the requisite service period over which stock-based compensationis expensed generally equals the vesting periods of the awards.

Under SFAS 123R, our stock-based compensation isaffected by our stock price as well as valuation assumptions, including thevolatility of our stock price, expected term of the option, risk-free interestrate and expected dividends. We utilize the Black-Scholes valuation model forestimating the fair value on the date of grant of employee stock options. Prior to January 1, 2006, we used historicalvolatility to estimate the grant-date fair value of stock options. Starting on January 1,2006, we changed our method to a combination of historical and impliedvolatility. We believe that a combination of historical and implied volatilityresults in a more accurate estimate of the grant-date fair value of employeestock options because it more appropriately reflects the market’s expectationsof future volatility. Historical volatility during the period associated withthe expected term of our stock options over the past few years included aperiod of time during or subsequent to our initial public offering when ourstock price experienced abnormally high volatility levels, which we believe isunlikely to be indicative of future stock price behavior. However, we have notplaced sole reliance on implied volatility as options in our common stock thatare actively traded on the open market generally have a term of two years orless - substantially shorter than our stock option’s expected term.

In connection with the restatement of our consolidatedfinancial statements, we determined that during the period from May 2000through December 31, 2005, we i) applied incorrect measurement dates inthe accounting for certain stock options and ii) incorrectly accounted forcertain stock options that should have been recorded using variable accounting.The correction of these errors related to stock option accounting resulted inadditional cumulative stock-based compensation charges of approximately $54.1million from 2000 through 2005.

Based on the available facts and circumstancessurrounding our stock option granting practices, we adopted a methodology fordetermining the most likely measurement dates. We believe the application ofthis methodology indicated the date where the number of options granted to eachemployee and the exercise price were known with finality.

We adopted thefollowing framework based on the facts and circumstances of each grant.

(1)         If the stock option grantwas approved at a Board-level meeting, the date reflected in meeting minutes ofour Board of Directors or Compensation Committee of the Board of Directors inwhich the number of options for each recipient and the exercise price for thegrant has been clearly approved was determined to be the most likelymeasurement date. Measurement dates for approximately 35% of the total numberof grants were determined based on this method.

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(2)         If the stock option grantwas approved by UWC, the date of communication of the principal terms of thegrant to the recipients if prior to the signature date on the UWC wasdetermined to be the most likely measurement date. Measurement dates forapproximately 42% of the total number of grants were determined based on thismethod.

(3)         If the stock option grantwas approved by UWC and we did not have clear prior evidence of the date theprincipal terms of the grant were communicated to the recipients, the date ofreceipt of the last signature for the UWC provided there was clear evidence ofthe date the last signature was received was determined to be the most likelymeasurement date. Measurement dates for approximately 2% of the total number ofgrants were determined based on this method.

(4)         If the stock option grantwas approved by UWC and we did not have clear evidence of the date theprincipal terms of the grant were communicated to the recipients or the date ofreceipt of the last signature on the UWC, we reviewed all other availableevidence and used its judgment to determine the most likely measurement date.The additional available evidence included, but was not limited to:

a.                  the next datethat the two Compensation Committee members were physically present at aBoard-level meeting where the UWC may have been signed and the meeting occurredwithin a reasonable time period; and

b.                 the date by whichat least 90% of the stock option grant was entered into the Company’s stockoption administration system.

Measurement dates for approximately 6% of the totalnumber of grants were determined based on the next date that the twoCompensation Committee members were physically present at a Board-level meetingand approximately 15% when at least 90% of the stock option grant was enteredinto the Company’s stock option administration system.

After selecting a measurement date through one of thefour steps in the above framework, the Company then determined if there wereany changes to the individual grant recipients or amount of options grantedafter the selected measurement date. If there were no changes following theselected measurement date, then the measurement date would remain unchanged. Ifthe Company identified changes following the selected measurement date, thenthe Company would evaluate whether the changes should delay the measurementdate for the entire list of grants until the list became final or whether thechanges should result in separate accounting for specific grants. Factorsconsidered in evaluating whether it would be appropriate to delay themeasurement date until the list was final included: 1) the frequency of anychanges as well as the reason for any changes; 2) whether the changes wereadministrative in nature (corrections of errors for grants to which recipientswould have been otherwise entitled); and 3) whether the changes reflectedre-allocation of options among a broader range of recipients.

We acknowledge that many of our measurement dateconclusions are dependent on the facts and circumstances of each stock optiongrant and involved the application of significant management judgment. Becausethe revised measurement date may not be the actual measurement date, weperformed several analyses to compare the results of selecting measurementdates based upon the above described methodology to what would have resultedunder different methodologies. In the first analysis, we considered that themeasurement dates for all the stock option grants would be the last date thelast required action for grants had taken place. In this analysis, themeasurement date would be the date approved at the Board or CompensationCommittee meeting, the date of last receipt of the unanimous written consentor, if there was no evidence as to the receipt of the last signature, the dateof the next board-level meeting at which the two members of the CompensationCommittee were present following the preparation of a final list of grantees. Hadwe applied this alternate approach, the new measurement 

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dates would have resultedin approximately $0.2 million less in cumulative stock-based compensationcharges being recorded from 2000 through 2005.

For anadditional analysis, we also considered what the results would have been had weselected measurement dates based upon the low, average and high closing pricesof our stock within the periods from the originally recorded grant dates to therevised measurement dates. Using this approach, we would have recorded (less)additional cumulative stock-based compensation from 2000 through 2005 of$(52.3) million, $1.4 million, and $55.1 million by selecting measurement datesbased upon the low, average and high closing prices during those periods,respectively. Theadditional (less) cumulative stock-based compensation from 2000 through 2005under each category of our framework and in total based upon the low, averageand high closing prices during those periods is as follows (in thousands):

| **Category** | ** ** | ** ** | ** ** | **Low** | ** ** | **Average** | ** ** | **High** | ** ** |
|--------------|------------|------------|------------|---------|------------|-------------|------------|----------|------------|
| (1)          |       | $          | —     |    |       | $           | —     |     |       | $ | — |   |
| (2)          |       | (43.2      | )          |    | 4.4        |        |       | 50.0     |       |
| (3)          |       | (1.3       | )          |    | (0.3       | )           |       | 0.8      |       |
| (4)          |       | (7.8       | )          |    | (2.7       | )           |       | 4.3      |       |
|         |       | $          | (52.3      | )       |       | $           | 1.4        |     |       | $ | 55.1 |   |

 

Theadditional (less) cumulative stock-based compensation by year from 2000 through2005 under categories two, three and four of our framework based upon the low,average and high closing prices during those periods is as follows (inmillions):

| ** ** | ** ** | **Category 2** | ** ** |
|------------|------------|---------------------|------------|
| ** ** | ** ** | **2000**            | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **Total** | ** ** |
| Low        |       |                | $          | — |   |   | $ | (13.4 | ) | $ | (19.9 | ) | $ | (5.4 | ) | $ | (2.6 | ) | $ | (1.9 | ) | $ | (43.2 | ) |
| Average    |       |                | $          | — |   |   | $ | 6.5 |   | $ | 2.0 |   | $ | (2.3 | ) | $ | (1.0 | ) | $ | (0.8 | ) | $ | 4.4 |   |
| High       |       |                | $          | — |   |   | $ | 33.1 |   | $ | 15.5 |   | $ | 0.2 |   | $ | 0.6 |   | $ | 0.6 |   | $ | 50.0 |   |

 

| ** ** | ** ** | **Category 3** | ** ** |
|------------|------------|---------------------|------------|
| ** ** | ** ** | **2000**            | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **Total** | ** ** |
| Low        |       |                | $          | — |   |   | $ | (0.1 | ) | $ | (0.7 | ) | $ | (0.4 | ) | $ | (0.1 | ) |   | $ | — |   |   | $ | (1.3 | ) |
| Average    |       |                | $          | — |   |   | $ | — |   | $ | (0.1 | ) | $ | (0.2 | ) | $ | — |   |   | $ | — |   |   | $ | (0.3 | ) |
| High       |       |                | $          | — |   |   | $ | 0.1 |   | $ | 0.6 |   | $ | 0.1 |   | $ | — |   |   | $ | — |   |   | $ | 0.8 |   |

 

| ** ** | ** ** | **Category 4** | ** ** |
|------------|------------|---------------------|------------|
| ** ** | ** ** | **2000**            | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **Total** | ** ** |
| Low        |       | $                   | —     |   | $ | (1.7 | ) | $ | (0.8 | ) | $ | (1.4 | ) | $ | (2.2 | ) | $ | (1.7 | ) | $ | (7.8 | ) |
| Average    |       | $                   | —     |   | $ | (0.6 | ) | $ | (0.1 | ) | $ | (0.6 | ) | $ | (0.9 | ) | $ | (0.5 | ) | $ | (2.7 | ) |
| High       |       | $                   | 4.1        |   | $ | (2.9 | ) | $ | 1.3 |   | $ | 0.3 |   | $ | 0.7 |   | $ | 0.8 |   | $ | 4.3 |   |

 

 

We believe our methodology based on the best evidenceavailable results in the most likely measurement dates for our stock optiongrants.

Information regarding the restatement is discussed inthe “Explanatory Note” preceding Part I, Item 1 and in Note 2,“Restatement of Consolidated Financial Statements”, of the Notes toConsolidated Financial Statements in this Form 10-Q.

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***Accounting forIncome Taxes.******  ***Our provisionfor income taxes is comprised of a current and a deferred portion. The currentincome tax provision is calculated as the estimated taxes payable or refundableon tax returns for the current year. We provide for deferred income taxesresulting from temporary differences between financial and taxable income. Suchdifferences arise primarily from tax net operating loss and creditcarryforwards, depreciation, deferred revenue, stock-based compensation expenseand accruals and reserves. We assess the recoverability of any tax assetsrecorded on the balance sheet and provide any necessary valuation allowances asrequired. If we were to determine that it was more likely than not that wewould be unable to realize all or part of our net deferred tax asset in thefuture, an adjustment to the deferred tax asset would be charged to operationsin the period that such determination was made. In evaluating our ability torecover our deferred tax assets, we consider all available positive andnegative evidence including our past operating results, the existence ofcumulative income in the most recent fiscal years, changes in the business inwhich we operate and our forecast of future taxable income. In determiningfuture taxable income, we are responsible for assumptions utilized includingthe amount of state, federal and international pre-tax operating income, thereversal of temporary differences and the implementation of feasible andprudent tax planning strategies. These assumptions require significant judgmentabout the forecasts of future taxable income and are consistent with the plansand estimates we are using to manage the underlying businesses. Such assessmentis completed on a jurisdiction by jurisdiction basis.

We provide for income taxes during interim periodsbased on the estimated effective tax rate for the full fiscal year. We record acumulative adjustment to the tax provision in an interim period in which achange in the estimated annual effective tax rate is determined.

We have not provided forU.S. income taxes on the undistributed earnings of non-U.S. subsidiaries, as weplan to permanently reinvest these amounts.

***Three and Six Months Ended June 30, 2006 and 2005***

***Revenue.******  ***Revenue forthe three and six months ended June 30, 2006 and 2005 was as follows (in thousands):

| ** **    | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **    | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Product       |       | $                                               | 48,853     |                                          | $          | 40,993 |   | $ | 93,395 |   | $ | 63,750 |   |
| Service       |       | 15,627                                          |       | 16,372                                        |       | 31,080 |   | 27,561 |   |
| Total revenue |       | $                                               | 64,480     |                                          | $          | 57,365 |   | $ | 124,475 |   | $ | 91,311 |   |

 

Product revenue is comprised of sales of our voiceinfrastructure products, including our GSX9000Ôand GSX4000TM.OpenServices Switches, PSX Call Routing Server, SGX Signaling Gateway, ASX FeatureServer, the Sonus InsightÔ Management Systemand related product offerings. Product revenue for the three and six monthsended June 30, 2006 increased 19.2% and 46.5%, respectively, from thecomparable periods in fiscal 2005. The increase in product revenue for thethree months ended June 30, 2006 was primarily the result of convertingcertain orders received in both the current and prior fiscal quarters toproduct revenue. The increase for the six months ended June 30, 2006 wasprimarily the result of the conversion to revenue of orders received in thesecond half of fiscal 2005. In addition, during the three and six months ended June 30,2006, we recorded $0.6 million and $3.5 million, respectively, of productrevenue in connection with a change in reporting revenue with Motorola to asell-in basis from a sell-through basis.

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Service revenue is primarily comprised hardware andsoftware maintenance and support, network design, installation and otherprofessional services. Service revenue for the six months ended June 30,2006 increased 12.8% from the comparable prior year period. However, servicerevenue in the three months ended June 30, 2006 decreased 4.6%, comparedto the same prior year period. The decrease for the three months ended June 30,2006 was primarily a result of lower installation revenue and late renewals ofseveral annual maintenance contracts in the second quarter of 2005 that weredue during the first quarter, partially offset by an increase in residentengineering revenue. The increase in service revenue for the six months ended June 30,2006 was primarily a result of increases in maintenance revenue due to ourgrowing installed customer base.

Cingular Wireless and Global Crossing each contributed10% or more of our revenue in at least one of the three and six month periodsended June 30, 2006 and 2005.

International revenue was approximately 5% and 18% ofrevenue for the three months ended June 30, 2006 and 2005, respectively,and 14% and 19% of revenue for the six months ended June 30, 2006 and2005, respectively. Due to uneven ordering patterns of our internationalcustomers, we expect that international revenue will remain uneven as apercentage of revenue from quarter to quarter.

Our deferred product revenue was $55.4 million and$54.8 million at June 30, 2006 and December 31, 2005, respectively. Ourdeferred service revenue was $60.5 million and $67.4 million at June 30,2006 and December 31, 2005, respectively. Our deferred revenue balance mayfluctuate as a result of the timing of revenue recognition, customer payments,maintenance contract renewals, contractual billing rights, customercreditworthiness and maintenance revenue deferrals included in multiple elementarrangements. At June 30, 2006 and December 31, 2005, deferredrevenue and accounts receivable excluded $10.1 million and $5.3 million,respectively, related to products shipped and billed to customers which arecollectible under extended payment terms or for which revenue is recognized ascash is collected, or for which title had not passed to the customer as of theperiod end date.

***Cost of Revenue/Gross Profit.******  ***Our cost ofrevenue consists primarily of amounts paid to third-party manufacturers forpurchased materials and services, royalties, manufacturing and professionalservices personnel and related costs and inventory obsolescence. Cost ofrevenue and gross profit as a percentage of revenue for the three and sixmonths ended June 30, 2006 and 2005 were as follows (in thousands, exceptpercentages):

| ** **                                     | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Cost of revenue                                |       |                                            |       |                                          |       |   |   |   |   |
| Product                                        |       | $                                               | 16,199     |                                          | $          | 14,179 |   | $ | 32,082 |   | $ | 21,691 |   |
| Service                                        |       | 6,987                                           |       | 5,706                                         |       | 13,716 |   | 11,025 |   |
| Total cost of revenue                          |       | $                                               | 23,186     |                                          | $          | 19,885 |   | $ | 45,798 |   | $ | 32,716 |   |
| Gross profit  margin (% of respective revenue) |       |                                            |       |                                          |       |   |   |   |   |
| Product                                        |       | 66.8                                            | %          | 65.4                                          | %          | 65.6 | % | 66.0 | % |
| Service                                        |       | 55.3                                            | %          | 65.1                                          | %          | 55.9 | % | 60.0 | % |
| Total gross  profit margin                     |       | 64.0                                            | %          | 65.3                                          | %          | 63.2 | % | 64.2 | % |

 

The increase in product gross profit as a percentageof revenue was primarily due to customer and product mix, partially offset by agreater percentage of revenue in fiscal 2006 from resellers with typicallylower gross margins. Our product gross profit remained higher than ourlong-term financial model of 58% to 62%. We can provide no assurance that thisfavorable customer and product mix will continue, and we expect that over timeour gross margins will return to levels consistent with our long-term financialmodel. The decrease in service gross profit as a percentage of service revenuewas primarily due to increased 

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investment in our serviceorganization to support the expansion of our installed base and stock-basedcompensation recorded during the three months and six months ended June 30,2006. For the six months ended June 30, 2006, this decrease was partiallyoffset by an increase in service revenue. Our service cost of revenues isrelatively fixed in advance of any particular quarter and, therefore, changesin service revenue will have a significant impact on service gross profitpercentage.

***Research andDevelopment Expenses.******  ***Research and development expensesconsist primarily of salaries and related personnel expenses and prototypecosts related to the design, development, testing and enhancement of ourproducts. Research and development expenses were $12.9 million for the threemonths ended June 30, 2006, an increase of $1.5 million, or 13.0%, from$11.4 million for the same period in fiscal 2005. Research and developmentexpenses were $26.0 million for the six months ended June 30, 2006, anincrease of $3.4 million, or 14.9%, from $22.6 million for the same period infiscal 2005. These increases primarily reflect an increase in salary andrelated expenses associated with increased headcount and stock-basedcompensation expense recorded during the three and six months ended June 30,2006. Some aspects of our research and development efforts require significantshort-term expenditures, the timing of which can cause significant variabilityin our expenses. We believe that rapid technological innovation is critical toour long-term success, and we intend to continue to make substantialinvestments to enhance our products and technologies to meet the requirementsof our customers and market.

***Sales and MarketingExpenses.******  ***Sales and marketing expenses consistprimarily of salaries and related personnel costs, commissions, travel andentertainment expenses, promotions, customer evaluations inventory and othermarketing and sales support expenses. Sales and marketing expenses were $15.6million for the three months ended June 30, 2006, an increase of $4.1million, or 35.5%, from $11.5 million for the same period in fiscal 2005. Salesand marketing expenses were $29.7 million for the six months ended June 30,2006, an increase of $8.5 million, or 39.8%, from $21.2 million for the sameperiod in fiscal 2005. These increases primarily reflect an increase insalaries and travel expenses associated with increased headcount related to theexpansion of our worldwide sales and support coverage, stock-based compensationexpense recorded during the three and six months ended June 30, 2006 andhigher evaluation equipment expenses. The increase for the three months ended June 30,2006 is partially offset by a decrease in commissions due to our revenue mix.

***General andAdministrative Expenses.******  ***General andadministrative expenses consist primarily of salaries and related personnelcosts for executive and administrative personnel, recruiting expenses,allowance for doubtful accounts and professional fees. General andadministrative expenses were $7.2 million for the three months ended June 30,2006, an increase of $0.5 million, or 7.4%, from $6.8 million for the sameperiod in fiscal 2005. General and administrative expenses were $14.2 millionfor the six months ended June 30, 2006, an increase of $0.5 million, or3.6%, from $13.7 million for the same period in fiscal 2005. These increasesprimarily reflect an increase in salary and related expenses associated withincreased headcount and the recording of stock-based compensation expenseduring the three and six months ended June 30, 2006, partially offset by adecrease in directors and officers insurance premiums and professional fees.

***Interest Income,net.******  ***Interest income consists of interestearned on our cash equivalents, marketable debt securities and long-terminvestments. Interest expense consists of interest incurred on a convertiblesubordinated note and capital lease obligations. Interest income, net ofinterest expense, was $3.8 million for the three months ended June 30,2006, compared to $2.1 million for the same period in fiscal 2005. Interestincome, net of interest expense, was $7.1 million for the six months ended June 30,2006, compared to $3.8 million for the same period in fiscal 2005. Theseincreases reflect the benefit of increases in the yield on our portfolio due toan increasing interest rate environment, shifting some of the marketable debtsecurities to longer-term investments with a higher yield during 2006, and anoverall increase in cash and investments compared to the prior year.

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***Income Taxes.******  ***We provide forincome taxes during interim periods based on the estimated effective tax ratefor the full fiscal year, and record a cumulative adjustment to the taxprovision in an interim period in which a change in the estimated annualeffective tax rate is determined. We recorded provisions for income taxes of$0.4 million and $0.3 million for the three months ended June 30, 2006 and2005, respectively. Our provisions for income taxes were $1.2 million and $0.4million for the six months ended June 30, 2006 and 2005, respectively. Provisionsfor income taxes are primarily attributable to foreign income taxes and stateand federal income taxes in the U.S. We have recorded a full valuationallowance for the related federal and state net deferred tax asset due to theuncertainty of realizing the benefit of this asset.

**Off-balance SheetArrangements**

We have no off-balancesheet arrangements that have or are reasonably likely to have a current orfuture material effect on our financial condition, changes in financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources.

**Liquidity andCapital Resources**

At June 30, 2006, our principal sources ofliquidity were our cash, cash equivalents, marketable debt securities andlong-term investments totaling $318.3 million.

Our operating activities provided $5.4 million of cashin the six months ended June 30, 2006, compared to $2.5 million of cash inthe same prior year period. Cash provided by operating activities in thecurrent year period came from $14.7 million of net income, after adjustmentsfor non-cash expense totaling $9.8 million, primarily stock-based compensationand depreciation and amortization of property and equipment, and from $4.2million of lower inventory levels. These amounts were partially offset bydecreases of $6.7 million and $3.7 million in deferred revenue and accountspayable, respectively, coupled with higher levels of accounts receivable andother operating assets aggregating $13.0 million. Cash provided by operatingactivities in the prior year period came from $4.5 million of net income, afternon-cash adjustments for depreciation and amortization of property andequipment and stock-based compensation totaling $4.5 million. Higher deferredrevenue and accounts payable levels contributed $21.7 million and $3.3 million,respectively, of cash to operating activities. These amounts were partiallyoffset by increases of $27.0 million in accounts receivable, $2.1 million ininventory and $2.0 million in other operating assets.

In the six months ended June 30, 2006, our netinvestments in marketable debt securities and long-term investments were $129.4million. At June 30, 2006, our investments had an average remainingmaturity of 6 months. During the current year period, we spent $5.2 million topurchase property and equipment, primarily equipment and software. In the sixmonths ended June 30, 2005, our investments in marketable debt securitiesand long-term investments were virtually equal to maturities of the same. Wespent $7.4 million of cash to purchase property and equipment.

Our financing activities provided $3.7 million of cashin the six months ended June 30, 2006, compared to $3.1 million in thesame prior year period. Net cash provided by financing activities in both thecurrent and prior year six month periods was primarily attributable to proceedsfrom the exercise of stock options and the sale of common stock in connectionwith our employee stock purchase plan. Cash from these transactions totaled$13.7 million and $3.2 million in the six months ended June 30, 2006 and2005, respectively. These proceeds in the current year period were partiallyoffset by the repayment, in May 2006, of our $10.0 million, 4.75%convertible subordinated note.

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Based on our currentexpectations, we believe our current cash, cash equivalents, marketable debtsecurities and long-term investments will be sufficient to meet our anticipatedcash needs for working capital and capital expenditures for at least 12 months.Although it is difficult to predict future liquidity requirements withcertainty, the rate at which we will consume cash will be dependent on the cashneeds of future operations, including changes in working capital, which will,in turn, be directly affected by the levels of demand for our products, thetiming and rate of expansion of our business, the resources we devote todeveloping our products and any litigation settlements. We anticipate devotingsubstantial capital resources to continue our research and development efforts,to maintain our sales, support and marketing, to improve our internal controlenvironment and for other general corporate activities, as well as tovigorously defend against existing and potential litigation relating to therestatement of our consolidated financial statements. See Note 5 to ourCondensed Consolidated Financial Statements.

**Recent AccountingPronouncements**

In February 2007, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities* (“SFAS159”). SFAS 159 permits an entity to measure certain financial assets andfinancial liabilities at fair value. Under SFAS 159, entities that elect thefair value option will report unrealized gains and losses in earnings at eachsubsequent reporting date. The fair value option may be elected on aninstrument-by-instrument basis, with a few exceptions, as long as it is appliedto the instrument in its entirety. SFAS 159 establishes presentation anddisclosure requirements, but does not eliminate disclosure requirements ofother accounting standards. Assets and liabilities that are measured at fairvalue must be displayed on the face of the balance sheet. SFAS 159 is effectivein fiscal years beginning after November 15, 2007, although its provisionsmay be applied earlier if certain conditions are met. We are currentlyevaluating the impact of SFAS 159 on our consolidated results of operations andfinancial condition.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements* (“SFAS 157”). SFAS 157provides a single definition of fair value, along with a framework formeasuring it, and requires additional disclosure about using fair value tomeasure assets and liabilities. SFAS 157 emphasizes that fair value measurementis market-based, not entity-specific, and establishes a fair value hierarchy inwhich the highest priority is quoted prices in active markets. Under SFAS 157,fair value measurements are disclosed according to their level within thishierarchy. While SFAS 157 does not add any new fair value measurements, it doeschange current practice in certain ways, including requiring entities toinclude their own credit standing when measuring their liabilities. SFAS 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years. We are currently evaluatingthe impact of SFAS 157 on our consolidated results of operations and financialcondition.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements* (“SAB 108”). SAB 108 providesspecific guidance on disclosures for companies who elect not to restate priorperiods for misstatements and instead elect to record a cumulative-effectadjustment. We applied the provisions of SAB 108 in the quarter ended March 31,2007. The application of SAB 108 had no impact on our consolidated results ofoperations or financial condition.

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**In June2006, the FASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109*(“FIN 48”), which clarifies the accounting for uncertainty in income taxesrecognized in a company’s financial statements in accordance with FASBStatement No. 109, Accounting for Income Taxes. FIN 48 prescribes a two-stepprocess to determine the amount of tax benefit to be recognized. First, the taxposition must be evaluated to determine the likelihood that it will besustained upon external examination. If the tax position is deemedmore-likely-than-not to be sustained, the tax position is then assessed todetermine the amount of benefit to recognize in the financial statements.  The amount of the benefit that may berecognized is the largest amount that has a greater than 50% likelihood ofbeing realized upon ultimate settlement. We adopted FIN 48 on January 1, 2007.The adoption of FIN 48 did not have a material impact on our consolidatedresults of operations or financial condition.**

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk

We are exposed to avariety of market risks, including changes in interest rates affecting thereturn on our investments and foreign currency fluctuations. We do not believethat a hypothetical 10% adverse movement in interest rates and foreign currencyexchange rates would have a materially different impact than what was disclosedin our Annual Report on Form 10-K for the fiscal year ended December 31,2005.

**Item 4.**                        Controlsand Procedures

**Disclosure Controlsand Procedures**

Our management, with the participation of ourprincipal executive officer and principal financial officer, has evaluated theeffectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Securities and Exchange Act of 1934 (the Exchange Act)), as of June 30,2006, which included an evaluation of disclosure controls and proceduresapplicable to the period covered by the filing of this periodic report. Theterm “disclosure controls and procedures,” as defined in Rule 13a-15(e),means controls and other procedures of a company that are designed to ensurethat information required to be disclosed by a company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms. Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is accumulated andcommunicated to our management, including its principal executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure.

In our *Management’sReport on Internal Control over Financial Reporting*filed with ourAnnual Report on Form 10-K for the year ended December 31,2005, we reported material weaknesses in our internal control over financialreporting (as defined in Rule 13a-15(f) under the SecuritiesExchange Act of 1934 (the “Exchange Act”)). As a result of these materialweaknesses in our internal control over financial reporting, we concluded thatour disclosure controls and procedures were not effective as of December 31,2005.

These materialweaknesses included the following:

·       Inadequateentity-level controls as defined in the Committee of Sponsoring Organizationsof the Treadway Commission (“COSO”) framework, including weaknesses (i) inour risk assessment process, (ii) information and communicationprocedures, and (iii) in monitoring controls;

·       Inadequaterevenue recognition procedures and controls; and

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·       Inadequatefinancial statement preparation and review procedures in relation totransactions, accounts reconciliations, journal entries recorded in thefinancial statements, investments, property and equipment, commissiontransactions, tax transactions, manual spreadsheets and the related accesscontrols, and the overall appropriate design and documentation of controls forall business process cycles.

Subsequent to the evaluation made in connection withthe filing of our Form 10-K for the year ended December 31,2005 and in connection with the restatement of our consolidated financialstatements for the years ended December 31, 2005 and 2004 that isdescribed in the Explanatory Note beginning on page 2 of this Form 10-Q,our management, with the participation of our principal executive officer andprincipal financial officer, identified the following additional materialweaknesses in internal control as of December 31, 2005:

·       ***Inadequate purchasing controls.***Wehave not designed and implemented effective controls related to thecompleteness, accuracy, review and timely recording of contractual obligations.

·       ***Inadequate controls over the accounting forstock-based compensation.***We have not designed effectivecontrols and procedures to ensure correct measurement dates were used in theaccounting for stock option grants.

Our management, with the participation of ourprincipal executive officer and principal financial officer, is responsible forestablishing and maintaining adequate control over financial reporting asdefined in Rules 13a-15(f) under the Exchange Act.

Public Accounting Oversight Board Auditing Standard No. 2defines a material weakness as a significant deficiency, or combination ofsignificant deficiencies, that results in there being more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.

*Management’s Report on Internal Control over FinancialReporting*in our AnnualReport on Form 10-K for December 31, 2005 described certainremediation initiatives designed to address the reported material weaknesses. Duringthe quarter ended June 30, 2006, we continued to design enhancements toour controls and implemented a limited number of changes to address thosereported material weaknesses as well as the two additional material weaknessessubsequently discovered in connection with the restatement of our consolidatedfinancial statements for the years ended December 31, 2005 and 2004. As aresult of the previously described material weaknesses, which were notremediated as of June 30, 2006, we have concluded that our disclosurecontrols and procedures were not effective as of June 30, 2006.

**Changes in InternalControl over Financial Reporting**

In an effort to remediatethe material weakness as described above, during the fiscal quarter ended June 30,2006, we made changes that have materially affected, or are reasonably likelyto materially affect our internal control over financial reporting as follows:

***Inadequate entity-level controls:***

**Riskassessment:**

·        Implementeda code of ethics training and annual certification and whistleblower programsto mitigate risk of fraud; and

·        Designed a fraudprevention and deterrence program that includes a corporate fraud,misappropriation and fiscal irregularity policy.

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**Informationand Communication:**

·        Establishedand posted a corporate governance web page on our intranet site; the web page setsforth policies, procedures and best practices with respect to corporategovernance;

·        Establishedan anonymous employee hotline for employees to submit complaints regardingcorporate governance, ethics and controls;

·        Communicatedto the entire organization the new corporate governance web page, the newanonymous employee hotline and our whistleblower policy through e-mailcommunication and in a company-wide employee meeting;

·        Establishedand posted on our intranet site a process for third parties to submitcomplaints regarding corporate governance, ethics and controls;

·        Establishedan on-line Incident Tracking and Reporting process to assist management intracking complaints and potential violations of our code of conduct, policiesand controls;

·        Hireda Manager of Internal Controls to work with business process owners to designand implement more effective controls and procedures;

·        Enhancedthe financial reporting distributed to operations management to allow for moreeffective and timely monitoring of business operations; and

·        Createda standard communication plan for executive management to provide ongoingcommunication to employees regarding internal controls and corporate ethics.

**Monitoring:**

·        Designed and implementedan international purchasing policy and signature authorization matrix at allforeign locations to strengthen controls related to authorization of allpurchases.

***Inadequate revenue recognition procedures andcontrols:***

·       Implementedweekly revenue meetings, a quarterly certification and disclosure process andcustomer account reviews to understand and document our customer arrangements;

·       Implementeda manual process to adequately document and support the assignment of customercredit worthiness;

·       Implementeda manual process to reconcile customer invoices to related purchase orders andshipping documentation to ensure accuracy, validity and completeness ofinvoicing;

·       Implementeda manual process to reconcile cash payments applied to customer accounts withinvoices and purchase orders; and

·       Created a credit memopolicy to standardize the process to be followed when issuing credits tocustomer accounts.

***Inadequate financial statement preparation and reviewprocedures:***

**Completeness, accuracy, review and timely recording oftransactions, reconciliations, and journal entries:**

·        Enhancedthe review of journal entries and account reconciliations, includinginternational entities, to provide reasonable assurance of complete andaccurate transactions;

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·        Utilizedoutside accounting and finance professionals to assist in the preparation,review and reconciliation of our accounts and financial statements;

·        Providedadditional training for our accounting, finance, tax and treasury personnel coveringproper preparation and review of journal entries and the reconciliation ofgeneral ledger accounts;

·        Initiateda process to require that all unusual, complex or significant accountingtransactions be thoroughly analyzed and consistently documented; and

·        Implementeda semi-annual process for management to assess segregation of duties forautomated and manual systems.

**Inadequatedesign and documentation of controls:**

·        Hired a Manager ofInternal Controls to work with business process owners to design and animplement more effective controls and procedures.

***Inadequate controls over the accounting forstock-based compensation:***

·       Improvedpolicies, procedures and controls related to the administration andauthorization of stock option grants related to non-executive employees,employee referrals and non-employees;

·       Provided additional training for finance,human resource and stock administration personnel covering thestock-option granting process and the accounting and financial reporting forequity awards and modifications of such awards;

·       Enhanced and standardizeddocumentation required to be maintained for the granting of all suchstock-based compensation awards;

·       Implemented the followingprocedures for the granting of stock options:

·        TheCompensation Committee issues grants pursuant to annual stock option incentiveprograms on August 15 of each year, or the next business day following August 15if August 15 falls on a weekend or holiday in any year;

·        TheCompensation Committee retains the right to change this date based on businessevents that might warrant using another date for the annual equity incentivegrant date;

·        Companymanagement issues all new hire stock option grants of 100,000 or less, pursuantto a delegation of authority by the Compensation Committee, that have a grantdate of the 15th day of the month following the employee’sstart date;

·        TheCompensation Committee approves all promotion, retention and awards of allother stock option grants with a grant date of the 15th day of the month following the CompensationCommittee’s approval of the grant;

·        Discontinuedthe use of unanimous written consents signed by the Compensation Committee forthe granting of equity compensation; and

·        Allindividual stock option grants required to be approved by the CompensationCommittee are submitted in the meeting materials in advance of the CompensationCommittee meeting. Minutes reflecting any stock option grants approved duringthe meeting are documented.

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In addition, we willcontinue to design and implement additional policies and procedures during theremediation of our reported material weaknesses.

***Risks and Inherent Limitations***

Prior to the complete remediation of these materialweaknesses, there remains risk that the processes and procedures on which wecurrently rely will fail to be sufficiently effective, which could result inmaterial misstatement of our financial position or results of operations andrequire a restatement. Moreover, because of the inherent limitations in allcontrol systems, no evaluation of controls—even where we conclude the controlsare operating effectively—can provide absolute assurance that all controlissues, including instances of fraud, if any, have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and breakdowns can occur because of a simple error or mistake.Additionally, controls can be circumvented by the individual acts of somepersons, by collusion of two or more people, or by management override of thecontrols. The design of any system of controls also is based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Over time, our control systems, as we developthem, may become inadequate because of changes in conditions, or the degree ofcompliance with the policies or procedures may deteriorate. Because of theinherent limitations in a cost-effective control system, misstatements due toerror or fraud may occur and not be detected and could be material to ourfinancial statements.

The certifications of our principal executive officerand principal financial officer required in accordance with Rule 13a-14(a) underthe Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002 areattached as exhibits to this Quarterly Report on Form 10-Q. Thedisclosures set forth in this Item 4 contain information concerning theevaluation of our disclosure controls and procedures, and changes in internalcontrol over financial reporting, referred to in paragraph 4 of thecertifications. Those certifications should be read in conjunction with thisItem 4 for a more complete understanding of the matters covered by the certifications.

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**PART II—OTHERINFORMATION**

**Item 1.**                        LegalProceedings

In November 2001, a purchaser of our common stockfiled a complaint in the United States District Court for the Southern Districtof New York against us, two of our officers and the lead underwriters allegingviolations of the federal securities laws in connection with our initial publicoffering (“IPO”) and seeking unspecified monetary damages. The purchaser seeksto represent a class of persons who purchased our common stock between the IPOon May 24, 2000 and December 6, 2000. An amended complaint was filedin April 2002. The amended complaint alleges that our registrationstatement contained false or misleading information or omitted to statematerial facts concerning the alleged receipt of undisclosed compensation bythe underwriters and the existence of undisclosed arrangements between theunderwriters and certain purchasers to make additional purchases in the aftermarket. The claims against us are asserted under Section 10(b) of theSecurities Exchange Act of 1934 (the “Exchange Act”) and Section 11 of theSecurities Act of 1933 and against the individual defendants under Sections 11and 15 of the Securities Act and Sections 10(b) and 20(a) of theExchange Act. Other plaintiffs have filed substantially similar class actioncases against approximately 300 other publicly traded companies and their IPOunderwriters which, along with the actions against us, have been transferred toa single federal judge for purposes of coordinated case management. On July 15,2002, we, together with the other issuers named as defendants in thesecoordinated proceedings, filed a collective motion to dismiss the consolidatedamended complaints on various legal grounds common to all or most of the issuerdefendants. The plaintiffs voluntarily dismissed the claims against many of theindividual defendants, including our officers named in the complaint. On February 19,2003, the court granted a portion of the motion to dismiss by dismissing the Section 10(b) claimsagainst certain defendants including us, but denied the remainder of the motionas to the defendants. In June 2003, a special committee of our Board ofDirectors authorized us to enter into a proposed settlement with the plaintiffson terms substantially consistent with the terms of a Memorandum ofUnderstanding negotiated among representatives of the plaintiffs, the issuerdefendants and the insurers for the issuer defendants. In October 2004,the court certified the class in a case against certain defendants. On February 15,2005, the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. On August 31,2005, the court approved the terms of the proposed settlement, as modified. On April 24,2006, the court held a hearing on a motion to approve the final settlement andtook the matter under advisement. On December 5, 2006, the Court ofAppeals for the Second Circuit reversed the court’s October 2004 ordercertifying a class. On June 25, 2007,the Court entered an order terminating the settlement. Accordingly, weare unable to determine the ultimate outcome or potential range of loss, if any.

Beginning in July 2002, several purchasers of ourcommon stock filed complaints in the United States District Court for the Districtof Massachusetts against us, certain officers and directors and a formerofficer under Sections 10(b) and 20(a) and Rule 10b-5 ofthe Exchange Act (the “Class Action Complaints”). The purchasers seek torepresent a class of persons who purchased our common stock between December 11,2000 and January 16, 2002, and seek unspecified monetary damages. The Class ActionComplaints were essentially identical and alleged that we made false andmisleading statements about our products and business. On March 3, 2003,the plaintiffs filed a Consolidated Amended Complaint. On April 22, 2003,we filed a motion to dismiss the Consolidated Amended Complaint on variousgrounds. On May 11, 2004, the court held oral argument on the motion, atthe conclusion of which the court denied our motion to dismiss. The plaintiffsfiled a motion for class certification on July 30, 2004. On February 16,2005, the court certified the class and appointed a class representative. On March 9,2005, the court appointed the law firm of Moulton & Gans as leadcounsel. After the court requested additional briefing on the adequacy of theclass representative, the class representative withdrew. Lead counsel thenfiled a motion to substitute a new plaintiff as the class representative. On May 19,2005, the court held a hearing on the motion and took the matter under 

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advisement. On August 15,2005, the court issued an order decertifying the class and requiring theparties to submit a joint report informing the court whether the cases havebeen settled and whether defendants would be seeking to recover attorney’s feesfrom the plaintiffs. On September 30, 2005, the plaintiffs filed motionsto voluntarily dismiss their complaints with prejudice. On October 5,2005, the court entered an order dismissing the cases. On June 26, 2006,the court issued an order denying our motion for recovery of attorneys’ fees.

On January 6, 2006, a purchaser of our commonstock filed a complaint in the United States District Court for the District ofMassachusetts that is essentially identical to the Consolidated AmendedComplaint previously filed against the defendants. The Court has appointed thePublic Employees’ Retirement System of Mississippi as lead plaintiff. The leadplaintiff has filed an Amended Consolidated Complaint. The defendants filed on April 19,2007 a motion to dismiss the Amended Consolidated Complaint. There is noassurance we will prevail in such a motion or defending this action. A judgmentor a settlement of the claims against the defendants could have a materialimpact on our financial results. It is too early to determine the ultimateoutcome or potential range of loss, if any.

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against us and certain of our currentofficers and directors. On June 28, 2004, the court consolidated theclaims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the Exchange Act andSections 11, 12(a), and 15 of the Securities Act, relating to our restatementof our financial results for 2001, 2002, and the first three quarters of 2003. Specifically,the complaint alleges that we issued a series of false or misleading statementsto the market concerning our revenues, earnings, and financial condition. Plaintiffscontend that such statements caused our stock price to be artificially inflated.The complaint seeks unspecified damages on behalf of a purported class ofpurchasers of our common stock during the period from March 28, 2002through March 26, 2004. On January 28, 2005, we filed a motion todismiss the Section 10(b) and 12(a) claims and joined the motionto dismiss the Section 11 claim filed by the individual defendants. On June 1,2005, the court held a hearing on the motion and allowed the plaintiff to filean amended complaint. The plaintiff filed an amended complaint that includedthe same claims and substantially similar allegations as set forth in theinitial complaint. On September 12, 2005, the defendants filed motions todismiss this amended complaint. On December 10, 2005, the court held ahearing on the motions and took the matter under advisement. On May 10,2006, the court issued an order granting the defendants’ motions in part anddenying the motions in part. The court dismissed the Section 12(a)(2) claimsagainst all the defendants and the Section 10(b) and Section 11claims against the individual defendants. The court denied the motions as tothe Section 10(b) and Section 11 claims against us and Section 15claims against the individual defendants. The plaintiff has filed a motion forclass certification, which the defendants have opposed. The court held ahearing on February 28, 2007 on plaintiff’s motion for class certificationand took the matter under advisement. We believe that we have substantial legaland factual defenses to the claims, which we intend to pursue vigorously. Weexpect to incur significant legal fees in defending this action. At this time,we are unable to determine the ultimate outcome or potential range of loss, ifany.

In February 2004, three purported shareholderderivative lawsuits were filed in the United States District Court for theDistrict of Massachusetts against us and certain of our officers and directors,naming us as a nominal defendant. Also in February 2004, two purportedshareholder derivative lawsuits were filed in the business litigation sessionof the superior court of Suffolk County of Massachusetts against us and certainof our directors and officers, also naming us as a nominal defendant. The suitsclaim that certain of our officers and directors breached their fiduciaryduties to our stockholders and to us. The complaints are derivative in natureand do not seek relief from us. However, we have entered into indemnificationagreements in the ordinary course of business with certain of the defendantofficers and directors and may 

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be obligated throughoutthe pendency of these actions to advance payment of legal fees and costsincurred by the defendants pursuant to our obligations under theindemnification agreements or applicable Delaware law. On September 27,2004, the state court granted our motion to dismiss. On October 26, 2004,the plaintiffs filed a notice appealing the state court’s dismissal of theactions. On June 24, 2005, the plaintiffs withdrew the appeal anddismissed the case with prejudice. In the federal actions, on June 28,2004, the court consolidated and stayed the three actions. On October 12,2004, the lead plaintiff filed a consolidated amended complaint. On June 1,2005, the court held a hearing on the motion and allowed the plaintiff to filean amended complaint. On July 1, 2005, the plaintiff filed an amendedcomplaint. Thedefendants renewed their motions to dismiss. On December 10, 2005, thecourt held a hearing on the motions and took the matter under advisement. On March 31,2006, the court entered an order granting the defendants’ motions to dismissthe amended complaint. On April 26, 2006, the plaintiffs filed a notice ofappeal of the dismissal order. On February 6, 2007, the First CircuitCourt of Appeals held a hearing on the appeal. We do not expect that this claimwill have a material impact on our financial statements.

In December 2004, a purchaser of our common stockfiled a complaint in the circuit court in Will County, Illinois, against us,one of our officers, and a former officer alleging misrepresentation and fraudin connection with the plaintiff’s purchase of our stock. The complaint seeksunspecified damages. We filed a motion to dismiss the complaint. On May 5,2005, the plaintiff filed an amended complaint. On October 26, 2005, thecourt held a hearing on the motion during which it dismissed the federal claimswithout prejudice and dismissed the state claims without prejudice. On November 23,2005, the plaintiff filed a second amended complaint with essentially the sameallegations as in the prior complaints. The defendants renewed their motions todismiss with respect to the second amended complaint. On March 9, 2006,the court held a hearing on the defendants’ motions during which the courtentered an order dismissing the second amended complaint with prejudice. On April 17,2006, the plaintiff filed a notice of appeal of the dismissal order. In orderto avoid the costs of an appeal, we agreed to settle the matter for a deminimus amount. On June 23, 2006, the court entered an order dismissingthe case.

On June 14, 2006, C2 Communications sued AT&T, Inc.,Verizon Communications, Inc., Qwest, Bellsouth Corporation, Sprint NextelCorporation, Global Crossing and Level 3 in the Eastern District of Texas,Marshall Division. C2 Communications has alleged that each of the defendantsinfringe U.S. Patent No. 6,243,373 entitled “Method and Apparatus forImplementing a Computer Network Internet Telephone System.”  We have agreed, subject to certainconditions, to assume the defense of Qwest, Global Crossing and Level 3 in thislitigation to the extent the claim results from their use of products purchasedfrom us. There can be no assurance that other defendants who have purchased ourproducts will not seek indemnification from us. The court issued a schedulingorder with a trial date of August 4, 2008. We believe that the defendantshave substantial legal and factual defenses to the infringement claim, which weintend to pursue vigorously on behalf of the defendant for whom we agree or arerequired to assume defense of the litigation. However, there is no assuranceany of the defendants will prevail in defending this action. There also can beno assurance that we will not be required to indemnify any of the defendantsfrom any judgment of infringement rendered against them. We may be required todevote significant time and resources in connection with assuming the defenseof the claim of infringement on behalf of the defendants for whom we haveagreed to assume defense of the litigation. An adverse outcome with respect tothe claim and our indemnification could have a material adverse impact on ourbusiness, operating results and financial condition. We cannot predict theultimate outcome of this litigation or any potential impact on our operatingresults or financial position.

On November 14, 2006, a purported shareholderderivative lawsuit was filed in the United District Court for the District ofMassachusetts against us and certain of our officers and directors, naming usas a nominal defendant. Other purported shareholders filed virtually identicalcomplaints. The suits claim that certain of our officers and directors breachedtheir fiduciary duties to our stockholders and to us in connection with ourannounced stock option review. The complaints are derivative in nature and donot 

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seek relief from us. However,we have entered into indemnification agreements in the ordinary course ofbusiness with certain of the defendant officers and directors and may beobligated throughout the pendency of these actions to advance payment of legalfees and costs incurred by the defendants pursuant to our obligations under theindemnification agreements or applicable Delaware law. By order dated December 18,2006, the Court consolidated the actions. The plaintiffs have filed aconsolidated complaint. The defendants filed on March 19, 2007 a motion todismiss the consolidated complaint. The Court held a hearing on July 11,2007, and took the motion under advisement. We believe that we have substantiallegal and factual defenses to the derivative claims, which we intend to pursuevigorously. There is no assurance we will prevail in defending these actions. Wecannot predict the ultimate outcome of this litigation or any potential impacton our operating results or financial position.

On January 19, 2007, a purported shareholderderivative lawsuit was filed in the Superior Court Department of MiddlesexCounty of Massachusetts against certain of our directors and officers, alsonaming us as a nominal defendant. Another purported shareholder filed avirtually identical complaint. The suits assert similar claims and seek reliefsimilar to the derivative suits filed in federal court. On May 7, 2007,the plaintiffs filed a consolidated complaint. On June 6, 2007, thedefendants moved to dismiss the consolidated complaint. The Court scheduled ahearing on the motion for August 14, 2007. We believe that we havesubstantial legal and factual defenses to the derivative claims, which weintend to pursue vigorously. There is no assurance we will prevail in defendingthese actions. We cannot predict the ultimate outcome of this litigation or anypotential impact on our operating results or financial position.

As announced on March 19, 2007, the SEC isconducting a formal private investigation into our historical stock optiongranting practices. If we are subject to adverse findings, we could be requiredto pay damages or penalties or have other remedies imposed, including criminalpenalties, which could adversely our business, financial position or results ofoperations.

We include standard intellectual propertyindemnification provisions in our product agreements in the ordinary course ofbusiness. Pursuant to our product agreements, we will indemnify, hold harmless,and reimburse the indemnified party for losses suffered or incurred by theindemnified party, generally business partners or customers, in connection withcertain patent, copyright or other intellectual property infringement claims bythird parties with respect to our products. Other agreements with our customersprovide indemnification for claims relating to property damage or personalinjury resulting from the performance of services by us or our subcontractors. Historically,our costs to defend lawsuits or settle claims relating to such indemnityagreements have been insignificant. Accordingly, the estimated fair value ofthese indemnification provisions is immaterial.

The Internal RevenueService has notified us that our payroll tax returns for the years ended December 31,2004, 2005 and 2006 have been selected for audit in connection with our stockoption review. In connection with the restatement of our financial statementsincluded in this Form 10-Q, we have recorded approximately $1.6million of accruals for additional tax, penalties and interest related toadjustments resulting from errors in stock option accounting. For moreinformation about stock-based compensation, including the financial statement impactfrom the restatement, see Note 2, “Restatement of Consolidated FinancialStatements” of the Notes to the Consolidated Financial Statements. We could berequired to pay additional tax, penalties or interest, or have other remediesimposed, which could adversely impact our business, financial position orresults of operations.

**Item 1A.**                RiskFactors

*Investing in our common stock involves a high degreeof risk. You should carefully consider the risks described below before buyingour common stock. If any of the following risks actually occurs, the tradingprice of our common stock could decline and you may lose all or part of yourinvestment.*

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***The investigation of our historical stock optionpractices and the restatement of our prior financial statements may require usto incur substantial expenses and direct our management’s attention from ourbusiness, which may impact*****our business, financial position and resultsof operations and****the trading price of ourcommon stock.**

Our internal review and our Audit Committee’sinvestigation into our historical stock option practices and accounting haverequired us to incur substantial expenses for legal, accounting, tax and otherprofessional services, have diverted management’s attention from our business,and could in the future harm our business, financial condition and results ofoperations.

While we believe we havemade appropriate judgments in determining the correct measurement dates for ourstock option grants, the U.S. Securities and Exchange Commission (“SEC”) maydisagree with the manner in which we have accounted for and reported, or notreported, the financial impact. Accordingly, there is a risk we may have tofurther restate our historical financial statements, amend prior filings withthe SEC, or take other actions not currently contemplated.

***Matters related to theinvestigation into our historical stock option granting practices and therestatement of our financial statements may result in additional litigation,regulatory proceedings and government enforcement actions for which we may berequired to pay damages or penalties or have other remedies imposed.***

Our historical stockoption granting practices and the restatement of our financial statements haveexposed us to greater risks associated with litigation, regulatory proceedingsand government enforcement action. For more information regarding our currentlitigation and related inquiries, please see Part I, Item 3 “LegalProceedings” as well as the other risk factors related to litigation set forthin this section. We have provided the results of our internal review andinvestigation to the SEC, which has notified us of a formal order of privateinvestigation. We have responded to requests for documents and additionalinformation and we intend to continue to cooperate with the SEC. No assurancecan be given regarding the outcomes from litigation, regulatory proceedings orgovernment enforcement actions relating to our past stock option practices. Theresolution of these matters will be time-consuming, expensive, and may distractmanagement from the conduct of our business. Furthermore, if we are subject toadverse findings in litigation, regulatory proceedings or governmentenforcement actions, we could be required to pay damages or penalties or haveother remedies imposed, which could harm our business, financial condition,results of operations and cash flows.

***We have identifiedmaterial weaknesses in our internal control over financial reporting, which, ifnot remedied effectively, could have an adverse effect on the trading price ofour common stock and impair our ability to timely file our SEC reports orotherwise seriously harm our business.***

Through, in part, thedocumentation, testing and assessment of our internal control over financialreporting pursuant to the rules promulgated by the SEC under Section 404of the Sarbanes-Oxley Act of 2002 and Item 308 of Regulation S-K, Managementhas concluded that our disclosure controls and procedures and our internalcontrol over financial reporting had material weaknesses as of December 31,2006, as described in our Annual Report on Form 10-K for the year endedDecember 31, 2006, to be filed immediately after the filing of thisQuarterly Report on Form 10-Q. We have taken certain actions to addressthose material weaknesses. Our inability to remedy such material weaknessespromptly and effectively could have a material adverse effect on our business,results of operations and financial condition, as well as impair our ability tomeet our quarterly and annual reporting requirements in a timely manner. Priorto the elimination of these material weaknesses, there remains risk that thetransitional controls on which we currently rely will fail to be sufficientlyeffective, which could result in a material misstatement of our financialposition or results of operations and require a restatement. In addition, evenif we are successful in strengthening our controls and procedures, suchcontrols and procedures may not be adequate to prevent or identifyirregularities or facilitate the fair presentation of our financial statementsor SEC reporting.

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***Failure or circumvention of our controls andprocedures could seriously harm our business.***

As described in Item 9A ofthis Form 10-K, we have made significant changes in our internalcontrol over financial reporting and our disclosure controls and procedures. Anysystem of controls, however well designed and operated, is based in part oncertain assumptions and can provide only reasonable, and not absolute,assurances that the objectives of the system are met. The failure orcircumvention of our controls, policies and procedures could have a materialadverse effect on our business, results of operations and financial position.

***We face risksrelated to securities litigation that could result in significant legalexpenses and settlement or damage awards.***

We have been named as a defendant in a number ofsecurities class action and derivative lawsuits. We are generally obliged, tothe extent permitted by law, to indemnify our current and former directors andofficers who are named as defendants in these lawsuits. Defending againstexisting and potential litigation may require significant attention andresources of management. Regardless of the outcome, such litigation will resultin significant legal expenses. If our defenses are ultimately unsuccessful, orif we are unable to achieve a favorable settlement, we could be liable forlarge damage awards that could have a material adverse effect on our business,results of operations and financial position.

Our historical stockoption practices and the restatement of our prior financial statements haveexposed us to greater risks associated with securities litigation. Severalderivative actions were filed against certain current and former directors andofficers based on allegations relating to our historical stock option practices.We may be subject to additional litigation arising in relation to ourhistorical stock option practices and the restatement of our prior periodfinancial statements.

***The limitations ofour director and officer liability insurance may require us to pay significantlegal expenses and settlement or damage awards.***

Our director and officerliability insurance policies provide only limited liability protection relatingto the securities class action and derivative lawsuits against us and certainof our officers and directors. If these policies do not adequately coverexpenses and certain liabilities relating to these lawsuits, our results ofoperations and our financial position could be materially harmed. The factsunderlying the lawsuits have made director and officer liability insuranceextremely expensive for us, and may make such insurance coverage unavailablefor us in the future. Increased premiums could materially harm our financialresults in future periods. The inability to obtain this coverage due to itsunavailability or prohibitively expensive premiums would make it more difficultto retain and attract officers and directors and potentially expose us toself-funding any future liabilities ordinarily mitigated by director andofficer liability insurance.

***If we are not current in our SEC filings, we will faceseveral adverse consequences.***

From August 9, 2006through August 2, 2007, we were not current in our SEC filings. If we areunable to remain current in our SEC filings, we will not be able to have aregistration statement under the Securities Act of 1933, covering a publicoffering of securities, declared effective by the SEC, and we will not be ableto make offerings pursuant to existing registration statements (includingregistration statements on Form S-8 covering employee stock plans),or pursuant to certain “private placement” rules of the SEC underRegulation D to any purchasers not qualifying as “accredited investors.”  Inaddition, our affiliates will not be able to sell our securities pursuant to Rule 144under the Securities Act. Finally, we will not be eligible to use a “short form”registration statement on Form S-3 until August 2, 2008 and wehave lost our status as a “well known seasoned issuer,” including theregistration advantages associated with such status. These restrictions mayimpair our ability to raise capital in the public markets should we desire todo so, and to attract and retain key employees.

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***Our common stockmay be delisted from the NASDAQ Global Select Market and transferred to theNational Quotation Service Bureau (“Pink Sheets”), which may, among otherthings, reduce the price of our common stock and the levels of liquidityavailable to our stockholders.***

On August 2, 2007, we filed this Quarterly Reporton Form 10-Q for the quarter ended June 30, 2006 (the “SecondQuarter Form 10-Q”), and will file our Quarterly Report on Form 10-Qfor the quarter ended September 30, 2006 (the “Third Quarter Form 10-Q”),our Annual Report on Form 10-K for the year ended December 31,2006 (the “2006 Form 10-K”) and our Quarterly Report on Form 10-Qfor the quarter ended March 31, 2007 (the “First Quarter Form 10-Q”)with the SEC. We consider that the filing of these reports has remedied ournon-compliance with Marketplace Rule 4310(c)(14), subject to NASDAQ’saffirmative completion of its compliance protocols and its notification to usaccordingly. However, if NASDAQ disagreeswith our position or if the SEC disagrees with the manner in which we haveaccounted for and reported, or not reported, the financial impact of past stockoption grants, there could be further delays in filing subsequent SEC reports orother actions that might result in delisting of our common stock from theNASDAQ Global Select Market.

In August 2006, we received a NASDAQ StaffDetermination letter stating that, as a result of the delayed filing of ourSecond Quarter Form 10-Q, we were not in compliance with the filingrequirements for continued listing as set forth in the Marketplace Rule 4310(c)(14)and were therefore subject to delisting from the NASDAQ Global Select Market. InNovember 2006, we received an additional letter from NASDAQ of similarsubstance relating to our Third Quarter Form 10-Q. In December 2006,the NASDAQ Listing Qualifications Panel granted our request for continuedlisting, provided that we file the Second Quarter Form 10-Q, theThird Quarter Form 10-Q and any required restatements with the SECon or before February 12, 2007. In February 2007, we received anotice from the NASDAQ Listing and Hearing Review Council which advised us thatany delisting determination by the NASDAQ Listing Qualifications Panel has beenstayed pending further review by the Review Council. In March 2007, wereceived a NASDAQ Staff Determination letter stating we were not in compliancewith the continued listing requirements due to the delayed filing of our 2006 Form 10-K.On May 14, 2007, we received a NASDAQ Staff Determination letter statingthat we were not in compliance with the continued listing requirements due tothe delayed filing our First Quarter Form 10-Q. On May 10,2007, we received a letter from NASDAQ that the NASDAQ Listing and HearingReview Council had granted us an exception to demonstrate compliance with thecontinued listing requirements until June 26, 2007. On June 25, 2007,we received a letter from NASDAQ informing us that the NASDAQ Board ofDirectors had called for review the decision of the NASDAQ Listing and HearingReview Council and granted a stay of delisting pending further review by theBoard in July 2007. We received a letter dated July 18, 2007 from NASDAQthat the NASDAQ Listing and Hearing Review Council had granted us an exceptionto demonstrate compliance with the continued listing requirements until September 17,2007.

In addition, if we fail totimely file all of our future periodic reports under the Exchange Act, ourcommon stock may be delisted from the NASDAQ Global Select Market andsubsequently would trade on the Pink Sheets. The trading of our common stock onthe Pink Sheets may reduce the price of our common stock and the levels ofliquidity available to our stockholders. Our delisting from the NASDAQ GlobalSelect Market and transfer to the Pink Sheets may also result in other negativeimplications, including the potential loss of confidence by suppliers,customers and employees, the loss of institutional investor interest and fewerbusiness development opportunities.

***Recent rulemakingby the Financial Accounting Standards Board requires us to expense equitycompensation given to our employees and may reduce our ability to effectivelyutilize equity compensation to attract and retain employees.***

We historically have used stock options as asignificant component of our employee compensation program in order to alignemployees’ interests with the interests of our stockholders, encourage employee

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retention, and providecompetitive compensation packages. The Financial Accounting Standards Board hasadopted changes that require companies to record a charge to earnings foremployee stock option grants and other equity incentives effective January 1,2006, which we have adopted. By causing us to incur significantly increasedcompensation costs, such accounting changes may cause us to reduce theavailability and amount of equity incentives provided to employees, which maymake it more difficult for us to attract, retain and motivate key personnel.

In addition, in order toeliminate the compensation expense associated with unvested employee stockoptions with an exercise price of $4.00 or greater at that time, in December 2005,we accelerated the vesting on the majority of these options. The acceleration ofthese unvested options may affect our ability to retain key personnel.

***We expect that amajority of our revenues will be generated from a limited number of customersand we will not be successful if we do not grow our customer base.***

To date, we haveshipped our products to a limited number of customers. We expect that in theforeseeable future, the majority of our revenues will continue to depend onsales of our products to a limited number of customers. Three customers eachcontributed more than 10% of our revenues in fiscal 2006, or approximately 43%of our revenues in the aggregate. One customer contributed approximately 28% ofour revenues in fiscal 2005. Two customers each contributed more than 10%, orapproximately 29% in the aggregate, of our revenues in fiscal 2004. Our futuresuccess will depend on our ability to attract additional customers beyond ourcurrent limited number. The growth of our customer base could be adverselyaffected by:

·       acquisitionsof or by our customers;

·       customerunwillingness to implement our new voice infrastructure products or renewcontracts as they expire;

·       potentialcustomer concerns with selecting an emerging telecommunications equipmentvendor;

·       delaysor difficulties that we may incur in completing the development andintroduction of our planned products or product enhancements;

·       furtherdeterioration in the general financial condition of service providers,including additional bankruptcies, or inability to raise capital;

·       newproduct introductions by our competitors;

·       failureof our products to perform as expected; or

·       difficultieswe may incur in meeting customers’ delivery requirements.

The loss of any of oursignificant customers or any substantial reduction in orders or contractualcommitments from these customers could materially and adversely affect ourfinancial position and results of operations. If we do not expand our customerbase to include additional customers that deploy our products in operationalcommercial networks, our business, operating results and financial positioncould be materially and adversely affected.

***Our business hasbeen adversely affected by developments in the telecommunications industry andthese developments may continue to affect our revenues and operating results.***

From our inception through the year 2000, thetelecommunications market experienced rapid growth spurred by a number offactors, including deregulation in the industry, entry of a large number of newemerging service providers, growth in data traffic and the availability ofsignificant capital from the financial markets. Commencing in 2001, thetelecommunications industry experienced a reversal of some 

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of these trends, marked bydramatic reductions in capital expenditures, financial difficulties, and, insome cases, bankruptcies of service providers. These conditions caused asubstantial, unexpected reduction in demand for telecommunications equipment,including our products.

We expect some ofthe developments described above to continue to affect our business in the followingmanner:

·       ourability to accurately forecast revenue and plan our business is diminished;

·       ourrevenues could be unexpectedly reduced; and

·       wemay incur losses because a high percentage of our operating expenses areexpected to continue to be fixed in the short-term.

Any one or a combinationof the above could materially and adversely affect our business, operatingresults and financial position.

***Consolidation in the telecommunications industry couldharm our business.***

The industry hasexperienced consolidation and we expect this trend to continue. Consolidationamong our customers may cause delays or reductions in capital expenditure plansand/or increased competitive pricing pressures as the number of availablecustomers declines and their relative purchasing power increases in relation tosuppliers. Any of these factors could adversely affect our business.

***The market forvoice infrastructure products for the public network is new and evolving andour business will suffer if it does not develop as we expect.***

The market for ourproducts continues to evolve. In particular, wireless, cable and broadbandaccess networks are becoming important markets for our products. Packet-based technology may not become widelyaccepted as a platform for voice and a viable market for our products may notbe sustainable. If this market does not develop, or develops more slowly thanwe expect, we may not be able to sell our products in significant volume.

***If we do notanticipate and meet specific customer requirements or if our products do notinteroperate with our customers’ existing networks, we may not retain currentcustomers or attract new customers.***

To achieve market acceptance for our products, we musteffectively anticipate, and adapt in a timely manner to, customer requirementsand offer products and services that meet changing customer demands.Prospective customers may require product features and capabilities that ourcurrent products do not have. The introduction of new or enhanced products alsorequires that we carefully manage the transition from older products in orderto minimize disruption in customer ordering patterns and ensure that adequatesupplies of new products can be delivered to meet anticipated customer demand.If we fail to develop products and offer services that satisfy customerrequirements, or to effectively manage the transition from older products, ourability to create or increase demand for our products would be seriously harmedand we may lose current and prospective customers.

Many of our customers willrequire that our products be designed to interface with their existingnetworks, each of which may have different specifications. Issues caused by anunanticipated lack of interoperability may result in significant warranty,support and repair costs, divert the attention of our engineering personnelfrom our hardware and software development efforts and cause significantcustomer relations problems. If our products do not interoperate with those ofour customers’ networks, installations could be delayed or orders for ourproducts could be cancelled, which would seriously harm our gross margins andresult in loss of revenues or customers.

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***Our large customers have substantial negotiatingleverage, which may require that we agree to terms and conditions that may havean adverse effect on our business.***

Large telecommunicationsproviders have substantial purchasing power and leverage in negotiatingcontractual arrangements with us. These customers may require us to developadditional features and require penalties for failure to deliver such features.As we seek to sell more products to this class of customer, we may be requiredto agree to such terms and conditions, which may affect the timing of revenuerecognition and amount of deferred revenues and may adversely affect ourfinancial position in the applicable period affected.

***We rely on distribution partners to sell our productsin certain markets, and disruptions to or our failure to effectively developand manage our distribution channel and the processes and procedures thatsupport it could adversely affect our ability to generate revenues from thesale of our products in those markets.***

Our future success ishighly dependent upon establishing and maintaining successful relationshipswith a variety of value-added reseller and distribution partners. A portion ofour revenues is derived through distributors, many of which sell competitiveproducts. Our revenues depend in part on sales by these distributors. The lossof or reduction in sales by these distributors could materially reduce ourrevenues. If we fail to maintain relationships with these distributionpartners, fail to develop new relationships with distributors in new markets,fail to manage, train, or provide incentives to existing distributorseffectively or if these partners are not successful in their sales efforts,sales of our products may decrease and our operating results could suffer.

In addition, we recognizea portion of our revenue based on a sell-through model using informationprovided by our distributors. If those distributors provide us with inaccurateor untimely information, the amount or timing of our revenues could be adverselyaffected.

***We may face risks associated with our internationalexpansion that could impair our ability to grow our international revenues.***

Internationalrevenues approximated $78 million and $48 million in fiscal 2006 and fiscal2005, respectively, and we intend to expand our sales in international markets.This expansion will require significant management attention and financialresources to successfully develop direct and indirect international sales andsupport channels. In addition, we may not be able to develop internationalmarket demand for our products, which could impair our ability to grow ourrevenues. We have limited experience marketing, distributing and supporting ourproducts internationally and, to do so, we expect that we will need to developversions of our products that comply with local standards. Furthermore,international operations are subject to other inherent risks, including:

·       relianceon distributors and resellers;

·       greaterdifficulty collecting accounts receivable and longer collection cycles;

·       difficultiesand costs of staffing and managing international operations;

·       theimpact of differing technical standards outside the United States;

·       theimpact of recessions in economies outside the United States;

·       changesin regulatory requirements and currency exchange rates;

·       certificationrequirements;

·       reducedprotection for intellectual property rights in some countries;

·       potentiallyadverse tax consequences; and

·       political and economicinstability.

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***The unpredictability of our quarterly results mayadversely affect the trading price of our common stock.***

Our revenues andoperating results may vary significantly from quarter to quarter due to anumber of factors, many of which are outside of our control and any of which maycause our stock price to fluctuate. Generally, purchases by service providersof telecommunications equipment from manufacturers have been unpredictable andclustered, rather than steady, as the providers build out their networks. Theprimary factors that may affect our revenues and operating results include thefollowing:

·       fluctuationin demand for our voice infrastructure products and the timing and size ofcustomer orders;

·       thecancellation or deferral of existing customer orders or the renegotiation ofexisting contractual commitments;

·       thelength and variability of the sales cycle for our products;

·       thetiming of revenue recognition;

·       newproduct introductions and enhancements by our competitors or by us;

·       changesin our pricing policies, the pricing policies of our competitors and the pricesof the components of our products;

·       ourability to develop, introduce and ship new products and product enhancementsthat meet customer requirements in a timely manner;

·       themix of product configurations sold;

·       ourability to obtain sufficient supplies of sole or limited source components;

·       ourability to attain and maintain production volumes and quality levels for ourproducts;

·       costsrelated to acquisitions of complementary products, technologies or businesses;

·       generaleconomic conditions, as well as those specific to the telecommunications,networking and related industries;

·       consolidationwithin the telecommunications industry, including acquisitions of or by ourcustomers; and

·       theapplication of complex revenue recognition accounting rules to ourcustomer arrangements.

As with other telecommunications product suppliers, wemay recognize a portion of our revenue in a given quarter from sales booked andshipped in the last weeks of that quarter. As a result, delays in customerorders may result in delays in shipments and recognition of revenue beyond theend of a given quarter.

A significant portion of our operating expenses isfixed in the short-term. If revenues for a particular quarter are belowexpectations, we may not be able to reduce operating expenses proportionallyfor the quarter. Any such revenue shortfall would, therefore, have asignificant effect on our operating results for the quarter.

Although we achieved profitability on an annual basisin fiscal 2006, fiscal 2005 and fiscal 2004, we have incurred a net loss incertain quarters and may incur additional losses in future quarters and years. Ourrevenues may not grow and we may never generate sufficient revenues to sustainprofitability.

We believe thatquarter-to-quarter comparisons of our operating results are not a goodindication of our future performance. It is likely that in some futurequarters, our operating results may be below the expectations of public marketanalysts and investors, which may adversely affect our stock price.

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***We are entirely dependent upon our voiceinfrastructure products, and our future revenues depend upon their commercialsuccess.***

Our future growth dependsupon the commercial success of our voice infrastructure products. We intend todevelop and introduce new products and enhancements to existing products in thefuture. We may not successfully complete the development or introduction ofthese products. If our target customers do not adopt, purchase and successfullydeploy our current or planned products, our revenues will not grow.

***If we do not respond rapidly to technological changesor to changes in industry standards, our products could become obsolete.***

The market for packetvoice infrastructure products is likely to be characterized by rapidtechnological change and frequent new product introductions. We may be unableto respond quickly or effectively to these developments. We may experiencedifficulties with software development, hardware design, manufacturing ormarketing that could delay or prevent our development, introduction ormarketing of new products and enhancements. The introduction of new products byour competitors, the market acceptance of products based on new or alternativetechnologies or the emergence of new industry standards could render ourexisting or future products obsolete. If the standards adopted are differentfrom those that we have chosen to support, market acceptance of our productsmay be significantly reduced or delayed. If our products become technologicallyobsolete, we may be unable to sell our products in the marketplace and generaterevenues.

***If we fail to compete successfully against incumbenttelecommunications equipment companies, our ability to increase our revenues andsustain profitability will be impaired.***

Competition in thetelecommunications market is intense. This market has historically beendominated by large incumbent telecommunications equipment companies, such asAlcatel-Lucent, NEC, Nortel Networks, Nokia Siemens and Ericsson, all of whichare our direct competitors. We also face competition from other largetelecommunications and networking companies, including Cisco Systems, some ofwhich have entered our market by acquiring companies that design competingproducts. Alcatel and Lucent recently completed their merger. Siemens hascombined its networking business with Nokia’s networking business. Othercompetitors may merge, intensifying competition. Additional competitors withsignificant financial resources also may enter our markets and furtherintensify competition.

Many of our current andpotential competitors have significantly greater selling and marketing,technical, manufacturing, financial and other resources. Further, some of ourcompetitors sell significant amounts of other products to our current andprospective customers and have the ability to offer lower prices to winbusiness. Our competitors’ broad product portfolios, coupled with alreadyexisting relationships, may cause our customers to buy our competitors’products or harm our ability to attract new customers.

Tocompete effectively, we must deliver innovative products that:

·       provideextremely high reliability and voice quality;

·       scaleeasily and efficiently;

·       interoperatewith existing network designs and other vendors’ equipment;

·       provideeffective network management;

·       areaccompanied by comprehensive customer support and professional services;

·       providea cost-effective and space efficient solution for service providers; and

·       meetprice competition from low cost equipment providers.

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If we are unable tocompete successfully against our current and future competitors, we couldexperience price reductions, order cancellations, loss of customers andrevenues and reduced gross profit margins.

***Because ourproducts are sophisticated and designed to be deployed in complex environments,they may have errors or defects that we find only after full deployment, whichcould seriously harm our business.***

Our products aresophisticated and are designed to be deployed in large and complex networks. Becauseof the nature of our products, they can only be fully tested when substantiallydeployed in very large networks with high volumes of traffic. Some of ourcustomers have only recently begun to commercially deploy our products and theymay discover errors or defects in the software or hardware, or the products maynot operate as expected. As we continue to expand our distribution channelthrough distributors and resellers, we will need to rely on and support theirservice and support organizations. If we are unable to fix errors or otherperformance problems that may be identified after full deployment of ourproducts, we could experience:

·       lossof, or delay in, revenues;

·       lossof customers and market share;

·       afailure to attract new customers or achieve market acceptance for our products;

·       increasedservice, support and warranty costs and a diversion of development resources;and

·       costly and time-consuminglegal actions by our customers.

***Because our productsare deployed in large, complex networks around the world, failure to establisha support infrastructure and maintain required support levels could seriouslyharm our business.***

Our products aredeployed in large and complex networks around the world. Our customers expectus to establish a support infrastructure and maintain demanding supportstandards to ensure that their networks maintain high levels of availabilityand performance. To support the continued growth of our business, our supportorganization will need to provide service and support at a high levelthroughout the world. If we are unable to provide the expected level of supportand service to our customers, we could experience:

·       lossof customers and market share;

·       afailure to attract new customers in new geographies;

·       increasedservice, support and warranty costs and a diversion of development resources;and

·       network performancepenalties.

***We have experienced changes in our senior managementwhich could affect our business and operations.***

We have made significantchanges in our senior management team since January 1, 2006. Because ofthese significant changes, our management team may not be able to work togethereffectively to successfully develop and implement our business strategies. Inaddition, management will need to devote significant attention and resources topreserve and strengthen relationships with employees, customers and theinvestor community. If our new management team is unable to achieve thesegoals, our ability to grow our business and successfully meet operationalchallenges could be impaired.

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***If we fail to hireand retain needed personnel, the implementation of our business plan could slowor our future growth could halt.***

Our business depends upon highly skilled engineering,sales, marketing and customer support personnel. Any failure to hire or retainneeded qualified personnel could impair our growth. We face increased risk associated with employeeretention due to restrictions imposed on our employees’ ability to exercisestock options, delays in stock purchases under our Employee Stock Purchase Planand the adverse tax impact of Section 409A on our employees’ stock options—allof which resulted from our review of historical stock granting practices andthe restatement of our financial statements.

Our future success dependsupon the continued services of our executive officers who have criticalindustry experience and relationships that we rely on to implement our businessplan. None of our officers or key employees are bound by an employmentagreement for any specific term. The loss of the services of any of ourofficers or key employees could delay the development and introduction of, andnegatively impact our ability to sell, our products.

***If we are subject to employment claims, we could incursubstantial costs in defending ourselves.***

We may become subject toemployment claims in connection with employee terminations. In addition,companies in our industry whose employees accept positions with competitors mayclaim that their competitors have engaged in unfair hiring practices. Theseclaims may result in material litigation. We could incur substantial costsdefending ourselves or our employees against those claims, regardless of theirmerits. In addition, defending ourselves from those types of claims coulddivert our management’s attention from our operations. If we are found liablein connection with any employment claim, we may incur significant costs thatcould adversely impact our financial position and results of operations.

***We depend upon asingle contract manufacturer and any disruption in this relationship may causeus to fail to meet the demands of our customers and damage our customerrelationships.***

We rely on a contract manufacturer to manufacture ourproducts according to our specifications and to fill orders on a timely basis. Ourcontract manufacturer provides comprehensive manufacturing services, includingassembly and certain tests of our products and procurement of materials. Ourcontract manufacturer also builds products for other companies and may notalways have sufficient quantities of inventory available to fill our orders ormay not allocate their internal resources to fill these orders on a timelybasis. We do not have a long-term supply contract with our manufacturer nor isour manufacturer required to manufacture products for any specified period. Wedo not have internal manufacturing capabilities to meet our customers’ demands.Qualifying a new contract manufacturer and commencing commercial scaleproduction is expensive and time consuming and could result in a significantinterruption in the supply of our products. If a change in contractmanufacturers results in delays in our fulfillment of customer orders or if acontract manufacturer fails to make timely delivery of orders, we may loserevenues and suffer damage to our customer relationships. In 2006, we consolidated our manufacturingto a single contract manufacturer. We also intend to move our contractmanufacturing to a lower cost, offshore facility. If we do not manage thisconsolidation effectively, these consolidation activities could result in thedisruption in the supply of our products and in delays in our fulfillment ofcustomer orders.

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***We and our contract manufacturer rely on single orlimited sources for supply of some components of our products and if we fail toadequately predict our manufacturing requirements or if our supply of any ofthese components is disrupted, we will be unable to ship our products.***

We and our contractmanufacturer currently purchase several key components of our products,including commercial digital signal processors, from single or limited sources.We purchase these components on a purchase order basis. If we overestimate ourcomponent requirements, we could have excess inventory, which would increaseour costs. If we underestimate our requirements, we may not have an adequatesupply, which could interrupt manufacturing of our products and result indelays in shipments and revenues.

We currently do not havelong-term supply contracts with our component suppliers and they are notrequired to supply us with products for any specified periods, in any specifiedquantities or at any set price, except as may be specified in a particularpurchase order. In the event of a disruption or delay in supply, or inabilityto obtain products, we may not be able to develop an alternate source in atimely manner or at favorable prices, or at all. A failure to find acceptablealternative sources could hurt our ability to deliver high-quality products toour customers and negatively affect our operating margins. In addition,reliance on our suppliers exposes us to potential supplier productiondifficulties or quality variations. Our customers rely upon our ability to meetcommitted delivery dates, and any disruption in the supply of key componentswould seriously adversely affect our ability to meet these dates and couldresult in legal action by our customers, loss of customers or harm our abilityto attract new customers.

***If we are not able to obtain necessary licenses ofthird-party technology at acceptable prices, or at all, our productscould become obsolete.***

We have incorporated third-party licensed technology into ourcurrent products. From time to time, we may be required to license additionaltechnology from third parties to develop new products or product enhancements. Third-party licenses may not be available orcontinue to be available to us on commercially reasonable terms. The inabilityto maintain or re-license any third-party licenses required in our currentproducts or to obtain any new third-partylicenses to develop new products and product enhancements could require us toobtain substitute technology of lower quality or performance standards or atgreater cost, and delay or prevent us from making these products orenhancements, any of which could seriously harm the competitiveness of ourproducts.

***Failures by our strategic partners or by us inintegrating products provided by our strategic partners could seriously harmour business.***

Oursolutions include the integration of products supplied by strategic partners,who offer complementary products and services. We rely on these strategicpartners in the timely and successful deployment of our solutions to ourcustomers. If the products provided by these partners have defects or do notoperate as expected or if we do not effectively integrate and support productssupplied by these strategic partners, then we may have difficulty with thedeployment of our solutions that may result in:

·       loss of, or delay in,revenues;

·       increased service, supportand warranty costs and a diversion of development resources; and

·       network performancepenalties.

Inaddition to cooperating with our strategic partners on specific customerprojects, we also may compete in some areas with these same partners. If thesestrategic partners fail to perform or choose not to cooperate with us oncertain projects, in addition to the effects described above, we couldexperience:

·       loss of customers andmarket share; and

·       afailure to attract new customers or achieve market acceptance for our products.

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***Our ability tocompete and our business could be jeopardized if we are unable to protect ourintellectual property or become subject to intellectual property rights claims,which could require us to incur significant costs.***

We rely on a combination of patent, copyright,trademark and trade secret laws and restrictions on disclosure to protect ourintellectual property rights. Despite our efforts to protect our proprietaryrights, unauthorized parties may attempt to copy or otherwise obtain and useour products or technology. Monitoring unauthorized use of our products isdifficult and we cannot be certain that the steps we have taken will preventunauthorized use of our technology, particularly in foreign countries where thelaws may not protect our proprietary rights as fully as in the United States. Ifcompetitors are able to use our technology, our ability to compete effectivelycould be harmed.

In addition, wehave received inquiries from other patent holders and may become subject toclaims that we infringe their intellectual property rights. Any partiesasserting that our products infringe upon their proprietary rights could forceus to license their patents for substantial royalty payments or to defendourselves and possibly our customers or contract manufacturers in litigation. Theseclaims and any resulting licensing arrangement or lawsuit, if successful, couldsubject us to significant royalty payments or liability for damages andinvalidation of our proprietary rights. Any potential intellectual propertylitigation also could force us to do one or more of the following:

·       stop selling, incorporatingor using our products that use the challenged intellectual property;

·       obtain from the owner ofthe infringed intellectual property right a license to sell or use the relevanttechnology, which license may not be available on reasonable terms, or at all;or

·       redesign those productsthat use any allegedly infringing technology.

Any lawsuits regarding intellectual property rights,regardless of their success, would be time-consuming, expensive to resolve andwould divert our management’s time and attention.

On June 14, 2006, C2Communications Technologies, Inc. (“C2 Communications”) sued AT&T, Inc.,Verizon Communications, Inc., Qwest Communications International, Inc.(“Qwest”), Bellsouth Corporation (“Bellsouth”), Sprint Nextel Corporation,Global Crossing Limited (“Global Crossing”) and Level 3 Communications, Inc.(“Level 3”) in the Eastern District of Texas, Marshall Division. C2 Communicationshas alleged that each of the defendants infringe U.S. Patent No. 6,243,373entitled “Method and Apparatus for Implementing a Computer Network InternetTelephone System.”  We have agreed,subject to certain conditions, to assume the defense of Qwest, Global Crossingand Level 3 in this litigation to the extent the claim results from their useof products purchased from us. There can be no assurance that other defendantswho have purchased our products will not seek indemnification from us. Webelieve that the defendants have substantial legal and factual defenses to theinfringement claim, which we intend to pursue vigorously on behalf of thedefendant for whom we agree or are required to assume defense of the litigation.However, there is no assurance any of the defendants will prevail in defendingthis action. There also can be no assurance that we will not be required toindemnify any of the defendants from any judgment of infringement renderedagainst them. We will be required to devote significant time and resources inconnection with assuming the defense of the claim of infringement on behalf ofthe defendants for whom we have agreed to assume defense of the litigation. Anadverse outcome with respect to the claim and our indemnification could have amaterial adverse impact on our business, operating results and financialcondition.

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***Any investments or acquisitions we make could disruptour business and seriously harm our financial condition.***

On April 13,2007, we acquired Zynetix Limited, designers of innovative Global System forMobile Communications infrastructure solutions. We intend to continue investingin, or acquiring, complementary products, technologies or businesses. In theevent of future investments or acquisitions, we could:

·       issue stock that woulddilute our current stockholders’ percentage ownership;

·       reduce significantly ourcash and investments;

·       incur debt or assumeliabilities;

·       incur significantimpairment charges related to the write-off of goodwill and purchasedintangible assets;

·       incur significantamortization expenses related to purchased intangible assets; or

·       incur large and immediatewrite-offs for in-process research and development and stock basedcompensation.

Our integration ofany acquired products, technologies or businesses will also involve numerousrisks, including:

·       problems and unanticipatedcosts associated with combining the purchased products, technologies orbusinesses;

·       diversion of management’sattention from our core business;

·       adverse effects on existingbusiness relationships with suppliers and customers;

·       risks associated withentering markets in which we have limited or no prior experience;

·       potential loss of keyemployees, particularly those of the acquired organizations; and

·       integration of internalcontrols and financial systems.

We may be unable tosuccessfully integrate any products, technologies, businesses or personnel thatwe might acquire in the future without significant costs or disruption to ourbusiness.

***Regulation of the telecommunications industry couldharm our operating results and future prospects.***

The telecommunicationsindustry is highly regulated and our business and financial condition could beadversely affected by the changes in the regulations relating to thetelecommunications industry. Currently, there are few laws or regulations thatapply directly to access to or delivery of voice services on IP networks. Wecould be adversely affected by regulation of IP networks and commerce in anycountry where we operate, including the United States. Such regulations couldinclude matters such as voice over the Internet or using Internet protocol,encryption technology, and access charges for service providers. The adoptionof such regulations could decrease demand for our products, and at the sametime increase the cost of selling our products, which could have a materialadverse effect on our business, operating results and financial position.

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***We may seek toraise additional capital in the future, which may not be available to us, andif it is available, may dilute the ownership of our common stock.***

In April and September 2003,we completed public offerings of 20,000,000 and 17,000,000 shares,respectively, of our common stock resulting in the dilution of our existinginvestors’ percentage ownership of our common stock. In the future, we may seekto raise additional funds through public or private debt or equity financingsin order to:

·       fund ongoing operations andcapital requirements;

·       take advantage ofopportunities, including more rapid expansion or acquisition of complementaryproducts, technologies or businesses;

·       develop new products; or

·       respond to competitivepressures.

Any additional capitalraised through the sale of convertible debt or equity may further dilute aninvestor’s percentage ownership of our common stock. Furthermore, additionalfinancings may not be available on terms favorable to us, or at all. A failureto obtain additional funding could prevent us from making expenditures that maybe required to grow or maintain our operations.

***Changes ineffective tax rates or adverse outcomes resulting from examination of ourincome or other tax returns could adversely affect our results.***

Our future effective taxrates could be adversely affected by earnings being lower than anticipated incountries where we have lower statutory rates and higher than anticipatedearnings in countries where we have higher statutory rates, by changes in thevaluation of our deferred tax assets and liabilities, or by changes in tax lawsor interpretations thereof. The Internal Revenue Service has notified us thatour payroll tax returns have been selected for audit in connection with ourstock option review. In addition, we are subject to the potential forexamination of our income tax returns by the Internal Revenue Service and othertax authorities. We regularly assess the likelihood of adverse outcomesresulting from these examinations to determine the adequacy of our provisionfor income taxes. There can be no assurance that the outcomes from thesepotential examinations will not have an adverse effect on our operating resultsand financial condition.

***Our stock price has been and may continue to bevolatile.***

The market fortechnology stocks has been and will likely continue to be extremely volatile. Thefollowing factors could cause the market price of our common stock to fluctuatesignificantly:

·       the addition or loss of anymajor customer;

·       consolidation in thetelecommunications industry;

·       changes in the financialcondition or anticipated capital expenditure purchases of any existing orpotential major customer;

·       quarterly variations in ouroperating results;

·       changes in financialestimates by securities analysts;

·       speculation in the press orinvestment community;

·       announcements by us or ourcompetitors of significant contracts, new products or acquisitions,distribution partnerships, joint ventures or capital commitments;

·       sales of common stock orother securities by us or by our stockholders in the future;

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·       securities and otherlitigation;

·       announcement of a stocksplit, reverse stock split, stock dividend or similar event;

·       economic conditions for thetelecommunications, networking and related industries; and

·       worldwideeconomic instability.

***Provisions of ourcharter documents and Delaware law have anti-takeover effects that couldprevent a change of control.***

Provisions of our amendedand restated certificate of incorporation, our amended and restated by-laws andDelaware law could make it more difficult for a third party to acquire us, evenif doing so would be beneficial to our stockholders.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

The 2006 Annual Meeting of Shareholders of SonusNetworks, Inc. was held on June 21, 2006 at the Radisson HotelChelmsford, 10 Independence Drive in Chelmsford, Massachusetts 01824. Of the251,778,037 shares outstanding as of April 24, 2006, the record date,222,411,022 shares (88.3%) were present or represented by proxy at the meeting.The only proposal before the Annual Meeting was the election of directors.

Thetable below presents the results of the election to our board of directors:

| **Nominee**         | ** ** | ** **  | ** ** | **Votes For** | ** ** | **Votes  Withheld** | ** ** |
|---------------------|------------|-------------|------------|--------------------|------------|---------------------|------------|
| Edward T.  Anderson |       | 209,717,244 |       | 12,693,778         |       |
| Albert A. Notini    |       | 213,847,184 |       | 8,563,838          |       |

 

The terms for Howard E.Janzen and H. Brian Thompson expire in 2007; and the terms for Hassan M. Ahmed,John P. Cunningham and Paul J. Severino expire in 2008.

**Item6.**                        Exhibits
| Exhibit  Number | ** ** | ** **                                                                                                           | ** ** | **Description** |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.1(a)         |       | Summary of 2006  Executive Incentive Compensation Plan.                                                              |
| 10.2(b)         |       | Employment letter  dated April 10, 2006, by and between the Registrant and James F. Collier III. |
| 31.1            |       | Certification of  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.      |
| 31.2            |       | Certification of  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |
| 32.1            |       | Certification of  Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.      |
| 32.2            |       | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  |

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(a)           Incorporatedby reference from the Registrant’s Form 8-K (File No. 000-30229)filed June 19, 2006 with the SEC.

(b)          Incorporatedby reference from the Registrant’s Form 8-K (File No. 000-30229)filed April 24, 2006 with the SEC.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
| Dated: August 2, 2007 |   | SONUS NETWORKS, INC.                                                                                               |
|----------------------------|--------|--------------------------------------------------------------------------------------------------------------------|
|                       | By:    | /s/ ELLEN B. RICHSTONE                                                                                             |
|                       |   | Ellen B. Richstone                                                                                                 |
|                       |   | *Chief  Financial Officer (Principal Financial Officer)*                                                           |
|                       | By:    | /s/ PAUL K. MCDERMOTT                                                                                              |
|                       |   | Paul K. McDermott                                                                                                  |
|                       |   | *Vice President of Finance, Corporate Controller  and Principal Accounting Officer (Principal Accounting Officer)* |

 

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**EXHIBITINDEX**
| Exhibit  Number | ** **                                                                                                 | ** ** | **Description** |
|-----------------|------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.1(a)         | Summary of 2006  Executive Incentive Compensation Plan.                                                    |
| 10.2(b)         | Employment letter  dated April 10, 2006, by and between the Registrant and James F.  Collier.         |
| 31.1            | Certification  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.    |
| 31.2            | Certification  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.    |
| 32.1            | Certification  Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.    |
| 32.2            | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |

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(a)           Incorporated byreference from the Registrant’s Form 8-K (File No. 000-30229)filed June 19, 2006 with the SEC.

(b)          Incorporated byreference from the Registrant’s Form 8-K (File No. 000-30229)filed April 24, 2006 with the SEC.

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