**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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FORM 10-Q

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

**For the quarterly periodended June 30, 2005**

**Commission File Number000-30229**

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SONUSNETWORKS, INC.

(Exact name of Registrant as specified in its charter)

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

 

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

(Address of principal executive offices, including zipcode)

**(978) 614-8100**

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the Registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes x  No o

Indicate by check mark whether the Registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x  No o

Asof July 31, 2005, there were 248,697,061 shares of $0.001 par value pershare, common stock outstanding.

 

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**SONUSNETWORKS, INC.FORM 10-QQUARTER ENDED JUNE 30, 2005TABLE OF CONTENTS**
|                                             | ** **                                                                                                                                  | **Page** | ** ** |
|---------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------|----------|------------|
| **PART I—FINANCIAL  INFORMATION** |                                                                                                                                        |     |       |   |
| Item 1:                                     | Financial  Statements                                                                                                                       |     |       |   |   |
|                                        | Condensed Consolidated  Balance Sheets as of June 30, 2005 and December 31, 2004  (unaudited)       |     | 1          |   |   |
|                                        | Condensed Consolidated  Statements of Operations for the Three and Six Months Ended June 30,  2005 and 2004 (unaudited)                |     | 2          |   |   |
|                                        | Condensed Consolidated  Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004  (unaudited)                          |     | 3          |   |   |
|                                        | Notes to  Condensed Consolidated Financial Statements (unaudited)                                                                           |     | 4          |   |   |
| Item  2:                                    | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                                 |     | 18         |   |   |
| Item  3:                                    | Quantitative and Qualitative  Disclosures About Market Risk                                                                                 |     | 40         |   |   |
| Item 4:                                     | Controls and Procedures                                                                                                                     |     | 40         |   |   |
| **PART II—OTHER INFORMATION**     |                                                                                                                                        |     |       |   |
| Item 1:                                     | Legal Proceedings                                                                                                                           |     | 43         |   |   |
| Item 5:                                     | Other Information                                                                                                                           |     | 45         |   |   |
| Item 6:                                     | Exhibits                                                                                                                                    |     | 45         |   |   |
|                                        | Signatures                                                                                                                                  |     | 46         |   |   |

 

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**PART I—FINANCIAL INFORMATION**

**Item 1: FinancialStatements**

**SONUSNETWORKS, INC.Condensed ConsolidatedBalance Sheets(In thousands, except share data)(unaudited)**
| ** **                                                                                                                                                                                                                | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                                | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **Current assets:**                                                                                                                                                                                                       |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                 |       | $                       | 120,291    |                        | $          | 121,931 |   |
| Marketable securities                                                                                                                                                                                                     |       | 183,703                 |       | 170,145                     |       |
| Accounts receivable, net                                                                                                                                                                                                  |       | 62,062                  |       | 32,486                      |       |
| Inventory, net                                                                                                                                                                                                            |       | 30,546                  |       | 28,346                      |       |
| Other current assets                                                                                                                                                                                                      |       | 12,020                  |       | 10,891                      |       |
| Total current assets                                                                                                                                                                                                      |       | 408,622                 |       | 363,799                     |       |
| **Property and equipment,**  net                                                                                                                                                                                          |       | 12,650                  |       | 8,217                       |       |
| **Long-term investments**                                                                                                                                                                                                 |       | 7,411                   |       | 21,029                      |       |
| **Other assets**                                                                                                                                                                                                          |       | 822                     |       | 783                         |       |
|                                                                                                                                                                                                                      |       | $                       | 429,505    |                        | $          | 393,828 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                            | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **Current liabilities:**                                                                                                                                                                                                  |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                                          |       | $                       | 11,982     |                        | $          | 8,654 |   |
| Accrued expenses                                                                                                                                                                                                          |       | 17,314                  |       | 18,240                      |       |
| Accrued restructuring  expenses                                                                                                                                                                                           |       | 191                     |       | 186                         |       |
| Current portion of  deferred revenue                                                                                                                                                                                      |       | 87,433                  |       | 65,105                      |       |
| Convertible subordinated  note                                                                                                                                                                                            |       | 10,000                  |       | —                      |       |
| Current portion of long-term  liabilities                                                                                                                                                                                 |       | 44                      |       | 30                          |       |
| Total current  liabilities                                                                                                                                                                                                |       | 126,964                 |       | 92,215                      |       |
| **Long-term  deferred revenue,**less current portion                                                                                                                                                                      |       | 27,428                  |       | 25,960                      |       |
| **Long-term liabilities,**  less current portion                                                                                                                                                                          |       | 600                     |       | 613                         |       |
| **Convertible subordinated note**                                                                                                                                                                                         |       | —                  |       | 10,000                      |       |
| **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, 250,699,142 and 249,755,118 shares  issued and 248,402,232 and 247,458,208 shares outstanding at  June 30, 2005 and December 31, 2004 |       | 251                     |       | 250                         |       |
| Capital in excess of par  value                                                                                                                                                                                           |       | 1,052,564               |       | 1,049,142                   |       |
| Accumulated deficit                                                                                                                                                                                                       |       | (778,035                | )          | (784,085                    | )          |
| Treasury stock, at cost;  2,296,910 common shares at June 30, 2005 and December 31, 2004                                                                                                                        |       | (267                    | )          | (267                        | )          |
| Total stockholders’ equity                                                                                                                                                                                           |       | 274,513                 |       | 265,040                     |       |
|                                                                                                                                                                                                                      |       | $                       | 429,505    |                        | $          | 393,828 |   |

 

*The accompanying notes are an integral part ofthese condensed consolidated financial statements.*

1

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**SONUSNETWORKS, INC.Condensed ConsolidatedStatements of Operations(In thousands, except per share data)(unaudited)**
| ** **                                          | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                        | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenues:**                                       |       |                                            |       |                                          |       |   |   |   |   |
| Product                                             |       | $                                               | 41,339     |                                          | $          | 30,587 |   | $ | 63,797 |   | $ | 56,832 |   |
| Service                                             |       | 16,754                                          |       | 11,774                                        |       | 27,906 |   | 22,061 |   |
| Total revenues                                      |       | 58,093                                          |       | 42,361                                        |       | 91,703 |   | 78,893 |   |
| **Cost of revenues**  (1):                          |       |                                            |       |                                          |       |   |   |   |   |
| Product                                             |       | 15,404                                          |       | 9,714                                         |       | 22,247 |   | 17,855 |   |
| Service                                             |       | 5,651                                           |       | 4,227                                         |       | 10,920 |   | 8,486 |   |
| Total cost of revenues                              |       | 21,055                                          |       | 13,941                                        |       | 33,167 |   | 26,341 |   |
| **Gross  profit**                                   |       | 37,038                                          |       | 28,420                                        |       | 58,536 |   | 52,552 |   |
| **Operating expenses:**                             |       |                                            |       |                                          |       |   |   |   |   |
| Research and development (1)                        |       | 11,098                                          |       | 8,923                                         |       | 22,115 |   | 17,851 |   |
| Sales and marketing (1)                             |       | 11,504                                          |       | 8,635                                         |       | 20,531 |   | 15,495 |   |
| General and administrative (1)                      |       | 6,477                                           |       | 5,745                                         |       | 13,277 |   | 10,572 |   |
| Stock-based compensation                            |       | 4                                               |       | 136                                           |       | 4 |   | 515 |   |
| Amortization of purchased intangible assets         |       | —                                          |       | 600                                           |       | — |   | 1,200 |   |
| Total operating expenses                            |       | 29,083                                          |       | 24,039                                        |       | 55,927 |   | 45,633 |   |
| **Income  from operations**                         |       | 7,955                                           |       | 4,381                                         |       | 2,609 |   | 6,919 |   |
| Interest expense                                    |       | (121                                            | )          | (121                                          | )          | (249 | ) | (243 | ) |
| Interest income                                     |       | 2,222                                           |       | 891                                           |       | 4,097 |   | 1,656 |   |
| **Income  before income taxes**                     |       | 10,056                                          |       | 5,151                                         |       | 6,457 |   | 8,332 |   |
| Provision for income taxes                          |       | 311                                             |       | 217                                           |       | 407 |   | 384 |   |
| **Net  income**                                     |       | $                                               | 9,745      |                                          | $          | 4,934 |   | $ | 6,050 |   | $ | 7,948 |   |
| **Net income per share:**                           |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                               |       | $                                               | 0.04       |                                          | $          | 0.02 |   | $ | 0.02 |   | $ | 0.03 |   |
| Diluted                                             |       | $                                               | 0.04       |                                          | $          | 0.02 |   | $ | 0.02 |   | $ | 0.03 |   |
| **Shares used in computing net  income per share:** |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                               |       | 248,249                                         |       | 245,390                                       |       | 248,064 |   | 244,906 |   |
| Diluted                                             |       | 250,651                                         |       | 250,127                                       |       | 252,709 |   | 253,480 |   |

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(1)          Excludesnon-cash, stock-based compensation expense as follows: 
| Cost of revenues            |   | $      | — |   | $      | 6      |   | $   | — |   | $ | 10  |   |
|-----------------------------|--------|--------|--------|--------|--------|--------|--------|-----|--------|--------|---|-----|--------|
| Research and  development   |   | — |   | 52     |   | — |   | 162 |   |
| Sales and  marketing        |   | 4      |   | 52     |   | 4      |   | 263 |   |
| General and  administrative |   | — |   | 26     |   | — |   | 80  |   |
|                        |   | $      | 4      |   | $      | 136    |   | $   | 4      |   | $ | 515 |   |

 

The accompanying notes arean integral part of these condensed consolidated financial statements.

2

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**SONUSNETWORKS, INC.Condensed ConsolidatedStatements of Cash Flows(In thousands)(unaudited)**
| ** **                                                                         | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| **Cash flows from operating  activities:**                                         |       |                                          |       |   |   |
| Net income                                                                         |       | $                                             | 6,050      |   | $ | 7,948 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                          |       |   |   |
| Depreciation                                                                       |       | 3,102                                         |       | 2,903 |   |
| Tax benefit from stock options exercised                                           |       | 225                                           |       | — |   |
| Stock-based compensation                                                           |       | 4                                             |       | 515 |   |
| Amortization of purchased intangible assets                                        |       | —                                        |       | 1,200 |   |
| Changes in  current assets and liabilities:                                        |       |                                          |       |   |   |
| Accounts receivable                                                                |       | (29,576                                       | )          | (8,156 | ) |
| Inventory                                                                          |       | (2,200                                        | )          | (6,462 | ) |
| Other current assets                                                               |       | (1,129                                        | )          | (7,624 | ) |
| Accounts payable                                                                   |       | 3,328                                         |       | 5,378 |   |
| Accrued expenses                                                                   |       | (1,016                                        | )          | (578 | ) |
| Deferred revenue                                                                   |       | 23,796                                        |       | 6,006 |   |
| Net cash provided by operating activities                                          |       | 2,584                                         |       | 1,130 |   |
| **Cash  flows from investing activities:**                                         |       |                                          |       |   |   |
| Purchases of property and equipment                                                |       | (7,373                                        | )          | (4,293 | ) |
| Maturities of marketable securities                                                |       | 122,746                                       |       | 31,285 |   |
| Purchases of marketable securities                                                 |       | (122,686                                      | )          | (37,015 | ) |
| Other assets                                                                       |       | (39                                           | )          | 328 |   |
| Net cash used in investing activities                                              |       | (7,352                                        | )          | (9,695 | ) |
| **Cash  flows from financing activities:**                                         |       |                                          |       |   |   |
| Sale of common stock in connection with employee  stock purchase plan              |       | 2,313                                         |       | 796 |   |
| Proceeds from exercise of stock options                                            |       | 881                                           |       | 400 |   |
| Payments of long-term liabilities                                                  |       | (66                                           | )          | (111 | ) |
| Net cash provided by financing activities                                          |       | 3,128                                         |       | 1,085 |   |
| **Net decrease in cash and cash equivalents**                                      |       | (1,640                                        | )          | (7,480 | ) |
| **Cash  and cash equivalents, beginning of period**                                |       | 121,931                                       |       | 133,715 |   |
| **Cash and cash equivalents, end of period**                                       |       | $                                             | 120,291    |   | $ | 126,235 |   |
| **Supplemental  disclosure of cash flow information:**                             |       |                                          |       |   |   |
| Cash paid for interest                                                             |       | $                                             | 241        |   | $ | 243 |   |
| Cash paid for  taxes                                                               |       | $                                             | 619        |   | $ | 213 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

3

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

**(1) Description of Business**

Sonus Networks, Inc.(Sonus) was incorporated on August 7, 1997 and is a leading provider ofpacket voice infrastructure solutions for wireline and wireless serviceproviders. Sonus offers a new generation of carrier-class switchingequipment and software that enables telecommunications service providers todeliver voice services over packet-based networks.

**(2) Summary of 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 consolidated financialstatements have been prepared by Sonus and reflect all adjustments, consistingonly of normal recurring adjustments that in the opinion of management arenecessary for a fair presentation of the results and financial position for theinterim periods. The unaudited consolidated financial statements have beenprepared in accordance with the regulations of the Securities and ExchangeCommission (SEC), and omit or condense certain information and footnotedisclosures pursuant to existing SEC rules and regulations. Results forthe interim periods are not necessarily indicative of results to be expectedfor any other interim period or for the entire fiscal year. These statementsshould be read in conjunction with the consolidated financial statements andrelated notes included in Sonus’ Annual Report on Form 10-K for the yearended December 31, 2004.

The accompanying consolidated financial statementsinclude the accounts of Sonus and its wholly owned subsidiaries. All materialintercompany transactions and balances have been eliminated.

Certain reclassificationshave been made to the consolidated financial statements for the year ended December 31,2004 in order to conform to the June 30, 2005 presentation.

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

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods. Significantestimates and judgments relied upon in preparing these financial statementsinclude revenue recognition for multiple element arrangements, allowances fordoubtful accounts, estimated fair value of investments, inventory reserves,expected future cash flows used to evaluate the recoverability of long-livedassets, restructuring and other related charges, contingencies associated withrevenue contracts, contingent liabilities, and recoverability of Sonus’ netdeferred tax assets and related valuation allowance. Although Sonus regularlyassesses these estimates, actual results could differ materially from theseestimates. Changes in estimates are recorded in the period in which they becomeknown. Sonus bases its estimates on historical experience and various otherassumptions that it believes to be reasonable under the circumstances. Actualresults may differ from Sonus’ estimates if past experience or otherassumptions do not turn out to be substantially accurate.

4

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

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

***(c) Cash Equivalents, Marketable Securities andLong-Term Investments***

Cash equivalents are stated at cost plus accruedinterest, which approximates market value, and have remaining maturities ofthree months or less at the date of purchase.

Marketable securities are classified asheld-to-maturity, as Sonus has the intent and ability to hold to maturity.Marketable securities are reported at amortized cost. Cash equivalents andmarketable securities are invested in high quality credit instruments,primarily U.S. Government, municipal and corporate obligations. Current marketablesecurities have remaining contractual maturities of less than one year as ofthe balance sheet date. There have been no material gains or losses to date.

Long-term investmentsconsist of high-quality credit instruments, primarily U.S. Government andcorporate obligations with remaining maturities of greater than one year as ofthe balance sheet date.

***(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,marketable securities, accounts receivables and long-term investments. Sonushas no off-balance sheet concentrations such as foreign exchangecontracts, options contracts or other foreign hedging arrangements as of June 30,2005. Subsequent to June 30, 2005, Sonus entered into a foreign exchangecontract to hedge against currency fluctuations related to a particular accountreceivable denominated in Japanese Yen. Sonus’ cash, cash equivalent andinvestment portfolio holdings are diversified among five financialinstitutions.

Forthe three months ended June 30, 2005 and 2004, one customer and threecustomers each contributed 10% or more of Sonus’ revenues, representing anaggregate of 41% and 48% of total revenues. For the six months ended June 30,2005 and 2004, two and four customers each contributed 10% or more of Sonus’revenues, representing an aggregate of 39% and 55% of total revenues. Thefollowing customers contributed 10% or more of Sonus’ revenues in the three andsix months ended June 30, 2005 and 2004:
| ** **               | ** ** | **Three months ended  June 30,**          | ** ** | **Six months ended  June 30,**            | ** ** |
|--------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **               | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| **Customer:**            | ** ** |                                                     | ** ** | ** **                                               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Cingular Wireless  **    |       |                                                     | 41         | %                                                        |       |   | 24 | % |   |   | 27 | % |   |   | 14 | % |   |
| Global Crossing          |       |                                                     | *          | ** **                                               |       |   | * | ** ** |   |   | 12 | ** ** |   |   | * | ** ** |   |
| Verizon Global  Networks |       |                                                     | *          | ** **                                               |       |   | * | ** ** |   |   | * | ** ** |   |   | 15 | ** ** |   |
| Softbank  Broadband      |       |                                                     | *          | ** **                                               |       |   | * | ** ** |   |   | * | ** ** |   |   | 14 | ** ** |   |
| Qwest  Communications    |       |                                                     | *          | ** **                                               |       |   | 14 | ** ** |   |   | * | ** ** |   |   | 12 | ** ** |   |
| Volo Communications      |       |                                                     | *          | ** **                                               |       |   | 10 | ** ** |   |   | * | ** ** |   |   | * | ** ** |   |

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*                    Representsless than 10% of revenues.

**             Includes revenuesfrom AT&T Wireless, which was acquired by Cingular Wireless effective October 26,2004.

5

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

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

As of June 30, 2005 and December 31, 2004,three and two customers each accounted for 10% or more of Sonus’ accountsreceivable balance, representing an aggregate of 74% and 53% of total accountsreceivable. Sonus performs ongoing credit evaluations of its customers andgenerally does not require collateral on accounts receivable. Sonus maintainsallowances for potential credit losses and such losses have been withinmanagement’s expectations.

International revenues, primarily attributable toJapan and Europe, were 19% and 13% of total revenues for the three months endedJune 30, 2005 and 2004, and were 19% and 20% of total revenues for the sixmonths ended June 30, 2005 and 2004.

Certain components andsoftware licenses from third parties used in Sonus’ products are procured fromsingle sources of supply. The failure of a supplier, including a subcontractor,to deliver on schedule could delay or interrupt Sonus’ delivery of products andthereby materially adversely affect Sonus’ revenues and operating results.

***(e) Accounts Receivable***

Accountsreceivable consist of the following, in thousands
| ** **                       | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Earned accounts  receivable      |       | $                       | 25,015     |                        |       | $ | 9,088 |   |   |
| Unearned accounts  receivable    |       | 37,482                  |       |                        | 23,807     |   |   |
| Accounts receivable,  gross      |       | 62,497                  |       |                        | 32,895     |   |   |
| Allowance for  doubtful accounts |       | (435                    | )          |                        | (409       | ) |   |
| Accounts receivable, net         |       | $                       | 62,062     |                        |       | $ | 32,486 |   |   |

 

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

***(f) Inventory***

Inventoryconsists of the following, in thousands:
| ** **                                             | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| On-hand  final assemblies and finished goods inventory |       | $                       | 12,238     |                        |       | $ | 18,725 |   |   |
| Unearned  inventory                                    |       | 21,494                  |       |                        | 14,054     |   |   |
| Evaluation  inventory                                  |       | 4,590                   |       |                        | 6,107      |   |   |
| Inventory, gross                                       |       | 38,322                  |       |                        | 38,886     |   |   |
| Excess, obsolete  and evaluation reserve               |       | (7,776                  | )          |                        | (10,540    | ) |   |
| Inventory, net                                         |       | $                       | 30,546     |                        |       | $ | 28,346 |   |   |

 

6

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

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

Unearned inventory represents deferred cost ofrevenues for product shipments prior to satisfaction of Sonus’ revenuerecognition criteria.

Sonus values inventory atthe lower of cost or net realizable value and provides inventory reserves basedon excess and obsolete inventory determined primarily by future demandforecasts and records adjustments to such reserves through charges to cost ofrevenues. Sonus also records a full inventory reserve for evaluation equipmentat the time of shipment to customers as a charge to sales and marketing expenseas Sonus’ experience with this type of inventory indicates it is probable thatthe value of the inventory will not be realizable. If these evaluationshipments should convert to revenue, Sonus records a benefit to sales andmarketing expense and records the full cost of revenues in the period ofrevenue recognition.

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

Property and equipment arestated at cost, net of accumulated depreciation. Expenditures for maintenanceand repairs are charged to expense as incurred. Depreciation is computed usingthe straight-line method over the estimated useful life of the relatedassets, which ranges from two to five years. Leasehold improvements areamortized over the lesser of the life of the lease or five years. When an itemis sold or retired, the cost and related accumulated depreciation is relieved,and the resulting gain or loss, if any, is recognized in the statement ofoperations.

***(h) Deferred Revenue***

Deferredrevenue consists of the following, in thousands:
| ** **                         | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Maintenance and  support contracts |       |                        | $          | 56,953                          |       |   |   | $ | 44,859 |   |   |
| Customer deposits                  |       |                        | 20,426     |                            |       |   | 22,399 |   |   |
| Unearned revenue                   |       |                        | 37,482     |                            |       |   | 23,807 |   |   |
| Total deferred  revenue            |       |                        | 114,861    |                            |       |   | 91,065 |   |   |
| Less current  portion              |       |                        | (87,433    | )                               |       |   | (65,105 | ) |   |
|                               |       |                        | $          | 27,428                          |       |   |   | $ | 25,960 |   |   |

 

Maintenance and supportcontracts are recognized ratably over the life of the service contract.Customer deposits represent payments received in advance of revenuerecognition. Unearned revenue represents billings for which payment has notbeen received and revenue recognition criteria have not been met. As of June 30,2005 and December 31, 2004, deferred revenue and accounts receivableexcluded $4.4 million and $6.5 million related to products shippedand billed to customers which are collectible under extended payment terms orfor which revenue is recognized as cash is collected. Such amounts will berecorded pursuant to Sonus’ revenue recognition policy.

7

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

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

***(i) Revenue Recognition***

Sonus recognizes revenue from product sales whenpersuasive evidence of an arrangement exists, delivery has occurred, the salesprice is fixed and determinable, and collectibility of the related receivableis probable under ordinary payment terms. When Sonus has future obligations,including a requirement to deliver additional elements which are essential tothe functionality of the delivered elements or for which vendor specificobjective evidence of fair value (VSOE) does not exist or customer acceptanceis required, Sonus defers revenue recognition and related costs until thoseobligations are satisfied. The ordering patterns and sales lead timesassociated with customer orders may vary significantly from period to period.

Many of Sonus’ sales are generated from complexcontractual arrangements which require significant revenue recognitionjudgments, particularly in the case of multiple element arrangements. When asale involves multiple elements, such as products, maintenance or professionalservices, Sonus allocates the entire sales price to each respective elementbased on VSOE or using the residual method when VSOE cannot be established fora single delivered element in the arrangement. Sonus then recognizes revenue oneach element in accordance with its policies for revenue recognition related toeach element. Sonus determines VSOE based upon the price charged when the sameelement is sold separately. If Sonus cannot establish VSOE for each undeliveredelement, it defers revenue recognition on the entire arrangement until theearlier of the establishment of VSOE or delivery of the undelivered element.

In addition, if an arrangement with a customerincludes a specified upgrade right for which VSOE cannot be established, Sonusdefers all revenue related to the arrangement until the earlier of the deliveryof the specified upgrade or the establishment of VSOE for the specifiedupgrade. Sonus has concluded that a specified upgrade exists if it is includedin the customer contract or otherwise becomes part of the arrangement with thecustomer. Sonus has concluded that communications with customers in the normalcourse of business regarding customer feature requests and Sonus’ product plansdo not create specified upgrade rights.

Maintenance and support services are recognizedratably over the life of the maintenance and support service period, whichtypically is one year when the services are sold separately and up to fiveyears when the fees for the services are bundled with the product fees as partof a multiple element arrangement, following recognition of the related productrevenue. Maintenance and support services include telephone support andunspecified rights to product upgrades and enhancements. Maintenance andsupport VSOE represents a consistent percentage of the sales prices charged tocustomers, and is dependent upon the size of the installed base of Sonusproduct at the customer. The application of judgment could affect the continueddetermination of maintenance and support VSOE and Sonus’ ability to recognizerevenue using the residual method.

Installation service revenues are generally recognizedat the time of the related product revenue recognition as installation is typicallycomplete by such time. Professional services are typically recognized as theservices are performed.

Sonus sells the majority of its products directly toend-users. For products sold through resellers and distributors, Sonus followsthe guidance provided in Statement of Financial Accounting Standards (SFAS) No. 48,*Revenue Recognition When Right of Return Exists,*andStaff Accounting Bulletin 104, *Revenue Recognition*.Sonus typically recognizes revenue on a sell-through 

8

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

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

method utilizinginformation provided to Sonus from its resellers and distributors. To date, norevenues have been recognized on a sell-in method due to the limited history ofshipments to resellers and distributors.

Sonus records deferred revenue for product shipped tocustomers and related services where amounts are billed pursuant to acontractual right and collection is probable, or collected, in the ordinarycourse of business if the revenue recognition criteria have not been satisfied.Deferred revenues include customer deposits and amounts associated withmaintenance contracts. Deferred revenues expected to be recognized as revenuemore than one year of the balance sheet date are classified as long-termdeferred revenues.

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) Software Development Costs***

Sonus accounts for itssoftware development costs in accordance with SFAS No. 86, *Accounting for the Costs of Computer Software to BeSold, Leased or Otherwise Marketed*. Accordingly, the costs for thedevelopment of new software and substantial enhancements to existing softwareare expensed as incurred until technological feasibility has been established,at which time any additional costs would be capitalized. Sonus has determinedthat technological feasibility is established at the time a working model ofthe software is completed. Because Sonus believes its current process fordeveloping software is essentially completed concurrently with theestablishment of technological feasibility, no costs have been capitalized todate.

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

SFAS No. 123, *Accountingfor Stock-Based Compensation,* provides that companies mayaccount for stock-based compensation under either the fair value-basedmethod of accounting under SFAS No. 123 or the intrinsic value-basedmethod provided by Accounting Principles Board (APB) No. 25, *Accounting for Stock Issued to Employees.*Sonus uses the intrinsic value-based method of APB No. 25 to accountfor all of its employee stock-based compensation plans and uses the fairvalue method of SFAS No. 123 to account for all non-employee stock-basedcompensation. Sonus follows Financial Interpretation No. (FIN) 28, *Accounting for Stock Appreciation Rights and OtherVariable Stock Option or Award Plans* and amortizes the intrinsicvalue for all awards as measured under APB No. 25 on an accelerated basis.SFAS No. 123, as amended by SFAS No. 148, *Accounting for Stock-Based Compensation—Transition andDisclosure—an amendment of FASB Statement No. 123,* requirescompanies following APB No. 25 to make pro forma disclosure in the notesto the consolidated financial statements using the measurement provisions ofSFAS No. 123.

Sonus has computed the proforma disclosures required under SFAS No. 123 for stock options granted toemployees and shares purchased under the 2000 Employee Stock Purchase Plan(ESPP) using the Black-Scholes option-pricing model. In valuing the stockoptions granted, Sonus used an assumed risk-free interest rate of 3.9%and 3.0% for the three and six months ended June 30, 2005 and 2004;volatility of 118% and 128% for the three months ended June 30, 2005 and2004 and 118% to 122% and 

9

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

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

128% forthe six months ended June 30, 2005 and 2004; and an expected life of fouryears for both the three and six months ended June 30, 2005 and four tofive years for both the three and six months ended June 30, 2004, with theassumption that dividends will not be paid. In valuing the ESPP, Sonus used anassumed risk-free interest rate of 1.6% to 3.0% for the three and months ended June 30,2005, 1.3% to 3.0% for the six months ended June 30, 2005 and 1.0% to3.0% for the three and six months ended June 30, 2004; volatility of 57%to 150% for the three months ended June 30, 2005, 57% to 154% for the sixmonths ended June 30, 2005, 26% to 164% for the three and six months endedJune 30, 2004; and an expected life ranging from six months to two years,with the assumption that dividends will not be paid. The pro forma informationis as follows, in thousands except per share data:
| ** **                                                                                                                      | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                      | ** ** | **2005**                                        | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net income (loss)—**                                                                                                     |       |                                            |       |                                          |       |   |   |   |   |
| As reported                                                                                                                     |       | $                                               | 9,745      |                                          | $          | 4,934 |   | $ | 6,050 |   | $ | 7,948 |   |
| Plus: Employee stock-based compensation  expense included in net income (loss) under intrinsic value method related to  options |       | 4                                               |       | 123                                           |       | 4 |   | 465 |   |
| Less: Employee stock-based compensation under fair  value method                                                                |       | (7,924                                          | )          | (11,363                                       | )          | (18,316 | ) | (23,033 | ) |
| Pro forma                                                                                                                       |       | $                                               | 1,825      |                                          | $          | (6,306 | ) | $ | (12,262 | ) | $ | (14,620 | ) |
| **Basic  and diluted net income (loss) per share—**                                                                        |       |                                            |       |                                          |       |   |   |   |   |
| As reported                                                                                                                     |       | $                                               | 0.04       |                                          | $          | 0.02 |   | $ | 0.02 |   | $ | 0.03 |   |
| Pro forma                                                                                                                       |       | $                                               | 0.01       |                                          | $          | (0.03 | ) | $ | (0.05 | ) | $ | (0.06 | ) |

 

***(l) Comprehensive Net Income***

Sonus applies SFAS No. 130,*Reporting Comprehensive Income*.The comprehensive net income for the three and six months ended June 30,2005 and 2004 does not differ from the reported net income.

***(m) Fair Value of Financial Instruments***

The carrying amounts ofSonus’ financial instruments, which include cash equivalents, marketablesecurities, long-term investments, accounts payable, long-term liabilities andthe convertible subordinated note, approximate their fair value.

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

SFAS No. 131, *Disclosures about Segments of an Enterprise andRelated Information*, established standards for reporting informationregarding operating segments and established standards for related disclosuresabout products and services and geographic areas. 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 assessing 

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

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

performance.To date, the chief operating decision maker has made such decisions andassessed performance at the company level.

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

Basic net income per share is computed by dividing thenet income for the period by the weighted average number of shares ofunrestricted common stock outstanding during the period. Diluted net income pershare is computed by dividing the net income for the period by the weightedaverage number of shares of unrestricted common stock and dilutive potentialcommon shares outstanding based on the average market price of Sonus’ commonstock (under the treasury stock method). Dilutive potential common sharesconsist of restricted common stock and common stock issuable upon the exerciseof stock options and conversion of a convertible subordinated note.

The following table setsforth the computation of shares used in calculating the basic and diluted netincome per share, in thousands:
| ** **                                                  | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                  | ** ** | **2005**                                        | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average  common shares outstanding                 |       | 248,249                                         |       | 245,759                                       |       | 248,064 |   | 245,610 |   |
| Less weighted  average restricted common shares outstanding |       | —                                          |       | 369                                           |       | — |   | 704 |   |
| Shares used in  basic per share calculation                 |       | 248,249                                         |       | 245,390                                       |       | 248,064 |   | 244,906 |   |
| Add effect of  dilutive potential common shares             |       | 2,402                                           |       | 4,737                                         |       | 4,645 |   | 8,574 |   |
| Shares used in diluted  per share calculation               |       | 250,651                                         |       | 250,127                                       |       | 252,709 |   | 253,480 |   |

 

Excluded from the sharesused in the calculations above are options to purchase shares of common stockand shares of common stock issuable upon conversion of a convertiblesubordinated note representing an aggregate of 21,861,572 and 4,092,197 for thethree months ended June 30, 2005 and 2004, and 10,686,499 and 3,432,090for six months ended June 30, 2005 and 2004 as their effects would havebeen anti-dilutive.

***(p) Warranty Reserve***

Sonus’ products are covered by a standard warranty of90 days for software and one year for hardware or a warranty of longerperiods under certain customer contracts. In addition, certain customercontracts include warranty-type provisions for epidemic or similar productfailures, generally for the contractual period or the life of the product inaccordance with published telecommunications standards. Sonus accrues forwarranty obligations when the occurrence of such obligation is probable and theamount of such obligation is reasonably estimable. Sonus has not incurredsignificant costs related to such obligations. Sonus’ customers typicallypurchase maintenance and support contracts, which encompass its warrantyobligations. Sonus’ estimates of anticipated rates of warranty claims and costsare primarily based on historical information and future forecasts.

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

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

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. Increases in product failurerates, material usage or service delivery costs may result in increases toSonus’ warranty reserve and its gross profit could be adversely affected. As ofJune 30, 2005 and December 31, 2004 Sonus had no warranty reserverecorded.

***(q) Recent Accounting Pronouncements***

In October 2004, the American Jobs Creation Actof 2004 (the “AJCA”) was passed. The AJCA provides a deduction for income fromqualified domestic production activities, which will be phased in from 2005through 2010. The AJCA also provides for a two-year phase-out of the existingextra-territorial income exclusion for foreign sales that was viewed tobe inconsistent with international trade protocols by the European Union. In December 2004,the FASB issued FASB Staff Position (“FSP”) No. 109-1, “*Application of FASB Statement No. 109,Accounting for Income Taxes, to the Tax Deduction on Qualified ProductionActivities Provided by the American Jobs Creation Act of 2004.*” FSP109-1 treats the deduction as a “special deduction” as described in SFAS No. 109.This special deduction has no effect on deferred tax assets and liabilitiesexisting at the enactment date and the effect of this deduction will bereported in the same period in which the deduction is claimed by Sonus in itstax return. The AJCA also creates a temporary incentive for U.S. corporationsto repatriate accumulated income earned abroad by providing an 85% dividendsreceived deduction for certain dividends from controlled foreign corporations.This deduction is subject to a number of limitations. Sonus does not believethat the AJCA will have a material impact on its financial condition, resultsof operations or cash flows.

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs, an amendment of AccountingResearch Bulletin (ARB) No. 43, Chapter 4.*SFAS 151 amendsthe guidance in ARB No 43, Chapter 4, “Inventory Pricing” to clarify thatabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage) should be recognized as current-period charges. Inaddition, SFAS 151 requires that allocation of fixed production overheadto the costs of conversion be based on the normal capacity of the productionfacilities. The provisions of SFAS 151 are effective for fiscal yearsbeginning after June 15, 2005. Sonus is evaluating the provisions ofSFAS 151 and presently do not believe that its adoption will have amaterial impact on its financial condition, results of operations or cashflows.

In December 2004, theFASB issued SFAS 123(R), *Share-BasedPayment*, which is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation*.SFAS 123(R) supersedes APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and amends SFAS No. 95, *Statement ofCash Flows*. Generally, the approach in SFAS 123(R) issimilar to the approach described in SFAS 123. However, SFAS 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the income statement based on their fair values atthe date of grant. Pro forma disclosure is no longer an alternative.SFAS 123(R) was due to be adopted in fiscal periods beginning after June 15,2005. In April 2005, the SEC delayed the adoption of SFAS 123(R) tofiscal years beginning after 

12

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

**(2) Summary ofSignificant Accounting Policies (Continued)**

June 15,2005. Early adoption will be permitted in periods in which financial statementshave not yet been issued. Sonus is required to adopt SFAS 123(R) on January 1,2006. SFAS 123(R) permits public companies to adopt its requirementsusing one of two methods: a “modified prospective” method, in which compensationcost is recognized beginning with the effective date (a) based on therequirements of SFAS 123(R) for all share-based paymentsgranted after the effective date, and (b) based on the requirements ofSFAS 123 for all awards granted to employees prior to the effective dateof SFAS 123(R) that remain unvested on the effective date; or a “modifiedretrospective” method, which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS 123 for purposes of proforma disclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption. Sonus has not yet determined whichmethod to use in adopting SFAS 123(R). As permitted by SFAS 123,Sonus currently accounts for share-based payments to employees using APBOpinion No. 25’s intrinsic value method and, as such, generally recognizesno compensation cost for employee stock options. Sonus is evaluatingSFAS 123(R) and has not yet determined the amount of stock optionexpense that will be incurred in future periods as a result of the adoption ofSFAS 123(R). The adoption of SFAS 123(R) will have no impact onSonus’ net cash flows or overall financial condition.

**(3) Restructuring Charges**

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

**2002 Restructuring Accrual**

Thefollowing table summarizes the activity during the six months ended June 30,2005 relating to Sonus’ accrual for fiscal 2002 restructuring actions, inthousands:
| ** **                   | ** ** | **December 31,  2004  Accrual  Balance** | ** ** | **Cash  Payments** | ** ** | **June 30,  2005  Accrual  Balance** | ** ** | **Current  Portion** | ** ** | **Long-term  Portion** | ** ** |
|------------------------------|------------|-----------------------------------------------|------------|--------------------|------------|-------------------------------------------|------------|----------------------|------------|------------------------|------------|
| Consolidation of  facilities |       |                                          | $          | 799                |       |                                      |       | $                    | (91        | )                      |       |   | $ | 708 |   |   |   | $ | 191 |   |   |   | $ | 517 |   |   |
|                              |            |                                               |            |                    |            |                                           |            |                      |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The remaining cashexpenditures relating to the consolidation of excess facilities are expected tobe paid through 2008.

**(4) Convertible Subordinated Note**

In May 2001, Sonuscompleted a private placement of an aggregate principal amount of $10,000,000of a 4.75% convertible subordinated note, due May 1, 2006, with acustomer. Interest payments are due semi-annually on May 1 and November 1of each year through May 2006. The note may be converted by 

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

**(4) ConvertibleSubordinated Note (Continued)**

theholder into shares of Sonus’ common stock at any time before its maturity orprior to its redemption or repurchase by Sonus. The conversion rate is 33.314shares per each $1,000 principal amount of the note, subject to adjustment incertain circumstances. Sonus has the option to redeem all or a portion of thenote at 100% of the principal amount. Also, at any time if the market price ofSonus’ common stock exceeds $60.04 per share for twenty trading days in anythirty trading-day period, Sonus may redeem this note through the issuance ofshares of common stock or for cash. In the event of a change of control inSonus, the holder at its option may require Sonus to redeem the note throughthe issuance of common stock or cash. Interest expense related to Sonus’convertible subordinated note was $119,000 for the three months ended June 30,2005 and 2004, and $238,000 for the six months ended June 30, 2005 and2004.

**(5) Contingencies**

In November 2001, a purchaser of Sonus’ commonstock filed a complaint in the United States District Court for the SouthernDistrict of New York against Sonus, two of its officers and the leadunderwriters alleging violations of the federal securities laws in connectionwith Sonus’ initial public offering (IPO) and seeking unspecified monetarydamages. The purchaser seeks to represent a class of persons who purchasedSonus’ common stock between the IPO on May 24, 2000 and December 6,2000. An amended complaint was filed in April 2002. The amended complaintalleges that Sonus’ registration statement contained false or misleadinginformation or omitted to state material facts concerning the alleged receiptof undisclosed compensation by the underwriters and the existence ofundisclosed arrangements between underwriters and certain purchasers to makeadditional purchases in the after market. The claims against Sonus are assertedunder Section 10(b) of the Securities Exchange Act of 1934 and Section 11of the Securities Act of 1933 and against the individual defendants underSections 11 and 15 of the Securities Act and Sections 10(b) and 20(a) ofthe Exchange Act. Other plaintiffs have filed substantially similar classaction cases against approximately 300 other publicly traded companies andtheir IPO underwriters which, along with the actions against Sonus, have beentransferred to a single federal judge for purposes of coordinated casemanagement. On July 15, 2002, Sonus, together with the other issuers namedas defendants in these coordinated proceedings, filed a collective motion todismiss the consolidated amended complaints on various legal grounds common toall or most of the issuer defendants. The plaintiffs voluntarily dismissed theclaims against many of the individual defendants, including those Sonusofficers named in the complaint. On February 19, 2003, the court granted aportion of the motion to dismiss by dismissing the Section 10(b) claimsagainst certain defendants including Sonus, but denied the remainder of themotion as to the defendants. In June 2003, a special committee of Sonus’Board of Directors authorized Sonus to enter into a proposed settlement withthe plaintiffs on terms substantially consistent with the terms of a Memorandumof Understanding negotiated among representatives of the plaintiffs, the issuerdefendants and the insurers for the issuer defendants. On February 15, 2005,the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. The settlement issubject to final approval by the court. No hearing date has been scheduled forfinal approval. It remains uncertain when the settlement will become final.Sonus does not expect that the settlement would have a material impact on itsbusiness or financial results.

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

**(5) Contingencies(Continued)**

Beginning in July 2002, several purchasers ofSonus’ common stock filed complaints in the United States District Court forthe District of Massachusetts against Sonus, certain officers and directors anda former officer under Sections 10(b) and 20(a) and Rule 10b-5of the Securities Exchange Act of 1934 (Class Action Complaints). Thepurchasers seek to represent a class of persons who purchased Sonus’ commonstock between December 11, 2000 and January 16, 2002, and seekunspecified monetary damages. The Class Action Complaints were essentiallyidentical and alleged that Sonus made false and misleading statements about itsproducts and business. On March 3, 2003, the plaintiffs filed aConsolidated Amended Complaint. On April 22, 2003, Sonus filed a motion todismiss the Consolidated Amended Complaint on various grounds. On May 11,2004, the court held oral argument on the motion, at the conclusion of whichthe court denied Sonus’ motion to dismiss. The plaintiffs filed a motion forclass certification on July 30, 2004, and Sonus filed its opposition on September 10,2004, to which the plaintiffs replied on September 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 filed amotion 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. Sonus believes the claims in the Consolidated Amended Complaint arewithout merit and that it has substantial legal and factual defenses, which itintends to pursue vigorously. There is no assurance Sonus will prevail indefending these actions.

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against Sonus and certain of itscurrent officers and directors. On June 28, 2004, the court consolidatedthe claims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the SecuritiesExchange Act of 1934 and Sections 11, 12(a), and 15 of the Securities Act of1933, relating to Sonus’ restatement of its financial results for 2001, 2002,and the first three quarters of 2003. Specifically, the complaint alleges thatSonus issued a series of false or misleading statements to the marketconcerning Sonus’ revenues, earnings and financial condition. Plaintiffscontend that such statements caused Sonus’ stock price to be artificiallyinflated. The complaint seeks unspecified damages on behalf of a purportedclass of purchasers of Sonus’ 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. In August 2005, theplaintiff filed an amended complaint. Sonus intends to file a motion to dismissthe amended complaint. Sonus believes that it has substantial legal and factualdefenses to the claims, which it intends to pursue vigorously. There is noassurance Sonus will prevail in defending these actions.

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 nominal 

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

**(5) Contingencies(Continued)**

defendant. The suits claimthat certain of Sonus’ officers and directors breached their fiduciary dutiesto Sonus’ stockholders and to the company. The complaints are derivative innature and do not seek relief from Sonus. However, Sonus has entered intoindemnification agreements in the ordinary course of business with certain ofthe defendant officers and directors and may be obligated throughout thependency of these actions to advance payment of legal fees and costs incurredby the defendants pursuant to Sonus’ obligations under the indemnificationagreements or applicable Delaware law. On September 27, 2004, the statecourt granted Sonus’ motion to dismiss. On October 26, 2004, theplaintiffs filed a notice appealing the state court’s dismissal of the actions.On June 24, 2005, the plaintiffs withdrew the appeal and dismissed thecase with prejudice. In the federal actions, on June 28, 2004, the courtconsolidated and stayed the three actions. On October 12, 2004, the leadplaintiff filed a consolidated amended complaint. On June 1, 2005, thecourt held a hearing on the motion and allowed the plaintiff to file an amendedcomplaint. On July 1, 2005, the plaintiff filed an amended complaint. Thedefendants will renew their motions to dismiss, which must be filed by August 15,2005. Sonus believes that it has substantial legal and factual defenses to thefederal claims. There is no assurance Sonus will prevail in defending theseactions.

In December 2004, a purchaser of Sonus’ commonstock filed a complaint in the circuit court in Will County, Illinois,against the Company, 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. A hearing on Sonus’ motion to dismiss the amended complaint isscheduled for August 30, 2005. Sonus believes that it has substantiallegal and factual defenses to these claims, which it intends to pursuevigorously. There is no assurance Sonus will prevail in defending this action.

In June 2004, Sonus received a formal order ofprivate investigation from the SEC. On June 7, 2005, Sonus received anotice from the SEC terminating the investigation with a recommendation that noenforcement action be taken.

Sonus has been contactedby third parties, who claim that Sonus’ products infringe on certainintellectual property of the third party. Sonus evaluates these claims andaccrues for royalties when the amounts are probable and reasonably estimable.While Sonus believes that the amounts accrued for estimated royalties areadequate, any subsequent change in Sonus’ estimates will be recorded at suchtime the change is probable and estimable.

**(6) Stockholders’ Equity**

***(a) 1997 Stock Incentive Plan***

On January 1 of eachyear, the aggregate number of shares of common stock available for issuanceunder the 1997 Stock Incentive Plan (Plan) shall increase by the lesser of (i) 5%of the outstanding shares on December 31 of the preceding year or (ii) anamount determined by the Board of Directors. As of June 30, 2005,135,227,031 shares were authorized and 46,730,583 shares were available underthe Plan for future issuance.

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

**(6) Stockholders’Equity (Continued)**

***(b) 2000 Employee Stock Purchase Plan***

On January 1 of eachyear, the aggregate number of shares of common stock available for purchaseunder the ESPP shall increase by the lesser of (i) 2% of the outstandingshares on December 31 of the preceding year or (ii) an amountdetermined by the Board of Directors. As of June 30, 2005, 25,290,812shares were authorized and 20,011,984 shares were available under the ESPP forfuture issuance.

***(c) Stock-Based Compensation***

Stock-based compensation expenses include theamortization of deferred employee compensation and other equity relatedexpenses for non-employees. Sonus has valued the stock options and theissuances of restricted common stock to non-employees based upon the fairmarket value of the services rendered where Sonus believes the value of theseservices is more readily determinable than the value of the options orrestricted stock.

Sonus recorded stock-based compensation of $4,000 forthe three and six months ended June 30, 2005. Sonus recorded stock-basedcompensation of $136,000 and $515,000 for the three and six months ended June 30,2004.

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**Item 2: Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

*This Management’s Discussion and Analysis of FinancialCondition and Results of Operations contains forward-looking statements,which are subject to a number of risks and uncertainties. These forward-lookingstatements are based on our current expectations, assumptions, estimates andprojections about our industry and ourselves, and we do not undertake anobligation to update our forward-looking statements to reflect futureevents or circumstances. Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of variousfactors, including the factors set forth in “Cautionary Statements” in theQuarterly Report on Form 10-Q. This discussion should be read inconjunction with the unaudited condensed consolidated financial statements andrelated notes for the periods specified. Further reference should be made toour Annual Report on Form 10-K for the year ended December 31, 2004and our Quarterly Report on Form 10-Q for the quarter ended March 31,2005, both on file with the SEC.*

**Overview**

We are a leading supplier of packet voiceinfrastructure solutions for wireline and wireless service providers. Ourproducts are a new generation of carrier-class switching equipment andsoftware that enable voice services to be delivered over packet-basednetworks.

In 2004 and continuing into 2005, there was increasedinterest and activity in the market for packet-based voice infrastructureproducts. While it remains uncertain as to the speed and extent of the adoptionof carrier packet voice infrastructure products by large carriers, we believethat over time the market opportunity for packet voice solutions is substantial.This has shown in our order activity as in the fourth quarter of fiscal 2004 weachieved record orders and in the first six months of fiscal 2005 orders wereat a ratio of slightly above revenue. For the three and six months ended June 30,2005, revenues were $58.1 million and $91.7 million, compared to $42.4 millionand $78.9 million for the three and six months ended June 30, 2004, andtotal deferred revenue increased to $114.9 million as of June 30, 2005from $91.1 million as of December 31, 2004. This variability in ourquarterly revenue and operating results was caused primarily by the impact ofan increase in orders in the fourth quarter of 2004 and first quarter of 2005,the timing of revenue recognition, including network installations, productdelays and customer acceptance, and the late renewal of several annualmaintenance contracts.

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

Since our inceptionthrough December 31, 2003, we incurred significant losses. As of June 30,2005, we had an accumulated deficit of $778.0 million. Although weachieved profitability in the second quarter of 2005 and in each quarter and onan annual basis in fiscal year 2004, we incurred a net loss for the quarterended March 31, 2005 and may incur additional losses in future quartersand years. We have a lengthy sales cycle for our products and, accordingly, weexpect to incur sales and other expenses before we realize the relatedrevenues. We expect to continue to incur significant sales and marketing,research and development and general and administrative expenses, many of whichare fixed prior to the beginning of any particular fiscal period and, as aresult, we will need to generate significant revenues to maintain profitability.

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**CriticalAccounting Policies and Estimates**

***Revenue Recognition.  ***Werecognize revenue from product sales when persuasive evidence of an arrangementexists, delivery has occurred, the sales price is fixed and 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 are generated from complexcontractual arrangements which require significant revenue recognitionjudgments, particularly in the case of multiple element arrangements. When asale involves multiple elements, such as products, maintenance or professionalservices, we allocate the entire sales price to each respective element basedon VSOE or using the residual method when VSOE cannot be established for asingle delivered element in the arrangement. We then recognize revenues on eachelement in accordance with our policies for revenue recognition related to eachelement. We determine VSOE based upon the price charged when the same elementis sold separately. If we cannot establish VSOE for each undelivered element,we defer revenue recognition on the entire arrangement until the earlier of theestablishment of VSOE or delivery of the undelivered element.

In addition, if an arrangement with a customerincludes a specified upgrade right for which VSOE cannot be established, wedefer all revenue related to the arrangement until the earlier of the deliveryof the specified upgrade or the establishment of VSOE for the specifiedupgrade. We have concluded that a specified upgrade exists if it is included inthe customer contract or otherwise becomes part of the arrangement with thecustomer. We have concluded that communications with customers in the normalcourse of business regarding customer feature requests and our product plans donot create specified upgrade rights.

Maintenance and support services are recognizedratably over the life of the maintenance and support service period, whichtypically is one year when the services are sold separately and up to fiveyears when the fees for the services are bundled with the product fees as partof a multiple element arrangement, following recognition of the related productrevenue. Maintenance and support services include telephone support andunspecified rights to product upgrades and enhancements. Maintenance andsupport VSOE represents a consistent percentage of the sales prices charged tocustomers, and is dependent upon the size of the installed base of our productat the customer. The application of judgment could affect the continueddetermination of maintenance and support VSOE and our ability to recognizerevenue using the residual method.

Installation service revenues are generally recognizedat the time of the related product revenue recognition as installation istypically complete by such time. Professional services are typically recognizedas the services are performed.

We sell the majority of our products directly toend-users. For products sold through resellers and distributors, we follow theguidance provided in SFAS No. 48, *Revenue Recognition WhenRight of Return Exists,* and SAB 104, *RevenueRecognition*. We typically recognize revenue on a sell-through methodutilizing information provided to us from our resellers and distributors. Todate, no revenues have been recognized on a sell-in method due to the limitedhistory of shipments to resellers and distributors.

We record deferred revenue for product shipped tocustomers and related services where amounts are billed pursuant to acontractual right and collection is probable, or collected, in the ordinarycourse of business if the revenue recognition criteria have not been satisfied.Deferred revenues include customer deposits and amounts associated withmaintenance contracts. Deferred revenues expected to be 

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recognized as revenue morethan one year of the balance sheet date are classified as long-term deferredrevenues.

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

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

***Allowance forDoubtful Accounts.  ***We establish billing terms atthe time we negotiate purchase agreements with our customers. We continuallymonitor for timely payments and potential collection issues. The allowance fordoubtful accounts is based on our detailed assessment of the collectibility ofspecific customer accounts. While we believe that our allowance for doubtfulaccounts is adequate and that the judgment applied is appropriate, if there isa deterioration of a customer’s creditworthiness or actual defaults are higherthan our historical experience, the actual results could differ from theseestimates. While such credit losses have historically been within our expectationsand the allowances we established, we can provide no assurance that we willcontinue to experience the same credit loss rates that we have in the past. Ifthe financial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payment, additional allowances may berequired. We defer revenue recognition for customers for which we believecollection is less than probable. Our failure to accurately estimate the lossesfor doubtful accounts or receive payments on a timely basis could have amaterial adverse effect on our business, financial condition and results ofoperations.

***Inventory Reserves.  ***Inventorypurchases and commitments are based upon estimated future demand for ourproducts. We value inventory at the lower of cost or net realizable value. Weprovide inventory reserves based on excess and obsolete inventory determinedprimarily by future demand forecasts and returns of defective product, andrecord charges to cost of revenues. We assess such demand forecasts and returnhistory on at least a quarterly basis. If we record a charge to reduceinventory to its estimated net realizable value, we do not increase itscarrying value due to subsequent changes in demand forecasts or productrepairs. Accordingly, if inventory previously reserved for is subsequentlysold, we may realize improved gross profit margins on those transactions in theperiod the related revenue is recognized.

We also record a full inventory reserve for evaluationequipment at the time of shipment to our customers as a charge to sales andmarketing expense as our experience with this type of inventory indicates it isprobable that the inventory value will not be realizable. If these evaluationshipments should convert to revenue, we record a benefit to sales and marketingexpenses and record the full cost of revenues in the period of revenuerecognition.

We have experienced significant changes in our productdemand and, as a result, our required inventory reserves have fluctuated inrecent periods. It is possible that significant changes in required inventoryreserves may continue to occur in the future if there is a sudden andsignificant change in the demand for our products, changes in the amount ofcustomer evaluation inventory or higher risks of inventory obsolescence becauseof rapidly changing technology.

***Warranty Reserve.  ***Ourproducts are covered by a standard warranty of 90 days for software andone year for hardware or a warranty for longer periods under certain customercontracts. In addition, certain customer contracts include warranty-typeprovisions for epidemic or similar product failures, generally for thecontractual period or the life of the product in accordance with publishedtelecommunications 

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standards**.**We accrue for warranty obligations when the occurrence ofsuch obligation is probable and the amount of such obligation is reasonablyestimable. We have not incurred significant costs related to such obligations.Our customers typically purchase maintenance and support contracts, whichencompass our warranty obligations. Our estimates of anticipated rates ofwarranty claims and costs are primarily based on historical information andfuture forecasts.

In addition, certain of our customer contracts includeprovisions under which we may be obligated to pay penalties generally for thecontractual period or for the life of the product if our products fail or donot perform in accordance with specifications. We accrue for such contingentobligations when the occurrence of such obligation is probable and the amountof such obligation is reasonably estimable. We have not incurred significantcosts related to such provisions. We periodically assess the adequacy of ourrecorded warranty liabilities and adjust the amounts as necessary. Increases inproduct failure rates, material usage or service delivery costs may result inincreases to our warranty reserve and our gross profit could be adverselyaffected. As of June 30, 2005 and December 31, 2004 we had nowarranty reserve recorded.

***Royalty Accrual.  ***Weaccrue for royalties for technology we license from vendors based onestablished royalty rates and usage. In certain cases, we have been contactedby third parties who claim that our products infringe on certain intellectualproperty of the third party. We evaluate these claims and accrue for royaltieswhen the amounts are probable and reasonably estimable. While we believe thatthe amounts accrued for estimated royalties are adequate, the amounts requiredto ultimately settle royalty obligations may be different.

***Reserve forLitigation and Legal Fees.  ***We are subject tovarious 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. Weintend to defend these matters vigorously, although the ultimate outcome ofthese items is uncertain and the potential loss, if any, may be significantlydifferent than the amounts we have previously accrued.

***Accounting forIncome Taxes.  ***SFAS No. 109, *Accounting for Income Taxes*, requires theestablishment of a valuation allowance to reflect the likelihood of realizationof deferred tax assets. Significant management judgment is required indetermining our provision for income taxes, our deferred tax assets andliabilities and any valuation allowance recorded against our net deferred taxassets. We evaluate all available evidence, such as recent and expected futureoperating results by tax jurisdiction, and current and enacted tax legislationand other temporary differences between book and tax accounting, to determinewhether it is more likely than not that some portion or all of the deferredincome tax assets will not be realized.

As a result of net operating losses incurred in prioryears in most jurisdictions in which we operate, a net operating loss in thefirst fiscal quarter of 2005, and uncertainty as to the extent, jurisdictionand timing of profitability in future periods, we have continued to record afull valuation allowance against deferred tax assets, which was approximately$85 million as of June 30, 2005. The establishment and amount of thevaluation allowance requires significant estimates and judgment and canmaterially affect our results of operations. If the realization of deferred taxassets in the future is considered more likely than not, an adjustment to thevaluation reserve for the deferred tax asset would be made. A portion of therelease of the valuation allowance will increase net income in the period suchdetermination was made. In addition, approximately $26 million of the valuationallowance relates to tax benefits from stock option compensation. A substantialportion of the tax benefit of that item, when realized, will result in anincrease in capital in excess of par value. Our effective tax rate may varyfrom period to period based on changes in estimated taxable income or loss ineach jurisdiction, changes to the valuation allowance, statutory minimum taxrates or changes to federal, state or foreign tax laws, future expansion intoareas with varying 

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country, state, and localincome tax rates including statutory minimum tax rates, deductibility ofcertain costs and expenses by jurisdiction and as a result of acquisitions.

***Stock-basedCompensation.  ***In October 1995, the FASB issuedSFAS No. 123, *Accounting for Stock-BasedCompensation*. SFAS No. 123 provides that companies may accountfor stock-based compensation under either the fair value-basedmethod of accounting under SFAS No. 123 or the intrinsic value-basedmethod provided by APB No. 25, *Accountingfor Stock Issued to Employees*. We use the intrinsic value basedmethod of APB No. 25 to account for all of our employee stock-basedcompensation plans and use the fair value method of SFAS No. 123 to accountfor all non-employee stock-based compensation. We follow FIN 28, andamortize the intrinsic value as measured under APB No. 25 on anaccelerated basis. SFAS No. 123, as amended by SFAS No. 148, *Accounting for Stock-BasedCompensation—Transition and Disclosure—an amendment of FASB Statement No. 123*,requires companies following APB No. 25 to make pro forma disclosure inthe notes to the consolidated financial statements using the measurementprovisions of SFAS No. 123.

Beginning on January 1, 2006, we will adoptSFAS 123(R), *Share-Based Payment*,which is a revision of SFAS No. 123 and supersedes APB Opinion No. 25.SFAS 123(R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in the income statementbased on their fair values at the date of grant in fiscal years beginning afterJune 15, 2005, and eliminates pro forma disclosure in the notes to thefinancial statements.

***Restructuring and Other Related Charges.  ***Weestablished exit plans for each of the restructuring activities which tookplace in 2001 and 2002 and accounted for these plans in accordance withEmerging Issues Task Force (EITF) Issue No. 94-3, *Liability Recognition for Certain Employee Benefitsand Other Costs to Exit an Activity (including Certain Costs incurred in aRestructuring)*. These exit plans required that we make estimates asto the nature, timing and amount of the exit costs that we specificallyidentified. The consolidation of facilities required us to make estimates,which included contractual rental commitments or lease buy-outs for officespace being vacated and related costs and leasehold improvement write-downs,offset by estimated sub-lease income. We have remaining accrued exit costs of$708,000 as of June 30, 2005, which relate to remaining leasepayments. SFAS No. 146, *Accounting forCosts Associated with Exit or Disposal Activities*, was effective forexit or disposal activities that are initiated after December 31, 2002.SFAS No. 146 requires that a liability for a cost that is associated withan exit or disposal activity be recognized when the liability is incurred. Aliability is recognized when the severance amounts relate to prior servicesrendered, the payment of the amount is probable and the amount can be reasonablyestimated.

***Three and Six Months Ended June 30, 2005 and 2004***

***Revenues.  ***Revenues for the threeand six months ended June 30, 2005 and 2004 were as follows, in thousands:
| ** **     | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **     | ** ** | **2005**                                        | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenues:**  |       |                                            |       |                                          |       |   |   |   |   |
| Product        |       | $                                               | 41,339     |                                          | $          | 30,587 |   | $ | 63,797 |   | $ | 56,832 |   |
| Service        |       | 16,754                                          |       | 11,774                                        |       | 27,906 |   | 22,061 |   |
| Total revenues |       | $                                               | 58,093     |                                          | $          | 42,361 |   | $ | 91,703 |   | $ | 78,893 |   |

 

Product revenues comprise sales of our voiceinfrastructure products, including our GSX9000TM Open Services Switch, PSX, SGX,ASX, Sonus InsightTM Management System and related product offerings. Productrevenues for the three and six months ended June 30, 2005 increased 35%and 12% from the comparable periods in fiscal 2004. These increases areprimarily due to timing of revenue recognition, 

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which in part is dependentupon completion of certain customer deployments and obligations as of the endof a fiscal quarter, and the impact of an increase in orders in the fourthquarter of 2004 and first quarter of 2005.

Service revenues primarily comprise hardware and softwaremaintenance, network design, installation and other professional services.Service revenues for the three and six months ended June 30, 2005increased 42% and 26% from the comparable periods in fiscal 2004. Theseincreases were primarily a result of higher maintenance revenues due to ourgrowing installed customer base and an increase in installation revenue,partially offset by lower resident engineering revenue. Additionally, for thethree months ended June 30, 2005, the increase included late renewals ofseveral annual maintenance contracts that were due during the first fiscalquarter of 2005.

Forthe three months ended June 30, 2005 and 2004, one customer and threecustomers each contributed 10% or more of Sonus’ revenues, representing anaggregate of 41% and 48% of total revenues. For the six months ended June 30,2005 and 2004, two and four customers each contributed 10% or more of Sonus’revenues, representing an aggregate of 39% and 55% of total revenues. Thefollowing customers contributed 10% or more of Sonus’ revenues in the three andsix months ended June 30, 2005 and 2004:
| ** **               | ** ** | **Three months ended  June 30,   ** | ** ** | **Six months ended  June 30,   ** | ** ** |
|--------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **               | ** ** | **    2005    **          | ** ** | **    2004    **        | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| **Customer:**            | ** ** |                                                              | ** ** | ** **                                                      |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Cingular Wireless  **    |       |                                                              | 41         | %                                                               |       |   | 24 | % |   |   | 27 | % |   |   | 14 | % |   |
| Global Crossing          |       |                                                              | *          | ** **                                                      |       |   | * | ** ** |   |   | 12 | ** ** |   |   | * | ** ** |   |
| Verizon Global  Networks |       |                                                              | *          | ** **                                                      |       |   | * | ** ** |   |   | * | ** ** |   |   | 15 | ** ** |   |
| Softbank  Broadband      |       |                                                              | *          | ** **                                                      |       |   | * | ** ** |   |   | * | ** ** |   |   | 14 | ** ** |   |
| Qwest  Communications    |       |                                                              | *          | ** **                                                      |       |   | 14 | ** ** |   |   | * | ** ** |   |   | 12 | ** ** |   |
| Volo Communications      |       |                                                              | *          | ** **                                                      |       |   | 10 | ** ** |   |   | * | ** ** |   |   | * | ** ** |   |

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*                    Representsless than 10% of revenues.

**             Includes revenuesfrom AT&T Wireless, which was acquired by Cingular Wireless effective October 26,2004.

International revenues, primarily attributable toJapan and Europe, were 19% and 13% of total revenues for the three months endedJune 30, 2005 and 2004, and were 19% and 20% of total revenues for the sixmonths ended June 30, 2005 and 2004.

Our deferred product revenue was $57.9 million and$46.2 million as of June 30, 2005 and December 31, 2004. Our deferredservice revenue was $57.0 million and $44.9 million as of June 30, 2005and December 31, 2004. Our deferred revenue balance may fluctuate as aresult of the timing of revenue recognition, customer payments, maintenance contractrenewals, contractual billing rights, customer creditworthiness and maintenancerevenue deferrals included in multiple element arrangements. As of June 30,2005 and December 31, 2004, deferred revenue and accounts receivableexcluded $4.4 million and $6.5 million related to products shipped and billedto customers which are collectible under extended payment terms or for whichrevenue is recognized as cash is collected. Such amounts will be recordedpursuant to our revenue recognition policy.

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***Cost of Revenues/Gross Profit.  ***Ourcost of revenues consists primarily of amounts paid to third-partymanufacturers for purchased materials and services, royalties, manufacturingand professional services personnel and related costs, and inventoryobsolescence. Cost of revenues and gross profit as a percentage of revenues forthe three and six months ended June 30, 2005 and 2004 were as follows (inthousands, except percentages):
| ** **                                        | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                        | ** ** | **2005**                                        | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cost of  revenues:**                            |       |                                            |       |                                          |       |   |   |   |   |
| Product                                           |       | $                                               | 15,404     |                                          | $          | 9,714 |   | $ | 22,247 |   | $ | 17,855 |   |
| Service                                           |       | 5,651                                           |       | 4,227                                         |       | 10,920 |   | 8,486 |   |
| Total cost of revenues                            |       | $                                               | 21,055     |                                          | $          | 13,941 |   | $ | 33,167 |   | $ | 26,341 |   |
| **Gross  profit****(% of respective  revenues):** |       |                                            |       |                                          |       |   |   |   |   |
| Product                                           |       | 63                                              | %          | 68                                            | %          | 65 | % | 69 | % |
| Service                                           |       | 66                                              |       | 64                                            |       | 61 |   | 62 |   |
| Total gross  profit                               |       | 64                                              | %          | 67                                            | %          | 64 | % | 67 | % |

 

The decrease in product gross profit as a percentageof product revenues for the three and six months ended June 30, 2005 wasprimarily due to customer and product mix. Our product gross profit remainedabove our long-term financial model of 58-62%. We can provide noassurance that this favorable customer and product mix will continue and weexpect that over time our gross margins will return to levels consistent withour long-term financial model. The increase in service gross profit as apercentage of service revenues for the three months ended June 30, 2005was primarily due to an increase in our service revenues. The decrease inservice gross profit as a percentage of service revenues for the six monthsended June 30, 2005 was primarily due to increased investment in ourservice organization to support the expansion of our installed base, partiallyoffset by an increase in service revenues. Our service cost of revenues isrelatively fixed in advance of any particular quarter and, therefore, changesin service revenue will have a significant impact on service gross profitpercentage.

***Research andDevelopment Expenses.  ***Research and developmentexpenses consist primarily of salaries and related personnel costs andprototype costs related to the design, development, testing and enhancement ofour products. Research and development expenses were $11.1 million for thethree months ended June 30, 2005, an increase of $2.2 million, or24%, from $8.9 million for the same period in fiscal 2004. Research anddevelopment expenses were $22.1 million for the six months ended June 30,2005, an increase of $4.3 million, or 24%, from $17.9 million for thesame period in fiscal 2004. These increases primarily reflect an increase insalary and related expenses associated with increased headcount and additionaldepreciation expenses associated with new capital expenditures. Some aspects ofour research and development efforts require significant short-termexpenditures, the timing of which can cause significant variability in ourexpenses. We believe that rapid technological innovation is critical to ourlong-term success and we intend to continue to make substantial investments toenhance our products and technologies to meet the requirements of our customersand market. We believe that our research and development expenses for the thirdquarter of fiscal 2005 will increase from the second quarter of fiscal 2005primarily as a result of increases in salary and related expenses associatedwith increased headcount, and depreciation expenses associated with new capitalexpenditures. The additional investments are directed primarily toward thegrowth of our access, wireless and international businesses as well as thestart up and expansion of our research and development operations in India.

***Sales and MarketingExpenses.  ***Sales and marketing expenses consistprimarily of salaries and related personnel costs, commissions, travel andentertainment expenses, promotions, customer evaluations and other marketingand sales support expenses. Sales and marketing expenses were$11.5 million for the 

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three months ended June 30,2005, an increase of $2.9 million, or 33%, from $8.6 million for thesame period in fiscal 2004. Sales and marketing expenses were$20.5 million for the six months ended June 30, 2005, an increase of$5.0 million, or 33%, from $15.5 million for the same period infiscal 2004. These increases primarily reflect an increase in salaries andtravel expenses associated with increased headcount related to the expansion ofour access, wireless and international sales opportunities and an increase incommission expense resulting from higher revenues. We believe that our salesand marketing expenses for the third quarter of fiscal 2005 will increase fromthe second quarter of fiscal 2005 related to evaluation equipment expenses. Themagnitude of the increase will be dependent upon our level of revenues in thethird quarter as commission expenses fluctuate primarily based on revenuelevels.

***General andAdministrative Expenses.  ***General and administrativeexpenses consist primarily of salaries and related personnel costs forexecutive and administrative personnel, recruiting expenses, allowance fordoubtful accounts and professional fees. General and administrative expenseswere $6.5 million for the three months ended June 30, 2005, anincrease of $732,000, or 13%, from $5.7 million for the same period infiscal 2004. General and administrative expenses were $13.3 million forthe six months ended June 30, 2005, an increase of $2.7 million, or 26%,from $10.6 million for the same period in fiscal 2004. These increasesprimarily reflect an increase in professional fees incurred to perform theassessment and audit of our internal control over financial reporting requiredunder Section 404 of the Sarbanes-Oxley Act of 2002 and to beginremedying identified material weaknesses in our internal control environment,an increase in salary and related expenses associated with increased headcountas well as an increase in directors and officers insurance costs. We believethat our general and administrative expenses for the third quarter of fiscal2005 will be consistent with the second quarter due to a reduction in directorand officers insurance costs, offset by continued costs associated withimprovements we are making in our internal control environment to addressmaterial weaknesses.

***Stock-basedCompensation Expenses.  ***Stock-basedcompensation expenses include the amortization of stock compensation chargesresulting from the granting of stock options, including the telecomtechnologies, inc. (TTI) stock options assumed by us, stock awards to TTIemployees under the 2000 Retention Plan, sales of restricted common stock andgranting of stock options to non-employees. Stock-based compensationexpenses were $4,000 for the three and six months ended June 30, 2005,compared to $136,000 and $515,000 for the three and six months ended June 30,2004. The decreases are due to deferred stock-based compensation being fullyamortized as of December 31, 2004, partially offset by a grant to anon-employee in the second quarter of 2005.

***Amortization ofPurchased Intangible Assets.  ***In fiscal 2001, weacquired certain intellectual property, in-process research and development andintangible assets in connection with our acquisitions of TTI and Linguateq, Inc.As of December 31, 2004, the purchased intangible assets were fullyamortized, therefore there was no amortization expense for the three and sixmonths ended June 30, 2005. Amortization of purchased intangible assetswas $600,000 and $1.2 million for the three and six months ended June 30, 2004.

***Interest Income,net.  ***Interest income consists of interest earned onour cash equivalent balances, marketable securities and long-term investments.Interest expense consists of interest incurred on a convertible subordinatednote and capital lease arrangements. Interest income, net of interest expense,was $2.1 million for the three months ended June 30, 2005, an increase of$1.3 million from $770,000 for the same period in fiscal 2004. Interest income,net of interest expense, was $3.8 million for the six months ended June 30,2005, an increase of $2.4 million from $1.4 million for the same period infiscal 2004. These increases primarily reflect the benefit of an increase inthe yield on our portfolio due to an increasing interest rate environment.

***Income Taxes.  ***Provisions forincome taxes were $311,000 and $217,000 for the three months ended June 30,2005 and 2004 and $407,000 and $384,000 for the six months ended June 30,2005 and 2004. The 

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income taxprovision in all periods is primarily attributable primarily to foreign incometaxes and state income taxes in the U.S.

**Off-balance Sheet Arrangements**

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 and Capital Resources**

At June 30, 2005, our principal sources ofliquidity were our cash, cash equivalents, marketable securities and long-terminvestments that totaled $311.4 million.

Our cash generated from operating activities was$2.6 million for the six months ended June 30, 2005 as compared to$1.1 million for the same period in fiscal 2004. This increase wasprimarily due to an increase in deferred revenue and decreases in inventory andother current assets, partially offset by an increase in accounts receivable, adecrease in accounts payable and lower net income for the six months ended June 30,2005 as compared to the prior year.

Net cash used in investing activities was$7.4 million for the six months ended June 30, 2005, as compared to$9.7 million for the same period in fiscal 2004. Net cash used in investingactivities for the six months ended June 30, 2005 primarily reflectscapital expenditures of $7.4 million. Net cash used in investing activities forthe six months ended June 30, 2004 primarily reflects net purchases ofmarketable securities and long-term investments of $5.7 million andcapital expenditures of $4.3 million. We expect to incur approximately $6-9 millionin additional capital expenditures in the remaining two fiscal quartersof 2005.

Net cash provided by financing activities was$3.1 million for the six months ended June 30, 2005, as compared to$1.1 million for the same period in fiscal 2004. The net cash provided byfinancing activities for the six months ended March 31, 2005 and 2004resulted from the sale of common stock in connection with our employee stockpurchase plan and proceeds from the exercise of stock options, partially offsetby payments on our long-term liabilities.

Based on our currentexpectations, we believe our current cash, cash equivalents, marketablesecurities and long-term investments will be sufficient to meet our anticipatedcash needs for working capital and capital expenditures for at least12 months. Although it is difficult to predict future liquidityrequirements with certainty, the rate at which we will consume cash will bedependent on the cash needs of future operations, including changes in workingcapital, which will, in turn, be directly affected by the levels of demand forour products, the timing and rate of expansion of our business, the resourceswe devote to developing our products and any litigation settlements. We anticipatedevoting substantial capital resources to continue our research and developmentefforts, to maintain our sales, support and marketing, to improve our controlsenvironment and for other general corporate activities, as well as tovigorously defend against existing and potential litigation.

***Recent Accounting Pronouncements***

In October 2004, the American Jobs Creation Actof 2004 (the “AJCA”) was passed. The AJCA provides a deduction for income fromqualified domestic production activities, which will be phased in from 2005through 2010. The AJCA also provides for a two-year phase-out of the existingextra-territorial income exclusion for foreign sales that was viewed tobe inconsistent with international trade protocols by the European Union. In December 2004,the FASB issued FASB Staff Position (“FSP”) No. 109-1, “*Application of FASB Statement No. 109,Accounting for Income Taxes, to the Tax Deduction on Qualified*

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*ProductionActivities Provided by the American Jobs Creation Act of 2004.*”FSP 109-1 treats the deduction as a “special deduction” as described inSFAS No. 109. This special deduction has no effect on deferred tax assetsand liabilities existing at the enactment date and the effect of this deductionwill be reported in the same period in which the deduction is claimed in ourtax return. The AJCA also creates a temporary incentive for U.S. corporationsto repatriate accumulated income earned abroad by providing an 85% dividendsreceived deduction for certain dividends from controlled foreign corporations.This deduction is subject to a number of limitations. We do not believe thatthe AJCA will have a material impact on our financial condition, results ofoperations or cash flows.

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs, an Amendment of AccountingResearch Bulletin (ARB) No. 43, Chapter 4.*SFAS 151 amendsthe guidance in ARB No 43, Chapter 4, “Inventory Pricing” to clarify thatabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage) should be recognized as current-period charges. Inaddition, SFAS 151 requires that allocation of fixed production overheadto the costs of conversion be based on the normal capacity of the productionfacilities. The provisions of SFAS 151 are effective for fiscal yearsbeginning after June 15, 2005. We are evaluating the provisions ofSFAS 151 and presently do not believe that its adoption will have amaterial impact on our financial condition, results of operations or cashflows.

In December 2004, theFASB issued SFAS 123(R), *Share-BasedPayment*, which is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation*.SFAS 123(R) supersedes APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and amends SFAS No. 95, *Statement ofCash Flows*. Generally, the approach in SFAS 123(R) issimilar to the approach described in SFAS 123. However, SFAS 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the income statement based on their fair values atthe date of grant. Pro forma disclosure is no longer an alternative.SFAS 123(R) was due to be adopted in fiscal periods beginning after June 15,2005. In April 2005, the SEC delayed the adoption of SFAS 123(R) tofiscal years beginning after June 15, 2005. Early adoption will bepermitted in periods in which financial statements have not yet been issued. Weare required to adopt SFAS 123(R) on January 1, 2006.SFAS 123(R) permits public companies to adopt its requirements usingone of two methods: a “modified prospective” method, in which compensation costis recognized beginning with the effective date (a) based on therequirements of SFAS 123(R) for all share-based paymentsgranted after the effective date, and (b) based on the requirements ofSFAS 123 for all awards granted to employees prior to the effective dateof SFAS 123(R) that remain unvested on the effective date; or a “modifiedretrospective” method, which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS 123 for purposes of proforma disclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption. We have not yet determined whichmethod to use in adopting SFAS 123(R). As permitted by SFAS 123, Wecurrently account for share-based payments to employees using APB OpinionNo. 25’s intrinsic value method and, as such, generally recognizes nocompensation cost for employee stock options. We are evaluating SFAS 123(R) andhave not yet determined the amount of stock option expense that will beincurred in future periods as a result of the adoption of SFAS 123(R). Theadoption of SFAS 123(R) will have no impact on our net cash flows oroverall financial condition.

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**Cautionary Statements**

*ThisQuarterly Report on Form 10-Q contains forward-lookingstatements within the meaning of the Securities Litigation Reform Act of 1995that involve risks and uncertainties. Our actual results could differmaterially from those anticipated in these forward-looking statements asa result of a number of factors, including those set forth in the followingcautionary statements and elsewhere in this Quarterly Report on Form 10-Q.If any of the following risks were to occur, our business, financial conditionor results of operations would likely suffer and the trading price of ourcommon stock would likely decline. Investing in our common stock involves ahigh degree of risk. You should carefully consider the risks described belowbefore buying our common stock.*

***We have identifiedmaterial weaknesses in our disclosure controls and procedures and our internalcontrol over financial reporting, which, if not remedied effectively, couldhave an adverse effect on the trading price of our common stock and otherwiseseriously harm our business.***

Management has concludedthat our disclosure controls and procedures and our internal control overfinancial reporting had material weaknesses as of June 30, 2005. We havetaken certain actions to begin to address those material weaknesses. Ourinability to remedy such material weaknesses promptly and effectively couldhave a material adverse effect on our business, results of operations andfinancial condition, as well as impair our ability to meet our quarterly andannual reporting requirements in a timely manner. These effects could in turnadversely affect the trading price of our common stock. Prior to theremediation 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.

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

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

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

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

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

Our director and officerliability insurance policies provide only limited liability protection relatingto the securities class action and derivative lawsuits against us and certainof our officers and directors. If these policies do not adequately coverexpenses and certain liabilities relating to these lawsuits, our results 

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ofoperations and our financial condition could be materially harmed. The factsunderlying the lawsuits have made director and officer liability insuranceextremely expensive for us, and may make this 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 expose us to potentiallyself-funding any potential future liabilities ordinarily mitigated by directorand officer liability insurance.

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

If we are unable to remaincurrent in our SEC filings, we will not be able to have a registrationstatement under the Securities Act of 1933, covering a public offering ofsecurities, declared effective by the SEC, and we will not be able to makeofferings pursuant to existing registration statements (including registrationstatements on Form S-8 covering employee stock plans), or pursuantto certain “private placement” rules of the SEC under Regulation D toany purchasers not qualifying as “accredited investors.” In addition, ouraffiliates 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 for a period of 12 monthsafter the time we become current in our filings. These restrictions may impairour ability to raise funds in the public markets should we desire to do so, andto attract and retain key employees.

***Our common stockmay be delisted from the NASDAQ National Market and transferred to the NationalQuotation Service Bureau (“Pink Sheets”), which may, among other things, reducethe price of our common stock and the levels of liquidity available to ourstockholders.***

NASDAQ has notified usthat we must timely file, without regard to any applicable 12b-25extension period, all periodic reports with the SEC and NASDAQ for allreporting periods ending on or before September 30, 2005 due to our havingbeen delisted in the third quarter of 2004. If we fail to keep current in ourSEC filings, our common stock may be delisted from the NASDAQ National Marketand subsequently would trade on the Pink Sheets. The trading of our commonstock on the Pink Sheets may reduce the price of our common stock and thelevels of liquidity available to our stockholders. In addition, the trading ofour common stock on the Pink Sheets will materially adversely affect our accessto the capital markets, and the limited liquidity and reduced price of ourcommon stock could materially adversely affect our ability to raise capitalthrough alternative financing sources on terms acceptable to us or at all.Stocks that trade on the Pink Sheets are no longer eligible for margin loans,and a company trading on the Pink Sheets cannot avail itself of federalpreemption of state securities or “blue sky” laws, which adds substantialcompliance costs to securities issuances, including pursuant to employee optionplans, stock purchase plans and private or public offerings of securities. Ourdelisting from the NASDAQ National Market and transfer to the Pink Sheets mayalso result in other negative implications, including the potential loss ofconfidence by suppliers, customers and employees, the loss of institutionalinvestor interest and fewer business development opportunities.

***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 andcontinuing into 2005, the telecommunications industry experienced a reversal ofsome of these trends, marked by dramatic reductions in capital expenditures,financial difficulties, and, in some cases, bankruptcies experienced by serviceproviders. These conditions 

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caused a substantial,unexpected reduction in demand for telecommunications equipment, including ourproducts.

We expect thedevelopments 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 condition.

***Consolidation in 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.

***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 for the first six months of fiscal2005, which represented an aggregate of 39% of total revenues. Two and fourcustomers each contributed more than 10% of our revenues for fiscal 2004 and2003, which represented an aggregate of 29% and 57% of total revenues. Onecustomer contributed more than 10% of our revenues for fiscal 2002, whichrepresented an aggregate of 42% of total revenues. Our future success willdepend on our ability to attract additional customers beyond our current limitednumber. The growth of our customer base could be adversely affected by:

·       acquisitionof or by our customers;

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

·       potentialcustomer concerns with selecting an emerging telecommunications equipmentvendor;

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

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

·       newproduct introductions by our competitors;

·       failureof our products to perform as expected; or

·       difficultieswe may incur in meeting customers’ delivery requirements.

The loss of any of oursignificant customers or any substantial reduction in orders or contractualcommitments from these customers could materially adversely affect ourfinancial condition and results of operations. If we do not expand our customerbase to include additional customers that deploy our 

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productsin operational commercial networks, our business, operating results andfinancial condition could be materially and adversely affected.

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

The market for ourproducts continues to evolve. In particular, wireless, cable and broadbandaccess networks are emerging to become important markets for our products.Packet-based technology may not become widely accepted as a platform forvoice and a viable market for our products may not be sustainable. If thismarket does not develop, or develops more slowly than we expect, we may not beable 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.

***Our large customershave substantial negotiating leverage, which may require that we agree to termsand conditions that may have an adverse effect on our business.***

Large telecommunicationsproviders have substantial purchasing power and leverage 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 have an adverse effect onour business and financial condition.

***We rely ondistribution partners to sell our products in certain markets, and disruptionsto or our failure to effectively develop and manage our distribution channeland the processes and procedures that support it could adversely affect ourability to generate revenues from the sale of our products in those markets.***

Our future success is highly dependent uponestablishing and maintaining successful relationships with a variety of value-addedreseller and distribution partners. A portion of our revenues is derivedthrough distributors, many of which sell competitive products. Our revenuesdepend in part on the performance of these distributors. The loss of orreduction in sales by these distributors could materially reduce our revenues.If we fail to maintain relationships with these distribution partners, fail todevelop new 

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relationships withdistributors in new markets, fail to manage, train, or provide incentives to,existing distributors effectively or if these partners are not successful intheir sales efforts, sales of our products may decrease and our operatingresults would 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 adverselyimpacted.

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

Internationalrevenues, primarily attributable to Japan and Europe, were approximately $17.3million for the first six months of fiscal 2005, and $28.8 million forfiscal 2004 and we intend to expand our sales in international markets. Thisexpansion will require significant management attention and financial resourcesto successfully develop direct and indirect international sales and supportchannels. In addition, we may not be able to develop international marketdemand for our products, which could impair our ability to grow our revenues.We have limited experience marketing, distributing and supporting our products internationallyand, to do so, we expect that we will need to develop versions of our productsthat comply with local standards. Furthermore, international operations aresubject to other inherent risks, including:

·       relianceon distributors and resellers;

·       greaterdifficulty collecting accounts receivable and longer collection periods;

·       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;

·       unexpectedchanges in regulatory requirements and currency exchange rates;

·       certificationrequirements;

·       reducedprotection for intellectual property rights in some countries;

·       potentiallyadverse tax consequences; and

·       politicaland economic instability.

***We may not return to or sustain profitability.***

We have incurredsignificant losses since inception and, as of June 30, 2005, had anaccumulated deficit of $778.0 million. Although we achieved profitability inthe second quarter of fiscal 2005 and in each quarter and on an annual basis infiscal year 2004, we incurred a net loss in the first quarter of fiscal 2005and may incur additional losses in future quarters and years. Our revenues maynot grow and we may never generate sufficient revenues to return to or sustainprofitability.

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

Our revenues andoperating results may vary significantly from quarter to quarter due to anumber of factors, many of which are outside of our control and any of 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 resultsinclude 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;

·       thefailure of certain of our customers to successfully and timely reorganize theiroperations, including emerging from bankruptcy;

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

·       thetiming of revenue recognition and amount of deferred revenues;

·       newproduct introductions and enhancements by our competitors and 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 substantial portion of our revenue in a given quarter fromsales booked and shipped in the last weeks of that quarter. As a result, delaysin customer orders may result in delays in shipments and recognition of revenuebeyond the end 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.

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

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***We are entirelydependent upon our voice infrastructure products and our future revenues dependupon their commercial success.***

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

***If we do notrespond rapidly to technological changes or to changes in industry standards,our products could become obsolete.***

The market for packetvoice infrastructure products is likely to be characterized by rapid technologicalchange and frequent new product introductions. We may be unable to respondquickly or effectively to these developments. We may experience difficultieswith software development, hardware design, manufacturing or marketing thatcould delay or prevent our development, introduction or marketing of newproducts and enhancements. The introduction of new products by our competitors,the market acceptance of products based on new or alternative technologies orthe emergence of new industry standards could render our existing or futureproducts obsolete. If the standards adopted are different from those that wehave chosen to support, market acceptance of our products may be significantlyreduced or delayed. If our products become technologically obsolete, we may beunable to sell our products in the marketplace and generate revenues.

***If we fail to compete successfully, our ability toincrease our revenues or return to profitability will be impaired.***

Competition in the telecommunications market isintense. This market has historically been dominated by large companies, suchas Lucent Technologies, NEC, Nortel Networks, Siemens and Ericsson, all ofwhich are our direct competitors. We also face competition from other largetelecommunications and networking companies, including Cisco Systems, some ofwhich have entered our market by acquiring companies that design competingproducts. Because this market is rapidly evolving, additional competitors withsignificant financial resources may enter these markets and further intensifycompetition.

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 customers.Our competitors’ broad product portfolios, coupled with already existingrelationships, may cause our customers to buy our competitors’ products or harmour ability to attract new customers.

To compete effectively,we must deliver innovative products that:

·       provideextremely high reliability and voice quality;

·       scaleeasily and efficiently;

·       interoperatewith existing network designs and other vendors’ equipment;

·       provideeffective network management;

·       areaccompanied by comprehensive customer support and professional services; and

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

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

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

Our products aresophisticated and are designed to be deployed in large and complex networks.Because of the nature of our products, they can only be fully tested whensubstantially deployed in very large networks with high volumes of traffic.Some of our customers have only recently begun to commercially deploy ourproducts and they may discover errors or defects in the software or hardware,or the products may not operate as expected. As we continue to expand ourdistribution channel through distributors and resellers, we will need to relyon and support their service and support organizations. If we are unable to fixerrors or other performance problems that may be identified after full deploymentof our products, we could experience:

·       lossof, or delay in, revenues;

·       lossof customers and market share;

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

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

·       costlyand time-consuming legal actions by our customers.

***Because ourproducts are deployed in large, complex networks around the world, failure toestablish a support infrastructure and maintain required support levels couldseriously harm our business.***

Our products aredeployed in large and complex networks around the world. Our customers expectus to establish a support infrastructure and maintain demanding supportstandards to ensure that their networks maintain high levels of availabilityand performance. To support the continued growth of our business, our supportorganization will need to provide service and support at a high 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

·       networkperformance penalties.

***We have experienced changes in our senior managementrecently, which could affect our business and operations.***

We have made significantchanges in our senior management team recently including the hiring of a VicePresident of Internal Operations in March 2005, and a new Chief FinancialOfficer in December 2004. In addition, on August 1, 2005, weannounced that our Vice President, Corporate Controller and Chief AccountingOfficer was leaving the Company effective August 12, 2005. Because of thesechanges, our management team may not be able to work together effectively tosuccessfully develop and implement our business strategies and financialoperations. In addition, management will need to devote significant attentionand resources to preserve and strengthen relationships with employees,customers and the investor community. If our new management team is unable toachieve these goals, our ability to grow our business and successfully meetoperational challenges could be impaired.

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

Our business depends uponhighly skilled engineering, sales, marketing and customer support personnel.Any failure to hire or retain needed qualified personnel could impair ourgrowth. Our future success depends upon the continued services of our executiveofficers who have critical industry experience and relationships that we relyon to implement our business plan. None of our officers or key employees isbound by an employment agreement for any specific term. The loss of theservices of any of our officers or key employees could delay the developmentand introduction of, and negatively impact our ability to sell, our products.

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

We may become subject toemployment claims in connection with employee terminations. In addition,companies in our industry whose employees accept positions with competitorsfrequently claim that their competitors have engaged in unfair hiringpractices. These claims may result in material litigation. We could incursubstantial costs defending ourselves or our employees against those claims,regardless of their merits. In addition, defending ourselves from those typesof claims could divert our management’s attention from our operations. If weare found liable in connection with any employment claim, we may incursignificant costs that could adversely impact our financial condition andresults of operations.

***We depend uponcontract manufacturers and any disruption in these relationships may cause usto fail to meet the demands of our customers and damage our customerrelationships.***

We rely on a small numberof contract manufacturers to manufacture our products according to ourspecifications and to fill orders on a timely basis. Our contract manufacturersprovide comprehensive manufacturing services, including assembly of ourproducts and procurement of materials. Each of our contract manufacturers alsobuilds products for other companies and may not always have sufficientquantities of inventory available to fill our orders or may not allocate theirinternal resources to fill these orders on a timely basis. We do not have long-termsupply contracts with our manufacturers and they are not required tomanufacture products for any specified period. We do not have internalmanufacturing capabilities to meet our customers’ demands. Qualifying a newcontract manufacturer and commencing commercial scale production is expensiveand time consuming and could result in a significant interruption in the supplyof our products. If a change in contract manufacturers results in delays in ourfulfillment of customer orders or if a contract manufacturer fails to maketimely delivery of orders, we may lose revenues and suffer damage to ourcustomer relationships.

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

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

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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 particular purchaseorder. In the event of a disruption or delay in supply, or inability to obtainproducts, we may not be able to develop an alternate source in a timely manneror at favorable prices, or at all. A failure to find acceptable alternativesources could hurt our ability to deliver high-quality products to ourcustomers and negatively affect our operating margins. In addition, reliance onour suppliers exposes us to potential supplier production difficulties orquality variations. Our customers rely upon our ability to meet committeddelivery dates, and any disruption in the supply of key components wouldseriously adversely affect our ability to meet these dates and could result inlegal action by our customers, loss of customers or harm our ability to attractnew customers.

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

We have incorporated third-partylicensed technology into our current products. From time to time, we may berequired to license additional technology from third parties to develop newproducts or product enhancements. Third-party licenses may not beavailable or continue to be available to us on commercially reasonable terms.The inability to maintain or re-license any third-party licenses requiredin our current products or to obtain any new third-party licenses todevelop new products and product enhancements could require us to obtainsubstitute technology of lower quality or performance standards or at greatercost, and delay or prevent us from making these products or enhancements, anyof which could seriously harm the competitiveness of our products.

***Failures by ourstrategic partners or by us in integrating products provided by our strategic partnerscould 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

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

***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 

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not protect ourproprietary rights as fully as in the United States. If competitors are able touse our technology, our ability to compete effectively could be harmed.

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

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

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

·       redesignthose products that use any allegedly infringing technology.

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

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

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

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

·       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.

Ourintegration of any acquired products, technologies or businesses will alsoinvolve numerous risks, 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; and

·       potentialloss of key employees, particularly those of the acquired organizations.

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.

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***Recent rulemaking by the Financial AccountingStandards Board will require us to expense equity compensation given to ouremployees and may significantly harm our operating results and may reduce ourability to effectively utilize equity compensation to attract and retainemployees.***

We historically have usedstock options as a significant component of our employee compensation program inorder to align employees’ interests with the interests of our stockholders,encourage employee retention, and provide competitive compensation packages.The Financial Accounting Standards Board has adopted changes that will requirecompanies to record a charge to earnings for employee stock option grants andother equity incentives beginning January 1, 2006. By causing us to incursignificantly increased compensation costs, such accounting changes will reduceour reported earnings and may cause us to reduce the availability and amount ofequity incentives provided to employees, which may make it more difficult forus to attract, retain and motivate key personnel. Each of these results couldmaterially and adversely affect our business.

***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 the telecommunicationsindustry. Currently, there are few laws or regulations that apply directly toaccess to or delivery of voice services on IP networks. We could be adverselyaffected by regulation of IP networks and commerce in any country, includingthe United States, where we operate. Such regulations could include matterssuch as voice over the Internet or using Internet protocol, encryptiontechnology, and access charges for service providers. The adoption of suchregulations could decrease demand for our products, and at the same timeincrease the cost of selling our products, which could have a material adverseeffect on our business, operating results and financial condition.

***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 of our commonstock resulting in the dilution of our existing investors’ percentage ownershipof our common stock. In the future, we may seek to raise additional fundsthrough public or private debt or equity financings in 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.

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

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

·       changesin our listing status on the NASDAQ Stock Market;

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·       theaddition or loss of any major customer;

·       consolidationin the telecommunications industry;

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

·       quarterlyvariations in our operating results;

·       changesin financial estimates by securities analysts;

·       speculationin the press or investment community;

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

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

·       securitiesand other litigation;

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

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

·       worldwideeconomic instability.

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

Some stockholders hold asubstantial number of shares of our common stock that have not yet been sold inthe public market. Further, additional shares may become available for saleupon the conversion or redemption of our convertible subordinated note. Salesof a substantial number of shares of our common stock within a short period oftime in the future could impair our ability to raise capital through the saleof additional debt or stock and /or cause our stock price to fall.

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

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

**Item 3: Quantitative and Qualitative Disclosures AboutMarket Risk**

We do not currently usederivative financial instruments. We generally place our marketable securityinvestments in high-quality credit instruments, primarily U.S. Government,state government obligations and corporate obligations with contractualmaturities of less than one year. We do not expect any material loss from ourmarketable security investments and therefore believe that our potentialinterest rate exposure is not material. As of June 30, 2005, we identifieda foreign currency rate fluctuation exposure related to an accounts receivablefrom an international customer, for which we entered into a foreign exchangecontract to mitigate our exposure subsequent to June 30, 2005. As wecontinue to expand internationally, we will continue to evaluate the impact offoreign currency exchange risk on our results of operations.

**Item 4: Controls and 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 

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Rule 13a-15(e) underthe Securities Exchange Act of 1934 (the Exchange Act)) as of June 30,2005, which included an evaluation of disclosure controls and proceduresapplicable to the period covered by the filing of this periodic report. Wepreviously reported ten material weaknesses in our internal control overfinancial reporting (as defined in Rule 13a-15(f) under theExchange Act), which were described in Item 9A and Management’s Report onInternal Control Over Financial Reporting in our Annual Report on Form 10-Kfor the year ended December 31, 2004. As a result of these materialweaknesses in our internal control over financial reporting, we have concludedthat our disclosure controls and procedures were not effective as of June 30,2005.

During the fiscalquarter ended June 30, 2005, we made changes that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting. These changes consist of the following:

·       Weimplemented controls intended to help ensure that all customer invoices and paymentsrecorded in our books and records are timely and accurate. In addition, to helpensure that we have appropriate segregation of responsibilities between custodyand recording of cash receipts, we entered into an arrangement for theestablishment of a lockbox for receipt of customer payments beginning in thethird quarter of 2005.

·       Weimplemented enhanced documentation and review and supervision processes andprocedures over equity-related reconciliations and analyses, intended to helpensure proper monitoring and reporting of equity transactions.

·       Weimplemented processes and procedures over our information systems controlenvironment intended to provide assurance that changes to financialapplications are properly authorized and tested and that access to ourinformation systems and financial applications are appropriately restrictedincluding a networks password policy.

·       We continuedto make improvements to our entity level controls including ongoingcommunications from senior management to employees regarding the importance ofinternal controls, the development and issuance of key policies overauthorization and approval of transactions and expenditures, revisions to useraccess privileges and job responsibilities and the addition of accounting, financeand information systems resources to further improve the level of experienceand quality of our systems in these departments.

·       Weimplemented processes intended to improve the financial reporting of ourbusiness at the close of each quarter, including the issuance of policies andprocedures covering account reconciliations, journal entries, supportingdocumentation and analysis for certain key accounts.

·       Wedesigned a quote and proposal review and approval process intended to providean enhanced level of management and cross-functional review for customer quotesand proposals before submission to our customers, capture the relevant data toidentify all commitments made to customers for our financial reporting anddefine, automate and document the required approvals.

·       Wedesigned system-based detail sub-ledgers related to revenue, deferred revenue,cost of revenue and inventory transactions to help ensure that balances areproperly summarized and posted to our general ledger, which will be implementedin the third quarter of 2005.

·       Weimplemented processes and procedures related to reserves and accruals,including inventory reserves, warranty accruals and royalty accruals, includingenhancing the level of analysis and supporting documentation for amountsreported in the financial statements.

·       Weimplemented processes and procedures to help ensure that inventory valuationaccounts are properly analyzed and that any resulting adjusting entries areaccurately and timely recorded in our general ledger.

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·       Weimplemented a new sales forecasting tool and process to more accuratelyquantify potential bookings and to support material requirements purchases.

·       Wehired additional personnel in our accounting, finance and information systemsorganizations, including an information systems business analyst, revenuecontroller and external reporting manager, to increase the overall expertise ofour personnel in these departments and improve segregation of duties.

·       Wecontinued with the design and implementation of our information systemsenhancement project to further address control deficiencies.

We continue to plan and expect to implement additionalchanges to our infrastructure and related processes that we believe are alsoreasonably likely to strengthen and materially affect our internal control overfinancial reporting.

The changes in our internal control over financialreporting implemented by us to date will not in and of themselves remediate thematerial weaknesses, and certain of these remedial measures will require sometime to be fully implemented or to take full effect. Prior to the remediationof these material weaknesses, there remains risk that the transitionalcontrols, described below, on which we currently rely will fail to besufficiently effective, which could result in material misstatement of ourfinancial position or results of operations and require a restatement.

We are currently implementing an enhanced controlsenvironment intended to address the material weaknesses in our internal controlover financial reporting and to remedy the ineffectiveness of our disclosurecontrols and procedures. While this implementation phase is underway, we arerelying on extensive manual procedures, including regular reviews and thesignificant utilization of outside accounting professionals, to assist us withmeeting the objectives otherwise fulfilled by an effective controlsenvironment. We expect to establish and implement a policy-based systemof controls. While we are undertaking the implementation of this new controlsenvironment, there remains risk that the transitional controls on which we arecurrently relying will fail to be sufficiently effective. We also note,however, that a control system, no matter how well conceived and operated, canprovide only reasonable, not absolute, assurance that the objectives of thecontrol system are met. Further, the design of a control system must include anassessment of the costs and related risks associated with the control and thepurpose for which it was intended. Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues including instances of fraud, if any, have been detected.These inherent limitations include the realities that judgments in decision-makingcan be faulty, and breakdowns can occur because of simple error or mistake.Additionally, controls can be circumvented by the individual acts of someperson, by collusion of two or more people, or by management override of the controls.The design of any system of controls also is based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Over time, our control systems, as we developthem, may become inadequate because of changes in conditions, or the degree ofcompliance with the policies or procedures may deteriorate. Because of theinherent limitations in a cost-effective control system, misstatements due toerror or fraud may occur and not be detected and could be material and requirea restatement of our financial statements.

The certifications of our principal executive officerand principal financial officer required in accordance with Rule 13a-14(a) underthe Exchange Act are attached as exhibits to this Quarterly Report on Form 10-Q.The disclosures set forth in this Item 4 contain information concerning theevaluation of our disclosure controls and procedures, and changes in our internalcontrol over financial reporting, referred to in paragraph 4 of thosecertifications. 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—OTHER INFORMATION**

**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 seeks torepresent a class of persons who purchased our common stock between the IPO on May 24,2000 and December 6, 2000. An amended complaint was filed in April 2002.The amended complaint alleges that our registration statement contained falseor misleading information or omitted to state material facts concerning thealleged receipt of undisclosed compensation by the underwriters and theexistence of undisclosed arrangements between underwriters and certainpurchasers to make additional purchases in the after market. The claims againstus are asserted under Section 10(b) of the Securities Exchange Act of1934 and Section 11 of the Securities Act of 1933 and against theindividual defendants under Sections 11 and 15 of the Securities Act andSections 10(b) and 20(a) of the Exchange Act. Other plaintiffs have filedsubstantially similar class action cases against approximately 300 otherpublicly traded companies and their IPO underwriters which, along with theactions against us, have been transferred to a single federal judge forpurposes of coordinated case management. On July 15, 2002, we, togetherwith the other issuers named as defendants in these coordinated proceedings,filed a collective motion to dismiss the consolidated amended complaints onvarious legal grounds common to all or most of the issuer defendants. Theplaintiffs voluntarily dismissed the claims against many of the individualdefendants, including our officers named in the complaint. On February 19,2003, the court granted a portion of the motion to dismiss by dismissing the Section 10(b)claims against certain defendants including us, but denied the remainder of themotion as to the defendants. In June 2003, a special committee of ourBoard of Directors authorized us to enter into a proposed settlement with theplaintiffs on 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. On February 15,2005, the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. The settlement issubject to final approval by the court. No hearing date has been scheduled forfinal approval. It remains uncertain when the settlement will become final. Wedo not expect that the settlement would have a material impact on our businessor financial results.

Beginning in July 2002, several purchasers of ourcommon stock filed complaints in the United States District Court for theDistrict of Massachusetts against us, certain officers and directors and aformer officer under Sections 10(b) and 20(a) and Rule 10b-5 ofthe Securities Exchange Act of 1934 (Class Action Complaints). Thepurchasers seek to represent a class of persons who purchased our common stockbetween December 11, 2000 and January 16, 2002, and seek unspecifiedmonetary damages. The Class Action Complaints were essentially identicaland alleged that we made false and misleading statements about our products andbusiness. On March 3, 2003, the plaintiffs filed a Consolidated AmendedComplaint. On April 22, 2003, we filed a motion to dismiss theConsolidated Amended Complaint on various grounds. On May 11, 2004, thecourt held oral argument on the motion, at the conclusion of which the courtdenied our motion to dismiss. The plaintiffs filed a motion for classcertification on July 30, 2004, and we filed our opposition on September 10,2004, to which the plaintiffs replied on September 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 filed amotion 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. We believe the claims in the Consolidated Amended Complaint arewithout merit and that we 

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have substantial legal andfactual defenses, which we intend to pursue vigorously. There is no assurancewe will prevail in defending these actions.

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against us and certain of our currentofficers and directors. On June 28, 2004, the court consolidated theclaims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the SecuritiesExchange Act of 1934 and Sections 11, 12(a), and 15 of the Securities Act of1933, relating to our restatement of our financial results for 2001, 2002, andthe first three quarters of 2003. Specifically, the complaint alleges that weissued a series of false or misleading statements to the market concerning ourrevenues, earnings, and financial condition. Plaintiffs contend that suchstatements caused our stock price to be artificially inflated. The complaintseeks unspecified damages on behalf of a purported class of purchasers of ourcommon stock during the period from March 28, 2002, through March 26,2004. On January 28, 2005, we filed a motion to dismiss the Section 10(b) and12(a) claims and joined the motion to dismiss the Section 11 claimfiled by the individual defendants. On June 1, 2005, the court held ahearing on the motion and allowed the plaintiff to file an amended complaint. InAugust 2005, the plaintiff filed an amended complaint. We intend to file amotion to dismiss the amended complaint. We believe that we have substantiallegal and factual defenses to the claims, which we intend to pursue vigorously.There is no assurance we will prevail in defending these actions.

In February 2004, three purported shareholderderivative lawsuits were filed in the United States District Court for theDistrict of Massachusetts against us and certain of our officers and directors,naming us as a nominal defendant. Also in February 2004, two purportedshareholder derivative lawsuits were filed in the business litigation sessionof the superior court of Suffolk County of Massachusetts against us and certainof our directors and officers, also naming us as a nominal defendant. The suitsclaim that certain of our officers and directors breached their fiduciaryduties to our stockholders and to us. The complaints are derivative in natureand do not seek relief from us. However, we have entered into indemnificationagreements in the ordinary course of business with certain of the defendantofficers and directors and may be obligated throughout the pendency of theseactions to advance payment of legal fees and costs incurred by the defendantspursuant to our obligations under the indemnification agreements or applicableDelaware law. On September 27, 2004, the state court granted our motion todismiss. On October 26, 2004, the plaintiffs filed a notice appealing thestate 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 and amended complaint. The defendants will renew theirmotions to dismiss, which must be filed by August 15, 2005. We believethat we have substantial legal and factual defenses to the federal claims.There is no assurance we will prevail in defending these actions.

In December 2004, a purchaser of our common stockfiled a complaint in the circuit court in Will County, Illinois, against us, oneof our officers, and a former officer alleging misrepresentation and fraud inconnection 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. A hearing on our motion todismiss the amended complaint is scheduled for August 30, 2005. We believethat we have substantial legal and factual defenses to these claims, which weintend to pursue vigorously. There is no assurance we will prevail in defendingthis action.

In June 2004, we received a formal order ofprivate investigation from the SEC. On June 7, 2005, we received a noticefrom the SEC terminating the investigation with a recommendation that noenforcement action be taken.

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We have been contacted bythird parties, who claim that our products infringe on certain intellectualproperty of the third party. We evaluate these claims and accrue for royaltieswhen the amounts are probable and reasonably estimable. While we believe thatthe amounts accrued for estimated royalties are adequate, any subsequent changein our estimates will be recorded at such time the change is probable andestimable.

**Item 5: Other Information**

On May 31, 2005, the Board of Directors of theCompany approved a compensation program for non-employee directors as describedin Exhibit 10.27, which is incorporated by reference into this Item 5.

On August 4, 2005,the Compensation Committee of the Board of Directors of the Company approved abonus program for fiscal year 2005 for executive officers and employees,including certain executive officers of the Company reporting under Section 16(a) ofthe Securities Exchange Act of 1934, as described in Exhibit 10.26 whichis incorporated by reference into this Item 5.

**Item 6: Exhibits**
| Exhibit Number                        | ** ** | **Description**                                                                                                                      |
|--------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|
|        10.26 |       | Summary of 2005 Executive Incentive Plan.                                                                                            |
|        10.27 |       | Summary of Director  Compensation Plan.                                                                                              |
|        31.1  |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Section 302 of  the Sarbanes Oxley Act of 2002. |
|        31.2  |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 302 of  the Sarbanes Oxley Act of 2002. |
|        32.1  |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Section 906 of  the Sarbanes Oxley Act of 2002. |
|        32.2  |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 906 of  the Sarbanes Oxley Act of 2002. |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theRegistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized. 
| Dated: August 8, 2005 | SONUS NETWORKS, INC. |
|----------------------------|---------------------------|
|                       | By:                       | /s/ ELLEN B. RICHSTONE |
|                       |                      | Ellen B. Richstone |
|                       |                      | *Chief Financial Officer (Principal  Financial  Officer)* |
|                       | SONUS NETWORKS, INC. |
|                       | By:                       | /s/  BRADLEY T. MILLER |
|                       | * *                  | Bradley  T. Miller |
|                       | * *                  | *Vice President of Finance, Corporate  Controller and Chief Accounting Officer  (Principal Accounting Officer)* |

 

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**EXHIBIT INDEX**
| Exhibit Number                        | ** ** | **Description**                                                                                                                      |
|--------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|
|        10.26 |       | Summary of 2005 Executive Incentive Plan.                                                                                            |
|        10.27 |       | Summary of Director  Compensation Plan.                                                                                              |
|        31.1  |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Section 302 of  the Sarbanes Oxley Act of 2002. |
|        31.2  |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 302 of  the Sarbanes Oxley Act of 2002. |
|        32.1  |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Section 906 of  the Sarbanes Oxley Act of 2002. |
|        32.2  |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 906 of  the Sarbanes Oxley Act of 2002. |

 

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