**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

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

**Forthe quarterly period ended September 30, 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      |   | (I.R.S. employer     |
| of incorporation  or organization) |   | identification  no.) |

 

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

(Address of principalexecutive offices, including zip code)

**(978) 614-8100**

(Registrant’s telephonenumber, including area code)

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

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

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

Indicate by check mark whetherthe Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer x | Accelerated filer  o | Non-accelerated  filer o |
|---------------------------|----------------------|--------------------------|

 

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

As of July 27, 2007, therewere 257,465,110 shares of the registrant’s common stock, $0.001 par value,outstanding.

 

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**Explanatory Note**

In this Form 10-Q (“Form 10-Q”),we are restating our consolidated financial statements as of December 31,2005 and for the three and nine months ended September 30, 2005. Immediatelyprior to the filing of this Form 10-Q, we filed a Quarterly Reporton Form 10-Q for the quarter ended June 30, 2006. Immediatelyfollowing the filing of this Form 10-Q, we filed an Annual Report onForm 10-K for the year ended December 31, 2006 (“Form 10-K”)and a Quarterly Report on Form 10-Q for the quarter ended March 31,2007. In our Form 10-K, we are restating our consolidated financialstatements as of December 31, 2005 and for each of the years ended December 31,2005 and 2004 and each of the quarters in 2005 and the three months ended March 31,2006, which are included in “Financial Statements and Supplementary Data” inItem 8.

Previously filed annual reports on Form 10-Kand quarterly reports on Form 10-Q affected by the restatements havenot been amended and should not be relied on.

The restatement of ourconsolidated financial statements reflects:

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

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

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

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

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

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

·       Our stockgranting and administration practices lacked adequate controls, processes anddocumentation during the period from May 2000, the date of our initialpublic offering, through December 2003;

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

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

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

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

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

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

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

*May 2000 IPOThrough Late 2004*

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

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

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

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

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*Late 2004 ThroughCurrent*

In response to a restatement of our consolidatedfinancial statements completed in July 2004, material weaknessesidentified in our internal control over financial reporting and the hiring ofnew members of senior management, including a new CFO in January 2005, wecommenced in late 2004 and continuing into 2006 implementing a number ofimprovements to our stock option granting practices and controls. Notwithstanding these improvements, we continuedto have issues with inadequate documentation and processes resulting in revisedmeasurement dates for certain grants through 2005.

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

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

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

*Measurement DateMethodology*

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

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

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

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

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

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

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

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

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

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

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

We acknowledge that many of our measurement dateconclusions are dependent on the facts and circumstances of each stock optiongrant and involved the application of significant management judgment. Becausethe revised measurement date may not be the actual measurement date, weperformed several analyses to compare the results of selecting measurementdates based upon the above described methodology to what would have resultedunder different methodologies. In the first analysis, we considered that themeasurement dates for all the stock option grants would be the last date thelast required action for grants had taken place. In this analysis, themeasurement date would be the date approved at the Board or CompensationCommittee meeting, the date of last receipt of the unanimous written consentor, if there was no evidence as to the receipt of the last signature, the dateof the next board-level meeting at which the two members of the Compensation Committeewere present following the preparation of a final list of grantees. Had weapplied this alternate approach, the new measurement dates would have resultedin approximately $0.2 million less in cumulative stock-based compensationcharges being recorded from 2000 through 2005.

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

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

 

The additional (less) cumulative stock-basedcompensation by year from 2000 through 2005 under categories two, three andfour of our framework based upon the low, average and high closing pricesduring those periods is as follows (in millions):

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

 

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

 

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

 

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

*Tax-RelatedAdjustments*

*Withholding Taxes*

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

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*Section 409A*

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

In the fourth quarter of 2006, we decided to reimburseour employees and former employees the additional taxes arising underSection 409A due to the exercise of certain discounted stock options in2006. As a result, we recorded expenses of approximately $0.9 million in 2006.Of this amount, $0.4 million relates to employees and former employees who aresubject to the disclosure requirements under Section 16 of the SecuritiesExchange Act of 1934 and $0.5 million relates to all other employees and formeremployees (the “qualifying employees”). In February 2007, the InternalRevenue Service (“IRS”) published guidance allowing companies to voluntarilypay the IRS directly on their employees’ behalf any Section 409A taxes andinterest by June 30, 2007. We notified the IRS of our intention to participatein this program and, accordingly, in June 2007 we paid $0.5 million to theapplicable federal and state tax agencies on behalf of the qualifyingemployees.

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

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

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

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*Income Taxes*

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

*Other Adjustments*

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

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**SONUS NETWORKS,INC.FORM 10-QQUARTER ENDED SEPTEMBER 30, 2006**TABLEOF CONTENTS

|                                        | ** **                                                                                                                                       | ** ** | **Page** |
|----------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I  FINANCIAL INFORMATION** |                                                                                                                                             |       |
| Item 1.                                | Financial  Statements                                                                                                                            |       |     |   |
|                                   | Condensed  Consolidated Balance Sheets as of September 30, 2006 and  December 31, 2005 (as restated) (unaudited)                       |       | 10       |   |
|                                   | Condensed  Consolidated Statements of Operations for the Three and Nine Months Ended  September 30, 2006 and 2005 (as restated) (unaudited) |       | 11       |   |
|                                   | Condensed  Consolidated Statements of Cash Flows for the Nine Months Ended  September 30, 2006 and 2005 (as restated) (unaudited)           |       | 12       |   |
|                                   | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                                |       | 13       |   |
| Item 2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                      |       | 40       |   |
| Item 3.                                | Quantitative  and Qualitative Disclosures About Market Risk                                                                                      |       | 54       |   |
| Item 4.                                | Controls  and Procedures                                                                                                                         |       | 54       |   |
| **PART II OTHER INFORMATION**     |                                                                                                                                             |       |     |
| Item 1.                                | Legal  Proceedings                                                                                                                               |       | 58       |   |
| Item 1A.                               | Risk Factors                                                                                                                                     |       | 61       |   |
| Item 6.                                | Exhibits                                                                                                                                         |       | 76       |   |
|                                   | Signatures                                                                                                                                       |       | 77       |   |
|                                   | Exhibit Index                                                                                                                               |       | 78       |   |

 

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**PART I—FINANCIALINFORMATION**

**Item1.**                        FinancialStatements

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

| ** **                                                                                                                                                                                                                         | ** ** | **September 30,** | ** ** | **December 31,**     | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                                                                                                                                                                                                                         | ** ** | **2006**               | ** ** | **2005**                  | ** ** |
| ** **                                                                                                                                                                                                                         | ** ** | ** **             | ** ** | **(As Restated,**    | ** ** |
| ** **                                                                                                                                                                                                                         | ** ** | ** **             | ** ** | **See Note 2)** | ** ** |
| **Assets**                                                                                                                                                                                                                         |       |                   |       |                      |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                    |       |                   |       |                      |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                          |       |                   | $          | 62,592                    |       |   |   | $ | 155,679 |   |   |
| Marketable debt securities                                                                                                                                                                                                         |       |                   | 219,187    |                      |       |   | 140,569 |   |   |
| Accounts receivable, net                                                                                                                                                                                                           |       |                   | 48,681     |                      |       |   | 72,261 |   |   |
| Inventory, net                                                                                                                                                                                                                     |       |                   | 26,053     |                      |       |   | 37,700 |   |   |
| Deferred income taxes                                                                                                                                                                                                              |       |                   | —     |                      |       |   | 519 |   |   |
| Other current assets                                                                                                                                                                                                               |       |                   | 15,043     |                      |       |   | 14,411 |   |   |
| Total current assets                                                                                                                                                                                                               |       |                   | 371,556    |                      |       |   | 421,139 |   |   |
| Property and equipment, net                                                                                                                                                                                                        |       |                   | 15,852     |                      |       |   | 15,331 |   |   |
| Long-term investments                                                                                                                                                                                                              |       |                   | 64,322     |                      |       |   | 17,993 |   |   |
| Deferred income taxes                                                                                                                                                                                                              |       |                   | 802        |                      |       |   | 802 |   |   |
| Other assets                                                                                                                                                                                                                       |       |                   | 6,471      |                      |       |   | 1,941 |   |   |
|                                                                                                                                                                                                                               |       |                   | $          | 459,003                   |       |   |   | $ | 457,206 |   |   |
| **Liabilities  and stockholders’ equity**                                                                                                                                                                                     |       |                   |       |                      |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                               |       |                   |       |                      |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                   |       |                   | $          | 10,296                    |       |   |   | $ | 20,375 |   |   |
| Accrued expenses                                                                                                                                                                                                                   |       |                   | 22,646     |                      |       |   | 24,081 |   |   |
| Accrued restructuring expenses                                                                                                                                                                                                     |       |                   | —     |                      |       |   | 195 |   |   |
| Current portion of deferred revenue                                                                                                                                                                                                |       |                   | 57,906     |                      |       |   | 88,336 |   |   |
| Convertible subordinated note                                                                                                                                                                                                      |       |                   | —     |                      |       |   | 10,000 |   |   |
| Current portion of long-term liabilities                                                                                                                                                                                           |       |                   | 300        |                      |       |   | 105 |   |   |
| Total current liabilities                                                                                                                                                                                                          |       |                   | 91,148     |                      |       |   | 143,092 |   |   |
| Long-term deferred revenue                                                                                                                                                                                                         |       |                   | 23,573     |                      |       |   | 33,853 |   |   |
| Long-term liabilities, net of current portion                                                                                                                                                                                      |       |                   | 979        |                      |       |   | 1,449 |   |   |
| Total liabilities                                                                                                                                                                                                                  |       |                   | 115,700    |                      |       |   | 178,394 |   |   |
| Commitments and  contingencies (Note 5)                                                                                                                                                                                            |       |                   |       |                      |       |   |   |   |   |
| Stockholders  equity:                                                                                                                                                                                                              |       |                   |       |                      |       |   |   |   |   |
| Preferred stock, $0.01 par value; 5,000,000 shares  authorized, none issued  and outstanding                                                                                                                                       |       |                   | —     |                      |       |   | — |   |   |
| Common stock, $0.001 par value; 600,000,000 shares  authorized, 259,005,207 and 251,730,706 shares issued and 256,708,297 and  249,433,796 shares outstanding at September 30, 2006 and December 31,  2005, respectively |       |                   | 259        |                      |       |   | 252 |   |   |
| Additional paid-in capital                                                                                                                                                                                                         |       |                   | 1,145,376  |                      |       |   | 1,110,057 |   |   |
| Deferred compensation                                                                                                                                                                                                              |       |                   | —     |                      |       |   | (99 | ) |   |
| Accumulated deficit                                                                                                                                                                                                                |       |                   | (801,987   | )                         |       |   | (831,087 | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                                                               |       |                   | (78        | )                         |       |   | (44 | ) |   |
| Treasury stock, at cost; 2,296,910 common shares at  September 30, 2006 and December 31, 2005                                                                                                                       |       |                   | (267       | )                         |       |   | (267 | ) |   |
| Total stockholders’ equity                                                                                                                                                                                                    |       |                   | 343,303    |                      |       |   | 278,812 |   |   |
|                                                                                                                                                                                                                               |       |                   | $          | 459,003                   |       |   |   | $ | 457,206 |   |   |

 

See notes to the condensed consolidated financial statements.

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

| ** **                                             | ** ** | **Three months ended    September 30,** | ** ** | **Nine months ended    September 30,** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                                         | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | ** **                                                       | ** ** | **(As Restated,**                                          | ** ** | ** ** | ** ** | **(As Restated,** | ** ** |
| ** **                                             | ** ** | ** **                                                       | ** ** | **See Note 2)**                                       | ** ** | ** ** | ** ** | **See Note 2)** | ** ** |
| Revenue:                                               |       |                                                             |       |                                                            |       |   |   |   |   |   |   |   |   |
| Product                                                |       | $                                                                | 53,485     |                                                            |       | $ | 29,384 |   |   | $ | 146,880 |   |   | $ | 93,134 |   |   |
| Service                                                |       | 22,524                                                           |       |                                                            | 16,596     |   |   | 53,604 |   |   | 44,157 |   |   |
| Total revenue                                          |       | 76,009                                                           |       |                                                            | 45,980     |   |   | 200,484 |   |   | 137,291 |   |   |
| Cost of revenue:                                       |       |                                                             |       |                                                            |       |   |   |   |   |   |   |   |   |
| Product                                                |       | 18,612                                                           |       |                                                            | 17,601     |   |   | 50,694 |   |   | 39,292 |   |   |
| Service                                                |       | 7,571                                                            |       |                                                            | 6,375      |   |   | 21,287 |   |   | 17,400 |   |   |
| Total cost of revenue                                  |       | 26,183                                                           |       |                                                            | 23,976     |   |   | 71,981 |   |   | 56,692 |   |   |
| Gross profit                                           |       | 49,826                                                           |       |                                                            | 22,004     |   |   | 128,503 |   |   | 80,599 |   |   |
| Operating  expenses:                                   |       |                                                             |       |                                                            |       |   |   |   |   |   |   |   |   |
| Research and development                               |       | 13,165                                                           |       |                                                            | 11,930     |   |   | 39,141 |   |   | 34,541 |   |   |
| Sales and marketing                                    |       | 16,959                                                           |       |                                                            | 10,940     |   |   | 46,630 |   |   | 32,159 |   |   |
| General and administrative                             |       | 8,213                                                            |       |                                                            | 6,163      |   |   | 22,441 |   |   | 19,900 |   |   |
| Total operating expenses                               |       | 38,337                                                           |       |                                                            | 29,033     |   |   | 108,212 |   |   | 86,600 |   |   |
| Income (loss) from operations                          |       | 11,489                                                           |       |                                                            | (7,029     | ) |   | 20,291 |   |   | (6,001 | ) |   |
| Interest expense                                       |       | (11                                                              | )          |                                                            | (121       | ) |   | (229 | ) |   | (378 | ) |   |
| Interest income                                        |       | 4,058                                                            |       |                                                            | 2,690      |   |   | 11,399 |   |   | 6,787 |   |   |
| Income (loss) before income taxes                      |       | 15,536                                                           |       |                                                            | (4,460     | ) |   | 31,461 |   |   | 408 |   |   |
| Income tax  benefit (provision)                        |       | (1,166                                                           | )          |                                                            | 640        |   |   | (2,361 | ) |   | 233 |   |   |
| Net income (loss)                                      |       | $                                                                | 14,370     |                                                            |       | $ | (3,820 | ) |   | $ | 29,100 |   |   | $ | 641 |   |   |
| Net income (loss)  per share:                          |       |                                                             |       |                                                            |       |   |   |   |   |   |   |   |   |
| Basic                                                  |       | $                                                                | 0.06       |                                                            |       | $ | (0.02 | ) |   | $ | 0.12 |   |   | $ | — |   |   |
| Diluted                                                |       | $                                                                | 0.06       |                                                            |       | $ | (0.02 | ) |   | $ |  0.11 |   |   | $ | — |   |   |
| Shares used in  computing net income (loss) per share: |       |                                                             |       |                                                            |       |   |   |   |   |   |   |   |   |
| Basic                                                  |       | 254,102                                                          |       |                                                            | 248,801    |   |   | 252,291 |   |   | 248,312 |   |   |
| Diluted                                                |       | 257,158                                                          |       |                                                            | 248,801    |   |   | 255,992 |   |   | 252,981 |   |   |

 

See notes to the condensed consolidated financial statements.

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

| ** **                                                                           | ** ** | **Nine months ended** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                           | ** ** | **September 30,**          | ** ** |
| ** **                                                                           | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| ** **                                                                           | ** ** | ** **                      | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Cash flows from operating  activities:                                               |       |                            |       |   |   |   |   |
| Net income                                                                           |       | $                               | 29,100     |   |   | $ | 641 |   |   |
| Adjustments to  reconcile net income to cash flows provided by operating activities: |       |                            |       |   |   |   |   |
| Depreciation and amortization of property and  equipment                             |       | 7,363                           |       |   | 5,189 |   |   |
| Stock-based compensation                                                             |       | 7,480                           |       |   | 1,933 |   |   |
| Deferred income taxes                                                                |       | 519                             |       |   | — |   |   |
| Loss on disposal of property and equipment                                           |       | 7                               |       |   | — |   |   |
| Changes in  operating assets and liabilities:                                        |       |                            |       |   |   |   |   |
| Accounts receivable                                                                  |       | 23,463                          |       |   | (7,558 | ) |   |
| Inventory                                                                            |       | 12,125                          |       |   | (2,044 | ) |   |
| Other operating assets                                                               |       | (5,255                          | )          |   | (2,013 | ) |   |
| Accounts payable                                                                     |       | (10,069                         | )          |   | 4,043 |   |   |
| Accrued expenses, deferred rent and accrued  restructuring expenses                  |       | (1,507                          | )          |   | (3,080 | ) |   |
| Long-term obligations                                                                |       | (418                            | )          |   | — |   |   |
| Deferred revenue                                                                     |       | (41,208                         | )          |   | 20,229 |   |   |
| Net cash provided by operating activities                                            |       | 21,600                          |       |   | 17,340 |   |   |
| Cash flows from  investing activities:                                               |       |                            |       |   |   |   |   |
| Purchases of property and equipment                                                  |       | (7,872                          | )          |   | (11,186 | ) |   |
| Maturities of available-for-sale marketable debt  securities                         |       | 103,814                         |       |   | 146,400 |   |   |
| Purchases of available-for-sale marketable debt  securities                          |       | (38,290                         | )          |   | (151,660 | ) |   |
| Maturities of held-to-maturity marketable debt  securities and long-term investments |       | 118,464                         |       |   | 38,316 |   |   |
| Purchases of held-to-maturity marketable debt  securities and long-term investments  |       | (308,934                        | )          |   | (31,980 | ) |   |
| Decrease in restricted cash                                                          |       | 250                             |       |   | 500 |   |   |
| Decrease in other assets                                                             |       | —                          |       |   | (97 | ) |   |
| Net cash used in investing activities                                                |       | (132,568                        | )          |   | (9,707 | ) |   |
| Cash flows from financing activities:                                                |       |                            |       |   |   |   |   |
| Sale of common stock in connection with employee  stock purchase plan                |       | 4,764                           |       |   | 4,516 |   |   |
| Proceeds from exercise of stock options                                              |       | 23,155                          |       |   | 1,877 |   |   |
| Principal payments of capital lease obligations                                      |       | (36                             | )          |   | (76 | ) |   |
| Repayment of convertible subordinated note                                           |       | (10,000                         | )          |   | — |   |   |
| Net cash provided by financing activities                                            |       | 17,883                          |       |   | 6,317 |   |   |
| Effect of exchange rate changes on cash and cash  equivalents                        |       | (2                              | )          |   | — |   |   |
| Net increase (decrease) in cash and cash equivalents                                 |       | (93,087                         | )          |   | 13,950 |   |   |
| Cash and cash  equivalents, beginning of period                                      |       | 155,679                         |       |   | 120,839 |   |   |
| Cash and cash  equivalents, end of period                                            |       | $                               | 62,592     |   |   | $ | 134,789 |   |   |
| Supplemental disclosure of cash flow information:                                    |       |                            |       |   |   |   |   |
| Interest paid                                                                        |       | $                               | 213        |   |   | $ | 244 |   |   |
| Income taxes paid                                                                    |       | $                               | 2,023      |   |   | $ | 713 |   |   |
| Income tax refunds received                                                          |       | $                               | —     |   |   | $ | 454 |   |   |
| Supplemental  disclosure of non-cash investing activities:                           |       |                            |       |   |   |   |   |
| Non-cash purchases of property and equipment                                         |       | $                               | 1,037      |   |   | $ | 1,543 |   |   |
| Property and equipment acquired as part of a facility  lease                         |       | $                               | 50         |   |   | $ | 500 |   |   |
| Property and  equipment acquired under capital lease                                 |       | $                               | —     |   |   | $ | 163 |   |   |

 

See notes to the condensed consolidated financial statements.

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

**(1)**          Descriptionof Business

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

**(2)**          Restatement ofConsolidated Financial Statements

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

As a result of the Audit Committee Investigation, theCompany performed a review of stock option grant measurement dates recorded forfinancial reporting purposes. The Company determined that during the periodfrom May 2000 through December 31, 2005, the Company i) appliedincorrect measurement dates in the accounting for certain stock options and ii)incorrectly accounted for certain stock options that should have been recordedusing  variable accounting. Accordingly,the Company has restated its accumulated deficit as of January 1, 2005 andits consolidated financial statements for the three and nine months ended September 30,2005 to record additional stock-based compensation to correctly account for itsstock options and related tax adjustments. The Company has also corrected otherpreviously unrecorded misstatements not related to the accounting for stock optionspreviously deemed to be immaterial.

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Thefollowing table reconciles net income (loss) and accumulated deficit aspreviously reported to the restated amounts (in thousands):

| ** **                                                                              | ** ** | **Net Income (Loss)**                        | ** ** | ** **                                            | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** | **Accumulated  Deficit as of  January 1,  2005** | ** ** |
| As previously  reported                                                                 |       |                                                   | $          | (2,704                                                | )          |   |   | $ | 3,346 |   |   |   | $ | (784,085 | ) |   |
| Changes in net income  (loss) and accumulated deficit                                   |       |                                                   |       |                                                  |       |   |   |   |   |   |   |   |   |
| Stock-based compensation adjustments related to  revised measurement dates              |       |                                                   | (417       | )                                                     |       |   | (1,887 | ) |   |   | (49,156 | ) |   |
| Stock-based compensation adjustments related to the  application of variable accounting |       |                                                   | (126       | )                                                     |       |   | (31 | ) |   |   | (1,370 | ) |   |
| Withholding tax adjustments                                                             |       |                                                   | (68        | )                                                     |       |   | (194 | ) |   |   | (755 | ) |   |
| Other adjustments                                                                       |       |                                                   | (505       | )                                                     |       |   | (593 | ) |   |   | (1,389 | ) |   |
| Income taxes                                                                            |       |                                                   | —     |                                                  |       |   | — |   |   |   | 883 |   |   |
| Total change in  net income (loss) and accumulated deficit                              |       |                                                   | (1,116     | )                                                     |       |   | (2,705 | ) |   |   | (51,787 | ) |   |
| As restated                                                                             |       |                                                   | $          | (3,820                                                | )          |   |   | $ | 641 |   |   |   | $ | (835,872 | ) |   |

 

*Stock-BasedCompensation Adjustments Related to Revised Measurement Dates*

In light of the findings of the Audit CommitteeInvestigation, the Company assessed the measurement dates for all of theCompany’s historical stock option grants and reviewed all available evidencefor each option grant. Based on the available facts and circumstancessurrounding the Company’s stock option granting practices, the Company adopteda methodology for determining the most likely measurement dates. The Companybelieves the application of this methodology indicated the date where thenumber of options granted to each recipient and the exercise price are knownwith finality. In determining the most likely measurement date, the Companyconsidered evidence such as the date of the completion of the granting process,clear communication to the recipients of the principal terms of the award, andthe date by which the grant was substantially entered into the Company’s stockadministration system.

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

Evidence of clear communication between the Companyand the recipients regarding a grant prior to the final granting action includesemail or oral communication of the grant date and exercise price to the entirerecipient population followed thereafter by individual communications regardingthe principal terms of the grant, offer letters stating the principal terms ofthe grant or a Form 3 or Form 4 filed with the SEC. The Companybelieves it is appropriate to rely on clear communication as evidence offinality because the Company’s past practice was to communicate terms of grantsto employees only when they were final and approved by those with authority.The Company viewed the communication as giving rise to a legal obligation tohonor the grants.

14

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

(1)         Ifthe stock option grant was approved at a Board-level meeting, the datereflected in meeting minutes of the Company’s Board of Directors or CompensationCommittee of the Board of Directors where the number of options for eachrecipient and the exercise price for the grant has been clearly approved wasdetermined to be the most likely measurement date. Measurement dates forapproximately 35% of the total number of grants were determined based on thismethod.

(2)         Ifthe stock option grant was approved by UWC, the date of communication of theprincipal terms of the grant to the recipients if prior to the signature dateon the UWC was determined to be the most likely measurement date. Measurementdates for approximately 42% of the total number of grants were determined basedon this method.

(3)         Ifthe stock option grant was approved by UWC and the Company did not have clearprior evidence of the date the principal terms of the grant were communicatedto the recipients, the date of receipt of the last signature for the UWCprovided there was clear evidence of the date the last signature was receivedwas determined to be the most likely measurement date. Measurement dates forapproximately 2% of the total number of grants were determined based on thismethod.

(4)         Ifthe stock option grant was approved by UWC and the Company did not have clearevidence of the date the principal terms of the grant were communicated to therecipients or the date of receipt of the last signature on the UWC, the Companyreviewed all other available evidence and used its judgment to determine themost likely measurement date. The additional available evidence included, butwas not limited to:

a.                  thenext date that the two Compensation Committee members were physically presentat a Board-level meeting where the UWC may have been signed and the meetingoccurred within a reasonable time period; and

b.                 thedate by which at least 90% of the stock option grant was entered into theCompany’s stock option administration system.

Measurement dates forapproximately 6% of the total number of grants were determined based on thenext date that the two Compensation Committee members were physically presentat a Board-level meeting and approximately 15% when at least 90% of the stockoption grant was entered into the Company’s stock option administration system.

After selecting ameasurement date through one of the four steps in the above framework, theCompany then determined if there were any changes to the individual grantrecipients or amount of options granted after the selected measurement date. Ifthere were no changes following the selected measurement date, then themeasurement date would remain unchanged. If the Company identified changesfollowing the selected measurement date, then the Company would evaluatewhether the changes should delay the measurement date for the entire list ofgrants until the list became final or whether the changes should result inseparate accounting for specific grants. Factors considered in evaluatingwhether it would be appropriate to delay the measurement date until the listwas final included: 1) the frequency of any changes as well as the reason forany changes; 2) whether the changes were administrative in nature (correctionsof errors for grants to which recipients would have been otherwise entitled);and 3) whether the changes reflected re-allocation of options among a broaderrange of recipients.

In applying thisframework, the Company revised the measurement dates for many grants whichresulted in exercise prices that were less than the fair market value of thestock on the revised 

15

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measurementdates. This outcome results in a stock-based compensation charge in accordancewith APB 25. Adjustments related to revised measurement dates resulted inthe Company recognizing additional stock-based compensation expense from 2000through 2005 of approximately $52.9 million. The additionalstock-based compensation for the three and nine months ended September 30,2005 was $0.4 million and $1.9 million, respectively.

*Stock-Based Compensation Adjustment Related to theApplication of Variable Accounting*

In 1999, tax regulationsbecame effective in the United Kingdom (“UK”) that required employers to remita 12% UK National Insurance Contribution (“NIC”) tax on gains resulting fromthe exercise of stock options held by UK citizens. In 2000, the UK passedregulations that allowed an employer to either (a) transfer its NIC tax liabilityto an employee or (b) be reimbursed by an employee for NIC paymentsincurred by an employer for options granted after April 1999. If a companydecided to transfer its NIC tax liability to an employee, a company wasrequired to obtain approval of the use of a standard election form from UKInland Revenue, which would then be signed by each employee.

Subsequent to theenactment of the new NIC regulations in 1999, the Company granted stock optionsto its UK employees. The Company entered into agreements whereby the employeewould be required to reimburse the Company for the taxes. Under the guidance ofIssue 15 of Emerging Issues Task Force (“EITF”) Issue No. 00-23, *Issues Related to the Accounting for Stock Compensation under APBOpinion No. 25 and FASB Interpretation No. 44,* variableaccounting is required for stock option grants when a cash payment contingentupon exercise is not fixed. Accordingly, an employee obligation to reimbursethe employer for the amount of NIC taxes triggered by an exercise causes avariable exercise price for the grant, and thus, the options issued to UKemployees resulted in the Company recording additional stock-based compensationexpense from 2000 through 2005 totaling approximately $1.2 million. The effecton stock-based compensation for the three months ended September 30, 2005was an increase to stock-based compensation of $126,000 and the effect onstock-based compensation for the nine months ended September 30, 2005 wasan increase to stock-based compensation of $31,000.

*Tax-Related Adjustments*

*Withholding Taxes*

In addition to the abovestock-based compensation charges, the Company has also recorded tax-relatedexpense related to the Company’s stock option grants. The Company hasdetermined that stock options previously classified as incentive stock options(“ISO”) no longer meet the criteria for ISO status since they were issued inthe money on the revised measurement date. The disqualification of ISO statusresulted in the failure to withhold certain employee income and payroll taxesand, consequently, the Company has recorded an additional expense, along withpenalties and interest, in the periods of exercise. Withholding tax adjustmentsrelated to the disqualification of the ISO status of stock options totaledapproximately $1.0 million from 2001 through 2005 and $0.1 million  and $0.2 million for the three and ninemonths ended September 30, 2005, respectively.

*Section 409A*

Under Section 409A ofthe Internal Revenue Code (“Section 409A”) individuals who received optiongrants with an exercise price below the fair market value of the underlyingstock at the revised measurement date will be subject to additional taxes andinterest with respect to options that vest after December 31, 2004. Holdersof these stock options will be required to recognize ordinary income atvesting. Pursuant to the interim Internal Revenue Service guidance, the incomeis calculated as the difference between the fair market value of the underlyingstock and the exercise price as of December 31 of the year of vesting. Theindividual must also recognize, in each subsequent year until the option isfully exercised or expires, ordinary income equal to the excess of the fairmarket value of the underlying stock 

16

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over thesum of the exercise price and any previously recorded income. In addition toordinary income and employment taxes, an additional 20% penalty tax on theresulting ordinary income is levied on the individual, plus interest on any taxto be paid.

In the fourth quarter of2006, the Company decided to reimburse its employees and former employees theadditional taxes arising under Section 409A due to the exercise of certaindiscounted stock options in 2006. As a result, the Company recorded expenses ofapproximately $0.9 million in 2006. Of this amount, $0.4 million relates toemployees and former employees who are subject to the disclosure requirementsunder Section 16 of the Securities Exchange Act of 1934 and $0.5 millionrelates to all other employees and former employees (the “qualifyingemployees”). In February 2007, the Internal Revenue Service (“IRS”)published guidance allowing companies to voluntarily pay the IRS directly ontheir employees’ behalf any Section 409A taxes and interest byJune 30, 2007. Sonus notified the IRS of its intention to participate inthis program and, accordingly, in June 2007 the Company paid $0.5 millionto the applicable federal and state tax agencies on behalf of the qualifyingemployees.

In order to remedy theunfavorable personal tax consequences for those who have not exercised stockoptions  subject to Section 409A,the Company intends to provide holders of these options the opportunity toamend their affected options. In December 2006, the Company entered intoagreements with its directors and officers under which the Company will amendany affected stock options to increase the exercise price to the quoted marketprice on the revised measurement date and either provide cash payment in 2008or issue restricted stock in 2007, at the Company’s discretion, to the optionholder based on the difference in exercise price between the revisedmeasurement date and original grant date. In February 2007, the Companydetermined it would provide a cash payment or restricted stock for the changein exercise price for the directors and officers. Certain directors andofficers agreed to waive such cash payment or restricted stock from the Companyfor the difference in exercise price of certain affected stock options. TheCompany’s agreement with its directors and executives resulted in additionalstock-based compensation expense of approximately $16,000 in the Company’sconsolidated financial statements in the fourth quarter of 2006 and will resultin additional stock-based compensation expense of approximately $1.2 million inthe three months ended March 31, 2007.

For all other currentemployees, the Company is working on a program that it expects to announcefollowing the filing of this Form 10-Q that will make the employees wholeand should eliminate the Section 409A taxes associated with the affectedstock options that have not yet been exercised. The modification of the stockoptions held by other current employees will result in additional stock-basedcompensation being recorded, commencing when the program is completed. TheCompany estimates the maximum aggregate cash payments to option holders underthe program to be approximately $3.7 million.

*Income Taxes*

As a result of the changesin the tax law in the UK in 2003, the Company should have recorded a deferredincome tax benefit related to the stock-based compensation for options issuedto its UK employees. As part of this restatement, the Company has recordedincome tax benefits of $10,000 and $5,000 for fiscal 2004 and 2005, respectively.In addition, the Company recorded $693,000 as an adjustment to its January 1,2004 beginning Accumulated Deficit balance related to fiscal 2003. In additionto the change related to the UK, the components of the Company’s deferredincome tax assets and valuation allowance have changed, but resulted in nosignificant net impact to the carrying value of the assets.

*Other Adjustments*

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

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***Statement of Operations Adjustments***

Thefollowing tables reconcile the amounts previously reported in the Company’sconsolidated statements of operations for the three and nine months ended September 30,2005 to the corresponding restated amounts, which reflect the restatementadjustments previously described (in thousands, except per share data):

| ** **                                                         | ** ** | ** **             | ** ** | **Stock-based**           | ** ** | ** **      | ** ** | ** **      | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|---------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                         | ** ** | ** **             | ** ** | **Compensation and** | ** ** | ** **      | ** ** | ** **      | ** ** |
| ** **                                                         | ** ** | **As Previously** | ** ** | **Tax-Related**           | ** ** | **Other**       | ** ** | ** **      | ** ** |
| **Three Months Ended September 30, 2005** | ** ** | ** **             | ** ** | **Reported**              | ** ** | **Adjustments** | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
| Revenue:                                                           |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Product                                                            |       |                   | $          | 29,107                    |       |            |       | $               | —     |   |   |   | $ | 277 |   |   |   | $ | 29,384 |   |   |
| Service                                                            |       |                   | 16,550     |                      |       |            | —     |            |       |   | 46 |   |   |   | 16,596 |   |   |
| Total revenue                                                      |       |                   | 45,657     |                      |       |            | —     |            |       |   | 323 |   |   |   | 45,980 |   |   |
| Cost of revenue:                                                   |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Product                                                            |       |                   | 17,410     |                      |       |            | 8          |            |       |   | 183 |   |   |   | 17,601 |   |   |
| Service                                                            |       |                   | 6,073      |                      |       |            | 83         |            |       |   | 219 |   |   |   | 6,375 |   |   |
| Total cost of revenue                                              |       |                   | 23,483     |                      |       |            | 91         |            |       |   | 402 |   |   |   | 23,976 |   |   |
| Gross profit                                                       |       |                   | 22,174     |                      |       |            | (91        | )               |       |   | (79 | ) |   |   | 22,004 |   |   |
| Operating  expenses:                                               |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Research and development                                           |       |                   | 11,787     |                      |       |            | 189        |            |       |   | (46 | ) |   |   | 11,930 |   |   |
| Sales and marketing                                                |       |                   | 10,845     |                      |       |            | 274        |            |       |   | (179 | ) |   |   | 10,940 |   |   |
| General and administrative                                         |       |                   | 5,455      |                      |       |            | 57         |            |       |   | 651 |   |   |   | 6,163 |   |   |
| Total operating expenses                                           |       |                   | 28,087     |                      |       |            | 520        |            |       |   | 426 |   |   |   | 29,033 |   |   |
| Loss from operations                                               |       |                   | (5,913     | )                         |       |            | (611       | )               |       |   | (505 | ) |   |   | (7,029 | ) |   |
| Interest expense                                                   |       |                   | (121       | )                         |       |            | —     |            |       |   | — |   |   |   | (121 | ) |   |
| Interest income                                                    |       |                   | 2,690      |                      |       |            | —     |            |       |   | — |   |   |   | 2,690 |   |   |
| Loss before income taxes                                           |       |                   | (3,344     | )                         |       |            | (611       | )               |       |   | (505 | ) |   |   | (4,460 | ) |   |
| Income tax benefit                                                 |       |                   | 640        |                      |       |            | —     |            |       |   | — |   |   |   | 640 |   |   |
| Net loss                                                           |       |                   | $          | (2,704                    | )          |            |       | $               | (611       | ) |   |   | $ | (505 | ) |   |   | $ | (3,820 | ) |   |
| Net loss per  share:                                               |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Basic and diluted                                                  |       |                   | $          | (0.01                     | )          |            |       | $               | (0.01      | ) |   |   | $ | — |   |   |   | $ | (0.02 | ) |   |
| Shares used in computing net loss per share:                       |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Basic                                                              |       |                   | 248,801    |                      |       |            | —     |            |       |   | — |   |   |   | 248,801 |   |   |
| Diluted                                                            |       |                   | 248,801    |                      |       |            | —     |            |       |   | — |   |   |   | 248,801 |   |   |
|                                                                    |            |                        |            |                           |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

18

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| ** **                                                        | ** ** | ** **             | ** ** | **Stock-based**           | ** ** | ** **      | ** ** | ** **      | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|---------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                        | ** ** | ** **             | ** ** | **Compensation and** | ** ** | ** **      | ** ** | ** **      | ** ** |
| ** **                                                        | ** ** | **As Previously** | ** ** | **Tax-Related**           | ** ** | **Other**       | ** ** | ** **      | ** ** |
| **Nine Months Ended September 30, 2005** | ** ** | ** **             | ** ** | **Reported**              | ** ** | **Adjustments** | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
| Revenue:                                                          |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Product                                                           |       |                   | $          | 92,904                    |       |            |       | $               | —     |   |   |   | $ | 230 |   |   |   | $ | 93,134 |   |   |
| Service                                                           |       |                   | 44,456     |                      |       |            | —     |            |       |   | (299 | ) |   |   | 44,157 |   |   |
| Total revenue                                                     |       |                   | 137,360    |                      |       |            | —     |            |       |   | (69 | ) |   |   | 137,291 |   |   |
| Cost of revenue:                                                  |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Product                                                           |       |                   | 39,657     |                      |       |            | 24         |            |       |   | (389 | ) |   |   | 39,292 |   |   |
| Service                                                           |       |                   | 16,993     |                      |       |            | 237        |            |       |   | 170 |   |   |   | 17,400 |   |   |
| Total cost of revenue                                             |       |                   | 56,650     |                      |       |            | 261        |            |       |   | (219 | ) |   |   | 56,692 |   |   |
| Gross profit                                                      |       |                   | 80,710     |                      |       |            | (261       | )               |       |   | 150 |   |   |   | 80,599 |   |   |
| Operating expenses:                                               |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Research and development                                          |       |                   | 33,902     |                      |       |            | 631        |            |       |   | 8 |   |   |   | 34,541 |   |   |
| Sales and marketing                                               |       |                   | 31,380     |                      |       |            | 830        |            |       |   | (51 | ) |   |   | 32,159 |   |   |
| General and administrative                                        |       |                   | 18,732     |                      |       |            | 390        |            |       |   | 778 |   |   |   | 19,900 |   |   |
| Total operating expenses                                          |       |                   | 84,014     |                      |       |            | 1,851      |            |       |   | 735 |   |   |   | 86,600 |   |   |
| Loss from operations                                              |       |                   | (3,304     | )                         |       |            | (2,112     | )               |       |   | (585 | ) |   |   | (6,001 | ) |   |
| Interest expense                                                  |       |                   | (370       | )                         |       |            | —     |            |       |   | (8 | ) |   |   | (378 | ) |   |
| Interest income                                                   |       |                   | 6,787      |                      |       |            | —     |            |       |   | — |   |   |   | 6,787 |   |   |
| Income (loss) before income taxes                                 |       |                   | 3,113      |                      |       |            | (2,112     | )               |       |   | (593 | ) |   |   | 408 |   |   |
| Income tax benefit                                                |       |                   | 233        |                      |       |            | —     |            |       |   | — |   |   |   | 233 |   |   |
| Net income (loss)                                                 |       |                   | $          | 3,346                     |       |            |       | $               | (2,112     | ) |   |   | $ | (593 | ) |   |   | $ | 641 |   |   |
| Net income (loss) per share                                       |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Basic and diluted:                                                |       |                   | $          | 0.01                      |       |            |       | $               | (0.01      | ) |   |   | $ | — |   |   |   | $ | — |   |   |
| Shares used in computing net income (loss) per  share:            |       |                   |       |                      |       |            |       |            |       |   |   |   |   |   |   |   |   |
| Basic                                                             |       |                   | 248,312    |                      |       |            | —     |            |       |   | — |   |   |   | 248,312 |   |   |
| Diluted                                                           |       |                   | 253,221    |                      |       |            | (240       | )               |       |   | — |   |   |   | 252,981 |   |   |
|                                                                   |            |                        |            |                           |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

19

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***Balance Sheet Adjustments***

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

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

 

20

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***Statement of Cash Flows Adjustments***

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

| ** **                                                                           | ** ** | **As  Previously  Reported** | ** ** | **Stock-based  Compensation  and  Tax-Related  Adjustments** | ** ** | **Other  Adjustments** | ** ** | **As Restated** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| Cash flows from operating activities:                                                |       |                         |       |                                                         |       |                   |       |                 |       |   |   |   |   |   |   |
| Net income                                                                           |       | $                            | 3,346      |                                                         |       | $                      | (2,112     | )                    |       |   | $ | (593 | ) |   |   | $ | 641 |   |   |
| Adjustments to reconcile net income (loss) to cash  flows from operating activities: |       |                         |       |                                                         |       |                   |       |                 |       |   |   |   |   |   |   |
| Depreciation and  amortization of property and equipment                             |       | 5,256                        |       |                                                         | —     |                   |       |                 | (67        | ) |   |   | 5,189 |   |   |
| Stock-based compensation                                                             |       | 15                           |       |                                                         | 1,918      |                   |       |                 | —     |   |   |   | 1,933 |   |   |
| Changes in current assets and liabilities:                                           |       |                         |       |                                                         |       |                   |       |                 |       |   |   |   |   |   |   |
| Accounts receivable                                                                  |       | (10,204                      | )          |                                                         | —     |                   |       |                 | 2,646      |   |   |   | (7,558 | ) |   |
| Inventory                                                                            |       | (1,942                       | )          |                                                         | —     |                   |       |                 | (102       | ) |   |   | (2,044 | ) |   |
| Other current assets                                                                 |       | (1,155                       | )          |                                                         | —     |                   |       |                 | (858       | ) |   |   | (2,013 | ) |   |
| Accounts payable                                                                     |       | 4,043                        |       |                                                         | —     |                   |       |                 | —     |   |   |   | 4,043 |   |   |
| Accrued expenses,  deferred rent and accrued restructuring expenses                  |       | (4,390                       | )          |                                                         | 194        |                   |       |                 | 1,116      |   |   |   | (3,080 | ) |   |
| Deferred revenue                                                                     |       | 22,295                       |       |                                                         | —     |                   |       |                 | (2,066     | ) |   |   | 20,229 |   |   |
| Cash flows  provided by operating activities                                         |       | 17,264                       |       |                                                         | —     |                   |       |                 | 76         |   |   |   | 17,340 |   |   |
| Cash flows from investing  activities:                                               |       |                         |       |                                                         |       |                   |       |                 |       |   |   |   |   |   |   |
| Purchases of property and  equipment                                                 |       | (11,271                      | )          |                                                         | —     |                   |       |                 | 85         |   |   |   | (11,186 | ) |   |
| Maturities of  available-for-sale marketable debt  securities                        |       | 146,400                      |       |                                                         | —     |                   |       |                 | —     |   |   |   | 146,400 |   |   |
| Purchases of  available-for-sale marketable debt  securities                         |       | (151,660                     | )          |                                                         | —     |                   |       |                 | —     |   |   |   | (151,660 | ) |   |
| Maturities of  held-to-maturity marketable debt securities and long-term investments |       | 38,316                       |       |                                                         | —     |                   |       |                 | —     |   |   |   | 38,316 |   |   |
| Purchases of  held-to-maturity marketable debt securities and long-term investments  |       | (31,980                      | )          |                                                         | —     |                   |       |                 | —     |   |   |   | (31,980 | ) |   |
| (Increase) decrease in  restricted cash                                              |       | (591                         | )          |                                                         | —     |                   |       |                 | 1,091      |   |   |   | 500 |   |   |
| Change in other assets                                                               |       | 63                           |       |                                                         | —     |                   |       |                 | (160       | ) |   |   | (97 | ) |   |
| Cash flows used in  investing activities                                             |       | (10,723                      | )          |                                                         | —     |                   |       |                 | 1,016      |   |   |   | (9,707 | ) |   |
| Cash flows from financing  activities:                                               |       |                         |       |                                                         |       |                   |       |                 |       |   |   |   |   |   |   |
| Sale of common stock in  connection with employee stock purchase plan                |       | 4,516                        |       |                                                         | —     |                   |       |                 | —     |   |   |   | 4,516 |   |   |
| Proceeds from exercise of  stock options                                             |       | 1,877                        |       |                                                         | —     |                   |       |                 | —     |   |   |   | 1,877 |   |   |
| Principal payments of  capital lease obligations                                     |       | (76                          | )          |                                                         | —     |                   |       |                 | —     |   |   |   | (76 | ) |   |
| Cash flows  provided by financing activities                                         |       | 6,317                        |       |                                                         | —     |                   |       |                 | —     |   |   |   | 6,317 |   |   |
| Net increase in  cash and cash equivalents                                           |       | 12,858                       |       |                                                         | —     |                   |       |                 | 1,092      |   |   |   | 13,950 |   |   |
| Cash and cash  equivalents, beginning of year                                        |       | 121,931                      |       |                                                         | —     |                   |       |                 | (1,092     | ) |   |   | 120,839 |   |   |
| Cash and cash  equivalents, September 30, 2005                                  |       | $                            | 134,789    |                                                         |       | $                      | —     |                 |       |   | $ | —- |   |   |   | $ | 134,789 |   |   |
| Supplemental disclosure  of cash flow information:                                   |       |                         |       |                                                         |       |                   |       |                 |       |   |   |   |   |   |   |
| Interest paid                                                                        |       | $                            | 244        |                                                         |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 244 |   |   |
| Income taxes paid                                                                    |       | $                            | 713        |                                                         |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 713 |   |   |
| Income tax refunds  received                                                         |       | $                            | 454        |                                                         |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 454 |   |   |
| Supplemental  disclosure of non-cash investing activities:                           |       |                         |       |                                                         |       |                   |       |                 |       |   |   |   |   |   |   |
| Non-cash purchases  of property and equipment                                        |       | $                            | 662        |                                                         |       | $                      | —     |                 |       |   | $ | 881 |   |   |   | $ | 1,543 |   |   |
| Property and equipment  acquired as part of a  facility lease                        |       | $                            | —     |                                                         |       | $                      | —     |                 |       |   | $ | 500 |   |   |   | $ | 500 |   |   |
| Property and  equipment acquired under capital lease                                 |       | $                            | —     |                                                         |       | $                      | —     |                 |       |   | $ | 163 |   |   |   | $ | 163 |   |   |

 

21

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**(3)**          Summaryof Significant Accounting Policies

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

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

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

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

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

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

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

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

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

Cash equivalents and marketable debt securities areinvested in high-quality debt instruments, primarily U.S. Government, municipaland corporate obligations. Investments in U.S. Government and corporateobligations are classified as held-to-maturity, as Sonus has the intent andability to hold them to maturity. Held-to-maturity marketable debt securitiesare reported at amortized cost. Investments in municipal obligations areclassified as available-for-sale and are reported at fair value. Unrealizedgains and losses from available-for-sale marketable debt securities were notmaterial for the periods presented. The unrealized losses related to thesesecurities at September 30, 2006 are not considered to be a permanentdecline in the fair value of such securities. There have been no materialrealized gains or losses 

22

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to date. Currentmarketable debt securities include held-to-maturity investments with remainingmaturities of less than one year as of the balance sheet date and available-for-saleinvestments that are expected to be sold in the current period or to be used incurrent operations. Long-term investments include held-to-maturity investmentswith remaining maturities of one to five years as of the balance sheet date.

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

| ** **                      | ** ** | **September 30, 2006** | ** ** |
|---------------------------------|------------|----------------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**              | ** ** | **Unrealized  Gains** | ** ** | **Unrealized   Losses** | ** ** | **Fair  Value** | ** ** |
| *Marketable debt securities*    |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:             |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| State and municipal obligations |       | $                                | 32,350     |   |   | $ | — |   |   |   | $ | — |   |   | $ | 32,350 |   |
| Held-to-maturity:               |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       | 85,358                           |       |   | 18 |   |   |   | (121 | ) |   | 85,255 |   |
| Corporate debt securities       |       | 32,413                           |       |   | 7 |   |   |   | (50 | ) |   | 32,370 |   |
| Commercial paper                |       | 68,441                           |       |   | 14 |   |   |   | (384 | ) |   | 68,071 |   |
| Certificates of deposit         |       | 625                              |       |   | — |   |   |   | — |   |   | 625 |   |
|                            |       | $                                | 219,187    |   |   | $ | 39 |   |   |   | $ | (555 | ) |   | $ | 218,671 |   |
| *Long-term investments*         |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:               |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       | $                                | 43,990     |   |   | $ | 42 |   |   |   | $ | (58 | ) |   | $ | 43,974 |   |
| Corporate debt securities       |       | 20,332                           |       |   | 14 |   |   |   | (20 | ) |   | 20,326 |   |
|                            |       | $                                | 64,322     |   |   | $ | 56 |   |   |   | $ | (78 | ) |   | $ | 64,300 |   |

 

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

 

At September 30, 2006and December 31, 2005, Sonus had $341,000 and $591,000, respectively, inrestricted cash, which is used to collateralize standby letters of credit. Restrictedcash is included in Other current assets in the Condensed Consolidated BalanceSheets.

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

23

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***(d) 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 receivables and long-term investments. Sonus’ cash,cash equivalents and investment portfolio holdings were diversified among fivefinancial institutions at September 30, 2006.

Beginning in the third quarter of 2005, Sonus enteredinto foreign exchange contracts to hedge against currency fluctuations relatedto a particular account receivable and orders denominated in Japanese Yen. Sonusrecorded income associated with such foreign exchange contracts of $196,000 and$125,000, respectively, during the three and nine months ended September 30,2006. These amounts are included in General and administrative expense in theCondensed Consolidated Statements of Operations for those periods.

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

| ** **   | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,**      | ** ** |
|--------------|------------|------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Customer** | ** ** | ** **                                           | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
| A            |       |                                                 | 43         | %                                                        |       |   | * |   |   |   | 16 | % |   |   | * |   |   |
| B       |       |                                                 | *          |                                                     |       |   | 33 | % |   |   | 25 | % |   |   | 29 | % |   |
|              |            |                                                      |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

*                    Representsless than 10% of revenue.

Two customers at both September 30, 2006 and December 31,2005, each accounted for at least 10% of Sonus’ accounts receivable balance,representing a total of approximately 32% and 43%, respectively, of the Company’stotal accounts receivable balances. Sonus performs ongoing credit evaluationsof its customers and generally does not require collateral on accountsreceivable. Sonus maintains an allowance for doubtful accounts and such losseshave been within management’s expectations.

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

| ** **                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States                   |       |                                                 | 46         | %                                                   |       |   | 76 | % |   |   | 71 | % |   |   | 80 | % |   |
| Japan                           |       |                                                 | 51         |                                                |       |   | 3 |   |   |   | 23 |   |   |   | 6 |   |   |
| Other Asia  Pacific             |       |                                                 | *          |                                                |       |   | 10 |   |   |   | 3 |   |   |   | 9 |   |   |
| Europe, Middle  East and Africa |       |                                                 | 3          |                                                |       |   | 8 |   |   |   | 3 |   |   |   | 4 |   |   |
| Other                           |       |                                                 | *          |                                                |       |   | 3 |   |   |   | * |   |   |   | 1 |   |   |
|                            |       |                                                 | 100        | %                                                   |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

----

*                    Representsless than 1% of revenue.

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

In 2006, Sonus consolidatedits manufacturing to a single manufacturer. Failure to manage theseconsolidation activities could result in a disruption in the supply of itsproducts and in delays in the fulfillment of the Company’s customer orders.

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***(e) Accounts Receivable***

Accountsreceivable consist of the following (in thousands):

| ** **                       | ** ** | **September 30,  2006** | ** ** | **December 31,  2005**                   | ** ** |
|----------------------------------|------------|------------------------------|------------|-----------------------------------------------|------------|
| ** **                       | ** ** | ** **                   | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Earned accounts  receivable      |       |                         | $          | 31,925                                        |       |   |   | $ | 48,804 |   |   |
| Unearned accounts  receivable    |       |                         | 17,387     |                                          |       |   | 23,883 |   |   |
| Accounts receivable, gross       |       |                         | 49,312     |                                          |       |   | 72,687 |   |   |
| Allowance for  doubtful accounts |       |                         | (631       | )                                             |       |   | (426 | ) |   |
| Accounts  receivable, net        |       |                         | $          | 48,681                                        |       |   |   | $ | 72,261 |   |   |

 

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

***(f) Inventory***

Inventoryconsists of the following (in thousands):

| ** **                                             | ** ** | **September 30,  2006** | ** ** | **December 31,  2005**                   | ** ** |
|--------------------------------------------------------|------------|------------------------------|------------|-----------------------------------------------|------------|
| ** **                                             | ** ** | ** **                   | ** ** | **(As Restated,  See Note 2)** | ** ** |
| On-hand final  assemblies and finished goods inventory |       |                         | $          | 18,537                                        |       |   |   | $ | 19,457 |   |   |
| Unearned  inventory                                    |       |                         | 13,956     |                                          |       |   | 20,979 |   |   |
| Evaluation  inventory                                  |       |                         | 5,228      |                                          |       |   | 4,615 |   |   |
| Inventory, gross                                       |       |                         | 37,721     |                                          |       |   | 45,051 |   |   |
| Excess, obsolete  and evaluation reserve               |       |                         | (7,243     | )                                             |       |   | (7,351 | ) |   |
| Inventory, net                                         |       |                         | 30,478     |                                          |       |   | 37,700 |   |   |
| Less current portion                                   |       |                         | (26,053    | )                                             |       |   | (37,700 | ) |   |
| Long-term portion  (included in Other assets)          |       |                         | $          | 4,425                                         |       |   |   | $ | — |   |   |

 

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

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

Sonus provides inventory reserves based on excess andobsolete inventory determined primarily by future demand forecasts, recordingany adjustments to such reserves through charges to cost of revenue. Sonus alsorecords a full inventory reserve for evaluation equipment at the time ofshipment to its customers as a charge to sales and marketing expense as it isprobable that the inventory will not be realizable. If these evaluationshipments are later purchased by Sonus’ customers, Sonus reclassifies amountspreviously charged to sales and marketing expense to cost of revenue in theperiod when all revenue recognition criteria are met.

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

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

***(h) Other Assets***

Otherassets consist of the following (in thousands):

| ** **           | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------|------------|------------------------------|------------|-----------------------------|------------|
| Prepaid  commissions |       |                         | $          | 980                         |       |   |   | $ | 1,310 |   |   |
| Prepaid royalties    |       |                         | 428        |                        |       |   | — |   |   |
| Deposits             |       |                         | 638        |                        |       |   | 631 |   |   |
| Unearned  inventory  |       |                         | 4,425      |                        |       |   | — |   |   |
|                 |       |                         | $          | 6,471                       |       |   |   | $ | 1,941 |   |   |

 

***(i) Revenue Recognition***

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

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

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

26

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Revenue from installationservices is generally recognized when the service is complete. Revenue fromother professional services for which VSOE has been established is typicallyrecognized based on the proportional performance method as the services aredelivered.

Revenue from consulting,custom development and other professional service-only engagements isrecognized as services are rendered.

Sonus sells the majorityof its products directly to end users. For products sold to resellers anddistributors, Sonus typically recognizes revenue on a sell-through basisutilizing information provided to Sonus from its resellers and distributors. ThroughDecember 31, 2005, no revenues had been recognized on a sell-in basis dueto the limited return history associated withshipments to resellers and distributors. During the first quarter of2006, Sonus began reporting revenue from its original equipment manufacturer (“OEM”)relationship with Motorola, Inc. (“Motorola”) on a sell-in basis, whererevenue is recognized upon the shipment of products to Motorola, assuming allother requirements for revenue recognition have been met. Sonus had previouslyrecognized revenue for sales to Motorola when products had been sold byMotorola to its customers. This change reflects two years of history withMotorola during which Sonus has experienced no returns, no price concessionsand an excellent payment history. As a result of this history, Sonus hasdetermined that the risk of a potential price concession has been eliminatedand therefore the price for products sold to Motorola is now fixed ordeterminable upon sale to Motorola. In the three and nine months ended September 30,2006, Sonus recognized revenue totaling approximately $0.1 million and $3.7million, respectively, in connection with sales of products to Motorola 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 negatively affected product gross margins as revenue from OEMrelationships typically have lower margin profiles than revenue from directsales to customers. This additional revenue and related costs reduced pre-taxincome by approximately $0.2 million in the three months ended September 30,2006. However, this additional revenue and related costs contributedapproximately $1.2 million of additional pre-tax income in the nine monthsended September 30, 2006. These transactions did not change reported basicand diluted net income per share for the three months ended September 30,2006 or diluted net income per share for the nine months then ended. However,these transactions increased basic net income share by $0.01 for the ninemonths ended September 30, 2006.

Sonus records deferredrevenue for product delivered or services performed for which collection of theamount billed is either probable or has been collected before all other revenuerecognition criteria have been satisfied. Deferred revenue includes customerdeposits and amounts associated with maintenance contracts. Deferred revenueexpected to be recognized as revenue more than one year subsequent to thebalance sheet date is classified as long-term deferred revenue.

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

***(j) DeferredRevenue***

Deferredrevenue consists of the following (in thousands):

| ** **                        | ** ** | **September 30,  2006** | ** ** | **December 31,  2005**                   | ** ** |
|-----------------------------------|------------|------------------------------|------------|-----------------------------------------------|------------|
| ** **                        | ** ** | ** **                   | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Maintenance and support contracts |       |                         | $          | 48,545                                        |       |   |   | $ | 67,354 |   |   |
| Customer deposits                 |       |                         | 15,547     |                                          |       |   | 30,952 |   |   |
| Unearned revenue                  |       |                         | 17,387     |                                          |       |   | 23,883 |   |   |
| Total deferred revenue            |       |                         | 81,479     |                                          |       |   | 122,189 |   |   |
| Less current portion              |       |                         | (57,906    | )                                             |       |   | (88,336 | ) |   |
|                              |       |                         | $          | 23,573                                        |       |   |   | $ | 33,853 |   |   |

 

27

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Revenue from maintenanceand support contracts is recognized ratably over the life of the maintenanceand support period. Customer deposits represent payments received in advance ofrevenue recognition. Unearned revenue represents billings for which payment hasnot been received and revenue recognition criteria have not been met. At September 30,2006 and December 31, 2005, both deferred revenue and accounts receivableexcluded $10.4 million and $5.3 million, respectively, related to productsshipped and billed to customers for which revenue is recognized as cash iscollected, or for which title had not passed to the customer.

***(k) Stock-Based Compensation***

Sonus issues stock options and restricted stockpursuant to the 1997 Stock Incentive Plan (“Stock Plan”) and provides employeesthe right to purchase stock pursuant to the 2000 Employee Stock Purchase Plan (“ESPP”).Prior to January 1, 2006, we accounted for all of employee andnon-employee director stock-based compensation awards using the intrinsic valuemethod under Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees (“APB 25”),*and provided the required disclosures in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”). On January 1, 2006, the Companyadopted SFAS No. 123R, *Share-Based Payment*(“SFAS 123R”). For stock-based compensation related to the ESPP, Sonus followsSFAS 123R, as interpreted by Financial Accounting Standards Board (“FASB”)Technical Bulletin No. 97-1, *Accounting under Statement123 for Certain Employee Stock Purchase Plans with a Look-Back Option*.Sonus accounts for all stock-based compensation awards to consultants and othernon-employees in accordance with the FASB EITF Issue No. 96-18, *Accounting for Equity Instruments that are Issued to Other thanEmployees for Acquiring or in Conjunction with Selling Goods or Services,*and SFAS 123, as amended by SFAS No. 148, *Accountingfor Stock Based Compensation—Transition and Disclosure* (prior to January 1,2006) or in accordance with SFAS 123R (subsequent to December 31, 2005). Modificationsto non-employee stock-based awards are accounted for in accordance with EITFIssue No. 00-19, *Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock*. Sonus followed FASB Interpretation No. 28, *Accounting for Stock Appreciation Rights and Other Variable StockOption or Award Plans,*in the recognition of stock-basedcompensation expense measured under APB 25 (prior to January 1, 2006) andthe straight-line method in the recognition of stock-based compensation expenseunder SFAS 123 (prior to January 1, 2006) and SFAS 123R (subsequent to December 31,2005). Under both APB 25 and SFAS 123R, the requisite service period over whichstock-based compensation is expensed generally equals the vesting periods ofthe awards.

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

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

Sonusrecorded $2.4 million and $7.5 million of stock-based compensation for thethree and nine months ended September 30, 2006, respectively, and $0.6million and $1.9 million of stock-based compensation for the three and ninemonths ended September 30, 2005, respectively. These amounts are 

28

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included as components of the following expensecategories in the Condensed Consolidated Statements of Operations (inthousands):

| ** **                  | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                  | ** ** | ** **                                           | ** ** | **(As Restated,  See Note 2)**       | ** ** | ** ** | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Product cost of  revenue    |       | $                                                    | 34         |                                                |       | $ | 7 |   |   | $ | 59 |   |   | $ | 22 |   |   |
| Service cost of  revenue    |       | 243                                                  |       |                                                | 79         |   |   | 726 |   |   | 227 |   |   |
| Research and  development   |       | 630                                                  |       |                                                | 183        |   |   | 2,050 |   |   | 613 |   |   |
| Sales and  marketing        |       | 769                                                  |       |                                                | 279        |   |   | 2,445 |   |   | 828 |   |   |
| General and  administrative |       | 761                                                  |       |                                                | 6          |   |   | 2,200 |   |   | 243 |   |   |
|                        |       | $                                                    | 2,437      |                                                |       | $ | 554 |   |   | $ | 7,480 |   |   | $ | 1,933 |   |   |

 

In addition, Sonus included in inventory approximately$27,000 of stock-based compensation at September 30, 2006.

At September 30, 2006, there was $15.5 million ofunrecognized compensation cost related to share-based awards, which is expectedto be recognized over a weighted average period of approximately three years.

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

| ** **                   | ** ** | **Three months  ended  September 30,  2006** | ** ** | **Nine months  ended  September 30,  2006** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Risk-free  interest rate     |       |                                                   | 4.8        | %                                                     |       |   | 4.8 | % |   |
| Expected dividend  yield     |       |                                                   | —     |                                                  |       |   | — |   |   |
| Expected  volatility         |       |                                                   | 62         | %                                                     |       |   | 62%-85 | % |   |
| Weighted average  volatility |       |                                                   | 62         | %                                                     |       |   | 75 | % |   |
| Expected life (years)        |       |                                                   | 4.5        |                                                  |       |   | 4.5 |   |   |

 

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

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

| **Stock Options**                                 | ** ** | ** ** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                             | ** ** | ** **                                                  | ** ** | **(in thousands)**             | ** ** |
| Outstanding at  January 1, 2006                   |       | 45,333,532 |       |                       | $          | 4.74                                   |       |                                                        |       |                                |       |   |   |   |   |   |
| Granted                                                |       | 4,313,000  |       |                       | $          | 4.80                                   |       |                                                        |       |                                |       |   |   |   |   |   |
| Exercised                                              |       | (6,081,999 | )          |                       | $          | 3.80                                   |       |                                                        |       |                                |       |   |   |   |   |   |
| Forfeited                                              |       | (275,016   | )          |                       | $          | 4.10                                   |       |                                                        |       |                                |       |   |   |   |   |   |
| Expired                                                |       | (1,206,807 | )          |                       | $          | 7.78                                   |       |                                                        |       |                                |       |   |   |   |   |   |
| Outstanding at  September 30, 2006                |       | 42,082,710 |       |                       | $          | 4.80                                   |       |                                                        |       | 6.30                                |       |   |   | $ | 33,070 |   |   |
| Vested or expected to vest at September 30,  2006 |       | 41,539,567 |       |                       | $          | 4.80                                   |       |                                                        |       | 6.26                                |       |   |   | $ | 32,731 |   |   |
| Exercisable at  September 30, 2006                |       | 36,103,174 |       |                       | $          | 4.84                                   |       |                                                        |       | 5.89                                |       |   |   | $ | 28,827 |   |   |

 

The weighted average fair value of stock optionsgranted during the three and nine months ended September 30, 2006 was$2.51 and $3.01, respectively. The total intrinsic value of options exercisedduring the three and nine months ended September 30, 2006 was $3.1 millionand $7.6 million, respectively. The total intrinsic value of options exercisedduring the three and nine months ended September 30, 2005 was $0.8 millionand $1.5 million, respectively. The total fair value of options vested duringthe three and nine months ended September 30, 2006 was $1.3 million and$4.8 million, respectively. The total fairvalue of options vested during the three and nine months ended September 30,2005 was $19.1 million and $42.8 million, respectively.

During the nine months ended September 30, 2006,Sonus awarded 200,000 restricted shares of common stock to an officer under the1997 Plan and 210,000 restricted shares of common stock in the aggregate tofive employees under the 1997 Plan. The award to the officer vests overapproximately two years while the awards to the employees vest over four years.The grant date fair value of the award to the officer was $4.82 per share. Thegrant-date fair value of the awards to the employees was $4.47 per share. Allawards were unvested at September 30, 2006.

Sonus used the Black-Scholes valuation model, to valueshares of common stock issued under the ESPP. In valuing the ESPP shares, Sonusused an assumed risk-free interest rate range of 2.7% to 5.1%, an expectedvolatility range of 51% to 117%, an expected life of six months to two yearsand no expected dividend yield for the three months ended September 30,2006. For the nine months ended September 30, 2006, Sonus used an assumedrisk-free interest rate range of 1.8% to 5.1%, an expected volatility range of51% to 126%, an expected life of six months to two years and no expecteddividend yield.

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SFAS123R requires the presentation of pro forma information for the comparativeperiod prior to the adoption as if Sonus had accounted for stock-basedcompensation expense under the fair value method under SFAS 123. The followingtable shows Sonus’ pro forma net loss and net loss per share as if accountedfor under SFAS 123 for the three and nine months ended September 30, 2005(in thousands, except per share data):

| ** **                                                                                                               | ** ** | **Three months  ended  September 30,  2005** | ** ** | **Nine months  ended  September 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **(As Restated,  See Note 2)**          | ** ** | **(As Restated,  See Note 2)**         | ** ** |
| Net income (loss)  as reported                                                                                           |       |                                                   | $          | (3,820                                                | )          |   |   | $ | 641 |   |   |
| Plus: Employee  stock-based compensation expense included in net income under intrinsic value  method related to options |       |                                                   | 554        |                                                  |       |   | 1,933 |   |   |
| Less: Employee stock-based compensation under fair  value method(1)                                                      |       |                                                   | (9,312     | )                                                     |       |   | (34,502 | ) |   |
| Pro forma net loss                                                                                                       |       |                                                   | (12,578    | )                                                     |       |   | $ | (31,928 | ) |   |
| Basic and diluted  net income (loss) per share:                                                                          |       |                                                   |       |                                                  |       |   |   |   |   |
| As reported                                                                                                              |       |                                                   | $          | (0.02                                                 | )          |   |   | $ | — |   |   |
| Pro forma                                                                                                                |       |                                                   | $          | (0.05                                                 | )          |   |   | $ | (0.13 | ) |   |

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(1)          As discussed in Note 2,stock-based compensation has been restated as a result of the Company applyingincorrect measurement dates in the accounting for certain stock options andincorrectly accounting for certain stock options that should have been recordedusing variable accounting. In addition, the historical accounting for theCompany’s ESPP was also accounted for incorrectly under the fair value method.

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

| ** **                   | ** ** | **Three months  ended  September 30,  2005** | ** ** | **Nine months  ended  September 30,  2005** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Risk-free  interest rate     |       |                                                   | 4.0        | %                                                     |       |   | 4.0 | % |   |
| Expected dividend  yield     |       |                                                   | —     |                                                  |       |   | — |   |   |
| Expected  volatility         |       |                                                   | 116        | %                                                     |       |   | 116%-124 | % |   |
| Weighted average  volatility |       |                                                   | 116        | %                                                     |       |   | 118 | % |   |
| Expected life (years)        |       |                                                   | 4.0        |                                                  |       |   | 4.0 |   |   |

 

The weighted average fair value of stock optionsgranted during the three and nine months ended September 30, 2005 was$3.79 and $3.72, respectively.

For shares purchased underthe ESPP during the three months ended September 30, 2005, Sonus used theBlack-Scholes model, with an assumed risk-free interest rate range of 1.8% to3.6%, an expected volatility range of 60% to 150%, an expected life of sixmonths to two years and no expected dividend yield. During the nine monthsended September 30, 2005, Sonus used an assumed risk-free interest rate of1.3% to 3.62%, expected volatility of 57% to 154%, an expected life of sixmonths to two years and a zero expected dividend yield.

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***(l) Comprehensive Income (Loss)***

Sonus’comprehensive income (loss) for the three and nine months ended September 30,2006 and 2005 is as follows (in thousands):

| ** **                                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | ** **                                           | ** ** | **(As Restated,  See Note 2)**       | ** ** | ** ** | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Net income (loss)                         |       | $                                                    | 14,370     |                                                |       | $ | (3,820 | ) |   | $ | 29,100 |   |   | $ | 641 |   |   |
| Foreign currency  translation adjustments |       | (13                                                  | )          |                                                | —     |   |   | (34 | ) |   | — |   |   |
| Comprehensive  income (loss)              |       | $                                                    | 14,357     |                                                |       | $ | (3,820 | ) |   | $ | 29,066 |   |   | $ | 641 |   |   |

 

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

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

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

Net income (loss) per share is computed in accordancewith SFAS No. 128, *Earnings per Share*.Basic net income (loss) per share is computed by dividing net income (loss) bythe weighted average number of shares of common stock outstanding during theperiod. For periods in which the Company reports net income, diluted net incomeper share is determined by using the weighted average number of common anddilutive common equivalent shares outstanding during the period unless theeffect is antidilutive. Potential dilutive common shares consist of commonstock issuable upon the exercise of stock options and purchases of commonshares under the Company’s ESPP using the treasury stock method.

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

| ** **                                        | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | ** **                                           | ** ** | **(As Restated,  See Note 2)**       | ** ** | ** ** | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Weighted average  shares outstanding—basic   |       | 254,102                                              |       |                                                | 248,801    |   |   | 252,291 |   |   | 248,312 |   |   |
| Potential  dilutive common shares                 |       | 3,056                                                |       |                                                | —     |   |   | 3,701 |   |   | 4,669 |   |   |
| Weighted average shares  outstanding—diluted |       | 257,158                                              |       |                                                | 248,801    |   |   | 255,992 |   |   | 252,981 |   |   |

 

The calculation above forthe three ended September 30, 2006 excludes options to purchase shares ofcommon stock aggregating 23,342,797 shares, as their effect would beantidilutive. The calculation above for the nine months ended September 30,2006 excludes options to purchase shares of common stock and shares of commonstock issuable upon conversion of a convertible subordinated note aggregating21,091,145 shares, as their effect would be antidilutive.

***(o) Warranty Reserve***

Sonus’ products are covered by a standard warranty of90 days for software and one year for hardware or a warranty of longer periodsunder certain customer contracts. In addition, certain customer contractsinclude warranty-type provisions for epidemic or similar product failures,generally for the contractual 

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period or the life of theproduct in accordance 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 anticipated rates of warranty claimsand costs are primarily based 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. At September 30, 2006and December 31, 2005, Sonus had $45,000 and $84,000, respectively, ofwarranty reserves recorded.

***(p) Income Taxes***

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

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

***(q) Reclassification***

The presentation ofstock-based compensation for the three and nine months ended September 30,2005, which historically has been presented separately in the CondensedConsolidated Statements of Operations, has been reclassified into theapplicable cost and expense categories to conform to the presentation for thethree and nine months ended September 30, 2006.

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

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS 159”). SFAS 159 permits an entity tomeasure certain financial assets and financial liabilities at fair value. UnderSFAS 159, entities that elect the fair value option will report unrealizedgains and losses in earnings at each subsequent reporting date. The fair valueoption may be elected on an instrument-by-instrument basis, with a fewexceptions, as long as it is applied to the instrument in its entirety. SFAS159 establishes presentation and disclosure requirements, but does noteliminate disclosure requirements of other accounting standards. Assets andliabilities that are measured at fair value must be displayed on the face ofthe balance sheet. SFAS 159 is effective in fiscal years beginning after November 15,2007, although its provisions may be applied earlier if certain conditions aremet. The Company is currently evaluating the impact of SFAS 159 on itsconsolidated results of operations and financial condition.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements* (“SFAS 157”). SFAS 157provides a single definition of fair value, along with a framework formeasuring it, and requires 

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additional disclosureabout using fair value to measure assets and liabilities. SFAS 157 emphasizesthat fair value measurement is market-based, not entity-specific, andestablishes a fair value hierarchy in which the highest priority is quotedprices in active markets. Under SFAS 157, fair value measurements are disclosedaccording to their level within this hierarchy. While SFAS 157 does not add anynew fair value measurements, it does change current practice in certain ways,including requiring entities to include their own credit standing whenmeasuring their liabilities. SFAS 157 is effective for financial statementsissued for fiscal years beginning after November 15, 2007 and interimperiods within those fiscal years. The Company is currently evaluating theimpact of SFAS 157 on its consolidated results of operations and financialcondition.

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

In June 2006, theFASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109*(“FIN 48”), which clarifies the accounting for uncertainty in income taxesrecognized in a company’s financial statements in accordance with FASB StatementNo. 109, *Accounting for Income Taxes.*FIN48 prescribes a two-step process to determine the amount of tax benefit to berecognized. First, the tax position must be evaluated to determine thelikelihood that it will be sustained upon external examination. If the taxposition is deemed more-likely-than-not to be sustained, the tax position isthen assessed to determine the amount of benefit to recognize in the financialstatements.  The amount of the benefitthat may be recognized is the largest amount that has a greater than 50%likelihood of being realized upon ultimate settlement. The Company adopted FIN 48on January 1, 2007. The adoption of FIN 48 did not have a material impacton the Company’s consolidated results of operations or financial condition.

**(4)**          AccruedRestructuring Expenses

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

***2002 Restructuring Accrual***

The Company periodically reviews its restructuringaccruals to identify any excess or deficits related to planned and previouslyrecorded initiatives, including changes to such plans. In the third quarter offiscal 2006, the Company revoked its decision to abandon a facility for whichcosts had been accrued as part of the 2002 restructuring initiative andaccordingly, reversed the accrual of $0.5 million related to this initiative. Thisreversal is reflected as a reduction to General and administrative expense inthe Company’s Condensed Consolidated Statements of Operations for both thethree and nine months ended September 30, 2006.

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

| ** **                   | ** ** | **Balance  December 31,  2005** | ** ** | **Cash  payments** | ** ** | **Reversal for  changes in  estimate** | ** ** | **Balance  September 30,  2006** | ** ** |
|------------------------------|------------|--------------------------------------|------------|--------------------|------------|--------------------------------------------------|------------|---------------------------------------|------------|
| Consolidation of  facilities |       |                                 | $          | 613                |       |                                             |       | $                                     | (146       | ) |   |   | $ | (467 | ) |   |   | $ | — |   |   |
|                              |            |                                      |            |                    |            |                                                  |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**(5)**          Contingencies

In November 2001, a purchaser of the Company’scommon stock filed a complaint in the United States District Court for theSouthern District of New York against Sonus, two of its officers and the leadunderwriters alleging violations of the federal securities laws in connectionwith Sonus’ initial public offering (“IPO”) and seeking unspecified monetarydamages. The purchaser seeks to represent a class of persons who purchased theCompany’s common stock between the IPO on May 24, 2000 and December 6,2000. An amended complaint was filed in April 2002. The amended complaintalleges that our registration statement contained false or misleadinginformation or omitted to state material facts concerning the alleged receiptof undisclosed compensation by the underwriters and the existence ofundisclosed arrangements between the underwriters and certain purchasers tomake additional purchases in the after market. The claims against Sonus areasserted under Section 10(b) of the Securities Exchange Act of 1934(the “Exchange Act”) and Section 11 of the Securities Act of 1933 andagainst the individual defendants under Sections 11 and 15 of the SecuritiesAct and Sections 10(b) and 20(a) of the Exchange Act. Otherplaintiffs have filed substantially similar class action cases againstapproximately 300 other publicly traded companies and their IPO underwriterswhich, along with the actions against Sonus, have been transferred to a singlefederal judge for purposes of coordinated case management. On July 15,2002, Sonus, together with the other issuers named as defendants in 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 ourBoard of Directors authorized Sonus to enter into a proposed settlement withthe plaintiffs on terms substantially consistent with the terms of a Memorandumof Understanding negotiated among representatives of the plaintiffs, the issuerdefendants and the insurers for the issuer defendants. In October 2004,the court certified the class in a case against certain defendants. On February 15,2005, the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. On August 31,2005, the court approved the terms of the proposed settlement, as modified. On April 24,2006, the court held a hearing on a motion to approve the final settlement andtook the matter under advisement. On December 5, 2006, the Court ofAppeals for the Second Circuit reversed the court’s October 2004 ordercertifying a class. On June 25, 2007, the Court entered an order terminatingthe settlement. Accordingly, the Company is unable to determine the ultimateoutcome or potential range of loss, if any.

Beginning in July 2002, several purchasers of theCompany’s common stock filed complaints in the United States District Court forthe District of Massachusetts against Sonus, certain officers and directors anda former officer under Sections 10(b) and 20(a) and Rule 10b-5of the Exchange Act (the “Class Action Complaints”). The purchasers seekto represent a class of persons who purchased the Company’s common stockbetween December 11, 2000 and January 16, 2002, and seek unspecifiedmonetary damages. The Class Action Complaints were essentially identicaland alleged that Sonus made false and misleading statements about its productsand business. On March 3, 2003, the plaintiffs filed a ConsolidatedAmended Complaint. On April 22, 2003, Sonus filed a motion to dismiss theConsolidated 

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Amended Complaint onvarious grounds. On May 11, 2004, the court held oral argument on themotion, at the conclusion of which the court denied Sonus’ motion to dismiss. Theplaintiffs filed a motion for class certification on July 30, 2004. On February 16,2005, the court certified the class and appointed a class representative. On March 9,2005, the court appointed the law firm of Moulton & Gans as leadcounsel. After the court requested additional briefing on the adequacy of theclass representative, the class representative withdrew. Lead counsel thenfiled a motion to substitute a new plaintiff as the class representative. On May 19,2005, the court held a hearing on the motion and took the matter underadvisement. On August 15, 2005, the court issued an order decertifying theclass and requiring the parties to submit a joint report informing the courtwhether the cases have been settled and whether defendants would be seeking torecover attorney’s fees from the plaintiffs. On September 30, 2005, theplaintiffs filed motions to voluntarily dismiss their complaints with prejudice.On October 5, 2005, the court entered an order dismissing the cases. On June 26,2006, the court issued an order denying Sonus’ motion for recovery of attorneys’fees.

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

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against Sonus and certain of itscurrent officers and directors. On June 28, 2004, the court consolidatedthe claims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the Exchange Act and Sections 11, 12(a), and 15 of the Securities Act,relating to the restatement of Sonus’ financial results for 2001, 2002, and thefirst three quarters of 2003. Specifically, the complaint alleges that Sonusissued a series of false or misleading statements to the market concerning itsrevenues, earnings and financial condition. Plaintiffs contend that suchstatements caused the Company’s stock price to be artificially inflated. Thecomplaint seeks unspecified damages on behalf of a purported class ofpurchasers of the Company’s common stock during the period from March 28,2002 through March 26, 2004. On January 28, 2005, Sonus filed amotion to dismiss the Section 10(b) and 12(a) claims and joinedthe motion to dismiss the Section 11 claim filed by the individualdefendants. On June 1, 2005, the court held a hearing on the motion andallowed the plaintiff to file an amended complaint. The plaintiff filed anamended complaint that included the same claims and substantially similarallegations as set forth in the initial complaint. On September 12, 2005,the defendants filed motions to dismiss this amended complaint. On December 10,2005, the court held a hearing on the motions and took the matter underadvisement. On May 10, 2006, the courtissued an order granting the defendants’ motions in part and denying themotions in part. The court dismissed the Section 12(a)(2) claimsagainst all the defendants and the Section 10(b) and Section 11claims against the individual defendants. The court denied the motions as tothe Section 10(b) and Section 11 claims against Sonus and Section 15claims against the individual defendants. The plaintiff has filed a motion forclass certification, which the defendants have opposed. The court held ahearing on February 28, 2007 on plaintiff’s motion for class certificationand took the matter under advisement. The Company believes that it hassubstantial legal and factual defenses to the claims, which it intends topursue vigorously. Sonus expects to incur significant legal fees in defendingthis action. At this time, Sonus is unable to determine the ultimate outcome orpotential range of loss, if any.

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

In December 2004, a purchaser of Sonus’ commonstock filed a complaint in the circuit court in Will County, Illinois,against Sonus, one of its officers, and a former officer allegingmisrepresentation and fraud in connection with the plaintiff’s purchase ofSonus’ stock. The complaint seeks unspecified damages. Sonus filed a motion todismiss the complaint. On May 5, 2005, the plaintiff filed an amendedcomplaint. On October 26, 2005, the court held a hearing on the motionduring which it dismissed the federal claims without prejudice and dismissedthe state claims without prejudice. On November 23, 2005, the plaintifffiled a second amended complaint with essentially the same allegations as inthe prior complaints. The defendants renewed their motions to dismiss withrespect to the second amended complaint. On March 9, 2006, the court held ahearing on the defendants’ motions during which the court entered an orderdismissing the second amended complaint with prejudice. On April 17, 2006,the plaintiff filed a notice of appeal of the dismissal order. In order toavoid the costs of an appeal, Sonus agreed to settle the matter for a deminimus amount. On June 23, 2006, the court entered an order dismissingthe case.

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

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the claim of infringementon behalf of the defendants for whom Sonus has agreed to assume defense of thelitigation. An adverse outcome with respect to the claim and Sonus’indemnification could have a material adverse impact on Sonus’ business,operating results and financial condition. Sonus cannot predict the ultimateoutcome of this litigation or any potential impact on the Company’s operatingresults or financial position.

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

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

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

Sonus includes standard intellectual propertyindemnification provisions in its product agreements in the ordinary course ofbusiness. Pursuant to its product agreements, Sonus will indemnify, holdharmless, and reimburse the indemnified party for losses suffered or incurredby the indemnified party, generally business partners or customers, inconnection with certain patent, copyright or other intellectual property infringementclaims by third parties with respect to Sonus products. Other agreements withSonus’ customers provide indemnification for claims relating to property damageor personal injury resulting from the performance of services by Sonus or itssubcontractors. Historically, Sonus’ costs to defend lawsuits or settle claimsrelating to such indemnity agreements have been insignificant. Accordingly, theestimated fair value of these indemnification provisions is immaterial.

The Internal RevenueService has notified the Company that its payroll tax returns for the yearsended December 31, 2004, 2005 and 2006 have been selected for audit inconnection with its stock option review. In connection with the restatement ofits financial statements included in this Form 10-Q, Sonus 

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hasrecorded approximately $1.6 million of accruals for additional tax, penaltiesand interest related to adjustments resulting from errors in stock optionaccounting. For more information about stock-based compensation, including thefinancial statement impact from the restatement, see “Explanatory Note”preceding part I, Item 1; Note 2, “Restatement of Consolidated FinancialStatements” of the Notes to the Consolidated Financial Statements. Sonus couldbe required to pay additional tax, penalties or interest, or have otherremedies imposed, which could adversely impact its business, financial positionor results of operations.

**(6)**          ConvertibleSubordinated Note

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

**(7)**          SubsequentEvents

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

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

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

The following informationhas been adjusted to reflect the restatement of the our financial results,which is more fully described in the “Explanatory Note” preceding Part I,Item 1 and in Note 2, “Restatement of Consolidated Financial Statements” inNotes to Condensed Consolidated Financial Statements of this Form 10-Q.The net of tax impact of the restatement on our results of operations amountedto the addition of $1.1 million and $2.7 million of net expense for the threeand nine months ended September 30, 2005, respectively.

**Overview**

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

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

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

Starting in 2004 and continuing into 2006, there wasincreased interest and activity in the market for packet-based voiceinfrastructure products. This trend has been reflected in our order activity aswe achieved record orders in the fourth quarter of fiscal 2004 and on an annualbasis in fiscal 2005. Customer 

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orders were greater thanrevenue for the three months ended September 30, 2006. While it remainsuncertain as to the speed and extent of the adoption of carrier packet voiceinfrastructure products by large carriers, we believe that over time the marketopportunity for packet voice solutions is substantial. For the three and ninemonths ended September 30, 2006, revenues were $76.0 million and $200.5million, respectively, compared to $46.0 million and $137.3 million for thethree and nine months ended September 30, 2005, respectively, reflectingcontinuing improvements 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 significantcommitment of resources and a lengthy evaluation, testing and product qualificationprocess. Our revenues and results of operations may vary significantly andunexpectedly from quarter to quarter as a result of long sales cycles, ourexpectation that customers will tend to sporadically place large orders withshort lead times and the application of complex revenue recognition rules tocertain transactions, which may result in customer shipments and orders frommultiple quarters being recognized as revenue in one quarter. We expect torecognize revenues from a limited number of customers for the foreseeablefuture.

Since our inceptionthrough December 31, 2003, we incurred significant losses. At September 30,2006, we had an accumulated deficit of $802.0 million. Although we achievedprofitability in the first three quarters of 2006 and on an annual basis infiscal years 2005 and 2004, we incurred net losses for 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, we expectto incur sales and other expenses before we realize the related revenues. Weexpect to continue to incur significant sales and marketing, research anddevelopment and general and administrative expenses, many of which are fixedprior to the beginning of any particular fiscal period and, as a result, wewill need to generate significant revenues to maintain profitability.

**Recent Developments**

On April 13, 2007, wecompleted the acquisition of Zynetix Limited (“Zynetix”), a privately-helddesigner of innovative Global Systems for Mobile Communications (“GSM”)infrastructure solutions located in the United Kingdom. In consideration, wepaid the selling shareholders £3,000,000 on the acquisition date (U.S. $5.9 millionas of the acquisition date) and £1,330,583 on June 11, 2007 (U.S. $2.6 millionas of June 11, 2007). The Share Purchase Agreement also includes two additionalpotential payments to the selling shareholders: (1) £1,500,000 (U.S. $3.0million as of the acquisition date) payable on May 1, 2008; and (2) 175,000shares of Sonus common stock deliverable on April 30, 2009, contingentupon the business achieving certain predetermined financial and businessmetrics.

**Stock-BasedCompensation**

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

Underthe modified prospective transition method, the unrecognized expense of awardsnot yet vested at the date of adoption shall be recognized in net income in theperiods after the date of adoption using 

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the same valuation method, Black-Scholes, andassumptions determined under the original provisions of SFAS 123. We recorded $2.4 million and $7.5million of stock-based compensation in the consolidated statement of operationsfor the three and nine months ended September 30, 2006, included in thefollowing expense categories (in thousands):

| ** **                  | ** ** | **Three Months  Ended  September 30, 2006** | ** ** | **Nine Months  Ended  September 30, 2006** | ** ** |
|-----------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Product cost of  revenue    |       |                                                       | $          | 34                                                        |       |   |   | $ | 59 |   |   |
| Service cost of  revenue    |       |                                                       | 243        |                                                      |       |   | 726 |   |   |
| Research and  development   |       |                                                       | 630        |                                                      |       |   | 2,050 |   |   |
| Sales and  marketing        |       |                                                       | 769        |                                                      |       |   | 2,445 |   |   |
| General and  administrative |       |                                                       | 761        |                                                      |       |   | 2,200 |   |   |
|                        |       |                                                       | $          | 2,437                                                     |       |   |   | $ | 7,480 |   |   |

 

In addition, we included in inventory approximately$27,000 of stock-based compensation at September 30, 2006.

The recording of stock-based compensation expense forthe three and nine months ended September 30, 2006 resulted in a decreasein net income of $2.4 million and $7.5 million, respectively and a decrease inbasic and diluted earnings per share of $0.01 and $0.03, respectively. As of September 30,2006, there was $15.5 million of unrecognized compensation cost related tooptions, which is expected to be recognized over a weighted average period of 3years.

Under the provisions of APB 25, we recorded $0.6million and $1.9 million for the three and nine months ended September 30,2005, respectively, of stock-based compensation in the consolidated statementsof operations, included in the following expense categories (in thousands):

| ** **                  | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|-----------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Product cost of  revenue    |       |                                                   | $          | 7                                                     |       |   |   | $ | 22 |   |   |
| Service cost of  revenue    |       |                                                   | 79         |                                                  |       |   | 227 |   |   |
| Research and  development   |       |                                                   | 183        |                                                  |       |   | 613 |   |   |
| Sales and  marketing        |       |                                                   | 279        |                                                  |       |   | 828 |   |   |
| General and  administrative |       |                                                   | 6          |                                                  |       |   | 243 |   |   |
|                        |       |                                                   | $          | 554                                                   |       |   |   | $ | 1,933 |   |   |

 

On December 21, 2005,our Board of Directors approved accelerating the vesting of out-of-the-money,unvested stock options held by all current employees, subject to employeeapproval to the extent accelerating of vesting would create a change inclassification of any grant from an incentive stock option to a non-qualifiedincentive stock option. Non-employee members of the Board of Directors wereexcluded from the acceleration. Unvested options having an exercise price of$4.00 per share or greater at that time, representing the right to purchase atotal of approximately 18.9 million shares, became exercisable as a result ofthe vesting acceleration. All other terms and conditions in the original grantsremained unchanged. The acceleration of vesting did not result in therecognition of compensation expense in fiscal 2005 as the exercise price of theaccelerated stock options exceeded the fair market value of the underlyingcommon stock on the date of modification. The decision to accelerate vesting ofthese stock options was made primarily to reduce compensation expense thatwould otherwise be recognized after the adoption of SFAS 123R.

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For more information aboutstock-based compensation, including the financial statement impact from therestatement, see “Explanatory Note” preceding Part I, Item 1, Note 2, “Restatementof Consolidated Financial Statements” and Note 3, “Summary of SignificantAccounting Policies” Item (j) “Stock-Based Compensation” in the Notes tothe Condensed Consolidated Financial Statements of this Form 10-Qand “Critical Accounting Policies and Estimates” below.

**Critical Accounting Policies and Estimates**

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

·       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 involvecomplex contractual, multiple-element arrangements. When a sale includesmultiple elements, such as products, maintenance and/or professional services,we recognize revenue using the residual method as we have not established VSOEof fair value for our products or specified features/upgrades. Revenueassociated with undelivered elements that are not considered essential to thefunctionality of the product and for which VSOE of fair value has beenestablished, is deferred based on the VSOE of fair value and any remainingarrangement fee is then allocated to, and recognized as, product revenue. Wehave established VSOE of fair value for maintenance arrangements (post-contractsupport) and some professional services. VSOE of fair value for maintenance andprofessional services is determined by either the price charged when the sameelement is sold separately or established by management having the relevantpricing authority. The Company’s Pricing Committee has the relevant authorityfor establishing pricing for products and services. If we cannot establish VSOEof fair value for any undelivered element, including specified features andupgrades, we defer revenue on the entire 

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arrangementuntil VSOE of fair value for all undelivered elements is known or all elementsare delivered and all other revenue recognition criteria are met.

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

Revenue from installationservices is generally recognized when the service is complete. Revenue fromother professional services for which VSOE has been established is typicallyrecognized based on proportional performance as the services are delivered.

Revenue from consulting,custom development and other professional services-only engagements arerecognized as services are completed.

We sell the majority ofour products directly to our service provider customers. For products sold toresellers and distributors, we typically recognize revenue on a sell-throughbasis utilizing information provided to us from our resellers and distributors.Through December 31, 2005, no revenues have been recognized on a sell-inbasis due to the limited history of shipments to resellers and distributors. Duringthe first quarter of 2006, we began reporting revenue from our originalequipment manufacturer (“OEM”) relationship with Motorola, Inc. (“Motorola”)on a sell-in basis, where revenue is recognized upon the shipment of productsto Motorola, assuming all other requirements for revenue recognition have beenmet. We had previously recognized revenue for sales to Motorola when productshad been sold through by Motorola to its customers. This change reflects 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 and nine months endedSeptember 30, 2006, we recognized revenue totaling approximately $0.1million and $3.7 million, respectively, in connection with sales of products toMotorola through September 30, 2006 that had not yet sold through toMotorola’s customers. This revenue would have been recognized in subsequentquarters if we had not changed to a sell-in basis for Motorola during the firstquarter. This additional revenue from Motorola in the quarter negativelyaffected product gross margins as revenue from OEM relationships typically havelower margin profiles than revenue from direct sales to customers. Thisadditional revenue and related costs reduced pre-tax income by approximately$0.2 million in the three months ended September 30, 2006. However, thisadditional revenue and related costs contributed approximately $1.2 million ofpre-tax income for the nine months ended September 30, 2006. Thesetransactions did not change reported basic and diluted net income per share forthe three months ended September 30, 2006 or diluted net income per sharefor the nine months then ended. However, these transactions increased basic netincome per share by $0.01 for the nine months ended September 30, 2006.

***Deferred Revenue.******  ***We record deferred revenuefor product delivered or services performed for which collection of the amountbilled is either probable or has been collected but other revenue recognitioncriteria have not been satisfied. Deferredrevenue includes customer deposits and amounts associated with maintenancecontracts. Deferred revenue expected to be recognized as revenue more than oneyear subsequent to the balance sheet date is classified as long-term deferredrevenues.

We defer recognition ofincremental direct costs, such as cost of goods, royalties, commissions andthird-party installation costs, until satisfaction of the criteria forrecognition of the related revenue.

***Allowance for Doubtful Accounts.******  ***We establishbilling terms at the time we negotiate purchase agreements with our customers.We continually monitor for timely payments and potential collection issues. Theallowance for doubtful accounts is estimated based on our detailed assessmentof the collectibility of specific customer accounts.

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

We record a full inventoryreserve for evaluation equipment at the time of shipment to our customers as acharge to sales and marketing expense, as it is probable that the inventoryvalue will not be realizable. If these evaluation shipments are later purchasedby our customers, we reclassify amounts previously charged to sales andmarketing expense to cost of revenue in the period that all revenue recognitioncriteria are met.

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

In addition, certain ofour customer contracts include provisions under which we may be obligated topay penalties, generally for the contractual period or for the life of theproduct, if our products fail or do not perform in accordance withspecifications. We accrue for such contingent obligations when the occurrenceof such obligation is probable and the amount of such obligation is reasonablyestimable. We have not incurred significant costs related to such provisions. Weperiodically assess the adequacy of our recorded warranty liabilities andadjust 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 for Litigation 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 Contingencies and Reserves.******  ***We are subjectto ongoing business risks arising in the ordinary course of business thataffect the estimation process of the carrying value of assets, the recording ofliabilities and the possibility of various loss contingencies. Under SFAS No. 5,*Accounting for Contingencies*, anestimated loss contingency is accrued when it is probable that a liability hasbeen incurred or an asset has been impaired and the amount of loss can bereasonably estimated. We regularly evaluate current information available todetermine whether such amounts should be adjusted and record changes inestimates in the period they become known.

***Stock-Based Compensation.*****  **Prior to January 1, 2006, we accounted for allof employee and non-employee director stock-based compensation awards using theintrinsic value method under APB 25, and 

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provided therequired disclosures in accordance with SFAS 123. On January 1, 2006, weadopted SFAS 123R, using the modified prospective transition method. Weaccount for all stock-based compensation awards to consultants and othernon-employees in accordance with the FASB Emerging Issues Task Force Issue No. 96-18,*Accounting for Equity Instruments that are Issuedto Other than Employees for Acquiring or in Conjunction with Selling Goods orServices,* and SFAS 123, as amended by SFAS No. 148, *Accounting for Stock Based Compensation—Transition and Disclosure*(priorto January 1, 2006), or in accordance with SFAS 123R (subsequent to December 31,2005). We followed FASB Interpretation No. 28, *Accountingfor Stock Appreciation Rights and Other Variable Stock Option or Award Plans—anInterpretation of APB Opinions No. 15 and 25,*in therecognition of stock-based compensation expense measured under APB 25 (prior toJanuary 1, 2006) and the straight-line method in the recognition ofstock-based compensation expense under SFAS 123 (prior to January 1, 2006)and SFAS 123R (subsequent to December 31, 2005). Under both APB 25 andSFAS 123R, the requisite service period over which stock-based compensation isexpensed generally equals the vesting periods of the awards.

Under SFAS 123R, ourstock-based compensation is affected by our stock price as well as valuationassumptions, including the volatility of our stock price, expected term of theoption, risk-free interest rate and expected dividends. We utilize theBlack-Scholes valuation model for estimating the fair value on the date ofgrant of employee stock options. Prior to January 1,2006, 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 our initialpublic offering when our stock price experienced abnormally high volatilitylevels, which we believe is unlikely to be indicative of future stock pricebehavior. However, we have not placed sole reliance on implied volatility asoptions in our common stock that are actively traded on the open marketgenerally have a term of two years or less - substantially shorter than ourstock option’s expected term.

In connection with therestatement of our consolidated financial statements, we determined that duringthe period from May 2000 through December 31, 2005, we i) appliedincorrect measurement dates in the accounting for certain stock options and ii)incorrectly accounted for certain stock options that should have been recordedusing variable accounting. The correction of these errors related to stockoption accounting resulted in additional cumulative stock-based compensationcharges of approximately $54.1 million from 2000 through 2005.

Based on the availablefacts and circumstances surrounding our stock option granting practices, weadopted a methodology for determining the most likely measurement dates. Webelieve the application of this methodology indicated the date where the numberof options granted to each employee and the exercise price were known withfinality.

Weadopted the following framework based on the facts and circumstances of eachgrant.

(1)         Ifthe stock option grant was approved at a Board-level meeting, the datereflected in meeting minutes of our Board of Directors or Compensation Committeeof the Board of Directors in which the number of options for each recipient andthe exercise price for the grant has been clearly approved was determined to bethe most likely measurement date. Measurement dates for approximately 35% ofthe total number of grants were determined based on this method.

(2)         Ifthe stock option grant was approved by UWC, the date of communication of theprincipal terms of the grant to the recipients if prior to the signature dateon the UWC was determined to be the most likely measurement date. Measurementdates for approximately 42% of the total number of grants were determined basedon this method.

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(3)         Ifthe stock option grant was approved by UWC and we did not have clear priorevidence of the date the principal terms of the grant were communicated to therecipients, the date of receipt of the last signature for the UWC providedthere was clear evidence of the date the last signature was received wasdetermined to be the most likely measurement date. Measurement dates forapproximately 2% of the total number of grants were determined based on thismethod.

(4)         Ifthe stock option grant was approved by UWC and we did not have clear evidenceof the date the principal terms of the grant were communicated to therecipients or the date of receipt of the last signature on the UWC, we reviewedall other available evidence and used its judgment to determine the most likelymeasurement date. The additional available evidence included, but was notlimited to:

a.                  thenext date that the two Compensation Committee members were physically presentat a Board-level meeting where the UWC may have been signed and the meetingoccurred within a reasonable time period; and

b.                 thedate by which at least 90% of the stock option grant was entered into our stockoption administration system.

Measurement dates forapproximately 6% of the total number of grants were determined based on thenext date that the two Compensation Committee members were physically presentat a Board-level meeting and approximately 15% when at least 90% of the stockoption grant was entered into our stock option administration system.

After selecting ameasurement date through one of the four steps in the above framework, we thendetermined if there were any changes to the individual grant recipients oramount of options granted after the selected measurement date. If there were nochanges following the selected measurement date, then the measurement datewould remain unchanged. If we identified changes following the selectedmeasurement date, then the Company would evaluate whether the changes shoulddelay the measurement date for the entire list of grants until the list becamefinal or whether the changes should result in separate accounting for specificgrants. Factors considered in evaluating whether it would be appropriate todelay the measurement date until the list was final included: (1) thefrequency of any changes as well as the reason for any changes; (2) whetherthe changes were administrative in nature (corrections of errors for grants towhich recipients would have been otherwise entitled); and (3) whether thechanges reflected re-allocation of options among a broader range of recipients.

We acknowledge that manyof our measurement date conclusions are dependent on the facts andcircumstances of each stock option grant and involved the application ofsignificant management judgment. Because the revised measurement date may notbe the actual measurement date, we performed several analyses to compare theresults of selecting measurement dates based upon the above describedmethodology to what would have resulted under different methodologies. In thefirst analysis, we considered that the measurement dates for all the stockoption grants would be the last date the last required action for grants hadtaken place. In this analysis, the measurement date would be the date approvedat the Board or Compensation Committee meeting, the date of last receipt of theunanimous written consent or, if there was no evidence as to the receipt of thelast signature, the date of the next board-level meeting at which the twomembers of the Compensation Committee were present following the preparation ofa final list of grantees. Had we applied this alternate approach, the newmeasurement dates would have resulted in approximately $0.2 million less incumulative stock-based compensation charges being recorded from 2000 through2005.

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

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

 

Theamount of additional (less) cumulative stock-based compensation by year from2000 through 2005 under categories two, three and four of our framework basedupon the low, average and high closing prices during those periods is asfollows (in millions):

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

 

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

 

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

 

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

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

***Accounting forIncome Taxes.******  ***Our provisionfor income taxes is comprised of a current and a deferred portion. The currentincome tax provision is calculated as the estimated taxes payable or refundableon tax returns for the current year. We provide for deferred income taxesresulting from temporary differences between financial and taxable income. Suchdifferences arise primarily from tax net operating loss and creditcarryforwards, depreciation, deferred revenue, stock-based compensation expenseand accruals and 

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reserves. We assess therecoverability of any tax assets recorded on the balance sheet and provide anynecessary valuation allowances as required. If we were to determine that it wasmore likely than not that we would be unable to realize all or part of our netdeferred tax asset in the future, an adjustment to the deferred tax asset wouldbe charged to operations in the period that such determination was made. Inevaluating our ability to recover our deferred tax assets, we consider allavailable positive and negative evidence including our past operating results,the existence of cumulative income in the most recent fiscal years, changes inthe business in which we operate and our forecast of future taxable income. Indetermining future taxable income, we are responsible for assumptions utilizedincluding the amount of state, federal and international pre-tax operatingincome, the reversal of temporary differences and the implementation offeasible and prudent tax planning strategies. These assumptions requiresignificant judgment about the forecasts of future taxable income and areconsistent with the plans and estimates we are using to manage the underlyingbusinesses. Such assessment is completed on a jurisdiction by jurisdictionbasis.

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

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

***Three and Nine Months Ended September 30, 2006and 2005***

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

| ** **    | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Product       |       | $                                                    | 53,485     |                                                | $          | 29,384 |   | $ | 146,880 |   | $ | 93,134 |   |
| Service       |       | 22,524                                               |       | 16,596                                              |       | 53,604 |   | 44,157 |   |
| Total revenue |       | $                                                    | 76,009     |                                                | $          | 45,980 |   | $ | 200,484 |   | $ | 137,291 |   |

 

Product revenue is comprised of sales of our voiceinfrastructure products, including our GSX9000TM and GSX4000TM. Open Services Switches, PSX CallRouting Server, SGX Signaling Gateway, ASX Feature Server, Sonus InsightTM Management System and related productofferings. Product revenue for the three and nine months ended September 30,2006 increased 82% and 57.7%, respectively, from the comparable prior yearperiods. The increase in product revenue for the three months ended September 30,2006 was primarily the result of converting certain orders received during theprior fiscal quarters to product revenue. The increase for the nine monthsended September 30, 2006 was primarily the result of the conversion torevenue of orders received in the second half of fiscal 2005, coupled with ahigher percentage of product orders received and converted to revenue in thecurrent year nine month period, compared to the same prior year period.

Service revenue is primarily comprised of hardware andsoftware maintenance and support network design, installation and otherprofessional services. Service revenue for the three and nine months ended September 30,2006 increased 35.7% and 21.4%, respectively, from the comparable prior yearperiods. These increases were primarily a result of higher maintenance revenuedue to our growing installed product base and an increase in installationrevenue. For the nine months ended September 30, 2005, service revenue waspartially offset by lower resident engineering revenue.

Cingular Wireless and KDDI Corporation eachcontributed 10% or more of our revenue during at least one of the three andnine month periods ended September 30, 2006 and 2005.

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International revenue was approximately 54% and 24% ofrevenue for the three months ended September 30, 2006 and 2005,respectively, and 29% and 20% of revenue for the nine months ended September 30,2006 and 2005, respectively. We expect that international revenue will remainuneven as a percentage of revenue from quarter to quarter.

Our deferred product revenue was $32.9 million and$54.8 million at September 30, 2006 and December 31, 2005,respectively. Our deferred service revenue was $48.6 million and $67.4 millionat September 30, 2006 and December 31, 2005, respectively. Ourdeferred revenue balance may fluctuate as a result of the timing of revenuerecognition, customer payments, maintenance contract renewals, contractualbilling rights, customer creditworthiness and maintenance revenue deferralsincluded in multiple element arrangements. At September 30, 2006 and December 31,2005, deferred revenue and accounts receivable excluded $10.4 million and $5.3million, respectively, related to products shipped and billed to customerswhich are collectible under extended payment terms, for which revenue isrecognized as cash is collected, or for which title had not passed to thecustomer as of the period end date.

***Cost of Revenue/Gross Profit.******  ***Ourcost of revenue 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 ofrevenue and gross profit as a percentage of revenue for the three and ninemonths ended September 30, 2006 and 2005 were as follows (in thousands,except percentages):

| ** **                                    | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Cost of revenue                               |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                       |       | $                                                    | 18,612     |                                                | $          | 17,601 |   | $ | 50,694 |   | $ | 39,292 |   |
| Service                                       |       | 7,571                                                |       | 6,375                                               |       | 21,287 |   | 17,400 |   |
| Total cost of revenue                         |       | $                                                    | 26,183     |                                                | $          | 23,976 |   | $ | 71,981 |   | $ | 56,692 |   |
| Gross profit margin (% of respective revenue) |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                       |       | 65.2                                                 | %          | 40.1                                                | %          | 65.5 | % | 57.8 | % |
| Service                                       |       | 66.4                                                 | %          | 61.6                                                | %          | 60.3 | % | 60.6 | % |
| Total gross  profit margin                    |       | 65.6                                                 | %          | 47.9                                                | %          | 64.1 | % | 58.7 | % |

 

The increase in product gross profit as a percentageof revenue was primarily due to customer and product mix, partially offset by agreater percentage of revenue in fiscal 2006 from resellers with typicallylower gross margins. Our product gross profit remained higher than ourlong-term financial model of 58% to 62%. We can provide no assurance that thisfavorable customer and product mix will continue, and we expect that over timeour gross margins will return to levels consistent with our long-term financialmodel. The increase in service gross profit as a percentage of service revenuein the three months ended September 30, 2006, compared to the same prioryear period, was primarily due to the increase in service revenue in thecurrent year period. The decrease in the nine months ended September 30,2006, compared to the nine months ended September 30, 2005, was primarilydue to increased investment in our service organization to support theexpansion of our installed base and stock-based compensation recorded in thecurrent year periods. For the nine months ended September 30, 2006, thisdecrease was partially offset by an increase in service revenue. Our servicecost of revenue is relatively fixed in advance of any particular quarter and,therefore, changes in service revenue will have a significant impact on servicegross profit percentage.

***Research andDevelopment Expenses.******  ***Research and development expensesconsist primarily of salaries and related personnel costs and prototype costsrelated to the design, development, testing and enhancement of our products.Research and development expenses were $13.2 million for the three months endedSeptember 30, 2006, an increase of $1.3 million, or 10.4%, from $11.9million for the same 

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period in fiscal 2005. Researchand development expenses were $39.1 million for the nine months ended September 30,2006, an increase of $4.6 million, or 13.3%, from $34.5 million for the sameperiod in fiscal 2005. These increases primarily reflect an increase in salaryand related expenses associated with increased headcount and stock-basedcompensation expense recorded during the three and nine months ended September 30,2006. Some aspects of our research and development efforts require significantshort-term expenditures, the timing of which can cause significant variabilityin our expenses. We believe that rapid technological innovation is critical toour long-term success and we intend to continue to make substantial investmentsto enhance our products and technologies to meet the requirements of ourcustomers and market.

***Sales and MarketingExpenses.******  ***Sales and marketing expenses consistprimarily of salaries and related personnel costs, commissions, travel andentertainment expenses, promotions, customer evaluations and other marketingand sales support expenses. Sales and marketing expenses were $17.0 million forthe three months ended September 30, 2006, an increase of $6.0 million, or55%, from $10.9 million for the same period in fiscal 2005. Sales and marketingexpenses were $46.6 million for the nine months ended September 30, 2006,an increase of $14.6 million, or 45.0%, from $32.2 million for the same periodin fiscal 2005. The increases in the current year periods primarily reflect anincrease in salaries and travel expenses associated with increased headcountrelated to the expansion of our worldwide sales and support coverage, highercommissions and stock-based compensation expense recorded during the three andnine months ended September 30, 2006.

***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 $8.2 million for the three months ended September 30,2006, an increase of $2.0 million, or 33.3%,from $6.2 million for the same period in fiscal 2005. General andadministrative expenses were $22.4 million for the nine months ended September 30,2006, an increase of $2.5 million, or 12.8%, from $19.9 million for the sameperiod in fiscal 2005. These increases primarily reflect an increase in salaryand related expenses associated with increased headcount and the recording ofstock-based compensation expense during the three and nine months ended September 30,2006, partially offset by a decrease in directors and officers insurancepremiums. Higher professional fees, primarily related to our previouslydescribed stock option historical review, also contributed to the increases inthe current year periods. These increases were partially offset by the reversalof $0.5 million of restructure reserves related to a change in our decision toabandon a facility for which costs had previously been accrued.

***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 $4.0 million for the three months ended September 30,2006, an increase of $1.5 million from $2.6 million for the same prior yearperiod. Interest income, net of interest expense, was $11.2 million for thenine months ended September 30, 2006, an increase of $4.8 million from$6.4 million for the same period in fiscal 2005. These increases reflect thebenefit of increases in the yield on our portfolio due to an increasinginterest rate environment, shifting some of the marketable debt securities tolonger-term investments with a higher yield during 2006, and an overallincrease in cash and investments compared to the prior year.

***Income Taxes.******  ***Weprovide for income taxes during interim periods based on the estimatedeffective tax rate for the full fiscal year, and record a cumulative adjustmentto the tax provision in an interim period in which a change in the estimatedannual effective tax rate is determined. Werecorded a provision for income taxes of $1.2 million and $2.4 million for thethree and nine months ended September 30, 2006, respectively. Theprovision in both current year periods includes $0.5 million of provisionattributable to a discrete item related to the recognition of revenue in aforeign jurisdiction that had previously been deferred. In the three and ninemonths ended September 30, 2005, we recorded benefits from income taxes of

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$0.6 millionand $0.2 million, respectively. Our provisions for income taxes are primarilyattributable to foreign income taxes and state income taxes in the U.S. We haverecorded a full valuation allowance for the related federal and state netdeferred tax asset due to the uncertainty of realizing the benefit of thisasset.

**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 September 30, 2006, our principal sources ofliquidity were our cash, cash equivalents, marketable debt securities andlong-term investments totaling $346.1 million.

Our operating activities provided $21.6 million ofcash in the nine months ended September 30, 2006, compared to $17.2million of cash in the same prior year period. Cash provided by operatingactivities in the current year period came from $29.1 million of net income,after adjustments for non-cash expense totaling $15.4 million, primarilystock-based compensation and depreciation and amortization of property andequipment. Net income and non-cash items were further benefited by decreases of$23.5 million and $12.1 million in accounts receivable and inventory. Theseamounts were partially offset by decreases of $41.2 million in deferredrevenue, $10.1 million in accounts payable, $1.5 million in accrued expenses,deferred rent and accrued restructuring expenses and $0.4 million of paymentsof long-term obligations. Increases in other operating assets used $5.3 millionin the current year period. Cash provided by operating activities in the ninemonths ended September 30, 2005 came from non-cash expenses related todepreciation and amortization of property and equipment and stock-basedcompensation. Higher levels of deferred revenue and accounts payable provided$20.2 million and $4.0 million of cash, respectively. These amounts werepartially offset by increases to accounts receivable, inventory and otheroperating assets totaling $11.6 million, coupled with $3.1 million of cashused for accrued expenses, deferred rent and accrued restructuring expenses.

In the nine months ended September 30, 2006, ournet investments in marketable debt securities and long-term investments were$124.9 million. At September 30, 2006, our investments had an averageremaining maturity of 6 months. During the current year period, we spent $7.9million to purchase property and equipment. In the nine months ended September 30, 2005, our investments inmarketable debt securities and long-term investments were virtually equal tomaturities of the same. We spent $11.2 million of cash to purchase property andequipment.

Our financing activities provided $17.9 million ofcash in the nine months ended September 30, 2006, compared to $6.3 millionin the same prior year period. Net cash provided by financing activities inboth the current and prior year nine month periods was primarily attributableto proceeds from the exercise of stock options and the sale of common stock inconnection with our employee stock purchase plan. Cash from these transactionstotaled $27.9 million and $6.4 million in the nine months ended September 30,2006 and 2005, respectively. These proceeds in the current year period werepartially offset by the repayment, in May 2006, of our $10.0 million,4.75% convertible subordinated note.

Based on our currentexpectations, we believe our current cash, cash equivalents, marketable debtsecurities and long-term investments will be sufficient to meet our anticipatedcash needs for working capital and capital expenditures for at least 12 months.Although it is difficult to predict future liquidity requirements withcertainty, the rate at which we will consume cash will be dependent on the cashneeds of future operations, including changes in working capital, which will,in turn, be directly affected by the levels of demand for our products, thetiming and rate of expansion of our business, the resources we devote todeveloping our products and any litigation settlements. We anticipate devotingsubstantial capital 

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resourcesto continue our research and development efforts, to maintain our sales,support and marketing operations, to improve our internal control environmentand for other general corporate activities, as well as to vigorously defendagainst existing and potential litigation relating to the restatement of ourconsolidated financial statements. See Note 5 to our condensed consolidatedfinancial statements.

**Recent AccountingPronouncement*s***

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS 159”). SFAS 159 permits an entity tomeasure certain financial assets and financial liabilities at fair value. UnderSFAS 159, entities that elect the fair value option will report unrealizedgains and losses in earnings at each subsequent reporting date. The fair valueoption may be elected on an instrument-by-instrument basis, with a fewexceptions, as long as it is applied to the instrument in its entirety. SFAS159 establishes presentation and disclosure requirements, but does noteliminate disclosure requirements of other accounting standards. Assets andliabilities that are measured at fair value must be displayed on the face ofthe balance sheet. SFAS 159 is effective in fiscal years beginning after November 15,2007, although its provisions may be applied earlier if certain conditions aremet. We are currently evaluating the impact of SFAS 159 on our consolidatedresults of operations and financial condition.

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

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

In June 2006, theFASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109*(“FIN 48”), which clarifies the accounting for uncertainty in income taxesrecognized in a company’s financial statements in accordance with FASB StatementNo. 109, *Accounting for Income Taxes.*FIN48 prescribes a two-step process to determine the amount of tax benefit to berecognized. First, the tax position must be evaluated to determine thelikelihood that it will be sustained upon external examination. If the taxposition is deemed more-likely-than-not to be sustained, the taxposition is then assessed to determine the amount of benefit to recognize inthe financial statements. The amount of the benefit that may be recognized isthe largest amount that has a greater than 50% likelihood of being realizedupon ultimate settlement. We adopted FIN 48 on January 1, 2007. Theadoption of FIN 48 did not have a material impact on our consolidated resultsof operations or financial condition.

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

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

**Item 4.**                        Controlsand Procedures

**Disclosure Controlsand Procedures**

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

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

These materialweaknesses included the following:

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

·       Inadequaterevenue recognition procedures and controls; and

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

Subsequent to theevaluation made in connection with the filing of our Form 10-K forthe year ended December 31, 2005 and in connection with the restatement ofour consolidated financial statements for the years ended December 31,2005 and 2004 that is described in the Explanatory Note beginning on page 2of this Form 10-Q, our management, with the participation of ourprincipal executive officer and principal financial officer, identified thefollowing additional material weaknesses in internal control as of December 31,2005:

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

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

Our management, with the participation of ourprincipal executive officer and principal financial officer, is responsible forestablishing and maintaining adequate control over financial reporting asdefined in Rules 13a-15(f) under the Exchange Act. Our internalcontrol system is designed to provide reasonable assurance to our managementand Board of Directors regarding the preparation and fair presentation ofpublished financial statements.

Public Accounting Oversight Board Auditing Standard No. 2defines a material weakness as a significant deficiency, or combination ofsignificant deficiencies, that results in there being more than a remote likelihoodthat a material misstatement of the annual or interim financial statements willnot be prevented or detected.

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

**Changes in InternalControl over Financial Reporting**

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

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

**Risk assessment:**

·       Enhancedand re-designed control activities for all business cycles to ensure theyproperly address business objectives and risks;

·       Enhancedthe annual planning process to ensure business risks to company objectives areappropriately addressed; and

·       Enhanced the level ofbackground checks performed on new employees to include all sales and financepersonnel, Board members and all other management, director level and above.

**Information andCommunication:**

·       Developed and conducted aweb-based corporate ethics training program to provide an efficient tool foremployees to meet annual compliance requirements.

**Monitoring:**

·       Improved foreign entitycompliance with company policy regarding accounting, reporting and asset management.

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

·       Enhancedthe effectiveness of the review process for all product commitments to ensurecommitted features are authorized and validated against independent sourcedocumentation before revenue is recognized; and

·       Enhanced the effectivenessof the review process for recognizing revenue by requiring the Director ofAccounting Operations to review and approve the reconciliation of the revenuesub-ledger report for the period to the general ledger balance.

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

**Completeness,accuracy, review and timely recording of transactions, reconciliations, andjournal entries:**

·       Implementedan automated travel and expense reimbursement application to improve thetimeliness, accuracy and completeness of all travel-related expensereimbursement requests;

·       Designed a process to tagall fixed assets additions and to validate these transactions against sourcedocuments before entering the data into the fixed asset system; and

**Inadequatedesign and documentation of controls:**

·       Enhanced and redesignedcontrol activities for all business cycles to ensure they properly addressbusiness objectives and risks.

***Inadequate controls over the accounting for stock-basedcompensation:***

·       Established procedures tohelp ensure that (a) stock option agreements are promptly prepared andsigned following each employee’s new hire date or the date of grant to anexisting****employee, and (b) the grantinformation is promptly entered into our automated third-party stockadministration system;

·       Improved communicationamong finance, human resource and legal functions to ensure potential issuesare identified timely and all transactions are recorded in accordance withgenerally accepted accounting principles; and

·       Enhanced stockadministration practices to address the new notification requirement of FAS123R:

·        Modified offer letters to new hire employees to communicate grantdate and number of shares.

·        Implemented a policy aspart of new hire orientation for U.S.-based employees where our human resourcesadministrator informs all new hires of the date of grant for their new hireoption grants. New hire orientation for U.S.-based employees typically takesplace on the employee’s start date.

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

***Risks and Inherent Limitations***

Prior to the complete remediation of these materialweaknesses, there remains risk that the processes and procedures on which wecurrently rely will fail to be sufficiently effective, which could result inmaterial misstatement of our financial position or results of operations andrequire a restatement. Moreover, because of the inherent limitations in allcontrol systems, no evaluation of controls—even where we conclude the controlsare operating effectively—can provide absolute assurance that all control 

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issues, includinginstances of fraud, if any, have been detected. These inherent limitationsinclude the realities that judgments in decision-making can be faulty, andbreakdowns can occur because of a simple error or mistake. Additionally,controls can be circumvented by the individual acts of some persons, by collusionof two or more people, or by management override of the controls. The design ofany system of controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions. Overtime, our control systems, as we develop them, may become inadequate because ofchanges in conditions, or the degree of compliance with the policies orprocedures may deteriorate. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected and could be material to our financial statements.

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

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**PART II—OTHERINFORMATION**

**Item 1.        Legal Proceedings**

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

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

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

On January 6, 2006, a purchaser of our commonstock filed a complaint in the United States District Court for the District ofMassachusetts that is essentially identical to the Consolidated AmendedComplaint previously filed against the defendants. The Court has appointed thePublic Employees’ Retirement System of Mississippi as lead plaintiff. The leadplaintiff has filed an Amended Consolidated Complaint. The defendants filed on April 19,2007 a motion to dismiss the Amended Consolidated Complaint. There is noassurance we will prevail in such a motion or defending this action. A judgment or a settlement of the claims against thedefendants could have a material impact on our financial results. It is tooearly to determine 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 us and certain of our currentofficers and directors. On June 28, 2004, the court consolidated theclaims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the Exchange Act andSections 11, 12(a), and 15 of the Securities Act, relating to our restatementof our financial results for 2001, 2002, and the first three quarters of 2003. Specifically,the complaint alleges that we issued a series of false or misleading statementsto the market concerning our revenues, earnings, and financial condition. Plaintiffscontend that such statements caused our stock price to be artificially inflated.The complaint seeks unspecified damages on behalf of a purported class ofpurchasers of our common stock during the period from March 28, 2002through March 26, 2004. On January 28, 2005, we filed a motion todismiss the Section 10(b) and 12(a) claims and joined the motionto dismiss the Section 11 claim filed by the individual defendants. On June 1,2005, the court held a hearing on the motion and allowed the plaintiff to filean amended complaint. The plaintiff filed an amended complaint that includedthe same claims and substantially similar allegations as set forth in theinitial complaint. On September 12, 2005, the defendants filed motions todismiss this amended complaint. On December 10, 2005, the court held ahearing on the motions and took the matter under advisement. On May 10,2006, the court issued an order granting the defendants’ motions in part anddenying the motions in part. The court dismissed the Section 12(a)(2) claimsagainst all the defendants and the Section 10(b) and Section 11claims against the individual defendants. The court denied the motions as tothe Section 10(b) and Section 11 claims against us and Section 15claims against the individual defendants. The plaintiff has filed a motion forclass certification, which the defendants have opposed. The court held ahearing on February 28, 2007 on plaintiff’s motion for class certificationand took the matter under advisement. We believe that we have substantial legaland factual defenses to the claims, which we intend to pursue vigorously. Weexpect to incur significant legal fees in defending this action. At this time,we are unable to determine the ultimate outcome or potential range of loss, ifany.

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

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

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

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

On November 14, 2006,a purported shareholder derivative lawsuit was filed in the United DistrictCourt for the District of Massachusetts against us and certain of our officersand directors, naming us as a nominal defendant. Other purported shareholdersfiled virtually identical complaints. The suits claim that certain of ourofficers and directors breached their fiduciary duties to our stockholders andto us in connection with our announced stock option review. The complaints arederivative in nature and do not 

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seekrelief from us. However, we have entered into indemnification agreements in theordinary course of business with certain of the defendant officers anddirectors and may be obligated throughout the pendency of these actions toadvance payment of legal fees and costs incurred by the defendants pursuant toour obligations under the indemnification agreements or applicable Delaware law.By order dated December 18, 2006, the Court consolidated the actions. Theplaintiffs have filed a consolidated complaint. The defendants filed on March 19,2007 a motion to dismiss the consolidated complaint. The Court held a hearingon July 11, 2007, and took the motion under advisement. We believe that wehave substantial legal and factual defenses to the derivative claims, which weintend to pursue vigorously. There is no assurance we will prevail in defendingthese actions. We cannot predict the ultimate outcome of this litigation or anypotential impact on our operating results or financial position.

On January 19, 2007,a purported shareholder derivative lawsuit was filed in the Superior CourtDepartment of Middlesex County of Massachusetts against certain of our directorsand officers, also naming us as a nominal defendant. Another purportedshareholder filed a virtually identical complaint. The suits assert similarclaims and seek relief similar to the derivative suits filed in federal court. OnMay 7, 2007, the plaintiffs filed a consolidated complaint. On June 6,2007, the defendants moved to dismiss the consolidated complaint. The Courtscheduled a hearing on the motion for August 14, 2007. We believe that wehave substantial legal and factual defenses to the derivative claims, which weintend to pursue vigorously. There is no assurance we will prevail in defendingthese actions. We cannot predict the ultimate outcome of this litigation or anypotential impact on our operating results or financial position.

As announced on March 19,2007, the SEC is conducting a formal private investigation into our stockoption granting practices. If we are subject to adverse findings, we could berequired to pay damages or penalties or have other remedies imposed, includingcriminal penalties, which could adversely our business, financial position orresults of operations.

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. Otheragreements with our customers provide indemnification for claims relating toproperty damage or personal injury resulting from the performance of servicesby us or our subcontractors. Historically, our costs to defend lawsuits orsettle claims relating to such indemnity agreements have been insignificant. Accordingly,the estimated fair value of these indemnification provisions is immaterial.

The Internal RevenueService has notified us that our payroll tax returns for the years ended December 31,2004, 2005 and 2006 have been selected for audit in connection with our stockoption review. In connection with the restatement of our financial statementsincluded in this Form 10-Q, we have recorded approximately $1.6 million of accruals for additional tax,penalties and interest related to adjustments resulting from errors in stockoption accounting. For more information about stock-based compensation,including the financial statement impact from the restatement, see “ExplanatoryNote” preceding part I, Item 1; Note 2, “Restatement of Consolidated FinancialStatements” of the Notes to the Condensed Consolidated Financial Statements. Wecould be required to pay additional tax, penalties or interest, or have otherremedies imposed, which could adversely impact our business, financial positionor results of operations.

**Item1A.     Risk Factors**

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

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***The investigationof our historical stock option practices and the restatement of our priorfinancial statements may require us to incur substantial expenses and directour management’s attention from our business, which may impact*** our business,financial position and results of operations and the trading price ofour common stock.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

On August 2, 2007, we filed our Quarterly Report on Form 10-Qfor the quarter ended June 30, 2006 (the “Second Quarter Form 10-Q”),this Quarterly Report on Form 10-Q for the quarter ended September 30,2005 (the “Third Quarter Form 10-Q”), and will file our AnnualReport on Form 10-K for the year ended December 31, 2006 (the “2006Form 10-K”) and our QuarterlyReport on Form 10-Q for the quarter ended March 31, 2007 (the “FirstQuarter Form 10-Q”) with the SEC. We consider that the filing ofthese reports has remedied our non-compliance with Marketplace Rule 4310(c)(14),subject to NASDAQ’s affirmative completion of its compliance protocols and itsnotification to us accordingly. However, if NASDAQ disagrees with our positionor if the SEC disagrees with the manner in which we have accounted for andreported, or not reported, the financial impact of past stock option grants,there could be further delays in filing subsequent SEC reports or other actionsthat might result in delisting of our common stock from the NASDAQ GlobalSelect Market.

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

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

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

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

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

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

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

To date, we haveshipped our products to a limited number of customers. We expect that in theforeseeable future, the majority of our revenues will continue to depend onsales of our products to a limited number of customers. Two customers eachcontributed more than 10% of our revenues in the nine months ended September 30,2006, or approximately 41% of revenue in the aggregate. One customercontributed approximately 28% of our revenues in fiscal 2005. Two customerseach contributed more than 10% of our revenues, or approximately 29% in theaggregate, in fiscal 2004. Our future success will depend on our ability toattract additional customers beyond our current limited number. The growth ofour customer base could be adversely 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 and adversely affect ourfinancial position and results of operations. If we do not expand our customerbase to include additional customers that deploy our products in operationalcommercial networks, our business, operating results and financial positioncould be materially and adversely affected.

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

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

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

We expect some ofthe developments described above to continue to affect our business in 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 public network is new and evolving andour business will suffer if it does not develop as we expect.***

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

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

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

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

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

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

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

Our future success is highly dependent uponestablishing and maintaining successful relationships with a variety ofvalue-added reseller and distribution partners. A portion of our revenues isderived through distributors, many of which sell competitive products. Ourrevenues depend in part on sales by these distributors. The loss of orreduction in sales by these distributors could materially reduce our revenues. Ifwe fail to maintain relationships with these distribution partners, fail todevelop new relationships with distributors in new markets, fail to manage,train, or provide incentives to existing distributors effectively or if thesepartners are not successful in their sales efforts, sales of our products maydecrease and our operating results could suffer.

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

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

Internationalrevenues approximated $29 million in the nine months ended September 30,2006 and $48 million in 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;

·       potentiallyadverse tax consequences; and

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·       political and economicinstability.

***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.

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

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

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

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

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

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

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

Competition in the telecommunications market isintense. This market has historically been dominated by large incumbenttelecommunications equipment companies, such as Alcatel-Lucent, NEC, Nortel Networks,Nokia Siemens and Ericsson, all of which are our direct competitors. We alsoface competition from other large telecommunications and networking companies,including Cisco Systems, some of which have entered our market by acquiringcompanies that design competing products. Alcatel and Lucent recently completedtheir merger. Siemens has combined its networking business with Nokia’snetworking business. Other competitors may merge, intensifying competition. Additionalcompetitors with significant financial resources also may enter our markets andfurther 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, maycause our customers to buy our competitors’ products or harm our ability toattract new customers.

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;

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·       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 tocompete successfully against our current and future competitors, we couldexperience price reductions, order cancellations, loss of customers andrevenues and reduced 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. Becauseof the nature of our products, they can only be fully tested when substantiallydeployed in very large networks with high volumes of traffic. Some of ourcustomers have only recently begun to commercially deploy our products and theymay discover errors or defects in the software or hardware, or the products maynot operate as expected. As we continue to expand our distribution channelthrough distributors and resellers, we will need to rely on and support theirservice and support organizations. If we are unable to fix errors or otherperformance problems that may be identified after full deployment of ourproducts, we could experience:

·       lossof, or delay in, revenues;

·       lossof customers and market share;

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

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

·       costly and time-consuminglegal actions by our customers.

***Because our products are deployed in large, complexnetworks around the world, failure to establish a support infrastructure andmaintain required support levels could seriously 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 levelthroughout the world. If we are unable to provide the expected level of supportand service to our customers, we could experience:

·       lossof customers and market share;

·       afailure to attract new customers in new geographies;

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

·       network performancepenalties.

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

We have made significantchanges in our senior management team since January 1, 2006. Because ofthese significant changes, our management team may not be able to work togethereffectively to successfully develop and implement our business strategies. Inaddition, management will need to devote 

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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 hire and retain needed personnel, theimplementation of our business plan could slow or our future growth could halt.***

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

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

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

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

***We depend upon a single contract manufacturer and anydisruption in this relationship may cause us to fail to meet the demands of ourcustomers and damage our customer relationships.***

We rely on a contractmanufacturer to manufacture our products according to our specifications and tofill orders on a timely basis. Our contract manufacturer provides comprehensivemanufacturing services, including assembly and certain tests of our productsand procurement of materials. Our contract manufacturer also builds productsfor other companies and may not always have sufficient quantities of inventoryavailable to fill our orders or may not allocate their internal resources tofill these orders on a timely basis. We do not have a long-term supply contractwith our manufacturer nor is our manufacturer required to manufacture productsfor any specified period. We do not have internal manufacturing capabilities tomeet our customers’ demands. Qualifying a new contract manufacturer andcommencing commercial scale production is expensive and time consuming andcould result in a significant interruption in the supply of our products. If achange in contract manufacturers results in delays in our fulfillment ofcustomer orders or if a contract manufacturer fails to make timely delivery oforders, we may lose revenues and suffer damage to our customer relationships. In 2006, we consolidated our manufacturingto a single contract manufacturer. We also intend to move our contractmanufacturing to a lower cost, offshore facility. If we do not manage thisconsolidation effectively, these consolidation activities could result in thedisruption in the supply of our products and in delays in our fulfillment ofcustomer orders.

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

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

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

***If we are not ableto obtain necessary licenses of third-party technology at acceptable prices, orat all, our products could become obsolete.***

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

***Failures by ourstrategic partners or by us in integrating products provided by our strategicpartners could seriously harm our business.***

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

·       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 to compete and our business could bejeopardized if we are unable to protect our intellectual property or becomesubject to intellectual property rights claims, which could require us to incursignificant costs.***

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

In addition, wehave received inquiries from other patent holders and may become subject toclaims that we infringe their intellectual property rights. Any partiesasserting that our products infringe upon their proprietary rights could forceus to license their patents for substantial royalty payments or to defendourselves and possibly our customers or contract manufacturers in litigation. These claims and any resulting licensingarrangement or lawsuit, if successful, could subject us to significant royaltypayments or liability for damages and invalidation of our proprietary rights. Anypotential intellectual property litigation also could force us to do one ormore 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 regarding intellectual property rights,regardless of their success, would be time-consuming, expensive to resolve andwould divert our management’s time and attention.

On June 14, 2006, C2Communications Technologies, Inc. (“C2 Communications”) sued AT&T, Inc.,Verizon Communications, Inc., Qwest Communications International, Inc.(“Qwest”), Bellsouth Corporation (“Bellsouth”), Sprint Nextel Corporation,Global Crossing Limited (“Global Crossing”) and Level 3 Communications, Inc.(“Level 3”) in the Eastern District of Texas, Marshall Division. C2 Communicationshas alleged that each of the defendants infringe U.S. Patent No. 6,243,373entitled “Method and Apparatus for Implementing a Computer Network InternetTelephone System.” We have agreed, subject to certain conditions, to assume thedefense of Qwest, Global Crossing and Level 3 in this litigation to the extentthe claim results from their use of products purchased from us. There can be noassurance that other defendants who have purchased our products will not seekindemnification from us. We believe that the defendants have substantial legaland factual defenses to the infringement claim, which we intend to pursuevigorously on behalf of the defendant for whom we agree or are required toassume defense of the litigation. However, there is no assurance any of thedefendants will prevail in defending this action. There also can be noassurance that we will not be required to indemnify any of the defendants fromany judgment of infringement rendered against them. We will be required todevote significant time and resources in connection with assuming the defenseof the claim of infringement on behalf of the defendants for whom we haveagreed to assume defense of the litigation. An adverse outcome with respect tothe claim and our indemnification could have a material adverse impact on ourbusiness, operating results and financial condition.

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

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

·       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;

·       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.

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

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

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***We may seek to raise additional capital in the future,which may not be available to us, and if it is available, may dilute theownership 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.

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

***Changes in effective tax rates or adverse outcomesresulting from examination of our income or other tax returns could adverselyaffect our results.***

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

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

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

·       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;

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·       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.

***Provisions of our charter documents and Delaware lawhave anti-takeover effects that could prevent a change of control.***

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

**Item6.**                        Exhibits

| Exhibit Number | ** ** | ** **                                                                                                | ** ** | **Description** |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|-----------------|
| 31.1                |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 |
| 31.2                |       | Certification of  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002 |
| 32.1                |       | Certification of  Chief Executive Officer Section 906 of the Sarbanes-Oxley Act of 2002              |
| 32.2                |       | Certification of Chief  Financial Officer Section 906 of the Sarbanes-Oxley Act of 2002              |

 

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**SIGNATURES**

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

 

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**EXHIBITINDEX**
| Exhibit Number | ** ** | ** **                                                                                                | **Description** |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------|-----------------|
| 31.1                |       | Certification of Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002  |
| 31.2                |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 |
| 32.1                |       | Certification of Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002 |
| 32.2                |       | Certification of Chief  Financial Officer pursuant Section 906 of the Sarbanes-Oxley Act of 2002     |

 

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