**UNITED STATES**

**SECURITIES 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 March 31, 2006**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 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.) |

 

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

(Address of principalexecutive offices, including zip code)

**(978) 614-8100**

(Registrant’s telephonenumber, including area code)

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 preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

Indicateby check mark whether the Registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

Large accelerated filer x       Acceleratedfiler o       Non-acceleratedfiler o

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

As of April 30, 2006,there were 252,505,040 shares of $0.001 par value per share, common stockoutstanding.

 

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**SONUSNETWORKS, INC.FORM 10-QQUARTER ENDED MARCH 31, 2006TABLE OF CONTENTS**
|                                            | **Page**                                                                                                                    |
|--------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------|
| **PART I—FINANCIAL INFORMATION** | ** **                                                                                                                  | ** ** | ** ** |
| Item 1:                                    | Financial Statements                                                                                                        |   |   |   |
|                                       | Condensed Consolidated Balance Sheets as of  March 31, 2006 and December, 31, 2005 (unaudited)     |   | 1 |   |
|                                       | Condensed Consolidated Statements of Operations for  the Three Months Ended March 31, 2006 and 2005 (unaudited)   |   | 2 |   |
|                                       | Condensed Consolidated Statements of Cash Flows for  the Three Months Ended March 31, 2006 and 2005 (unaudited)        |   | 3 |   |
|                                       | Notes to  Condensed Consolidated Financial Statements (unaudited)                                                           |   | 4 |   |
| Item  2:                                   | Management’s  Discussion and Analysis of Financial Condition and Results of  Operations                                |   | 19 |   |
| Item  3:                                   | Quantitative  and Qualitative Disclosures About Market Risk                                                                 |   | 27 |   |
| Item 4:                                    | Controls  and Procedures                                                                                                    |   | 27 |   |
| **PART II—OTHER INFORMATION**    | ** **                                                                                                                  | ** ** | ** ** |
| Item 1:                                    | Legal  Proceedings                                                                                                          |   | 30 |   |
| Item 1A:                                   | Risk Factors                                                                                                                |   | 32 |   |
| Item 6:                                    | Exhibits                                                                                                                    |   | 45 |   |
|                                       | Signatures                                                                                                                  |   | 46 |   |
|                                       | Exhibit Index                                                                                                          |   | 47 |   |

 

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**PART I—FINANCIALINFORMATION**

**Item 1: FinancialStatements**

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

| ** **                                                                                                                                                                                                       | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                       |       |                     |       |                        |       |   |   |
| **Current assets:**                                                                                                                                                                                              |       |                     |       |                        |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                        |       | $                        | 50,309     |                        |       | $ | 155,679 |   |   |
| Marketable debt  securities                                                                                                                                                                                      |       | 239,312                  |       |                        | 140,569    |   |   |
| Accounts receivable, net                                                                                                                                                                                         |       | 33,272                   |       |                        | 72,321     |   |   |
| Inventory, net                                                                                                                                                                                                   |       | 37,169                   |       |                        | 37,831     |   |   |
| Other current assets                                                                                                                                                                                             |       | 15,197                   |       |                        | 15,833     |   |   |
| Deferred income taxes                                                                                                                                                                                            |       | 519                      |       |                        | 519        |   |   |
| Total current assets                                                                                                                                                                                             |       | 375,778                  |       |                        | 422,752    |   |   |
| **Property and equipment,**net                                                                                                                                                                                   |       | 15,315                   |       |                        | 15,181     |   |   |
| **Long-term investments**                                                                                                                                                                                        |       | 50,616                   |       |                        | 17,993     |   |   |
| **Other assets**                                                                                                                                                                                                 |       | 1,878                    |       |                        | 631        |   |   |
|                                                                                                                                                                                                             |       | $                        | 443,587    |                        |       | $ | 456,557 |   |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                   |       |                     |       |                        |       |   |   |
| **Current liabilities:**                                                                                                                                                                                         |       |                     |       |                        |       |   |   |
| Accounts payable                                                                                                                                                                                                 |       | $                        | 16,370     |                        |       | $ | 20,408 |   |   |
| Accrued expenses                                                                                                                                                                                                 |       | 19,384                   |       |                        | 23,204     |   |   |
| Accrued restructuring  expenses                                                                                                                                                                                  |       | 198                      |       |                        | 195        |   |   |
| Current portion of  deferred revenue                                                                                                                                                                             |       | 73,209                   |       |                        | 88,199     |   |   |
| Current portion of long-term  liabilities                                                                                                                                                                        |       | 49                       |       |                        | 48         |   |   |
| Convertible subordinated  note                                                                                                                                                                                   |       | 10,000                   |       |                        | 10,000     |   |   |
| Total current  liabilities                                                                                                                                                                                       |       | 119,210                  |       |                        | 142,054    |   |   |
| **Long-term deferred  revenue,** net of current portion                                                                                                                                                          |       | 28,990                   |       |                        | 33,853     |   |   |
| **Long-term  liabilities,** net of current portion                                                                                                                                                               |       | 422                      |       |                        | 485        |   |   |
| Total liabilities                                                                                                                                                                                                |       | 148,622                  |       |                        | 176,392    |   |   |
| **Commitments and contingencies**  (Note 4)                                                                                                                                                                      |       | —                   |       |                        | —     |   |   |
| **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, 253,670,005 and 251,730,706 shares  issued and 251,373,095 and 249,433,796 shares outstanding at March 31,  2006 and December 31, 2005 |       | 254                      |       |                        | 252        |   |   |
| Capital in excess of par  value                                                                                                                                                                                  |       | 1,064,989                |       |                        | 1,055,941  |   |   |
| Accumulated deficit                                                                                                                                                                                              |       | (769,973                 | )          |                        | (775,717   | ) |   |
| Accumulated other  comprehensive loss                                                                                                                                                                            |       | (38                      | )          |                        | (44        | ) |   |
| Treasury stock, at cost;  2,296,910 common shares at March 31, 2006 and December 31, 2005                                                                                                              |       | (267                     | )          |                        | (267       | ) |   |
| Total stockholders’  equity                                                                                                                                                                                 |       | 294,965                  |       |                        | 280,165    |   |   |
|                                                                                                                                                                                                             |       | $                        | 443,587    |                        |       | $ | 456,557 |   |   |

 

See notes to the condensed consolidated financial statements.

1

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

| ** **                                                 | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **Revenues:**                                              |       |                                             |       |   |   |
| Product                                                    |       | $                                                | 44,383     |   | $ | 22,458 |   |
| Service                                                    |       | 15,589                                           |       | 11,152 |   |
| Total revenues                                             |       | 59,972                                           |       | 33,610 |   |
| **Cost of revenues:**                                      |       |                                             |       |   |   |
| Product                                                    |       | 15,853                                           |       | 6,843 |   |
| Service                                                    |       | 7,381                                            |       | 5,269 |   |
| Total cost of revenues                                     |       | 23,234                                           |       | 12,112 |   |
| **Gross  profit**                                          |       | 36,738                                           |       | 21,498 |   |
| **Operating expenses:**                                    |       |                                             |       |   |   |
| Research and development                                   |       | 12,891                                           |       | 11,017 |   |
| Sales and marketing                                        |       | 13,898                                           |       | 9,027 |   |
| General and administrative                                 |       | 6,719                                            |       | 6,800 |   |
| Total operating expenses                                   |       | 33,508                                           |       | 26,844 |   |
| **Income  (loss) from operations**                         |       | 3,230                                            |       | (5,346 | ) |
| Interest expense                                           |       | (137                                             | )          | (128 | ) |
| Interest income                                            |       | 3,442                                            |       | 1,875 |   |
| **Income  (loss) before income taxes**                     |       | 6,535                                            |       | (3,599 | ) |
| Provision for income taxes                                 |       | 791                                              |       | 96 |   |
| **Net  income (loss)**                                     |       | $                                                | 5,744      |   | $ | (3,695 | ) |
| **Net income (loss) per share:**                           |       |                                             |       |   |   |
| Basic and diluted                                          |       | $                                                | 0.02       |   | $ | (0.01 | ) |
| **Shares used in computing net  income (loss) per share:** |       |                                             |       |   |   |
| Basic                                                      |       | 250,064                                          |       | 247,877 |   |
| Diluted                                                    |       | 254,459                                          |       | 247,877 |   |

 

See notes to the condensed consolidated financial statements.

2

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

| ** **                                                                                                  | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **Cash flows from operating activities:**                                                                   |       |                                             |       |   |   |
| Net income (loss)                                                                                           |       | $                                                | 5,744      |   | $ | (3,695 | ) |
| Adjustments to reconcile net income (loss) to cash  flows provided by (used in) operating activities:. |       |                                             |       |   |   |
| Depreciation                                                                                                |       | 2,293                                            |       | 1,476 |   |
| Stock-based  compensation                                                                                   |       | 1,903                                            |       | — |   |
| Loss of disposal of  property and equipment                                                                 |       | 6                                                |       | — |   |
| Changes in operating assets and liabilities:                                                                |       |                                             |       |   |   |
| Accounts receivable                                                                                         |       | 39,071                                           |       | 4,855 |   |
| Inventory                                                                                                   |       | 713                                              |       | (2,910 | ) |
| Other operating assets                                                                                      |       | (857                                             | )          | (762 | ) |
| Accounts payable                                                                                            |       | (4,072                                           | )          | 1,334 |   |
| Accrued expenses and  accrued restructuring expenses                                                        |       | (3,926                                           | )          | (1,330 | ) |
| Deferred revenue                                                                                            |       | (19,920                                          | )          | 948 |   |
| Net cash provided by  (used in) operating activities                                                        |       | 20,955                                           |       | (84 | ) |
| **Cash flows from investing activities:**                                                                   |       |                                             |       |   |   |
| Purchases of property  and equipment                                                                        |       | (2,328                                           | )          | (4,303 | ) |
| Maturities of  available-for-sale marketable debt securities                                                |       | 25,500                                           |       | 26,700 |   |
| Purchases of available-for-sale  marketable debt securities                                                 |       | (12,825                                          | )          | (31,601 | ) |
| Maturities of  held-to-maturity marketable debt securities and long-term investments                        |       | 22,950                                           |       | 8,921 |   |
| Purchases of  held-to-maturity marketable debt securities and long-term investments                         |       | (166,991                                         | )          | (1,043 | ) |
| Decrease in restricted  cash                                                                                |       | 250                                              |       | — |   |
| Other assets                                                                                                |       | 85                                               |       | (81 | ) |
| Net cash used in  investing activities                                                                      |       | (133,359                                         | )          | (1,407 | ) |
| **Cash flows from financing activities:**                                                                   |       |                                             |       |   |   |
| Sale of common stock in  connection with employee stock purchase plan                                       |       | 2,311                                            |       | 2,313 |   |
| Proceeds from exercise  of stock options                                                                    |       | 4,821                                            |       | 420 |   |
| Payments of long-term  liabilities                                                                          |       | (12                                              | )          | (58 | ) |
| Net cash provided by  financing activities                                                                  |       | 7,120                                            |       | 2,675 |   |
| **Effect  of exchange rate changes on cash and cash equivalents**                                           |       | (86                                              | )          | — |   |
| **Net (decrease) increase in cash  and cash equivalents**                                                   |       | (105,370                                         | )          | 1,184 |   |
| **Cash and cash equivalents,  beginning of period**                                                         |       | 155,679                                          |       | 121,931 |   |
| **Cash  and cash equivalents, end of period**                                                               |       | $                                                | 50,309     |   | $ | 123,115 |   |
| **Supplemental disclosure of cash flow  information:**                                                      |       |                                             |       |   |   |
| Interest paid                                                                                               |       | $                                                | 12         |   | $ | 2 |   |
| Income taxes paid                                                                                           |       | $                                                | 905        |   | $ | 551 |   |
| Non-cash purchases of  property and equipment                                                               |       | $                                                | 1,081      |   | $ | 1,582 |   |
| Property and equipment  acquired as part of a facility lease                                                |       | $                                                | 50         |   | $ | — |   |
| Property and equipment acquired under capital lease                                                         |       | $                                                | —     |   | $ | 101 |   |

 

See notes to the condensed consolidated financial statements.

3

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

**(1) Descriptionof Business**

Sonus Networks, Inc.(Sonus) was incorporated in August 1997 and is a leading provider of voiceinfrastructure solutions for wireline and wireless service providers. Sonusoffers a new generation of carrier-class switching equipment and softwarethat enable voice services to be delivered over packet-based networks.

**(2) Summary ofSignificant 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 notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States of America for complete financialstatements and should be read in conjunction with the audited financialstatements included in Sonus’ Annual Report on Form 10-K for theyear ended December 31, 2005.

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 condensed consolidated financialstatements include the accounts of Sonus and its wholly owned subsidiaries. Allmaterial intercompany transactions and balances have been eliminated.

The presentation of transactionsin marketable debt securities in the condensed consolidated statement of cashflows for the three months ended March 31, 2005 has been adjusted toconform to the presentation for the three months ended March 31, 2006.

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

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting periods, actual results may differ. Significant estimates andjudgments relied upon in preparing these financial statements include revenuerecognition for multiple element arrangements, allowances for doubtfulaccounts, estimated fair value of investments, inventory reserves, expectedfuture cash flows used to evaluate the recoverability of long-lived assets,restructuring and other related charges, contingencies associated with revenuecontracts, contingent liabilities, estimated commissions expense, assumptionsfor recorded stock-based compensation and recoverability of Sonus’ net deferredtax assets and related valuation allowance. Although Sonus regularly assessesthese estimates, actual results could differ 

4

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

**(2) Summaryof Significant Accounting Policies (Continued)**

materiallyfrom these estimates. Changes in estimates are recorded in the period in whichthey become known. Sonus bases its estimates on historical experience andvarious other assumptions that it believes to be reasonable under thecircumstances.

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

Cash equivalents are stated at cost, which approximatesfair value, and have remaining maturities of three months or less at the dateof purchase.

Cash equivalents and marketable debt securities consistof high quality debt instruments, primarily U.S. Government, municipal andcorporate obligations. Investments in U.S. Government and corporate obligationsare classified as held-to-maturity, as Sonus has the intent and ability to holdthem to maturity. Held-to-maturity marketable debt securities are reported atamortized cost. Investments in municipal obligations are classified asavailable-for-sale and are reported at fair value. Unrealized gains and lossesfrom available-for-sale marketable debt securities were not material for theperiods presented. The unrealized losses related to these securities at March 31,2006 are not considered to be a permanent decline in the fair value of suchsecurities. There have been no material realized gains or losses to date. Currentmarketable debt securities include held-to-maturity investments with remainingmaturities of less than one year as of the balance sheet date andavailable-for-sale investments that are expected to be sold in the currentperiod or to be used in current operations. Long-term investments includeheld-to-maturity investments with remaining maturities of one to five years asof the balance sheet date.

As of March 31,2006 and December 31, 2005, marketable debt securities consisted of thefollowing, in thousands:

| ** **                      | ** ** | **March 31, 2006** | ** ** |
|---------------------------------|------------|------------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**          | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| *Marketable  debt securities*   | * *   |                         | * *   | * * |   |   | * * | * * |   |   | * * | * * |   | * * | * * |
| Available-for-sale:             |       |                         |       | * * |   |   |   | * * |   |   |   | * * |   |   |   |
| State and municipal obligations |       |                         | $          | 85,200 | * * |   |   | $ | — | * * |   |   | $ | — | * * |   | $ | 85,200 |   |
| Held-to-maturity:               |       |                         |       | * * |   |   |   | * * |   |   |   | * * |   |   |   |
| U.S. government agency notes    |       |                         | 65,670     | * * |   |   | — | * * |   |   | (161 | ) |   | 65,509 |   |
| Corporate debt securities       |       |                         | 16,176     | * * |   |   | — | * * |   |   | (54 | ) |   | 16,122 |   |
| Commercial paper                |       |                         | 70,368     | * * |   |   | — | * * |   |   | (209 | ) |   | 70,159 |   |
| Certificates of deposit         |       |                         | 1,898      | * * |   |   | — | * * |   |   | (4 | ) |   | 1,894 |   |
|                            |       |                         | $          | 239,312 | * * |   |   | $ | — | * * |   |   | $ | (428 | ) |   | $ | 238,884 |   |
| *Long-term  investments*        | * *   |                         | * *   | * * |   |   | * * | * * |   |   | * * |   |   | * * | * * |
| Held-to-maturity:               |       |                         |       | * * |   |   |   | * * |   |   |   |   |   |   |   |
| U.S. government agency notes    |       |                         | $          | 41,035 | * * |   |   | $ | — | * * |   |   | $ | (170 | ) |   | $ | 40,865 |   |
| Corporate debt securities       |       |                         | 9,581      | * * |   |   | — | * * |   |   | (61 | ) |   | 9,520 |   |
|                            |       |                         | $          | 50,616 | * * |   |   | $ | — | * * |   |   | $ | (231 | ) |   | $ | 50,385 |   |

 

5

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

**(2) Summary of Significant Accounting Policies (Continued)**

| ** **                      | ** ** | **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 |   |

 

As of March 31, 2006,Sonus had $341,000 in restricted cash, which is used to collateralize standbyletters of credit. Restricted cash is included in other current assets on theconsolidated balance sheet.

***(d) Concentrations of Credit and Off-BalanceSheet Risk, Significant Customers and Limited Suppliers***

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 portfolio holdings were diversified among fivefinancial institutions at March 31, 2006. Beginning in 2005, Sonus enteredinto foreign exchange contracts to hedge against currency fluctuations relatedto a particular account receivable and orders denominated in Japanese Yen. Sonusrecords changes in fair value of foreign exchange contracts to general andadministrative expenses in the condensed consolidated statement of operations,which totaled a gain of $10,000 for the three months ended March 31, 2006.

The followingcustomers contributed 10% or more of Sonus’ revenues for the three months endedMarch 31, 2006 and 2005:

| **Customer** | ** ** | ** ** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------|------------|------------|------------|----------|------------|----------|------------|
| A            |       |       | 18         | %        |       |     | 15         | % |   |
| B            |       |       | 12         |     |       |     | 25         |   |   |
| C            |       |       | 11         |     |       |     | *          |   |   |

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*                    Representsless than 10% of revenues.

As of March 31, 2006 and December 31, 2005,two customers each accounted for 10% or more of Sonus’ accounts receivablebalance, representing an aggregate of 25% and 43% of the accounts receivablebalance, respectively. Sonus performs ongoing credit evaluations of itscustomers and generally does not require collateral on accounts receivable.Sonus maintains an allowance for potential doubtful accounts and such losseshave been within management’s expectations.

6

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

**(2) Summaryof Significant Accounting Policies (Continued)**

The following table showspercentage of revenue by region for the three months ended March 31, 2006and 2005:

| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| United States                   |       |     | 77         | %        |       |   | 81 | % |   |
| Japan                           |       |     | 11         |     |       |   | 9 |   |   |
| Other Asia  Pacific             |       |     | 9          |     |       |   | 4 |   |   |
| Europe, Middle  East and Africa |       |     | 3          |     |       |   | 5 |   |   |
| Other                           |       |     | —     |     |       |   | 1 |   |   |
|                            |       |     | 100        | %        |       |   | 100 | % |   |

 

Certaincomponents and software licenses from third parties used in Sonus’ products areprocured from single sources of supply. The failure of a supplier, including asubcontractor, to deliver on schedule could delay or interrupt Sonus’ deliveryof products and thereby materially adversely affect Sonus’ revenues andoperating results.

***(e) Accounts Receivable***

Accountsreceivable consist of the following, in thousands:

| ** **                       | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Earned accounts  receivable      |       |                     | $          | 20,562                      |       |   |   | $ | 48,924 |   |   |
| Unearned accounts  receivable    |       |                     | 13,307     |                        |       |   | 23,823 |   |   |
| Accounts  receivable, gross      |       |                     | 33,869     |                        |       |   | 72,747 |   |   |
| Allowance for  doubtful accounts |       |                     | (597       | )                           |       |   | (426 | ) |   |
| Accounts receivable, net         |       |                     | $          | 33,272                      |       |   |   | $ | 72,321 |   |   |

 

Unearnedaccounts receivable 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.

7

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

**(2) Summaryof Significant Accounting Policies (Continued)**

***(f) Inventory***

Inventoryconsists of the following, in thousands:

| ** **                                             | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| On-hand  final assemblies and finished goods inventory |       |                     | $          | 21,032                      |       |   |   | $ | 19,457 |   |   |
| Deferred cost of  sales                                |       |                     | 18,823     |                        |       |   | 21,110 |   |   |
| Evaluation  inventory                                  |       |                     | 4,693      |                        |       |   | 4,615 |   |   |
| Inventory, gross                                       |       |                     | 44,548     |                        |       |   | 45,182 |   |   |
| Excess, obsolete  and evaluation reserve               |       |                     | (7,379     | )                           |       |   | (7,351 | ) |   |
| Inventory, net                                         |       |                     | $          | 37,169                      |       |   |   | $ | 37,831 |   |   |

 

Deferred cost of sales inventory represents deferredcost of revenues prior to satisfaction of Sonus’ revenue recognition criteria.

Sonus values inventory atthe lower of cost or net realizable value and provides inventory reserves basedon excess and obsolete inventory determined primarily by future demandforecasts and records adjustments to such reserves through charges to cost ofrevenues. Sonus also records a full inventory reserve for evaluation equipmentat the time of shipment to its customers as a charge to sales and marketingexpense as it is probable that the inventory will not be realizable. If theseevaluation shipments are later purchased by Sonus’ customers, Sonusreclassifies amounts previously charged to sales and marketing expenses to costof revenues in the period when all revenue recognition criteria are met.

***(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 life 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 consolidated statement of operations.

***(h) Deferred Revenue***

Deferred revenue consistsof the following, in thousands:

| ** **                        | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Maintenance and support contracts |       | $                        | 59,927     |                        |       | $ | 67,277 |   |   |
| Customer deposits                 |       | 28,965                   |       |                        | 30,952     |   |   |
| Unearned revenue                  |       | 13,307                   |       |                        | 23,823     |   |   |
| Total deferred revenue            |       | 102,199                  |       |                        | 122,052    |   |   |
| Less current portion              |       | (73,209                  | )          |                        | (88,199    | ) |   |
| Long-term deferred  revenue       |       | $                        | 28,990     |                        |       | $ | 33,853 |   |   |

 

8

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

**(2) Summaryof Significant Accounting Policies (Continued)**

Maintenance and supportcontracts are recognized ratably over the life of the maintenance and supportperiod. Customer deposits represent payments received in advance of revenuerecognition. Unearned revenue represents billings for which payment has notbeen received and revenue recognition criteria have not been met. As of March 31,2006 and December 31, 2005, deferred revenue and accounts receivable excluded$15.3 million and $5.3 million related to products shipped and billed tocustomers which are collectible under extended payment terms, for which revenueis recognized as cash is collected, or for which title had not passed to thecustomer as of the period end date.

***(k) 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, the Company considers itsprincipal products to be software related. Sonus recognizes revenue fromproduct sales when persuasive evidence of an arrangement exists, delivery hasoccurred, the sales price is fixed or determinable, and collectibility of therelated receivable is probable under ordinary payment terms. When Sonus hasfuture obligations, including a requirement to deliver additional elementswhich are essential 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. Revenues associated with undelivered elements thatare considered not essential to the functionality of the product and for whichVSOE has been established, are deferred based on the VSOE value and anyremaining arrangement fee is then allocated to, and recognized as, product revenue.VSOE is determined based upon the price charged when the same element is soldseparately or established by the relevant pricing authority. If Sonus cannotestablish VSOE for each undelivered element, including specified upgrades, itdefers revenue on the entire arrangement until VSOE for all undeliveredelements is known or all elements are delivered and all other revenuerecognition criteria are met.

Maintenance and support services are recognizedratably over the life of the service period, ranging from one to five years.Earned maintenance revenues are typically deferred until the associated productrevenue is accepted and all other revenue recognition are met. Maintenance andsupport services include telephone support, return and repair support andunspecified rights to product upgrades and enhancements.

Installation service revenues which are considered tobe perfunctory are generally recognized when the service is complete. Otherprofessional services for which VSOE has been established are typicallyrecognized based on the proportional performance method as the services aredelivered.

Consulting, custom development and other professionalservice only engagements are recognized as services are completed.

9

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

**(2)Summary of Significant Accounting Policies (Continued)**

Sonus sells the majority of its products directly toits service provider customers. For products sold to resellers anddistributors, Sonus generally recognizes revenue on a sell-through basis utilizinginformation provided to Sonus from its resellers and distributors. Through December 31,2005, no revenues had been recognized on a sell-in basis due to the limited returnhistory associated with shipments to resellers and distributors. During the threemonths ended March 31, 2006, Sonus began reporting revenue from itsoriginal equipment manufacturer (OEM) relationship with Motorola, Inc. ona sell-in basis where revenue is recognized upon the shipment of products toMotorola, assuming all other requirements for revenue recognition have been met.Sonus had previously recognized revenue for sales to Motorola when products hadbeen sold through by Motorola to its customers. This change reflects the twoyears of history with Motorola during which Sonus has experienced no returns,no price concessions and an excellent payment history. As a result of thishistory, Sonus has determined that the risk of a potential price concession hasbeen eliminated and therefore the price for products sold to Motorola is nowfixed or determinable upon sale to Motorola. In the three months ended March 31,2006, Sonus recognized revenue totaling approximately $3.0 million inconnection with sales of products to Motorola through March 31, 2006 thathad not yet sold through to Motorola’s customers. This revenue would have beenrecognized in subsequent quarters if the Company had not changed to a sell-inbasis for Motorola during the first quarter. This additional revenue fromMotorola in the quarter negatively affected product gross margins during thefirst quarter as revenue from OEM relationships typically have lower marginprofiles than revenue from direct sales to customers. This additional revenueresulted in approximately $1.0 million of additional net income in the quarter,but did not change reported basic and diluted earnings per share.

Sonus records deferred revenue for product deliveredor services performed for which collection of the amount billed is eitherprobable or has been collected but other revenue recognition criteria have notbeen 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.

***(l) Stock-based Compensation***

Sonus issues stock options and provides employees theright to purchase stock pursuant to the 1997 Stock Incentive Plan (Stock Plan)and the 2000 Employee Stock Purchase Plan (ESPP Plan). Effective January 1,2006, Sonus adopted the provisions of SFAS No. 123 (revised 2004), *Share-Based Payment* (SFAS No. 123R). Priorto January 1, 2006, Sonus followed Accounting Principles Board Opinion 25,*Accounting for Stock Issued to Employees,*and related interpretations in accounting for its employee stock-basedcompensation.

Stock options are generally issued at the currentmarket price on the date of grant with a four-year vesting period andcontractual term of ten years. Under the provisions of SFAS No. 123R,Sonus recognizes the fair value of stock compensation in its consolidatedfinancial statements over the requisite service period, which generally equalsthe vesting period, on a straight-line single option approach. Sonus includesas part of its inventory a portion of the fair value of stock compensation,which is expensed as inventory is relieved, generally over six months. All ofSonus’ stock-based compensation is accounted for as 

10

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

**(2) Summaryof Significant Accounting Policies (Continued)**

an equity instrument andthere have been no liability awards granted. The Company’s policy is to issuenew shares upon exercise of stock options.

Sonus has elected the modified prospectivetransition method for adopting SFAS No. 123R. Under this method, theprovisions of SFAS No. 123R apply to all awards granted or modified afterthe date of adoption. The unrecognized expense of awards not yet vested at thedate of adoption shall be recognized in net income in the periods after thedate of adoption using the same valuation method, Black-Scholes, andassumptions determined under the original provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*. Sonus recorded $1.9 million ofstock-based compensation in the condensed consolidated statement of operationsfor the three months ended March 31, 2006 in the following expensecategories (in thousands): 

| Product cost of  revenues   |   | $   | 3      |   |
|-----------------------------|--------|-----|--------|--------|
| Service cost of  revenues   |   | 252 |   |
| Research and  development   |   | 610 |   |
| Sales and  marketing        |   | 405 |   |
| General and  administrative |   | 633 |   |
|                        |   | $   | 1,903  |   |

 

In addition, Sonus included in inventory approximately$16,000 of stock-based compensation at March 31, 2006.

The recording of stock-based compensation expense forthe three months ended March 31, 2006 in the condensed consolidatedstatement of operations resulted in a decrease in net income of $1.9 millionand in basic and diluted earnings per share of $0.01, while in the condensedconsolidated statement of cash flows for the three months ended March 31,2006 cash flows from operating activities increased $1.9 million with no impactto cash flows from financing activities.

Sonus utilized theBlack-Scholes valuation model for estimating the fair value on the date ofgrant of employee stock options granted after the adoption of SFAS No. 123Rusing the following assumptions for the three months ended March 31, 2006:

| Risk-free  interest rate   |   | 4.6 | %      |
|----------------------------|--------|-----|--------|
| Expectant  dividend yield. |   | 0.0 | %      |
| Expected  volatility       |   | 85  | %      |
| Expected life (years)      |   | 4.5 |   |

 

The risk-free interestrate is the average U.S. Treasury Constant Maturities Rate for the expectedterm. The expectant dividend yield of zero is based on the fact that Sonus hasnever paid dividends and has no present intention to pay cash dividends.Expected volatility is based on a combination of the historical volatility ofSonus’ common stock over the option’s expected life and estimated volatility onoption contracts traded in the open market. Prior to January 1, 2006, Sonusused historical volatility to estimate the grant-date fair value of stockoptions.  Starting on January 1, 2006,Sonus changed its method to a combination of historical and implied volatility.Sonus believes that a combination of historical and 

11

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

**(2) Summaryof Significant Accounting Policies (Continued)**

implied volatilityresults in a more accurate estimate of thegrant-date fair value of employee stock options because it more appropriatelyreflects the market’s expectations of future volatility. Historical volatilityduring the period associated with the expected term of the Company’s 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 currently have a term of less than one year - substantially shorterthan its stock option’s expected term.Theexpected life is based on a combination of exercise patterns of the optionholder over the option’s life and exercise patterns within similar industries.Sonus estimates forfeitures to occur at a rate of 5% per year. 

Thefollowing table summarizes information relating to Stock Plan activity duringthe three months ended March 31, 2006:

| ** **                                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|-------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | ** **                 | ** ** | ** **                                 | ** ** | **(Years)**                                                 | ** ** | **(in thousands)**         | ** ** |
| Outstanding at  January 1, 2006               |       | 45,333,532                 |       |                                       | $          | 4.74                                                        |       |                            |       |   |   |   |   |   |   |   |
| Granted                                            |       | 1,998,350                  |       |                                       | 4.80       |                                                        |       |                            |       |   |   |   |   |   |   |
| Exercised                                          |       | (1,359,769                 | )          |                                       | 3.55       |                                                        |       |                            |       |   |   |   |   |   |   |
| Forfeited                                          |       | (127,000                   | )          |                                       | 4.00       |                                                        |       |                            |       |   |   |   |   |   |   |
| Expired                                            |       | (205,817                   | )          |                                       | 6.75       |                                                        |       |                            |       |   |   |   |   |   |   |
| Outstanding at  March 31, 2006                |       | 45,639,296                 |       |                                       | $          | 4.78                                                        |       |                            |       | 7.17 |   |   |   | $ | 47,919 |   |   |
| Vested or  expected to vest at March 31, 2006 |       | 45,314,098                 |       |                                       | $          | 4.78                                                        |       |                            |       | 7.15 |   |   |   | $ | 47,582 |   |   |
| Exercisable at  March 31, 2006                |       | 41,241,100                 |       |                                       | $          | 4.83                                                        |       |                            |       | 6.97 |   |   |   | $ | 42,625 |   |   |

 

The weighted average fair value of stock optionsgranted during the three months ended March 31, 2006 was $3.31. The totalintrinsic value of options exercised during the three months ended March 31,2006 and 2005 was $2.1 million and $0.2 million, respectively. The total fairvalue of options vested during the three months ended March 31, 2006 and2005 was $1.7 million and $8.0 million, respectively. As of March 31,2006, there was $12.9 million of unrecognized compensation cost related tooptions, which is expected to be recognized over a weighted average period of 3.0years.

For shares purchased under the ESPP Plan, Sonusutilized the Black-Scholes model, with a range for a majority of assumptionsfor the three months ended March 31, 2006. In valuing the ESPP Plan, Sonusused an assumed risk-free interest rate of 1.8%-4.8%, expected volatilityof 56%-126%, an expected life of six months to two years and a zeroexpectant dividend yield.

12

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

**(2) Summaryof Significant Accounting Policies (Continued)**

SFAS No. 123Rrequires the presentation of pro forma information for the comparative periodprior to the adoption as if Sonus had accounted for stock-based compensationexpense under the fair value method under SFAS No. 123. The followingtable shows Sonus’ pro forma net loss and net loss per share as if accountedfor under SFAS No. 123 for the three months ended March 31, 2005, inthousands except per share data:

| Net loss as reported                                             |   | $       | (3,695  | ) |
|------------------------------------------------------------------|--------|---------|---------|---|
| Less: Employee stock-based compensation under  fair value method |   | (10,391 | )       |
| Pro forma net loss                                               |   | $       | (14,086 | ) |
| **Basic  and diluted net loss per share—**                  |   |    |    |
| As reported                                                      |   | $       | (0.01   | ) |
| Pro forma                                                        |   | $       | (0.06   | ) |

 

Sonus utilized theBlack-Scholes valuation model for estimating the fair value of employee stockoptions granted for during the three months ended March 31, 2005 using thefollowing assumptions:

| Risk-free  interest rate   |   | 3.9 | %      |
|----------------------------|--------|-----|--------|
| Expectant  dividend yield. |   | 0.0 | %      |
| Expected  volatility       |   | 122 | %      |
| Expected life (years)      |   | 4.0 |   |

 

The weighted average fair value of stock optionsgranted during the three months ended March 31, 2005 was $3.85.

For shares purchased underthe ESPP Plan during the three months ended March 31, 2005, Sonus utilizedthe Black-Scholes model, with an assumed risk-free interest rate of 1.3%-2.1%,expected volatility of 72%-154%, an expected life of six months to twoyears and a zero expectant dividend yield.

***(m) Comprehensive Net Income (Loss)***

Thefollowing table shows Sonus’ comprehensive net income (loss) for the threemonths ended March 31, 2006 and 2005 in thousands:

| ** **                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Net income  (loss).                       |       | $        | 5,744      |     | $          | (3,695 | ) |
| Foreign currency  translation adjustments |       | 6        |       | —   |       |
| Comprehensive income  (loss)              |       | $        | 5,750      |     | $          | (3,695 | ) |

 

***(n) 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 

13

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

**(2) Summaryof Significant Accounting Policies (Continued)**

regardingresource allocation and assessing performance. To date, the chief operatingdecision maker has made such decisions and assessed performance at the companylevel.

***(o) Net Income (Loss) Per Share***

Dilutive potential common shares consist of commonstock issuable upon the exercise of stock options and conversion of aconvertible subordinated note.

Thefollowing table sets forth the computation of shares used in calculating thenet income (loss) per share, in thousands:

| ** **                                                               | ** ** | **Three months ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Weighted average  shares used in computing basic per share calculation   |       | 250,064                                          |       | 247,877 |   |
| Add effect of  dilutive potential common shares                          |       | 4,395                                            |       | — |   |
| Weighted average shares  used in computing diluted per share calculation |       | 254,459                                          |       | 247,877 |   |

 

Excluded from the sharesused in the calculations above are options to purchase shares of common stockand shares of common stock issuable upon conversion of a convertiblesubordinated note representing an aggregate of 20,399,453 shares as of March 31,2006 as their effect would have been anti-dilutive.

***(p) Warranty Reserve***

Sonus’ products are covered by a standard warranty of90 days for software and one year for hardware or a warranty for longerperiods under certain customer contracts. In addition, certain customercontracts include warranty-type provisions for epidemic or similar productfailures, generally for the contractual period or the life of the product inaccordance with published telecommunications standards**.**Sonusaccrues for warranty obligations when the occurrence of such obligation isprobable and the amount of such obligation is reasonably estimable. Sonus hasnot incurred significant costs related to such obligations. Sonus’ customerstypically purchase maintenance and support contracts, which encompass itswarranty obligations. Sonus’ estimates of warranty obligations are primarilybased on historical information and future forecasts.

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. As of March 31, 2006 andDecember 31, 2005, Sonus had $45,000 and $84,000 of warranty reservesrecorded, respectively.

14

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

**(2) Summaryof Significant Accounting Policies (Continued)**

***(q) Income Taxes***

Sonus provides for incometaxes during interim periods based on the estimated effective tax rate for thefull fiscal year. Sonus records cumulative adjustments to the tax provision inan interim period in which a change in the estimated annual effective rate isdetermined.

**(3) 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 RestructuringAccrual**

Thefollowing table summarizes the activity during the three months ended March 31,2006 relating to Sonus’ accrual for fiscal 2002 restructuring actions, inthousands:

| ** **                   | ** ** | **December 31,  2005  Accrual  Balance** | ** ** | **Cash  Payments** | ** ** | **March 31,  2006  Accrual  Balance** | ** ** | **Current  Portion** | ** ** | **Long-term  Portion** | ** ** |
|------------------------------|------------|-----------------------------------------------|------------|--------------------|------------|--------------------------------------------|------------|----------------------|------------|------------------------|------------|
| Consolidation of  facilities |       |                                          | $          | 613                |       |                                       |       | $                    | (47        | )                      |       |   | $ | 566 |   |   |   | $ | 198 |   |   |   | $ | 368 |   |   |
|                              |            |                                               |            |                    |            |                                            |            |                      |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

**(4) Contingencies**

In November 2001, a purchaser of Sonus’ commonstock filed a complaint in the United States District Court for the SouthernDistrict of New York against Sonus, two of its officers and the leadunderwriters alleging violations of the federal securities laws in connectionwith our initial public offering (IPO) and seeking unspecified monetarydamages. The purchaser seeks to represent a class of persons who purchasedSonus’ 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 Sonus’ 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 underwriters and certain purchasers to makeadditional purchases in the after market. The claims against Sonus are assertedunder Section 10(b) of the Securities Exchange Act of 1934 and Section 11of the Securities Act of 1933 and against the individual defendants underSections 11 and 15 of the Securities Act and Sections 10(b) and 20(a) ofthe Exchange Act. Other plaintiffs have filed substantially similar classaction cases against approximately 300 other publicly traded companies andtheir IPO underwriters which, along with the actions against Sonus, have beentransferred to a single federal judge for purposes of coordinated casemanagement. On July 15, 2002, Sonus, together with the other issuers namedas 

15

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

**(4) Contingencies(Continued)**

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 Sonus 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 Sonus, but denied the remainder of themotion as to the defendants. In June 2003, a special committee of Sonus’Board 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. 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. As the settlement would not require anypayment by Sonus, Sonus does not expect that the settlement would have amaterial impact on its business or financial results.

Beginning in July 2002, several purchasers ofSonus’ 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 Securities Exchange Act of 1934 (Class Action Complaints). Thepurchasers seek to represent a class of persons who purchased Sonus commonstock between December 11, 2000 and January 16, 2002, and seekunspecified monetary damages. The Class Action Complaints were essentiallyidentical and alleged that Sonus made false and misleading statements about itsproducts and business. On March 3, 2003, the plaintiffs filed aConsolidated Amended Complaint. On April 22, 2003, Sonus filed a motion todismiss the Consolidated Amended Complaint on various grounds. On May 11,2004, the court held oral argument on the motion, at the conclusion of whichthe court denied Sonus’ motion to dismiss. The plaintiffs filed a motion forclass certification on July 30, 2004. On February 16, 2005, the courtcertified the class and appointed a class representative. On March 9,2005, the court appointed lead counsel. After the court requested additionalbriefing on the adequacy of the class representative, the class representativewithdrew. Lead counsel then filed a motion to substitute a new plaintiff as theclass representative. On May 19, 2005, the court held a hearing on themotion and took the matter under advisement. On August 15, 2005, the courtissued an order decertifying the class and requiring the parties to submit ajoint report informing the court whether the cases have been settled andwhether defendants would be seeking to recover attorney’s fees from theplaintiffs. On September 30, 2005, the plaintiffs filed motions tovoluntarily dismiss their complaints with prejudice. On October 5, 2005,the court entered an order dismissing the cases. On October 21, 2005, thedefendants filed a motion seeking the recovery of attorneys’ fees fromplaintiffs. The plaintiffs have opposed the motion. No hearing date has beenscheduled.

On January 6, 2006, a purchaser of Sonus’ 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. Three shareholders havefiled motions seeking appointment as lead plaintiff. The court has not yetruled on these motions. Following the appointment of a lead plaintiff, thedefendants intend to file a motion to dismiss the complaint. There is noassurance Sonus will prevail in such a motion or defending this action. Ajudgment or a settlement of the claims 

16

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

**(4) Contingencies(Continued)**

against the defendantscould have a material impact on Sonus’ financial results. It is too early todetermine the ultimate outcome 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 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 SecuritiesExchange Act of 1934 and Sections 11, 12(a), and 15 of the Securities Act of1933, relating to Sonus’ restatement of its financial results for 2001, 2002,and the first three quarters of 2003. Specifically, the complaint alleges thatSonus issued a series of false or misleading statements to the marketconcerning our revenues, earnings, and financial position. Plaintiffs contendthat such statements caused Sonus’ stock price to be artificially inflated. Thecomplaint seeks unspecified damages on behalf of a purported class ofpurchasers of Sonus’ common stock during the period from March 28, 2002through March 26, 2004. On January 28, 2005, Sonus 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 the priorcomplaint. On September 12, 2005, the defendants filed motions to dismissthis amended complaint. On December 10, 2005, the court held a hearing onthe motions and took the matter under advisement. Sonus believes that it hassubstantial legal and factual defenses to the claims, which it intends topursue vigorously. Sonus does not expect that this claim will have a materialimpact on its financial statements.

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 Sonus’ stockholders and to Sonus. The complaintsare derivative 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 throughoutthese actions to advance payment of legal fees and costs incurred by thedefendants pursuant to Sonus’ obligations under the indemnification agreementsor applicable Delaware law. On September 27, 2004, the state court grantedSonus’ motion to dismiss. On October 26, 2004, the plaintiffs filed anotice appealing the state court’s dismissal of the actions. On June 24,2005, the plaintiffs withdrew the appeal, the case was dismissed withprejudice. In the federal actions, on June 28, 2004, the courtconsolidated and stayed the three actions. On October 12, 2004, the leadplaintiff filed a consolidated amended complaint. On June 1, 2005, thecourt held a hearing on the motion and allowed the plaintiff to file an amendedcomplaint. On July 1, 2005, the plaintiff filed an amended complaint. The defendantsrenewed their motions to dismiss. On December 10, 2005, the court held ahearing on the motions and took the matter under advisement. On March 31,2006, the court entered an order granting the defendants’ motions and dismissingthe amended complaint. On April 26, 2006, the plaintiffs filed a notice of appeal of thedismissal order. Sonus does not expect that this claim will have a materialimpact on its financial statements.

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

**(4) Contingencies(Continued)**

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. The complaintseeks unspecified damages. Sonus 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. Sonus doesnot expect that this claim will have a material impact on its financialresults.

Sonus includes standard intellectual propertyindemnification provisions in its product agreements in the ordinary course ofbusiness. Pursuant to Sonus’ 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.

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

*This Management’s Discussion and Analysis of FinancialCondition and Results of Operations contains forward-looking statements,which are subject to a number of risks and uncertainties. These forward-lookingstatements are based on our current expectations, assumptions, estimates andprojections about our industry and ourselves, and we do not undertake anobligation to update our forward-looking statements to reflect futureevents or circumstances. Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of variousfactors, including the factors set forth in “Risk Factors” in this QuarterlyReport on Form 10-Q. This discussion should be read in conjunctionwith the unaudited condensed consolidated financial statements and relatednotes for the periods specified. Further reference should be made to our AnnualReport on Form 10-K for the year ended December 31, 2005, onfile with the SEC.*

**Overview**

We are a leading supplier of packet voiceinfrastructure solutions for wireline and wireless service providers. Ourproducts are a new generation of carrier class switching equipment and softwarethat enable voice services to be delivered over packet-based networks. Ourvoice solutions allow wireline and wireless operators to build converged voiceover IP networks based on the same principles as the IP Multimedia Subsystem(IMS) architecture, which network operators globally are embracing as thecommon standard for constructing next generation networks.

Starting in 2004 and continuing into 2006, there hasbeen increased 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 less than revenue for the threemonths ended March 31, 2006 due to the seasonally slower period forcustomer order activity and the strong revenue for the quarter. While itremains uncertain as to the speed and extent of the adoption of carrier packetvoice infrastructure products by large carriers, we believe that over time themarket opportunity for packet voice solutions is substantial. For the threemonths ended March 31, 2006, revenues were $60.0 million compared to$33.6 million in the same period in fiscal 2005, reflecting continuingimprovements in the market for packet-based voice infrastructureproducts, as well as increased service revenues resulting from the growinginstalled 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 inceptionthrough December 31, 2003, we have incurred significant losses. As of March 31,2006, we had an accumulated deficit of $770.0 million. Although weachieved profitability in the first quarter of 2006 and on an annual basis infiscal years 2005 and 2004, we incurred a net loss 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.

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**Critical AccountingPolicies and Estimates**

Management’sdiscussion and analysis of the financial position 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 andprojections, there could be a material effect on our financial statements. Thesignificant accounting policies that we believe are the most critical to aid infully understanding and evaluating our reported financial results 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 is required, we defer revenue recognitionand related costs until those obligations are satisfied. The ordering patternsand sales lead times associated with customer orders may vary significantlyfrom 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. Revenues associated with undelivered elements that areconsidered not essential to the functionality of the product and for which VSOEhas been established, are deferred based on the VSOE value and any remainingarrangement fee is then allocated to, and recognized as, product revenue. VSOEis determined based upon the price charged when the same element is soldseparately or established by the relevant pricing authority. If we cannotestablish VSOE for each undelivered element, including specified upgrades, wedefer revenue on the entire arrangement until VSOE for all undelivered elementsis known or all elements are delivered and all other revenue recognitioncriteria are met.

Maintenance and support services are recognizedratably over the service period, ranging from one to five years. Earnedmaintenance revenues are typically deferred until the associated productrevenue is accepted 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.

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Installation service revenues which are considered tobe perfunctory are generally recognized when the service is complete. Otherprofessional services for which VSOE has been established are typicallyrecognized based on the proportional performance as the services are delivered.

Consulting, custom development and other professionalservices only engagements are recognized as services are completed.

We sell the majority of our products directly to ourservice provider customers. For products sold to resellers and distributors, werecognize revenue on a sell-through basis utilizing information provided to usfrom our resellers and distributors. Through December 31, 2005, norevenues had been recognized on a sell-in basis due to the limited returnhistory associated with shipments to resellers and distributors. During thethree months ended March 31, 2006, we began reporting revenue from ouroriginal equipment manufacturer (OEM) relationship with Motorola, Inc. ona sell-in basis where revenue is recognized upon the shipment of products toMotorola, assuming all other requirements for revenue recognition have been met.We had previously recognized revenue for sales to Motorola when products hadbeen sold through by Motorola to its customers. This change reflects the twoyears of history with Motorola during which we have experienced no returns, noprice concessions and an excellent payment history. As a result of thishistory, we have determined that the risk of a potential price concession hasbeen eliminated and therefore the price for products sold to Motorola is nowfixed or determinable upon sale to Motorola. In the three months ended March 31,2006, we recognized revenue totaling approximately $3.0 million in connectionwith sales of products to Motorola through March 31, 2006 that had not yetsold through to Motorola’s customers. This revenue would have been recognizedin subsequent quarters if we had not changed to a sell-in basis for Motoroladuring the first quarter. This additional revenue from Motorola in the quarternegatively affected product gross margins during the first quarter as revenuefrom OEM relationships typically have lower margin profiles than revenue fromdirect sales to customers. This additional revenue resulted in approximately$1.0 million of additional net income in the quarter, but did not changereported basic and diluted earnings per share.

***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 revenues include customer depositsand amounts associated with maintenance contracts. Deferred revenues expectedto be recognized as revenue more than one year subsequent to the balance sheetdate are classified as long-term deferred revenues.

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

***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. Allowance fordoubtful accounts is estimated based on our detailed assessment of the collectibilityof specific customer accounts.

***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 revenues.We assess such demand forecasts and return history on at least a quarterlybasis. If we record a charge to reduce inventory to its estimated netrealizable value, we do not increase its carrying value due to subsequentchanges in demand forecasts or product repairs. Accordingly, if inventorypreviously reserved for is subsequently sold, we may realize improved grossprofit margins on those transactions in the period the related revenue isrecognized.

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We also 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 probable that the inventory value will not berealizable. If these evaluation shipments are later purchased by our customers,we reclassify amounts previously charged to sales and marketing expenses tocost of revenues in the period all revenue recognition criteria are met.

***Warranty Reserve.******  ***Our productsare covered by a standard warranty of 90 days for software and one yearfor hardware or a warranty for longer periods under certain customer contracts.In addition, 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 obligationswhen the occurrence of such obligation is probable and the amount of suchobligation is reasonably estimable. We have not incurred significant costsrelated to such obligations. Our customers typically purchase maintenance andsupport contracts, which encompass our warranty obligations. Our estimates ofwarranty obligations are primarily based on historical information and futureforecasts.

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 amount ofsuch obligation is reasonably estimable. We have not incurred significant costsrelated to such provisions. We periodically assess the adequacy of our recordedwarranty 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*, an estimatedloss contingency is accrued when it is probable that a liability has beenincurred or 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.

***Stock-basedCompensation.******  ***Effective January 1,2006, we adopted the provisions of SFAS No. 123 (revised 2004), *Share-Based Payment* (SFAS No. 123R). Priorto January 1, 2006, we followed Accounting Principles Board Opinion 25, *Accounting for Stock Issued to Employees,*and related interpretations in accounting for our employee stock-basedcompensation.

Under the provisions of SFAS No. 123R, werecognize the fair value of stock-based compensation in our consolidatedfinancial statements over the requisite service period, which generally equalsthe vesting period. We record into our inventory a portion of the fair value ofstock-based compensation, which is expensed as inventory is relieved, generallyover six months.

We have elected the modified prospectivetransition method for adopting SFAS No. 123R. Under this method, theprovisions of SFAS No. 123R apply to all awards granted or modified afterthe date of 

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adoption. 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 No. 123, *Accounting for Stock-Based Compensation*. We recorded $1.9 million ofstock-based compensation in the condensed consolidated statement of operationsfor the three months ended March 31, 2006, included in the followingexpense categories (in thousands):

| Product cost of  revenues   |   | $   | 3      |   |
|-----------------------------|--------|-----|--------|--------|
| Service cost of  revenues   |   | 252 |   |
| Research and  development   |   | 610 |   |
| Sales and  marketing        |   | 405 |   |
| General and  administrative |   | 633 |   |
|                        |   | $   | 1,903  |   |

 

In addition, we included in inventory approximately$16,000 of stock-based compensation at March 31, 2006.

The recording of stock-based compensation expense forthe three months ended March 31, 2006 resulted in a decrease in net income of$1.9 million and a decrease in basic and diluted earnings per share of $0.01. We expect stock-based compensation expenseto reduce diluted net income per share by approximately $0.03 to $0.05 pershare for fiscal 2006. As of March 31, 2006, there was $12.9million of unrecognized compensation cost related to options, which is expectedto be recognized over a weighted average period of 3.0 years.

However, our assessment of the estimated compensationcharges is affected by our stock price as well as assumptions regarding anumber of complex and subjective variables and the related tax impact. Thesevariables include, but are not limited to, the volatility of our stock priceand employee stock option exercise behaviors. We utilize the Black-Scholesvaluation model for estimating the fair value on the date of grant of employeestock options. The Black-Scholes model requires us to make several assumptions,one of which is volatility. Prior to January1, 2006, we used historical volatility to estimate the grant-date fair value ofstock options. Starting on January 1, 2006, we changed our method to acombination of historical and implied volatility. We believe that a combinationof historical and implied volatility results in a more accurate estimate of thegrant-date fair value of employee stock options because it more appropriatelyreflects the market’s expectations of future volatility. Historical volatilityduring the period associated with the expected term of our stock options overthe past few years included a period of time during or subsequent to ourinitial public offering when our stock price experienced abnormally highvolatility levels, which we believe is unlikely to be indicative of futurestock price behavior. However, we have not placed sole reliance on impliedvolatility as options in our common stock that are actively traded on the openmarket currently have a term of less than one year - substantially shorter thanour stock option’s expected term.

On December 21, 2005, our Board of Directors approvedaccelerating the vesting of out-of-the-money, unvested stock options held byall current employees, subject to employee approval to the extent acceleratingof vesting would create a change in classification of any grant from anincentive 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, representingthe right to purchase a total of approximately 18.9 million shares, becameexercisable as a result of the vesting acceleration. All other terms andconditions in the original grants remained unchanged. The acceleration ofvesting did not result in the recognition of compensation expense in fiscal2005 as the exercise price of the accelerated stock options exceeded the fairmarket value of the underlying common stock on the date of modification. Thepro forma results reported for fiscal 2005 included approximately $63.8 millionof pro forma compensation expense, net of tax, resulting from the vesting 

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acceleration. The decisionto accelerate vesting of these stock options was made primarily to reducecompensation expense that would otherwise be recognized after the adoption ofSFAS No. 123R.

***Accounting for Income Taxes.******  ***We provide fordeferred income taxes resulting from temporary differences between financialand taxable income. Such differences arise primarily from depreciation,accruals and reserves, deferred revenue, capitalized software costs, taxcarryforwards, and allowances for accounts receivable. We record valuationallowances to reduce deferred income tax assets to the amount that is morelikely than not to be realized. We have not provided for U.S. income taxes onthe undistributed earnings of non-U.S. subsidiaries, as these earnings havebeen permanently reinvested or would be principally offset by foreign taxcredits. Cumulative undistributed foreign earnings were approximately $497,000at March 31, 2006.

***Three Months Ended March 31, 2006 and 2005***

***Revenues.******  ***Revenues forthe three months ended March 31, 2006 and 2005 were as follows, inthousands:

| ** **     | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| **Revenues:**  |       |     |       |     |       |
| Product        |       | $        | 44,383     |     | $          | 22,458 |   |
| Service        |       | 15,589   |       | 11,152   |       |
| Total revenues |       | $        | 59,972     |     | $          | 33,610 |   |

 

Product revenues comprise sales of our voiceinfrastructure products, including our GSX9000TM Open Services Switch, PSX, SGX,ASX, the Sonus InsightTM Management System and related product offerings.Product revenues for the three months ended March 31, 2006 increased 98%from the comparable period in fiscal 2005. The increase in product revenues wasprimarily the result of the conversion to revenue of orders received in thesecond half of fiscal 2005. In addition, during the three months ended March 31,2006, we recorded $2.7 million of product revenue in connection with a changein reporting revenue with Motorola to a sell-in basis from a sell-throughbasis.

Service revenues primarily comprise hardware andsoftware maintenance and support, network design, installation and otherprofessional services. Service revenues for the three months ended March 31,2006 increased 40% from the comparable period in fiscal 2005. The increase inservice revenues was primarily a result of increases in maintenance revenuesdue to our growing installed customer base.

Global Crossing, Level 3 Communications and Motorolaeach contributed more than 10% of our revenues during one or more of the threemonths ended March 31, 2006 and 2005.

International revenues, primarily from Japan and theremainder of the Asia Pacific region, were 23% and 19% of revenues for thethree months ended March 31, 2006 and 2005. International revenuesincreased due to uneven ordering patterns of our international customers andthe achievement of revenue recognition criteria associated with each customer’sarrangement. We expect that international revenues will remain uneven as apercentage of revenue from quarter to quarter.

Our deferred product revenue was $42.3 millionand $54.8 million as of March 31, 2006 and December 31, 2005.Our deferred service revenue was $59.9 million and $67.3 million asof March 31, 2006 and December 31, 2005. Our deferred revenue balancemay fluctuate as a result of the timing of revenue recognition, customerpayments, maintenance contract renewals, contractual billing rights, customercreditworthiness and maintenance revenue deferrals included in multiple elementarrangements. As of March 31, 2006 and December 31, 2005, deferredrevenue and accounts receivable excluded $15.3 million and$5.3 million related to products shipped and billed to customers which arecollectible under extended 

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payment terms or for whichrevenue is recognized as cash is collected, or for which title had not passedto the customer as of the period end date.

***Cost ofRevenues/Gross Profit.******  ***Our cost ofrevenues consists primarily of amounts paid to third-party manufacturersfor purchased materials and services, royalties, manufacturing and professionalservices personnel and related costs and inventory obsolescence. Cost ofrevenues and gross profit as a percentage of revenues for the three monthsended March 31, 2006 and 2005 were as follows (in thousands, exceptpercentages):

| ** **                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| **Cost of revenues:**                                |       |     |       |     |       |
| Product                                              |       | $        | 15,853     |     | $          | 6,843 |   |
| Service                                              |       | 7,381    |       | 5,269    |       |
| Total cost of revenues                               |       | $        | 23,234     |     | $          | 12,112 |   |
| **Gross profit margin (% of  respective revenues):** |       |     |       |     |       |
| Product                                              |       | 64       | %          | 70       | %          |
| Service                                              |       | 53       |       | 53       |       |
| Total gross profit  margin                           |       | 61       | %          | 64       | %          |

 

The decrease in product gross profit as a percentageof revenues was primarily due to customer and product mix, including a greaterpercentage of revenue in fiscal 2006 from resellers with typically lower grossmargins. Our product gross profit remained higher than our long-term financialmodel of 58-62%. We can provide no assurance that this favorable customerand product mix will continue, and we expect that over time our gross marginswill return to levels consistent with our long-term financial model. Theconsistency in service gross profit as a percentage of service revenues wasprimarily due to increased investment in our service organization to supportthe expansion of our installed base and stock-based compensation recordedduring the three months ended March 31, 2006, offset by an increase inservice revenues. Our service cost of revenues is relatively fixed in advanceof any particular quarter and, therefore, changes in service revenue will havea significant impact on service gross profit percentage.

***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 thethree months ended March 31, 2006, an increase of $1.9 million, or17%, from $11.0 million for the same period in fiscal 2005. This increaseprimarily reflects an increase in salary and related expenses associated withincreased headcount and stock-based compensation expense recorded during thethree months ended March 31, 2006. Some aspects of our research anddevelopment efforts require significant short-term expenditures, the timing ofwhich can cause significant variability in our expenses. We believe that rapidtechnological innovation is critical to our long-term success, and we intend tocontinue to make substantial investments to enhance our products andtechnologies to meet the requirements of our customers and market. We believethat our research and development expenses for the second quarter of fiscal2006 will increase from the first quarter of fiscal 2006 primarily as a resultof continued investment in new products, including the continued expansion ofour research and development operations in India.

***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$13.9 million for the three months ended March 31, 2006, an increaseof $4.9 million, or 54%, from $9.0 million for the same period infiscal 2005. This increase primarily reflects an increase in salaries andtravel expenses associated with increased headcount related to the expansion ofour worldwide sales and support coverage, an increase in commissions associatedwith higher revenues, stock-based compensation 

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expense recorded duringthe three months ended March 31, 2006 and higher evaluation equipmentexpenses. We believe that our sales and marketing expenses for the secondquarter of fiscal 2006 will increase from the first quarter of fiscal 2006related to personnel costs and trade show expenses. The magnitude of theincrease will be dependent upon our level of revenues in the second quarter ascommission expenses fluctuate primarily based on revenue levels.

***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 $6.7 million for the three months ended March 31,2006, a decrease of $0.1 million, or 1%, from $6.8 million for thesame period in fiscal 2005. This decrease primarily reflects a decrease indirectors and officers insurance premiums and a decrease in professional fees,offset by an increase in salary and related expenses associated with increasedheadcount and the recording of stock-based compensation expense during thethree months ended March 31, 2006. We believe that our general andadministrative expenses for the second quarter of fiscal 2006 will remaingenerally consistent with the first quarter of fiscal 2006 due to continuedcosts associated with improvements we are making in our internal controlenvironment to address material weaknesses.

***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 $3.3 million for the three months ended March 31,2006, as compared to $1.7 million for the same period in fiscal 2005. Thisincrease reflects the benefit of an increase in the yield on our portfolio dueto an increasing interest rate environment, shifting some of the marketabledebt securities to longer-term investments with a higher yield during the threemonths ended March 31, 2006, and an overall increase in cash andinvestments compared to the prior year.

***Income Taxes.******  ***Provisions forincome taxes were $791,000 and $96,000 for the three months ended March 31,2006 and 2005, which are primarily attributable to foreign income taxes andstate and federal income taxes in the U.S. As of March 31, 2006, we hadnet operating loss carryforwards for federal and state income tax purposes ofapproximately $142 million and $86 million, respectively. The federal netoperating loss carryforwards expire at various dates from 2019 through 2023. Thestate net operating loss carryforwards expire at various dates from 2006through 2023. We have recorded a full valuation allowance for the relatedfederal and state net deferred tax asset due to the uncertainty of realizingthe benefit of this asset. We have recorded a foreign deferred income tax assetof $519,000 with no valuation allowance as of March 31, 2006 as it is morelikely than not that it will be realized. We provide for income taxes duringinterim periods based on the estimated effective tax rate for the full fiscalyear. We record cumulative adjustments to the tax provision in an interimperiod in which a change in the estimated annual effective rate is determined.

**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 March 31, 2006, our principal source ofliquidity was our cash, cash equivalents, marketable debt securities andlong-term investments that totaled $340.2 million.

Our cash from operating activities was $21.0 millionfor the three months ended March 31, 2006, as compared to cash used inoperating activities of $84,000 for the same period in fiscal 2005. Theincrease in 

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cash flow from operatingactivities was primarily due to net income for the three months ended March 31,2006 as compared to a net loss in the prior year and a decrease in accountsreceivable, partially offset by decreases in deferred revenue, accounts payableand accrued expenses.

Net cash used in investing activities was$133.4 million for the three months ended March 31, 2006, as comparedto net cash used in investing activities of $1.4 million for the sameperiod in fiscal 2005. Net cash used in investing activities for the threemonths ended March 31, 2006 primarily reflects net purchases of marketabledebt securities and long-term investments of $131.4 million and capitalexpenditures of $2.3 million. Net cash used in investing activities forthe three months ended March 31, 2005 primarily reflects capitalexpenditures of $4.3 million, primarily offset by net maturities of marketabledebt securities and long-term investments of $3.0 million. We expect toincur approximately $10-12 million in additional capitalexpenditures in the remaining three fiscal quarters of 2006.

Net cash provided by financing activities was$7.1 million for the three months ended March 31, 2006, as comparedto $2.7 million for the same period in fiscal 2005 The net cash providedby financing activities for the three months ended March 31, 2006 and 2005primarily resulted from the sale of common stock in connection with ouremployee stock purchase plan and proceeds from the exercise of stock options.

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 least12 months. In addition, we had a convertible subordinated note with acustomer that matured on May 1, 2006 for which we made a payment of$10,000,000 plus accrued interest on that date. Although it is difficult topredict future liquidity requirements with certainty, the rate at which we willconsume cash will be dependent on the cash needs of future operations,including changes in working capital, which will, in turn, be directly affectedby the levels of demand for our products, the timing and rate of expansion ofour business, the resources we devote to developing our products and anylitigation settlements. We anticipate devoting substantial capital resources tocontinue our research and development efforts, to maintain our sales, supportand marketing, to improve our internal control environment and for othergeneral corporate activities, as well as to vigorously defend against existingand potential litigation relating to the restatement of our consolidatedfinancial statements. See Note 4 to our condensed consolidated financialstatements.

**Item3: Quantitative and 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.

**Item4: Controls and Procedures**

Our management, with theparticipation of our principal executive officer and principal financialofficer, has evaluated the effectiveness of our disclosure controls and procedures(as defined in Rule 13a-15(e) under the Securities Exchange Actof 1934 (the Exchange Act)), as of March 31, 2006, which included anevaluation of disclosure controls and procedures applicable to the periodcovered by the filing of this periodic report. The term “disclosure controlsand procedures,” as defined in Rule 13a-15(e), means controls andother procedures of a company that are designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Exchange Act is recorded, processed, summarized and reported, withinthe 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 the company’s management, including its principal executive andprincipal financial officers, as appropriate to allow timely decisionsregarding required disclosure.

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In our *Management’s Report onInternal Control over Financial Reporting*filed with our AnnualReport on Form 10-K for the year ended December 31, 2005, wereported three (3) material weaknesses in our internal control overfinancial reporting (as defined in Rule 13a-15(f) under theExchange Act). As a result of these material weaknesses, which were notremediated as of March 31, 2006, we have concluded that our disclosurecontrols and procedures were not effective as of March 31, 2006.

During the fiscalquarter ended March 31, 2006, we made changes that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting. In particular, we implemented changes to thecommunication and monitoring of entity-level controls throughout theorganization to provide reasonable assurance that appropriate information isdisseminated to all employees in order for them to understand our corporatepolicies thoroughly, and to understand and accomplish their assigned duties, includingtheir internal control responsibilities. These changes consist of thefollowing:

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

·       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 Internet 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 business conduct,policies and controls; and

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

We expect these changes will contribute to theremediation of the material weakness relating to inadequate entity-levelcontrols.

We have established a plan to implement procedures andcontrols during 2006 to remediate the remaining material weaknesses to ourentity level, revenue recognition, and financial statement preparation andreview procedures and controls. We will report each quarter on our progress andon changes made during the quarter that materially affect, or are reasonablylikely to materially affect, our internal control over financial reporting.

We have implementedpolicies and procedures to ensure our financial reports are complete andaccurate pending the remediation of the reported material weaknesses. Thesepolicies and procedures include:

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

·       Enhancedreview of journal entries and account reconciliations, including internationalentities, to provide reasonable assurance of complete and accuratetransactions;

·       Weeklyrevenue meetings, quarterly certifications and disclosure process and customeraccount reviews and revenue files to understand and document our customerarrangements;

·       Manualdocumentation to adequately support the assignment of customercreditworthiness;

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·       Manualreconciliation of customer invoices to related purchase orders and shippingdocumentation;

·       Manualreconciliation of cash payments applied to customer accounts with invoices andpurchase orders; and

·       Useof outside accounting and financial professionals to assist in the preparation,review and reconciliation of our accounts and financial statements.

In addition, we will continue to design and implementadditional policies and procedures during the remediation of our reportedmaterial weaknesses.

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 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 2002are attached as exhibits to this Quarterly Report on Form 10-Q. Thedisclosures set forth in this Item 4 contain informationconcerning the evaluation of our disclosure controls and procedures, andchanges in internal control over financial reporting, referred to inparagraph 4 of the certifications. Those certifications should be read inconjunction with this Item 4 for a more complete understanding of the matterscovered 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 seeks torepresent a class of persons who purchased our common stock between the IPO on May 24,2000 and December 6, 2000. An amended complaint was filed in April 2002.The amended complaint alleges that our registration statement contained falseor misleading information or omitted to state material facts concerning thealleged receipt of undisclosed compensation by the underwriters and theexistence of undisclosed arrangements between underwriters and certainpurchasers to make additional purchases in the after market. The claims againstus are asserted under Section 10(b) of the Securities Exchange Act of1934 and Section 11 of the Securities Act of 1933 and against theindividual defendants under Sections 11 and 15 of the Securities Act andSections 10(b) and 20(a) of the Exchange Act. Other plaintiffs have filedsubstantially similar class action cases against approximately 300 otherpublicly traded companies and their IPO underwriters which, along with theactions against us, have been transferred to a single federal judge forpurposes of coordinated case management. On July 15, 2002, we, togetherwith the other issuers named as defendants in these coordinated proceedings,filed a collective motion to dismiss the consolidated amended complaints onvarious legal grounds common to all or most of the issuer defendants. Theplaintiffs voluntarily dismissed the claims against many of the individualdefendants, including our officers named in the complaint. On February 19,2003, the court granted a portion of the motion to dismiss 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 of Understandingnegotiated among representatives of the plaintiffs, the issuer defendants andthe insurers for the issuer defendants. On February 15, 2005, the courtpreliminarily approved the terms of the proposed settlement contingent onmodifications to the proposed settlement. On August 31, 2005, the courtapproved the terms of the proposed settlement, as modified. The settlement issubject to class certification and final approval by the court. On April 24,2006, the court held a hearing on a motion to approve the final settlement andtook the matter under advisement. As the settlement would not require anypayment by us, we do not expect that the settlement would have a materialimpact on our business or financial results.

Beginning in July 2002, several purchasers of ourcommon stock filed complaints in the United States District Court for theDistrict of Massachusetts against us, certain officers and directors and aformer officer under Sections 10(b) and 20(a) and Rule 10b-5of the Securities Exchange Act of 1934 (Class Action Complaints). Thepurchasers seek to represent a class of persons who purchased our common stockbetween December 11, 2000 and January 16, 2002, and seek unspecifiedmonetary damages. The Class Action Complaints were essentially identicaland alleged that we made false and misleading statements about our products andbusiness. On March 3, 2003, the plaintiffs filed a Consolidated AmendedComplaint. On April 22, 2003, we 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 our 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 lead counsel. After the court requested additionalbriefing on the adequacy of the class representative, the class representativewithdrew. Lead counsel then filed a motion to substitute a new plaintiff as theclass representative. On May 19, 2005, the court held a hearing on themotion and took the matter under advisement. On August 15, 2005, the courtissued an order decertifying the class and requiring the parties to submit ajoint report informing the court whether 

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the cases have beensettled and whether defendants would be seeking to recover attorney’s fees fromthe plaintiffs. On September 30, 2005, the plaintiffs filed motions tovoluntarily dismiss their complaints with prejudice. On October 5, 2005,the court entered an order dismissing the cases. On October 21, 2005, thedefendants filed a motion seeking the recovery of attorneys’ fees fromplaintiffs. The plaintiffs have opposed the motion. No hearing date has beenscheduled.

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. Three shareholders havefiled motions seeking appointment as lead plaintiff. The court has not yetruled on these motions. Following the appointment of a lead plaintiff, thedefendants intend to file a motion to dismiss the 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 SecuritiesExchange Act of 1934 and Sections 11, 12(a), and 15 of the Securities Act of1933, relating to our restatement of our financial results for 2001, 2002, andthe first three quarters of 2003. Specifically, the complaint alleges that weissued a series of false or misleading statements to the market concerning ourrevenues, earnings, and financial condition. Plaintiffs contend that suchstatements caused our stock price to be artificially inflated. The complaintseeks unspecified damages on behalf of a purported class of purchasers of ourcommon stock during the period from March 28, 2002, through March 26,2004. On January 28, 2005, we 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 claims andsubstantially similar allegations as set forth in the prior 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.

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 be obligated throughout these actions to advancepayment of legal fees and costs incurred by the defendants pursuant to ourobligations under the indemnification agreements or applicable Delaware law. OnSeptember 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 ofthe actions. On June 24, 2005, the plaintiffs withdrew the appeal, thecase was dismissed 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 and 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’ 

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motions and dismissing the amended complaint. On April 26,2006, the plaintiffs filed a notice of appeal of the dismissal order. We do notexpect that this claim will 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.

We include standardintellectual property indemnification provisions in our product agreements inthe ordinary course of business. Pursuant to our product agreements, we willindemnify, hold harmless, and reimburse the indemnified party for lossessuffered or incurred by the indemnified party, generally business partners orcustomers, in connection with certain patent, copyright or other intellectualproperty infringement claims by third parties with respect to our products.Other agreements with our customers provide indemnification for claims relatingto property damage or personal injury resulting from the performance ofservices by us or our subcontractors. Historically, our costs to defendlawsuits or settle claims relating to such indemnity agreements have beeninsignificant. Accordingly, the estimated fair value of these indemnificationprovisions is immaterial.

**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. There have been no material changes to the risk factors previouslydisclosed in our Annual Report on Form 10-K for the year ended December 31,2005.*

***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 otherwise seriously harm our business.***

We have taken and continueto take significant steps to improve our overall control over financialreporting. In 2005, we remediated seven of ten material weaknesses in ourinternal control over financial reporting that we had reported as of December 31,2004. However, there is additional work and focus required to address remainingdeficiencies in some of these areas. Management has concluded that our internalcontrol over financial reporting continues to have certain material weaknessesas of March 31, 2006 and that our disclosure controls and procedures areineffective. These weaknesses could have a material adverse effect on ourbusiness, results of operations and financial condition, as well as impair ourability to meet our quarterly and annual reporting requirements in a timelymanner. These effects could in turn adversely affect the trading price of ourcommon stock. Prior to the remediation of these remaining material weaknesses,there remains risk that the processes and procedures on which we currently relywill fail to be sufficiently effective, which could result in a materialmisstatement of our financial position or results of operations. In addition,even if we are successful in strengthening our controls and procedures, suchcontrols and procedures may not be adequate to prevent or identifyirregularities or fraud or facilitate the fair presentation of our financialstatements, SEC reporting or other disclosures.

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

We have made significantchanges in our internal control over financial reporting and our disclosurecontrols and procedures. Any system of controls, however well designed andoperated, is based in part on certain assumptions and can provide onlyreasonable, and not absolute, assurances that the objectives of the system aremet. The failure or circumvention of our controls, policies and procedurescould have a material adverse effect on our business, results of operations andfinancial position.

***We face risksrelated to securities litigation that could have a material adverse effect onour business, financial position and results of operations.***

We have been named as adefendant in a number of securities class action and derivative lawsuits. Weare generally obliged, to the extent permitted by law, to indemnify our currentand former directors and officers who are named as defendants in some of theselawsuits. Defending against existing and potential litigation may requiresignificant attention and resources of management. Regardless of the outcome,such litigation will result in significant legal expenses. If our defenses areultimately unsuccessful, or if we are unable to achieve a favorable settlement,we could be liable for large damage awards that could have a material adverseeffect on our business, results of operations and financial position.

***The limitations ofour director and officer liability insurance may materially harm our businessand financial condition.***

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 its unavailabilityor prohibitively expensive premiums would make it more difficult to retain andattract officers and directors and expose us to potentially self-funding anypotential future liabilities ordinarily mitigated by director and officerliability insurance.

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

In 2004, we were not current in our SEC filings and,as a result, our common stock was delisted from the NASDAQ National Market fora short period of time.

If we are unable to remain current in our SEC filings,we will not be able to have a registration statement under the Securities Actof 1933, covering a public offering of securities, declared effective by theSEC, and we will not be able to make offerings pursuant to existingregistration statements (including registration statements on Form S-8covering employee stock plans), or pursuant to certain “private placement” rules ofthe SEC under Regulation D to any purchasers not qualifying as “accreditedinvestors.” In addition, our affiliates will not be able to sell our securitiespursuant to Rule 144 under the Securities Act. Finally, we will not beeligible to use a “short form” registration statement on Form S-3for a period of 12 months after the time we become current in our filingsand we will lose 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.

If we fail to keep currentin our SEC filings, our common stock may be delisted from the NASDAQ NationalMarket and subsequently would trade on the Pink Sheets. The trading of ourcommon stock on the Pink Sheets may reduce the price of our common stock andthe levels of liquidity available to our 

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stockholders.Our delisting from the NASDAQ National Market and transfer to the Pink Sheetsmay also result in other negative implications, including the potential loss ofconfidence by suppliers, customers and employees, the loss of institutionalinvestor interest and fewer business development opportunities.

***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 customerscontributed more than 10% of our revenues for the first three months of fiscal2006, which represented an aggregate of 41% of total revenues. One customercontributed more than 10% of our revenues for fiscal 2005, which represented anaggregate of 28% of total revenues. Two and four customers each contributedmore than 10% of our revenues for fiscal 2004 and 2003, respectively, whichrepresented an aggregate of 29% and 57% of total revenues, respectively. Ourfuture success will depend on our ability to attract additional customersbeyond our current limited number. The growth of our customer base could beadversely affected 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 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, the telecommunicationsmarket experienced rapid growth spurred by a number of factors, includingderegulation in the industry, entry of a large number of new emerging serviceproviders, growth in data traffic and the availability of significant capitalfrom the financial markets. Commencing in 2001, the telecommunications industryexperienced a reversal of some of these trends, marked by dramatic reductionsin capital expenditures, financial difficulties, and, in some cases,bankruptcies of service providers. These conditions caused a substantial,unexpected reduction in demand for telecommunications equipment, including ourproducts.

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We expect some ofthe developments described above to continue to affect our business in thefollowing manner:

·       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 new public network is new and evolvingand our business will suffer if it does not develop as we expect.***

The market for our productscontinues to evolve. In particular, wireless, cable and broadband accessnetworks are emerging to become important markets for our products. Packet-basedtechnology may not become widely accepted as a platform for voice and a viablemarket for our products may not be sustainable. If this market does notdevelop, or develops more slowly than we expect, we may not be able to sell ourproducts in significant volume.

***If we do notanticipate and meet specific customer requirements or if our products do not interoperatewith our customers’ existing networks, we may not retain current customers orattract 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 customershave substantial negotiating leverage, which may require that we agree to termsand conditions that may have an 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 ondistribution partners to sell our products in certain markets, and disruptionsto or our failure to effectively develop and manage our distribution channeland the processes and procedures that support it could adversely affect ourability to generate revenues from the sale of our products in those markets.***

Our future success is highly dependent uponestablishing and maintaining successful relationships with a variety of value-addedreseller and distribution partners. A portion of our revenues is derivedthrough distributors, many of which sell competitive products. Our revenuesdepend in part on sales by these distributors. The loss of or reduction insales by these distributors could materially reduce our revenues. If we fail tomaintain relationships with these distribution partners, fail to develop newrelationships with distributors in new markets, fail to manage, train, orprovide incentives to existing distributors effectively or if these partnersare not successful in their sales efforts, sales of our products may decreaseand 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 beadversely affected.

***We may face risksassociated with our international expansion that could impair our ability togrow our revenues abroad.***

Internationalrevenues, primarily attributable to Japan and the remainder of the Asia Pacificregion, were approximately $13.8 million for the first three months of fiscal2006, and $47.8 million for fiscal 2005, and we intend to expand our sales ininternational markets. This expansion will require significant managementattention and financial resources to successfully develop direct and indirectinternational sales and support channels. In addition, we may not be able todevelop international market demand for our products, which could impair ourability to grow our revenues. We have limited experience marketing,distributing and supporting our products internationally and, to do so, weexpect that we will need to develop versions of our products that comply withlocal standards. Furthermore, international operations are subject to otherinherent 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;

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·       potentiallyadverse tax consequences; and

·       political and economicinstability.

***We may not sustain profitability.***

We have incurred significantlosses since inception and, as of March 31, 2006, had an accumulateddeficit of $770.0 million. Although we achieved profitability in the firstquarter of fiscal 2006 and on an annual basis in fiscal 2005 and 2004, weincurred a net loss in the first and third quarters of fiscal 2005 and mayincur additional losses in future quarters and years. Our revenues may not growand we may never generate sufficient revenues to sustain profitability.

***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 whichmay cause our stock price to fluctuate. Generally, purchases by serviceproviders of telecommunications equipment from manufacturers have beenunpredictable and clustered, rather than steady, as the providers build outtheir networks. The primary factors that may affect our revenues and operatingresults include the following:

·       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.

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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.

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.

***We are entirelydependent upon our voice infrastructure products, and our future revenuesdepend upon their commercial success.***

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 notrespond rapidly to technological changes or 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 or marketingof new products and enhancements. The introduction of new products by ourcompetitors, 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 tocompete successfully, our ability to increase our revenues or return toprofitability will be impaired.***

Competition in thetelecommunications market is intense. This market has historically beendominated by large companies, such as Alcatel, Lucent Technologies, NEC, NortelNetworks, Siemens and Ericsson, all of which are our direct competitors. Wealso face competition from other large telecommunications and networkingcompanies, including Cisco Systems, some of which have entered our market byacquiring companies that design competing products. Alcatel and Lucent haveannounced the merger of the two companies and other competitors may merge,intensifying competition. Additional competitors with significant financialresources also may enter our markets and further intensify competition.

Many of our current and potential competitors havesignificantly greater selling and marketing, technical, manufacturing,financial and other resources. Further, some of our competitors sellsignificant amounts of other products to our current and prospective customersand have the ability to offer lower prices to win business. Our competitors’broad product portfolios, coupled with already existing relationships, may causeour customers to buy our competitors’ products or harm our ability to attractnew customers.

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To competeeffectively, 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.

If we are unable to competesuccessfully against our current and future competitors, we could experienceprice reductions, order cancellations, loss of customers and revenues andreduced gross profit margins.

***Because our products are sophisticated and designed tobe deployed in complex environments, they may have errors or defects that wefind only after full deployment, which could seriously harm our business.***

Our products aresophisticated and are designed to be deployed in large and complex networks.Because of the nature of our products, they can only be fully tested whensubstantially deployed in very large networks with high volumes of traffic.Some of our customers have only recently begun to commercially deploy ourproducts and they may discover errors or defects in the software or hardware,or the products may not operate as expected. As we continue to expand ourdistribution channel through distributors and resellers, we will need to relyon and support their service and support organizations. If we are unable to fixerrors or other performance problems that may be identified after fulldeployment of our products, 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 ourproducts are deployed in large, complex networks around the world, failure toestablish a support infrastructure and maintain required support levels couldseriously harm 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 level throughoutthe world. If we are unable to provide the expected level of support andservice 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.

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

We have made significantchanges in our senior management team, including the hiring of new Vice Presidentsof Engineering and Sales since January 1, 2006. Because of thesesignificant changes, our management team may not be able to work togethereffectively to successfully develop and implement our business strategies andfinancial operations. In addition, management will need to devote significantattention and resources to preserve and strengthen relationships withemployees, customers and the investor community. If our new management team isunable to achieve these goals, our ability to grow our business andsuccessfully meet operational challenges could be impaired.

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

Our business depends uponhighly skilled engineering, sales, marketing and customer support personnel.Any failure to hire or retain needed qualified personnel could impair ourgrowth. Our future success depends upon the continued services of our executiveofficers who have critical industry experience and relationships that we relyon to implement our business plan. None of our officers or key employees isbound by an employment agreement for any specific term. The loss of theservices of any of our officers or key employees could delay the developmentand introduction of, and negatively 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 uponcontract manufacturers and any disruption in these relationships may cause usto fail to meet the demands of our customers and damage our customerrelationships.***

We rely on a small numberof contract manufacturers to manufacture our products according to ourspecifications and to fill orders on a timely basis. Our contract manufacturersprovide comprehensive manufacturing services, including assembly and certaintests of our products and procurement of materials. Each of our contractmanufacturers also builds products for other companies and may not always havesufficient quantities of inventory available to fill our orders or may notallocate their internal resources to fill these orders on a timely basis. We donot have long-term supply contracts with our manufacturers and they are notrequired to manufacture products for any specified period. We do not haveinternal manufacturing capabilities to meet our customers’ demands. Qualifyinga new contract manufacturer and commencing commercial scale production isexpensive and time consuming and could result in a significant interruption inthe supply of our products. If a change in contract manufacturers results indelays in our fulfillment of customer orders or if a contract manufacturerfails to make timely delivery of orders, we may lose revenues and suffer damageto our customer relationships. In2006, we intend to consolidate our manufacturing to a single contractmanufacturer. We also intend to move our contract manufacturing to a lowercost, offshore facility. If we do not manage this consolidation effectively,these consolidation activities could result in the disruption in the supply ofour products and in delays in our fulfillment of customer orders.

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***We and our contract manufacturers 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 contractmanufacturers 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, relianceon our suppliers exposes us to potential supplier production difficulties orquality variations. Our customers rely upon our ability to meet committeddelivery dates, and any disruption in the supply of key components wouldseriously adversely affect our ability to meet these dates and could result inlegal action by our customers, loss of customers or harm our ability to attractnew 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-partylicensed technology into our current products. From time to time, we may berequired to license additional technology from third parties to develop newproducts or product enhancements. Third-party licenses may not beavailable or continue to be available to us on commercially reasonable terms.The inability to maintain or re-license any third-party licenses requiredin our current products or to obtain any new third-party licenses to developnew products and product enhancements could require us to obtain substitutetechnology of lower quality or performance standards or at greater cost, anddelay or prevent us from making these products or enhancements, any of whichcould seriously harm the competitiveness of our products.

***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, whooffer complementary products and services. We rely on these strategic partnersin the timely and successful deployment of our solutions to our customers. Ifthe products provided by these partners have defects or do not operate asexpected or if we do not effectively integrate and support products supplied bythese strategic partners, then we may have difficulty with the deployment ofour solutions that may result in:

·       lossof, or delay in, revenues;

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

·       networkperformance penalties.

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:

·       lossof customers and market share; and

·       a failure to attract newcustomers 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.If competitors are able to use our technology, our ability to competeeffectively could 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.These claims and any resulting licensing arrangement or lawsuit, if successful,could subject 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:

·       stopselling, incorporating or using our products that use the challengedintellectual property;

·       obtainfrom the owner of the infringed intellectual property right a license to sellor use the relevant technology, which license may not be available onreasonable terms, or at all; or

·       redesignthose products that use any allegedly infringing technology.

Any lawsuits regardingintellectual property rights, regardless of their success, would betime-consuming, expensive to resolve and would divert our management’s time andattention.

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

We intend toconsider investing in, or acquiring, complementary products, technologies orbusinesses. In the event of future investments or acquisitions, we could:

·       issuestock that would dilute our current stockholders’ percentage ownership;

·       reducesignificantly our cash and investments;

·       incurdebt or assume liabilities;

·       incursignificant impairment charges related to the write-off of goodwill andpurchased intangible assets;

·       incursignificant amortization expenses related to purchased intangible assets; or

·       incurlarge and immediate write-offs for in-process research and development andstock based compensation.

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

·       problemsand unanticipated costs associated with combining the purchased products,technologies or businesses;

·       diversionof management’s attention from our core business;

·       adverseeffects on existing business relationships with suppliers and customers;

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·       risksassociated with entering markets in which we have limited or no priorexperience;

·       potentialloss of key employees, particularly those of the acquired organizations; and

·       integrationof internal controls 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.

***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 employeeretention, and provide competitive compensation packages. The FinancialAccounting Standards Board has adopted changes that require companies to recorda charge to earnings for employee stock option grants and other equity incentiveseffective January 1, 2006, which we have adopted. By causing us to incursignificantly increased compensation costs, such accounting changes may causeus to reduce the availability and amount of equity incentives provided toemployees, which may make it more difficult for us to attract, retain andmotivate key personnel.

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

***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.We could 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.

***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:

·       fundongoing operations and capital requirements;

·       takeadvantage of opportunities, including more rapid expansion or acquisition ofcomplementary products, technologies or businesses;

·       developnew products; or

·       respondto competitive pressures.

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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.

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

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

·       theaddition or loss of any major customer;

·       consolidationin the telecommunications industry;

·       changesin the financial condition or anticipated capital expenditure purchases of anyexisting or potential major customer;

·       quarterlyvariations in our operating results;

·       changesin financial estimates by securities analysts;

·       speculationin the press or investment community;

·       announcementsby us or our competitors of significant contracts, new products oracquisitions, distribution partnerships, joint ventures or capital commitments;

·       salesof common stock or other securities by us or by our stockholders in the future;

·       securitiesand other litigation;

·       announcementof a stock split, reverse stock split, stock dividend or similar event;

·       economicconditions for the telecommunications, networking and related industries; and

·       worldwide economicinstability.

***Sales of a substantial amount of our common stock inthe future could cause our stock price to fall.***

Some stockholders hold asubstantial number of shares of our common stock that have not yet been sold inthe public market. Sales of a substantial number of shares of our common stockwithin a short period of time in the future could impair our ability to raisecapital through the sale of additional debt or stock and /or cause our stockprice to fall.

***Provisions of our charterdocuments and Delaware law may have anti-takeover effects that could prevent achange of control.***

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

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**Item6: Exhibits**
| Exhibit Number | ** ** | **Description**                                                                                                                      |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(a)             |       | Sublease agreement  between Sonus Networks, Inc. and Teradyne, Inc. dated as of  February 22, 2006.                   |
| 10.2(b)             |       | Summary of 2005  Executive Incentive Compensation Awards.                                                                            |
| 10.3(c)             |       | Employment letter  dated April 10, 2006, by and between the Registrant and James F. Collier.                          |
| 31.1                |       | Certification of  Sonus Networks, Inc. Chief Executive Officer pursuant to  Section 302 of the Sarbanes Oxley Act of 2002. |
| 31.2                |       | Certification of  Sonus Networks, Inc. Chief Financial Officer pursuant to  Section 302 of the Sarbanes Oxley Act of 2002. |
| 32.1                |       | Certification of  Sonus Networks, Inc. Chief Executive Officer pursuant to  Section 906 of the Sarbanes Oxley Act of 2002. |
| 32.2                |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 906 of  the Sarbanes Oxley Act of 2002. |

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(a)           Incorporated byreference from an exhibit to the Registrant’s Form 8-K (File No. 000-30229)filed March 9, 2006 with the SEC.

(b)          Incorporated byreference from Item 1.01 to the Registrant’s Form 8-K (File No. 000-30229)filed March 27, 2006 with the SEC.

(c)           Incorporated byreference from an exhibit to 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, as amended, theRegistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
| Dated: May 8, 2006 | 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)             |       | Sublease agreement between Sonus Networks, Inc.  and Teradyne, Inc. dated as of February 22, 2006.                    |
| 10.2(b)             |       | Summary of 2005  Executive Incentive Compensation Awards.                                                                            |
| 10.3(c)             |       | Employment letter dated  April 10, 2006, by and between the Registrant and James F. Collier.                                    |
| 31.1                |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Section 302 of  the Sarbanes Oxley Act of 2002. |
| 31.2                |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 302 of  the Sarbanes Oxley Act of 2002. |
| 32.1                |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Section 906 of  the Sarbanes Oxley Act of 2002. |
| 32.2                |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 906 of  the Sarbanes Oxley Act of 2002. |

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(a)           Incorporated byreference from an exhibit to the Registrant’s Form 8-K (File No. 000-30229)filed March 9, 2006 with the SEC.

(b)          Incorporated byreference from Item 1.01 to the Registrant’s Form 8-K (File No. 000-30229)filed March 27, 2006 with the SEC.

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

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