**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

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

**For the quarterly period ended June 30, 2007**

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

**CommissionFile Number 000-30229**

**SONUS NETWORKS, INC.**

(Exact name of Registrantas specified in its charter)

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

 

**7Technology Park Drive, Westford, Massachusetts 01886**(Address of principal executiveoffices, including zip code)

**(978)614-8100**(Registrant’s telephonenumber, 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 for suchshorter period that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x  No o

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

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

 

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

Asof August 7, 2007, there were 259,995,241 shares of the registrant’scommon stock, $0.001 par value, outstanding.

 

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**SONUSNETWORKS, INC.FORM 10-QQUARTER ENDED JUNE 30, 2007TABLE OF CONTENTS**

|                                        | ** ** | ** **                                                                                                                  | ** ** | **Page** |
|----------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I  FINANCIAL INFORMATION** | ** ** | ** **                                                                                                                  |
| Item  1.                               |       | Financial  Statements                                                                                                       |       |     |
|                                   |       | Condensed Consolidated Balance Sheets as of  June 30, 2007 and December 31, 2006 (unaudited)                      |       | 3        |
|                                   |       | Condensed Consolidated Statements of Operations for  the Three and Six Months Ended June 30, 2007 and 2006 (unaudited) |       | 4        |
|                                   |       | Condensed Consolidated Statements of Cash Flows for  the Six Months Ended June 30, 2007 and 2006 (unaudited)           |       | 5        |
|                                   |       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                           |       | 6        |
| Item 2.                                |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                 |       | 26       |
| Item 3.                                |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                 |       | 37       |
| Item 4.                                |       | Controls and Procedures                                                                                                     |       | 37       |
| **PART II  OTHER INFORMATION**    |       |                                                                                                                        |
| Item  1.                               |       | Legal  Proceedings                                                                                                          |       | 40       |
| Item  1A.                              |       | Risk  Factors                                                                                                               |       | 43       |
| Item 2.                                |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                                                |       | 57       |
| Item 6.                                |       | Exhibits                                                                                                                    |       | 58       |
|                                   |       | Signatures                                                                                                                  |       | 59       |
|                                   |       | Exhibit Index                                                                                                          |       | 60       |

 

2

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**PART I - FINANCIAL INFORMATION**

**Item 1. FinancialStatements**

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

| ** **                                                                                                                                                                                                                 | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                 | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                                                                                                 |       |              |       |                  |       |   |   |
| Current assets:                                                                                                                                                                                                            |       |              |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                  |       | $                 | 61,617     |                  |       | $ | 44,206 |   |   |
| Marketable debt securities                                                                                                                                                                                                 |       | 243,605           |       |                  | 256,485    |   |   |
| Accounts receivable, net                                                                                                                                                                                                   |       | 72,438            |       |                  | 70,726     |   |   |
| Inventory, net                                                                                                                                                                                                             |       | 33,177            |       |                  | 22,266     |   |   |
| Deferred income taxes                                                                                                                                                                                                      |       | 21,833            |       |                  | 21,808     |   |   |
| Other current assets                                                                                                                                                                                                       |       | 27,178            |       |                  | 18,523     |   |   |
| Total current assets                                                                                                                                                                                                       |       | 459,848           |       |                  | 434,014    |   |   |
| Property and  equipment, net                                                                                                                                                                                               |       | 20,174            |       |                  | 19,051     |   |   |
| Purchased  intangible assets, net                                                                                                                                                                                          |       | 2,900             |       |                  | —     |   |   |
| Goodwill                                                                                                                                                                                                                   |       | 7,841             |       |                  | —     |   |   |
| Long-term  investments                                                                                                                                                                                                     |       | 39,470            |       |                  | 60,189     |   |   |
| Deferred income  taxes                                                                                                                                                                                                     |       | 46,968            |       |                  | 52,613     |   |   |
| Other assets                                                                                                                                                                                                               |       | 20,744            |       |                  | 23,737     |   |   |
|                                                                                                                                                                                                                       |       | $                 | 597,945    |                  |       | $ | 589,604 |   |   |
| **Liabilities and stockholders’ equity**                                                                                                                                                                              |       |              |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                                                       |       |              |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                                           |       | $                 | 24,989     |                  |       | $ | 17,219 |   |   |
| Accrued expenses                                                                                                                                                                                                           |       | 36,950            |       |                  | 43,653     |   |   |
| Accrued restructuring expenses                                                                                                                                                                                             |       | —            |       |                  | 61         |   |   |
| Current portion of deferred revenue                                                                                                                                                                                        |       | 55,270            |       |                  | 60,383     |   |   |
| Current portion of long-term liabilities                                                                                                                                                                                   |       | 1,630             |       |                  | 501        |   |   |
| Total current liabilities                                                                                                                                                                                                  |       | 118,839           |       |                  | 121,817    |   |   |
| Long-term deferred  revenue                                                                                                                                                                                                |       | 31,319            |       |                  | 33,787     |   |   |
| Deferred income  taxes                                                                                                                                                                                                     |       | 912               |       |                  | —     |   |   |
| Long-term liabilities,  net of current portion                                                                                                                                                                             |       | 2,748             |       |                  | 1,467      |   |   |
| Total liabilities                                                                                                                                                                                                          |       | 153,818           |       |                  | 157,071    |   |   |
| 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; 262,091,030 and 262,065,332 shares issued; 259,794,120 and  259,768,422 shares outstanding at June 30, 2007 and December 31,  2006, respectively |       | 262               |       |                  | 262        |   |   |
| Additional paid-in capital                                                                                                                                                                                                 |       | 1,183,548         |       |                  | 1,160,853  |   |   |
| Accumulated deficit                                                                                                                                                                                                        |       | (739,237          | )          |                  | (728,233   | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                                                       |       | (179              | )          |                  | (82        | ) |   |
| Treasury stock, at cost; 2,296,910 common shares at  June 30, 2007 and December 31, 2006                                                                                                                         |       | (267              | )          |                  | (267       | ) |   |
| Total stockholders’ equity                                                                                                                                                                                            |       | 444,127           |       |                  | 432,533    |   |   |
|                                                                                                                                                                                                                       |       | $                 | 597,945    |                  |       | $ | 589,604 |   |   |

 

See notes to the condensed consolidated financial statements.

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

| ** **                                             | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                             | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue:                                               |       |                             |       |                           |       |   |   |   |   |
| Product                                                |       | $                                | 52,171     |                           | $          | 48,853 |   | $ | 103,798 |   | $ | 93,395 |   |
| Service                                                |       | 23,322                           |       | 15,627                         |       | 42,841 |   | 31,080 |   |
| Total revenue                                          |       | 75,493                           |       | 64,480                         |       | 146,639 |   | 124,475 |   |
| Cost of revenue:                                       |       |                             |       |                           |       |   |   |   |   |
| Product                                                |       | 23,561                           |       | 16,199                         |       | 40,643 |   | 32,082 |   |
| Service                                                |       | 9,563                            |       | 6,987                          |       | 18,142 |   | 13,716 |   |
| Total cost of revenue                                  |       | 33,124                           |       | 23,186                         |       | 58,785 |   | 45,798 |   |
| Gross profit                                           |       | 42,369                           |       | 41,294                         |       | 87,854 |   | 78,677 |   |
| Operating expenses:                                    |       |                             |       |                           |       |   |   |   |   |
| Research and development                               |       | 22,350                           |       | 12,900                         |       | 41,048 |   | 25,976 |   |
| Sales and marketing                                    |       | 21,219                           |       | 15,646                         |       | 44,269 |   | 29,671 |   |
| General and administrative                             |       | 14,202                           |       | 7,248                          |       | 28,264 |   | 14,228 |   |
| Total operating expenses                               |       | 57,771                           |       | 35,794                         |       | 113,581 |   | 69,875 |   |
| Income (loss)  from operations                         |       | (15,402                          | )          | 5,500                          |       | (25,727 | ) | 8,802 |   |
| Interest expense                                       |       | (79                              | )          | (81                            | )          | (83 | ) | (218 | ) |
| Interest income                                        |       | 4,522                            |       | 3,899                          |       | 9,146 |   | 7,341 |   |
| Other income  (expense), net                           |       | (256                             | )          | —                         |       | (936 | ) | — |   |
| Income (loss)  before income taxes                     |       | (11,215                          | )          | 9,318                          |       | (17,600 | ) | 15,925 |   |
| Income tax  benefit (provision)                        |       | 4,239                            |       | (404                           | )          | 6,646 |   | (1,195 | ) |
| Net income (loss)                                      |       | $                                | (6,976     | )                              | $          | 8,914 |   | $ | (10,954 | ) | $ | 14,730 |   |
| Net income (loss)  per share:                          |       |                             |       |                           |       |   |   |   |   |
| Basic                                                  |       | $                                | (0.03      | )                              | $          | 0.04 |   | $ | (0.04 | ) | $ | 0.06 |   |
| Diluted                                                |       | $                                | (0.03      | )                              | $          | 0.03 |   | $ | (0.04 | ) | $ | 0.06 |   |
| Shares used in  computing net income (loss) per share: |       |                             |       |                           |       |   |   |   |   |
| Basic                                                  |       | 259,786                          |       | 252,664                        |       | 259,777 |   | 251,371 |   |
| Diluted                                                |       | 259,786                          |       | 256,326                        |       | 259,777 |   | 255,454 |   |

 

See notes to the condensed consolidated financial statements.

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

| ** **                                                                                         | ** ** | **Six months ended** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                         | ** ** | **June 30,**              | ** ** |
| ** **                                                                                         | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| Cash flows from operating activities:                                                              |       |                           |       |   |   |
| Net income (loss)                                                                                  |       | $                              | (10,954    | ) | $ | 14,730 |   |
| Adjustments to reconcile net income (loss) to cash  flows provided by operating activities:        |       |                           |       |   |   |
| Depreciation and  amortization of property and equipment                                           |       | 6,351                          |       | 4,732 |   |
| Amortization of purchased  intangible assets                                                       |       | 141                            |       | — |   |
| Stock-based compensation                                                                           |       | 23,486                         |       | 5,042 |   |
| Loss on disposal of  property and equipment                                                        |       | —                         |       | 6 |   |
| Increase in fair value of  modified stock options held by former employees                         |       | 936                            |       | — |   |
| Deferred income taxes                                                                              |       | 5,645                          |       | — |   |
| Changes in operating assets and liabilities:                                                       |       |                           |       |   |   |
| Accounts receivable                                                                                |       | (1,261                         | )          | (5,162 | ) |
| Inventory                                                                                          |       | (10,579                        | )          | 4,170 |   |
| Other operating assets                                                                             |       | (5,693                         | )          | (7,812 | ) |
| Accounts payable                                                                                   |       | 6,541                          |       | (3,712 | ) |
| Accrued expenses,  deferred rent and accrued restructuring expenses                                |       | (6,901                         | )          | 52 |   |
| Deferred revenue                                                                                   |       | (7,377                         | )          | (6,661 | ) |
| Net cash provided by  operating activities                                                         |       | 335                            |       | 5,385 |   |
| Cash flows from investing activities:                                                              |       |                           |       |   |   |
| Purchases of property and  equipment                                                               |       | (7,138                         | )          | (5,163 | ) |
| Acquisition of Zynetix  Limited                                                                    |       | (8,825                         | )          | — |   |
| Maturities of  available-for-sale marketable debt securities                                       |       | 38,158                         |       | 68,775 |   |
| Purchases of  available-for-sale marketable debt securities                                        |       | (36,008                        | )          | (31,175 | ) |
| Maturities of  held-to-maturity marketable debt securities and long-term investments               |       | 170,000                        |       | 58,006 |   |
| Purchases of  held-to-maturity marketable debt securities and long-term investments                |       | (138,551                       | )          | (225,007 | ) |
| Decrease in restricted  cash                                                                       |       | 261                            |       | 250 |   |
| Net cash provided by  (used in) investing activities                                               |       | 17,897                         |       | (134,314 | ) |
| Cash flows from financing activities:                                                              |       |                           |       |   |   |
| Sale of common stock in  connection with employee stock purchase plan                              |       | —                         |       | 2,310 |   |
| Proceeds from exercise of  stock options                                                           |       | —                         |       | 11,386 |   |
| Repayment of convertible  subordinated note                                                        |       | —                         |       | (10,000 | ) |
| Repayment of notes  payable to Zynetix Limited shareholders                                        |       | (335                           | )          | — |   |
| Payment of tax  withholding obligations related to net share settlement of restricted stock  award |       | (300                           | )          | — |   |
| Principal payments of  capital lease obligations                                                   |       | (73                            | )          | (23 | ) |
| Net cash provided by  (used in) financing activities                                               |       | (708                           | )          | 3,673 |   |
| Effect of exchange  rate changes on cash and cash equivalents                                      |       | (113                           | )          | (40 | ) |
| Net increase  (decrease) in cash and cash equivalents                                              |       | 17,411                         |       | (125,296 | ) |
| Cash and cash  equivalents, beginning of period                                                    |       | 44,206                         |       | 155,679 |   |
| Cash and cash  equivalents, end of period                                                          |       | $                              | 61,617     |   | $ | 30,383 |   |
| Supplemental disclosure of cash flow information:                                                  |       |                           |       |   |   |
| Interest paid                                                                                      |       | $                              | 23         |   | $ | 211 |   |
| Income taxes paid                                                                                  |       | $                              | 1,886      |   | $ | 1,649 |   |
| Supplemental disclosure of non-cash investing  activities:                                         |       |                           |       |   |   |
| Non-cash purchases of  property and equipment                                                      |       | $                              | 267        |   | $ | 872 |   |
| Property and equipment  acquired as part of a facility lease                                       |       | $                              | —     |   | $ | 50 |   |
| Supplemental disclosure of non-cash financing  activities:                                         |       |                           |       |   |   |
| Issuance of restricted  stock                                                                      |       | $                              | 193        |   | $ | — |   |
| Modifications of stock options—reclassification from  equity to liability award               |       | $                              | 849        |   | $ | — |   |

 

See notes to the condensed consolidated financial statements.

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

**(1) Descriptionof Business**

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

**(2) Summary ofSignificant Accounting Policies**

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

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

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

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

The accompanying condensed consolidated financialstatements include the accounts of Sonus and its wholly owned subsidiaries. Allintercompany transactions and balances have been eliminated in consolidation.

On April 13, 2007,the Company completed the acquisition of Zynetix Limited (“Zynetix”) (see Note 3).The operating results of Zynetix have been included in the Company’s condensedconsolidated financial statements for the period subsequent to its acquisition.

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

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

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becomeknown. Sonus bases its estimates on historical experience and various otherassumptions that it believes to be reasonable under the circumstances. Actualresults could differ from those estimates.

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

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

Cash equivalents and marketable debt securities areinvested in high-quality debt instruments, primarily U.S. Government, municipaland corporate obligations. Investments in U.S. Government and corporateobligations are classified as held-to-maturity, as Sonus has the intent andability to hold them to maturity. Held-to-maturity marketable debt securitiesare reported at amortized cost. Investments in municipal obligations areclassified as available-for-sale and are reported at fair value. Unrealizedgains and losses from available-for-sale marketable debt securities were notmaterial for the periods presented. The unrealized losses related to thesesecurities at June 30, 2007 are not considered to be a permanent declinein the fair value of such securities. There have been no material realizedgains or losses to date. Current marketable debt securities includeheld-to-maturity investments with remaining maturities of less than one year asof the balance sheet date and available-for-sale investments that are expectedto be sold in the current period or to be used in current operations. Long-terminvestments include held-to-maturity investments with remaining maturities of oneto five years as of the balance sheet date.

At June 30,2007 and December 31, 2006, marketable debt securities and long-terminvestments consisted of the following (in thousands):

| ** **                      | ** ** | **June 30, 2007** | ** ** |
|---------------------------------|------------|-----------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**         | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| *Marketable  debt securities*   |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:             |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| State and municipal obligations |       | $                           | 26,000     |   |   | $ | — |   |   |   | $ | — |   |   | $ | 26,000 |   |
| Held-to-maturity:               |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       | 101,568                     |       |   | 1 |   |   |   | (111 | ) |   | 101,458 |   |
| Corporate debt securities       |       | 38,168                      |       |   | 2 |   |   |   | (50 | ) |   | 38,120 |   |
| Commercial paper                |       | 77,869                      |       |   | 1 |   |   |   | (216 | ) |   | 77,654 |   |
|                            |       | $                           | 243,605    |   |   | $ | 4 |   |   |   | $ | (377 | ) |   | $ | 243,232 |   |
| *Long-term  investments*        |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:               |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       | $                           | 27,965     |   |   | $ | — |   |   |   | $ | (67 | ) |   | $ | 27,898 |   |
| Corporate debt securities       |       | 11,505                      |       |   | — |   |   |   | (43 | ) |   | 11,462 |   |
|                            |       | $                           | 39,470     |   |   | $ | — |   |   |   | $ | (110 | ) |   | $ | 39,360 |   |

 

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| ** **                      | ** ** | **December 31, 2006** | ** ** |
|---------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**             | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| *Marketable debt securities*    |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:             |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| State and municipal obligations |       | $                               | 28,150     |   |   | $ | — |   |   |   | $ | — |   |   | $ | 28,150 |   |
| Held-to-maturity:               |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       | 97,698                          |       |   | 9 |   |   |   | (110 | ) |   | 97,597 |   |
| Corporate debt securities       |       | 32,878                          |       |   | 6 |   |   |   | (43 | ) |   | 32,841 |   |
| Commercial paper                |       | 97,759                          |       |   | 7 |   |   |   | (358 | ) |   | 97,408 |   |
|                            |       | $                               | 256,485    |   |   | $ | 22 |   |   |   | $ | (511 | ) |   | $ | 255,996 |   |
| *Long-term investments*         |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:               |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency  notes   |       | $                               | 44,835     |   |   | $ | 11 |   |   |   | $ | (39 | ) |   | $ | 44,807 |   |
| Corporate debt securities       |       | 15,354                          |       |   | 5 |   |   |   | (25 | ) |   | 15,334 |   |
|                            |       | $                               | 60,189     |   |   | $ | 16 |   |   |   | $ | (64 | ) |   | $ | 60,141 |   |

 

At June 30, 2007 and December 31, 2006,Sonus had $80,000 and $341,000, respectively, of restricted cash, which is usedto collateralize standby letters of credit. Restricted cash is included inOther current assets in the Condensed Consolidated Balance Sheets.

In connection with therelocation of its headquarters to Westford, Massachusetts in January 2007,the Company issued a $500,000 standby letter of credit. The standby letter ofcredit may be drawn upon in the event of the Company’s noncompliance with theterms and conditions of the sublease for the Westford headquarters facility.

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

The financial instruments that potentially subjectSonus to concentrations of credit risk are cash, cash equivalents, marketabledebt securities, accounts receivable and long-term investments. Sonus’ cash,cash equivalents and investment portfolio holdings were diversified among fourfinancial institutions at June 30, 2007.

Onecustomer contributed at least 10% of Sonus’ revenue for the three and sixmonths ended June 30, 2007 and 2006:

| ** **   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,**            | ** ** |
|--------------|------------|-------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Customer** | ** ** | ** **                                      | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** |
| A            |       |                                            | 36         | %                                                        |       |   | 61 | % |   |   | 40 | % |   |   | 36 | % |   |
|              |            |                                                 |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At June 30, 2007 and December 31,2006, two customers and three customers, respectively, each accounted for atleast 10% of Sonus’ accounts receivable balance, representing a total ofapproximately 55% and 45% of the Company’s total accounts receivable balances. Sonusperforms ongoing credit evaluations of its customers and generally does notrequire collateral on accounts receivable. Sonus maintains an allowance fordoubtful accounts and such losses have been within management’s expectations.

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The following table shows the percentage ofrevenue by geographic region for the three and six  months ended June 30, 2007 and 2006:

| ** **                      | ** ** | **Three months ended  June 30,**          | ** ** | **Six months ended  June 30,**            | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                      | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** |
| United States                   |       |                                                     | 75         | %                                                        |       |   | 95 | % |   |   | 79 | % |   |   | 86 | % |   |
| Japan                           |       |                                                     | 13         |                                                     |       |   | 2 |   |   |   | 10 |   |   |   | 6 |   |   |
| Other Asia  Pacific             |       |                                                     | *          |                                                     |       |   | * |   |   |   | * |   |   |   | 5 |   |   |
| Europe, Middle  East and Africa |       |                                                     | 11         |                                                     |       |   | 3 |   |   |   | 9 |   |   |   | 3 |   |   |
| Other                           |       |                                                     | 1          |                                                     |       |   | * |   |   |   | 2 |   |   |   | * |   |   |
|                            |       |                                                     | 100        | %                                                        |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

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*                    Representsless than 1% of revenue.

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

In 2006, Sonusconsolidated its manufacturing to a single manufacturer. Failure to managethese consolidation activities could result in a disruption in the supply ofits products and in delays in the fulfillment of the Company’s customer orders.

***(e) Accounts Receivable***

Accountsreceivable consist of the following (in thousands):

| ** **                           | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Earned accounts receivable | ** ** | $                       | 55,936     | ** **                  |       | $ | 42,086 | ** ** |   |
| Unearned accounts  receivable        |       | 16,855                  |       |                        | 29,232     |   |   |
| Accounts receivable, gross           |       | 72,791                  |       |                        | 71,318     |   |   |
| Allowance for  doubtful accounts     |       | (353                    | )          |                        | (592       | ) |   |
| Accounts receivable,  net            |       | $                       | 72,438     |                        |       | $ | 70,726 |   |   |

 

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.

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***(f) Inventory***

Inventoryconsists of the following (in thousands):

| ** **                                             | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| On-hand final  assemblies and finished goods inventory |       | $                       | 15,538     |                        |       | $ | 15,738 |   |   |
| Unearned  inventory                                    |       | 35,330                  |       |                        | 27,166     |   |   |
| Evaluation  inventory                                  |       | 4,535                   |       |                        | 4,380      |   |   |
| Inventory, gross                                       |       | 55,403                  |       |                        | 47,284     |   |   |
| Excess, obsolete  and evaluation reserve               |       | (5,721                  | )          |                        | (5,969     | ) |   |
| Inventory, net                                         |       | 49,682                  |       |                        | 41,315     |   |   |
| Less current  portion                                  |       | (33,177                 | )          |                        | (22,266    | ) |   |
| Long-term portion  (included in Other assets)          |       | $                       | 16,505     |                        |       | $ | 19,049 |   |   |

 

Inventory is stated at thelower of cost (first-in, first-out basis) or market and consists of finalassembly materials and finished goods.

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

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

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

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

***(h) Acquisitions***

In accordance with thepurchase method of accounting and Statement of Financial Accounting Standards (“SFAS”)No. 141, *Business Combinations* (“SFAS 141”),the fair values of tangible and identifiable intangible assets acquired andliabilities assumed are determined and recorded as of the date of theacquisition. Costs to acquire the business, including transaction costs, areallocated to the fair value of net assets acquired. Any excess of the purchaseprice over the estimated fair value of the net assets acquired is recorded asgoodwill. The Company typically employs valuation consultants to assist in thedetermination of fair values of tangible and identifiable intangible assetsacquired.

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***(i) PurchasedIntangible Assets and Goodwill***

Purchasedintangible assets consist of certain identifiable intangible assets resultingfrom the April 13, 2007 acquisition of Zynetix. The components of theCompany’s purchased intangible assets at June 30, 2007 consist of thefollowing (in thousands):

| ** **              | ** ** | **Useful life** | ** ** | **Cost** | ** ** | **Accumulated  amortization** | ** ** | **Net  carrying value** | ** ** |
|-------------------------|------------|----------------------|------------|----------|------------|-------------------------------|------------|------------------------------|------------|
| Customer  relationships |       |                 | 7 years    |     |       | $                             | 1,419      |                         |       | $ | (50 | ) |   |   | $ | 1,369 |   |   |
| Intellectual  property  |       |                 | 5 years    |     |       | 1,318                         |       |                         | (66        | ) |   |   | 1,252 |   |   |
| Trade name              |       |                 | 3 years    |     |       | 304                           |       |                         | (25        | ) |   |   | 279 |   |   |
|                    |       |                 |       |     |       | $                             | 3,041      |                         |       | $ | (141 | ) |   |   | $ | 2,900 |   |   |

 

TheCompany amortizes its purchased intangible assets over the estimated usefullives of the respective assets, which have a weighted average useful life of5.7 years. Amortization expense related to purchased intangible assets was$141,000 in both the three and six months ended June 30, 2007. Estimatedfuture amortization expense for purchased intangible assets recorded by theCompany at June 30, 2007 is as follows (in thousands):

| Remainder of 2007 |   | $   | 284    |   |
|-------------------|--------|-----|--------|--------|
| 2008              |   | 568 |   |
| 2009              |   | 568 |   |
| 2010              |   | 492 |   |
| 2011              |   | 466 |   |
| Thereafter        |   | 522 |   |
|              |   | $   | 2,900  |   |

 

Goodwill is recorded when the consideration for anacquisition exceeds the fair value of net tangible and identifiable intangibleassets acquired. In accordance with SFAS No. 142, *Goodwill andOther Intangible Assets* (“SFAS 142”), goodwill is not amortized, butrather, is tested at least annually for impairment at the reporting unit level.The Company has recorded goodwill aggregating $7.8 million at June 30,2007, related to the acquisition of Zynetix. The changes in the carrying amountsof goodwill in the six months ended June 30, 2007 are as follows (inthousands):

| Balance at  January 1, 2007         |   | $     | — |   |
|------------------------------------------|--------|-------|--------|--------|
| Acquisition of Zynetix  Limited          |   | 7,734 |   |
| Foreign currency  translation adjustment |   | 107   |   |
| Balance at June 30, 2007            |   | $     | 7,841  |   |

 

***(j) Impairmentof Goodwill and Long-Lived Assets***

In accordance with SFAS142, goodwill and intangible assets with indefinite lives are tested forimpairment on an annual basis and between annual tests if indicators of potentialimpairment exist. Intangible assets with estimated lives and other long-livedassets are reviewed for impairment when events or changes in circumstancesindicate that the carrying amount of an asset or asset group may not berecoverable in accordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets* (“SFAS 144”).Recoverability of intangible assets with estimated lives and other long-livedassets is measured by a comparison of the carrying amount of an asset or assetgroup to future net undiscounted pretax cash flows expected to be generated bythe asset or asset group. If these comparisons indicate that an asset is notrecoverable, the Company will recognize an impairment loss for the amount bywhich the carrying value of the asset or asset group exceeds the relatedestimated fair value. Estimated fair value is based on either discounted futurepretax operating cash flows or appraised values, depending on the nature of theasset.

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Factors that couldindicate that an impairment may exist include significant underperformancerelative to plan or long-term projections, strategic changes in businessstrategy, significant negative industry or economic trends, a significantchange in circumstances relative to a large customer, a significant decline inthe Company’s stock price for a sustained period, and a decline in the Company’smarket capitalization to below net book value.

***(k) Other Assets***

Otherassets consist of the following (in thousands):

| ** **           | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------|------------|-------------------------|------------|-----------------------------|------------|
| Prepaid  commissions |       | $                       | 1,984      |                        |       | $ | 3,103 |   |   |
| Prepaid royalties    |       | 1,382                   |       |                        | 336        |   |   |
| Deposits             |       | 873                     |       |                        | 1,249      |   |   |
| Unearned  inventory  |       | 16,505                  |       |                        | 19,049     |   |   |
|                 |       | $                       | 20,744     |                        |       | $ | 23,737 |   |   |

 

***(l) Accrued Expenses***

Accruedexpenses consist of the following (in thousands):

| ** **                               | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Employee  compensation and related costs |       | $                       | 19,071     |                        |       | $ | 21,715 |   |   |
| Employee stock  purchase plan            |       | 4,550                   |       |                        | 1,966      |   |   |
| Professional fees                        |       | 4,241                   |       |                        | 4,223      |   |   |
| Royalties                                |       | 1,372                   |       |                        | 2,640      |   |   |
| Income taxes  payable                    |       | 28                      |       |                        | 7,239      |   |   |
| Sales taxes  payable                     |       | 1,114                   |       |                        | 761        |   |   |
| Other taxes                              |       | 4,181                   |       |                        | 3,486      |   |   |
| Other                                    |       | 2,393                   |       |                        | 1,623      |   |   |
|                                     |       | $                       | 36,950     |                        |       | $ | 43,653 |   |   |

 

***(m) Revenue Recognition***

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

Many of Sonus’ sales involve complex contractual,multiple element arrangements. When a sale includes multiple elements, such asproducts, maintenance and/or professional services, Sonus recognizes revenueusing the residual method. Revenue associated with undelivered elements thatare considered not essential to the functionality of the product and for whichVSOE has been established, is deferred based on the VSOE value and anyremaining arrangement fee is then allocated to, and recognized as, productrevenue. VSOE is determined based upon the price charged when the same elementis sold separately or 

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established by therelevant pricing authority. If Sonus cannot establish VSOE for each undeliveredelement, including specified upgrades, it defers revenue on the entirearrangement until VSOE for all undelivered elements is known or all elementsare delivered and all other revenue recognition criteria are met.

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

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

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

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

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

***(n) Deferred Revenue***

Deferredrevenue consists of the following (in thousands):

| ** **                         | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Maintenance and  support contracts |       | $                       | 45,047     |                        |       | $ | 41,077 |   |   |
| Customer deposits                  |       | 24,686                  |       |                        | 23,861     |   |   |
| Unearned revenue                   |       | 16,855                  |       |                        | 29,232     |   |   |
| Total deferred revenue             |       | 86,588                  |       |                        | 94,170     |   |   |
| Less current  portion              |       | (55,269                 | )          |                        | (60,383    | ) |   |
| Long-term portion                  |       | $                       | 31,319     |                        |       | $ | 33,787 |   |   |

 

Revenue from maintenanceand support contracts is recognized ratably over the life of the maintenanceand support period. Customer deposits represent payments received in advance ofrevenue recognition. Unearned revenue represents billings for which payment hasnot been received and revenue recognition criteria have not been met. At June 30,2007 and December 31, 2006, both deferred revenue and accounts receivableexcluded $21.7 million and $12.4 million, respectively, related to productsshipped and billed to customers for which revenue is recognized as cash iscollected, or for which title had not passed to the customer as of the periodend date.

***(o) Stock-based Compensation***

Sonus issues stock options and restricted stockpursuant to the 1997 Stock Incentive Plan (“Stock Plan”) and provides employeesthe right to purchase stock pursuant to the 2000 Employee Stock Purchase Plan (“ESPP”).The Stock Plan provides for the award of stock options and restricted stock toemployees, 

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officers, directors(including those directors who are not employees or officers of the Company),consultants and advisors of the Company and its subsidiaries.

The ESPP is designed to provide eligible employees ofthe Company and its participating subsidiaries an opportunity to purchasecommon stock of the Company through accumulated payroll deductions. The ESPPhas a two year offering period comprised of four six month purchase periods(subject to extension). The purchase price of the stock is equal to 85% of thelower of the market price on the first day of the two year offering period orthe market price on the last day of any of the four purchase periods. If themarket price at any of the four purchase periods is less than the market priceon the first date of the two year offering period, subsequent to the purchase,the offering period is cancelled and the employee is entered into a new two yearoffering period with the then current market price as the new base price. Sonusrecognizes compensation expense associated with the ESPP in accordance with theprovisions of SFAS No. 123(R), *Share-based Payment*(“SFAS 123R”), and Financial Accounting Standards Board (“FASB”) TechnicalBulletin 97-1, *Accounting under Statement123 for Certain Employee Stock Purchase Plans with a Look-Back Option*.

Stock options are generally issued with an exerciseprice equal to the current market price on the date of grant with a four-yearvesting period and contractual term of ten years. Restricted stock is generallyissued with no purchase price, with fair value based on the market price on thedate of grant. Sonus includes as part of its inventory a portion of the fairvalue of stock compensation, which is expensed as inventory is relieved,generally over six months. All of Sonus’ stock-based compensation is accountedfor as an equity instrument and there have been no liability awards granted;however, modifications to stock awards for certain former employees have beenrecorded as liabilities in accordance with EITF 00-19, *Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock*(“EITF 00-19”). Theseliability awards are accounted for as derivative financial instruments, andaccordingly, are marked to market at each interim reporting date and thechanges in fair value are recorded as Other income or expense. Sonus recorded$0.2 million and $0.9 million to Other expense for the three and six monthsended June 30, 2007, respectively, as a result of changes in the fairvalue of the liability awards.

EffectiveJanuary 1, 2006, Sonus adopted the fair value recognition provisions ofSFAS 123R, using the modified prospective transition application method, whichrequires measurement of compensation cost at fair value on the date of grantand recognition of compensation expense over the service period for awardsexpected to vest. As a result, Sonus recorded $14.6 million and $2.7 million ofstock-based compensation for the three months ended June 30, 2007 and2006, respectively, and $23.5 million and $5.0 million, respectively, for thesix months then ended. These amounts are included as components of thefollowing expense categories in the Condensed Consolidated Statements ofOperations (in thousands):

| ** **                  | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Product cost of  revenue    |       | $                                               | 188        |                                          | $          | 10 |   | $ | 278 |   | $ | 25 |   |
| Service cost of  revenue    |       | 1,023                                           |       | 199                                           |       | 1,605 |   | 483 |   |
| Research and  development   |       | 6,482                                           |       | 633                                           |       | 9,691 |   | 1,420 |   |
| Sales and  marketing        |       | 5,699                                           |       | 1,166                                         |       | 9,221 |   | 1,676 |   |
| General and  administrative |       | 1,225                                           |       | 735                                           |       | 2,691 |   | 1,438 |   |
|                        |       | $                                               | 14,617     |                                          | $          | 2,743 |   | $ | 23,486 |   | $ | 5,042 |   |

 

In addition, Sonus included in inventory approximately$405,000 and $32,000 of stock-based compensation at June 30, 2007 and December 31,2006, respectively.

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At June 30, 2007,there was $23.1 million of unrecognized compensation cost related toshare-based awards, which is expected to be recognized over a weighted averageperiod of approximately three years. At June 30, 2007, there was $1.2 millionof additional stock-based compensation expense to be recorded over theremaining ESPP period.

***Valuation Assumptions***

Thegrant-date fair value of options to purchase common stock granted in the threeand six months ended June 30, 2007 and 2006 was estimated using theBlack-Scholes valuation model with the following assumptions:

| ** **                   | ** ** | **Three months ended  June 30,** |       | **Six months ended  June 30,** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                   | ** ** | **2007**                                        | ** ** | **2006**                                      |       | **2007** | ** ** | **2006** | ** ** |
| Risk-free  interest rate     |       | 4.8                                             | %          | 5.0                                           | %          | 4.7 | % | 4.7 | % |
| Expected dividend  yield     |       | —                                          |       | —                                        |       | — |   | — |   |
| Expected volatility          |       | 62.4                                            | %          | 70                                            | %          | 57.5%–62.4 | % | 70%–78 | % |
| Weighted average  volatility |       | 62.4                                            | %          | 70                                            | %          | 60.1 | % | 78 | % |
| Expected life (years)        |       | 4.5                                             |       | 4.5                                           |       | 4.5 |   | 4.5 |   |

 

Based on the above assumptions, the weighted averagefair value of stock options granted during the three and six months ended June 30,2007 was $4.46 and $4.16, respectively, and $2.90 and $3.13 for the three andsix months ended June 30, 2006, respectively.

Thefair value of the rights to purchase shares of common stock under the ESPP wasestimated on the commencement date of the offering period using theBlack-Scholes valuation model with the following assumptions:

| ** **                   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                   | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Risk-free  interest  rate    |       | 3.6%–5.1                                   | %          | 2.7%–4.8                                 | %          | 3.6%–5.1 | % | 1.8%–4.8 | % |
| Expected dividend  yield     |       | —                                          |       | —                                        |       | — |   | — |   |
| Weighted average  volatility |       | 46%–79                                     | %          | 55%–117                                  | %          | 46%–79 | % | 55%–126 | % |
| Expected life   (years)      |       | 0.33–2.0 years                             |       | 0.5–2.0 years                            |       | 0.33–2.0 years |   | 0.5–2.0 years |   |

 

The risk-free interestrate is the average U.S. Treasury Constant Maturities Rate for the expectedterm. The expected dividend yield of zero is based on the fact that Sonus hasnever paid dividends and has no present intention to pay cash dividends.Expected volatility is based on a combination of historical and impliedvolatility; the Company believes that such a combination provides a moreaccurate estimate of the grant-date fair value because it is a more accurateindicator of the market’s expectations regarding future volatility. Theexpected life for stock options is based on a combination of the Company’shistorical option patterns and exercise patterns within similar industries. Theexpected life for stock purchase rights under the ESPP is based on the purchaseperiods defined within the ESPP. The Company estimates its forfeiture rate at5% per year.

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***Stock Option and Restricted Stock Grant Activity***

Thefollowing table summarizes information relating to Stock Plan activity duringthe six months ended June 30, 2007:

| **Stock Options**                            | ** ** | ** ** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Life  (Years)** | ** ** | **Aggregate  Intrinsic Value  (in thousands)** | ** ** |
|---------------------------------------------------|------------|------------|------------|----------------------------|------------|--------------------------------------------|------------|------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Outstanding at  January 1, 2007              |       | 39,200,777 |       |                       | $          | 4.78                                       |       |                                                             |       |                                                     |       |   |   |   |   |   |
| Granted                                           |       | 2,949,495  |       |                       | $          | 7.85                                       |       |                                                             |       |                                                     |       |   |   |   |   |   |
| Exercised                                         |       | —     |       |                       | $          | —                                     |       |                                                             |       |                                                     |       |   |   |   |   |   |
| Canceled                                          |       | (419,453   | )          |                       | $          | 5.65                                       |       |                                                             |       |                                                     |       |   |   |   |   |   |
| Outstanding at  June 30, 2007                |       | 41,730,819 |       |                       | $          | 4.99                                       |       |                                                             |       | 6.00                                                     |       |   |   | $ | 153,570 |   |   |
| Vested or  expected to vest at June 30, 2007 |       | 41,066,330 |       |                       | $          | 4.97                                       |       |                                                             |       | 5.95                                                     |       |   |   | $ | 151,974 |   |   |
| Exercisable at  June 30, 2007                |       | 34,386,417 |       |                       | $          | 4.78                                       |       |                                                             |       | 5.35                                                     |       |   |   | $ | 134,518 |   |   |

 

The total intrinsic value of options exercised duringthe three and six months ended June 30, 2006 was $2.4 million and $4.5million, respectively. There were no options exercised during the three or sixmonths ended June 30, 2007. The total fair value of options vested duringthe three and six months ended June 30, 2007 was $6.7 million and $13.1million, respectively, and $1.6 million and $3.2 million during the three andsix months ended June 30, 2006.

During December 2006, in order to remedy theunfavorable personal tax consequences for those who have not exercised stockoptions after December 31, 2005 subject to Section 409A of theInternal Revenue Code, theCompany entered into agreements with its directors and executive officers whoare subject to the disclosure requirements of Section 16 of the SecuritiesExchange Act of 1934. The Company’s agreement with its directors and executiveofficers originally had a vesting requirement, but was amended in the firstquarter of 2007 to eliminate such vesting requirement. This resulted inadditional stock-based compensation expense of approximately $1.2 million inthe Company’s consolidated financial statements in the first quarter of 2007.

The Company could not issue any securities under itsregistration statements on Form S-8 until it became current in itsSEC reporting obligations for filing its periodic reports under the SecuritiesExchange Act of 1934 (the “Exchange Act”). Consequently, during the first andsecond quarters of 2007, the Company extended the contractual terms ofapproximately 833,000 and 1.7 million vested stock options, respectively, heldby former executives and other former employees. The Company accounted for themodifications to extend the contractual term of the awards for formerexecutives and other former employees in accordance with SFAS 123R. Based onthe guidance in SFAS 123R and related FASB Staff Positions, after themodification those stock options held by former executives and other formeremployees became subject to the provisions of EITF 00-19. As aresult, certain of those stock option awards were reclassified as liabilityawards within current liabilities. Therefore, at the end of each reportingperiod, the Company determines the fair value of those awards utilizing theBlack-Scholes valuation model and recognizes any change in fair value in theCompany’s Condensed Consolidated Statement of Operations in the period ofchange until the awards are exercised, expire, or are otherwise settled. As aresult of the modifications, the Company recorded additional stock-basedcompensation of $7.2 million and $10.8 million in the three and six monthsended June 30, 2007, respectively. The aggregate fair value of theseliability awards included in current liabilities was $4.5 million and $1.1million at June 30, 2007 and December 31, 2006, respectively. TheCompany recorded Other expense of $0.2 million and $0.9 million in the threeand six months ended June 30, 2007 as a result of changes in the fairvalue of the liability awards.

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During the first quarter of 2007, as a result of theCompany’s inability to issue any securities under its registration statement onForm S-8, the Company extended the contractual terms ofapproximately 185,000 vested stock options held by current employees which weredue to expire. The Company accounted for the modifications to extend the contractualterm of the awards for current employees in accordance with SFAS 123R, andrecorded expense of $0.8 million at the time of the extension.

The Company was not able to issue shares under theESPP as scheduled on February 28, 2007. As a result, the Company mademultiple modifications to the ESPP in order to delay the issuance of sharesuntil after it became current in its SEC reporting obligations. The Companyalso delayed the commencement of the next scheduled ESPP purchase period from March 1,2007 to April 1, 2007. These modifications to the ESPP resulted inadditional stock-based compensation expense of $2.8 million and $5.6 million inthe three and six months ended June 30, 2007, respectively, and willresult in an additional $3.3 million during the three months endingSeptember 30, 2007.

Theactivity related to the Company’s outstanding restricted stock awards for thesix months ended June 30, 2007 is as follows:

| ** **                                   | ** ** | **Shares** | ** ** | **Weighted Average  Grant-date  Fair Value** | ** ** |
|----------------------------------------------|------------|------------|------------|--------------------------------------------------------|------------|
| Nonvested balance  at December 31, 2006 |       | 330,000    |       |                                                   | $          | 4.60 |   |   |
| Granted                                      |       | 15,000     |       |                                                   | $          | 7.62 |   |   |
| Vested                                       |       | (40,000    | )          |                                                   | $          | 4.82 |   |   |
| Nonvested balance at  June 30, 2007     |       | 305,000    |       |                                                   | $          | 4.72 |   |   |

 

***(p) Comprehensive Income (Loss)***

Sonus’comprehensive income (loss) for the three and six months ended June 30,2007 and 2006 is as follows (in thousands):

| ** **                                | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net income (loss)                         |       | $                                               | (6,976     | )                                             | $          | 8,914 |   | $ | (10,954 | ) | $ | 14,730 |   |
| Foreign currency  translation adjustments |       | (158                                            | )          | (27                                           | )          | (97 | ) | (21 | ) |
| Comprehensive income  (loss)              |       | $                                               | (7,134     | )                                             | $          | 8,887 |   | $ | (11,051 | ) | $ | 14,709 |   |

 

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

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

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

Net income (loss) per share is computed in accordancewith SFAS No. 128, Earnings per Share. Basic net income (loss) per shareis computed by dividing net income (loss) by the weighted average number ofshares of common stock outstanding during the period. For periods in which theCompany reports net income, diluted net income per share is determined by usingthe weighted average number of common and dilutive common equivalent sharesoutstanding during the period unless the effect is antidilutive. Potentialdilutive common shares consist of common stock issuable upon the exercise ofstock options and purchases of common shares under the Company’s ESPP using thetreasury stock method.

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

| ** **                                        | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                        | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Weighted average  shares outstanding—basic   |       | 259,786                                         |       | 252,664                                       |       | 259,777 |   | 251,371 |   |
| Potential  dilutive common shares                 |       | —                                          |       | 3,662                                         |       | — |   | 4,083 |   |
| Weighted average shares  outstanding—diluted |       | 259,786                                         |       | 256,326                                       |       | 259,777 |   | 255,454 |   |

 

Thecalculation above for the three and six months June 30, 2006 excludesoptions to purchase shares of common stock and shares of common stock issuableupon conversion of a convertible subordinated note aggregating approximately21.4 million shares and 20.7 million shares, respectively, as their effectwould be antidilutive.

***(s)***      WarrantyReserve

Sonus’ products are covered by a standard warranty of90 days for software and one year for hardware or a warranty of longer periodsunder certain customer contracts. In addition, certain customer contractsinclude warranty-type provisions for epidemic or similar product failures,generally for the contractual period or the life of the product in accordancewith published telecommunications standards**.**Sonus accruesfor warranty obligations when the occurrence of such obligation is probable andthe amount 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.

Inaddition, certain of Sonus’ customer contracts include provisions under whichSonus may be obligated to pay penalties generally for the contractual period orfor the life of the product if Sonus’ products fail or do not perform inaccordance with specifications. Sonus accrues for such contingent obligationswhen the occurrence of such obligation is probable and the amount of suchobligation is reasonably estimable. Sonus has not incurred significant costsrelated to such provisions. Sonus periodically assesses the adequacy of itsrecorded warranty liabilities and adjusts the amounts as necessary. At June 30,2007 and December 31, 2006, Sonus had $80,000 and $45,000, respectively,of warranty reserves recorded.

***(t)***       IncomeTaxes

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

In June 2006, the FASB issued FIN 48, *Accounting for Uncertainty in Income Taxes, an interpretation of FASBStatement No. 109* (“FIN 48”), which clarifies the accounting foruncertainty in income taxes recognized in a company’s financial statements inaccordance with FASB Statement No. 109, *Accounting for IncomeTaxes*.  FIN 48 describes atwo-step process to determine the amount of tax benefit to be recognized.  First, the tax position must be evaluated todetermine the likelihood that it will be sustained upon externalexamination.  If the tax position isdeemed more-likely-than-not to be sustained, the tax position is then assessedto determine the amount of benefit to recognize in the financialstatements.  The amount of the benefitthat may be recognized is the largest amount that has a greater than 50%likelihood of being realized upon ultimate settlement.

Sonus adopted the provisions of FIN 48 on January 1,2007. As a result of the implementation of FIN 48, the Company recognizedan increase of approximately $0.1 million in the liability for unrecognized 

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tax benefits, which wasaccounted for as an increase to the accumulated deficit. In addition, theCompany has $7.1 million of federal and state unrecognized tax benefitsconsisting of $5.6 million related to research and development creditspreviously fully reserved for probable tax exposure and $1.5 million thatreduced our state net operating loss carryforward which previously had a fullvaluation allowance. These amounts did not result in an adjustment to theaccumulated deficit at January 1, 2007. To the extent these unrecognizedtax benefits are ultimately recognized, they will impact the effective tax ratein a future period.

As of January 1, 2007, the Company had accrued$31,000 of interest and penalties related to uncertain tax positions. As of June 30,2007, the total amount of accrued interest and penalties was $37,000. TheCompany accounts for interest and penalties related to uncertain tax positionsas part of its provision for federal and state income taxes.

TheCompany and its subsidiaries file income tax returns in the U.S. federaljurisdiction, as well as various states and foreign jurisdictions. Generally,the tax years 2003 through 2006 remain open to examination by the major taxingjurisdictions to which we are subject. The Company’s federal net operatinglosses generated prior to 2003 could be adjusted on examination even though theyear in which the loss was generated is otherwise closed by the statute oflimitations. In 2006, the Massachusetts Department of Revenue (“Mass. DOR”)commenced an examination of the Company’s Massachusetts state income taxreturns for 2002 and 2003. We extended the statute for the 2002 tax year toallow for additional time to complete this audit. As of June 30, 2007, theMass. DOR had not proposed any significant adjustments to the Company’s taxpositions.

***(u)***    RecentAccounting Pronouncements

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS 159”). SFAS 159 permits an entity tomeasure certain financial assets and financial liabilities at fair value. UnderSFAS 159, entities that elect the fair value option will report unrealizedgains and losses in earnings at each subsequent reporting date. The fair valueoption may be elected on an instrument-by-instrument basis, with a fewexceptions, as long as it is applied to the instrument in its entirety. SFAS 159establishes presentation and disclosure requirements, but does not eliminatedisclosure requirements of other accounting standards. Assets and liabilitiesthat are measured at fair value must be displayed on the face of the balancesheet. SFAS 159 is effective in fiscal years beginning after November 15,2007, although its provisions may be applied earlier if certain conditions aremet. The Company is currently evaluating the impact of SFAS 159 on itsconsolidated results of operations and financial condition.

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

In September 2006,the SEC issued Staff Accounting Bulletin No. 108, *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*(“SAB 108”). SAB 108 provides specific guidance on disclosures forcompanies who elect not to restate prior periods for 

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misstatements and instead elect to record acumulative-effect adjustment. Sonus applied the provisions of SAB 108 effectiveDecember 31, 2006. The application of SAB 108 had no impact on the Company’sconsolidated results of operations or financial condition.

**(3) Acquisitionof Zynetix Limited**

On April 13,2007, Sonus completed the acquisition of Zynetix, a privately-held designer ofinnovative Global System for Mobile Communications (“GSM”) infrastructuresolutions located in the United Kingdom. The Company believes that integratingZynetix technology with Sonus’ IMS portfolio is a critical step in thedevelopment of Sonus’ wireless portfolio of 3G and GSM next generationsolutions that address the demand for carrier-class, end-to-end IP-basednetworks. In consideration, Sonus paid the selling shareholders £3,000,000 onthe acquisition date (U.S. $5.9 million as of the acquisition date) and£1,330,583 on June 11, 2007 (U.S. $2.6 million as of June 11, 2007). TheShare Purchase Agreement also includes two additional potential payments (the “earnouts”)to the selling shareholders: (1) £1,500,000 (U.S. $3.0 million as of theacquisition date) payable on May 1, 2008; and (2) 175,000 shares ofSonus common stock deliverable on April 30, 2009, contingent upon thebusiness achieving certain predetermined financial and business metrics. Eachearnout will be recorded as an addition to the purchase price at the time thecontingency is resolved and consideration is distributable. In addition, theCompany paid $265,000 in transaction costs related to the acquisition. Asummary of the transaction is as follows (in thousands):

| Consideration:                                         |   |   |   |
|--------------------------------------------------------|--------|--------|--------|
| Cash paid                                              |   | $      | 8,560  |   |
| Transaction costs                                      |   | 265    |   |
| Total consideration                                    |   | $      | 8,825  |   |
| Preliminary allocation of the purchase  consideration: |   |   |   |
| Current assets                                         |   | $      | 1,015  |   |
| Other assets                                           |   | 25     |   |
| Identifiable intangible assets:                        |   |   |   |
| Customer relationships                                 |   | 1,400  |   |
| Intellectual property                                  |   | 1,300  |   |
| Trade name                                             |   | 300    |   |
| Goodwill                                               |   | 7,734  |   |
| Current liabilities                                    |   | (1,714 | )      |
| Deferred income taxes                                  |   | (900   | )      |
| Notes payable to shareholders                          |   | (335   | )      |
|                                                   |   | $      | 8,825  |   |

 

Current assets acquired primarily relate to accountsreceivable and inventory. Current liabilities assumed primarily relate toaccounts payable, accrued royalties and accrued payroll taxes.

The preliminary amountsassigned to identifiable intangible assets acquired were based on theirrespective fair values determined as of the acquisition date. The Company isamortizing these identifiable intangible assets using the straight line methodover their respective useful lives, which range from three to seven years. Theexcess of the purchase price over net assets acquired was recorded as goodwill.In accordance with SFAS 142, the goodwill will not be amortized, but willinstead test for impairment at least annually. The goodwill is not deductiblefor income tax purposes. Pro forma results of operations are not presented asthe amounts are not material to the Company’s historical results.

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**(4) AccruedRestructuring Expenses**

In the fourth quarter of fiscal 2006, Sonus recorded$61,000 of restructuring charges related to the closing of an office in India. Thesecharges include severance and fringe benefit costs for two eliminated positionsand lease and facility-related obligations. This initiative was completed inthe first quarter of fiscal 2007.

Thefollowing table summarizes the activity related to this initiative during thesix months ended June 30, 2007 (in thousands):

| ** **                     | ** ** | **Balance  December 31,  2006** | ** ** | **Cash  payments** | ** ** | **Balance  June 30,  2007** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|--------------------|------------|----------------------------------|------------|
| Severance and  fringe benefits |       |                                 | $          | 54                 |       |                             |       | $ | (54 | ) |   |   | $ | — |   |   |
| Facility and  related costs    |       |                                 | 7          |               |       |                             | (7         | ) |   |   | — |   |   |
|                           |       |                                 | $          | 61                 |       |                             |       | $ | (61 | ) |   |   | $ | — |   |   |

 

**(5) Contingencies**

In November 2001, a purchaser of the Company’scommon stock filed a complaint in the United States District Court for theSouthern District of New York against Sonus, two of its officers and the leadunderwriters alleging violations of the federal securities laws in connectionwith Sonus’ initial public offering (“IPO”) and seeking unspecified monetary damages.The purchaser seeks to represent a class of persons who purchased the Company’scommon stock between the IPO on May 24, 2000 and December 6, 2000. Anamended complaint was filed in April 2002. The amended complaint allegesthat our registration statement contained false or misleading information oromitted to state material facts concerning the alleged receipt of undisclosedcompensation by the underwriters and the existence of undisclosed arrangementsbetween the underwriters and certain purchasers to make additional purchases inthe after market. The claims against Sonus are asserted under Section 10(b) ofthe Exchange Act and Section 11 of the Securities Act of 1933 and againstthe individual defendants under Sections 11 and 15 of the Securities Act andSections 10(b) and 20(a) of the Exchange Act. Other plaintiffs havefiled substantially similar class action cases against approximately 300 otherpublicly traded companies and their IPO underwriters which, along with theactions against Sonus, have been transferred to a single federal judge forpurposes of coordinated case management. On July 15, 2002, Sonus, 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 Sonus’ officers named in the complaint. On February 19,2003, the court granted a portion of the motion to dismiss by dismissing the Section 10(b) claimsagainst certain defendants including Sonus, but denied the remainder of themotion as to the defendants. In June 2003, a special committee of ourBoard of Directors authorized Sonus to enter into a proposed settlement withthe plaintiffs on terms substantially consistent with the terms of a Memorandumof Understanding negotiated among representatives of the plaintiffs, the issuerdefendants and the insurers for the issuer defendants. In October 2004,the court certified the class in a case against certain defendants. On February 15,2005, the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. On August 31,2005, the court approved the terms of the proposed settlement, as modified. On April 24,2006, the court held a hearing on a motion to approve the final settlement andtook the matter under advisement. On December 5, 2006, the Court ofAppeals for the Second Circuit reversed the court’s October 2004 ordercertifying a class.  On June 25,2007, the Court entered an order terminating the settlement. Accordingly, theCompany is unable to determine the ultimate outcome or potential range of loss,if any.

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

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

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against Sonus and certain of itscurrent officers and directors. On June 28, 2004, the court consolidatedthe claims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the Exchange Act and Sections 11,12(a), and 15 of the Securities Act, relating to the restatement of Sonus’financial results for 2001, 2002, and the first three quarters of 2003. Specifically,the complaint alleges that Sonus issued a series of false or misleadingstatements to the market concerning its revenues, earnings and financialcondition. Plaintiffs contend that such statements caused the Company’s stockprice to be artificially inflated. The complaint seeks unspecified damages onbehalf of a purported class of purchasers of the Company’s common stock duringthe period from March 28, 2002 through March 26, 2004. On January 28,2005, Sonus filed a motion to dismiss the Section 10(b) and 12(a) claimsand joined the motion to dismiss the Section 11 claim filed by theindividual defendants. On June 1, 2005, the court held a hearing on themotion and allowed the plaintiff to file an amended complaint. The plaintifffiled an amended complaint that included the same claims and substantiallysimilar allegations as set forth in the initial complaint. On September 12,2005, the defendants filed motions to dismiss this amended complaint. On December 10,2005, the court held a hearing on the motions and took the matter underadvisement. On May 10, 2006, the court issued an order granting thedefendants’ motions in part and denying the motions in part. The courtdismissed the Section 12(a)(2) claims against all the defendants and the Section 10(b)and Section 11 claims against the 

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individual defendants. Thecourt denied the motions as to the Section 10(b) and Section 11claims against Sonus and Section 15 claims against the individualdefendants. The plaintiff has filed a motion for class certification, which thedefendants have opposed. The court held a hearing on February 28, 2007 onplaintiff’s motion for class certification and took the matter under advisement.The Company believes that it has substantial legal and factual defenses to theclaims, which it intends to pursue vigorously. Sonus expects to incursignificant legal fees in defending this action. At this time, Sonus is unableto determine the ultimate outcome or potential range of loss, if any.

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

On June 14, 2006, C2Communications sued AT&T, Inc., Verizon Communications, Inc.,Qwest, Bellsouth Corporation, Sprint Nextel Corporation, Global Crossing andLevel 3 in the Eastern District of Texas, Marshall Division. C2 Communicationshas alleged that each of the defendants infringe U.S. Patent No. 6,243,373entitled “Method and Apparatus for Implementing a Computer Network InternetTelephone System.”  Sonus has agreed,subject to certain conditions, to assume the defense of Qwest, Global Crossingand Level 3 in this litigation to the extent the claim results from their useof products purchased from Sonus. There can be no assurance that otherdefendants who have purchased Sonus products will not seek indemnification fromSonus. The court issued a scheduling order with a trial date of August 4,2008. Sonus believes that the defendants have substantial legal and factualdefenses to the infringement claim, which the Company intends to pursuevigorously on behalf of the defendants for whom Sonus agrees or is required toassume defense of the litigation. However, there is no assurance any of thedefendants will prevail in defending this action. There also can be noassurance that Sonus will not be required to indemnify any of the defendantsfrom any judgment of infringement rendered against them. Sonus may be requiredto devote significant time and resources in connection with assuming thedefense of the claim of infringement on behalf of the defendants for whom Sonushas agreed to assume defense of the litigation. An adverse outcome with respectto the claim and Sonus’ indemnification could have a material adverse impact onSonus’ business, operating results and financial condition. Sonus cannotpredict the ultimate outcome of this litigation or any potential impact on theCompany’s operating results or financial position.

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On November 14, 2006,a purported shareholder derivative lawsuit was filed in the United DistrictCourt for the District of Massachusetts against Sonus and certain of itsofficers and directors, naming Sonus as a nominal defendant. Other purportedshareholders filed virtually identical complaints. The suits claim that certainof Sonus’ officers and directors breached their fiduciary duties to itsstockholders and to Sonus in connection with its announced stock option review.The complaints are derivative in nature and do not seek relief from Sonus. However,Sonus has entered into indemnification agreements in the ordinary course ofbusiness with certain of the defendant officers and directors and may beobligated throughout the pendency of these actions to advance payment of legalfees and costs incurred by the defendants pursuant to the Company’s obligationsunder the indemnification agreements or applicable Delaware law. By order datedDecember 18, 2006, the Court consolidated the actions. The plaintiffs havefiled a consolidated complaint. The defendants filed on March 19, 2007 amotion to dismiss the consolidated complaint. The Court held a hearing on July 11,2007, and took the motion under advisement. Sonus believes that it hassubstantial legal and factual defenses to the derivative claims, which itintends to pursue vigorously. There is no assurance Sonus will prevail indefending these actions. Sonus cannot predict the ultimate outcome of thislitigation or any potential impact on the Company’s operating results orfinancial position.

On January 19, 2007,a purported shareholder derivative lawsuit was filed in the Superior CourtDepartment of Middlesex County of Massachusetts against certain of the Sonus’directors and officers, also naming Sonus as a nominal defendant. Anotherpurported shareholder filed a virtually identical complaint. The suits assertsimilar claims and seek relief similar to the derivative suits filed in federalcourt. On May 7, 2007, the plaintiffs filed a consolidated complaint. On June 6,2007, the defendants moved to dismiss the consolidated complaint. The Court hasscheduled a hearing on the motion for August 14, 2007. Sonus believes thatit has substantial legal and factual defenses to the derivative claims, which itintends to pursue vigorously. There is no assurance Sonus will prevail indefending these actions. Sonus cannot predict the ultimate outcome of thislitigation or any potential impact on the Company’s operating results orfinancial position.

As announced on March 19,2007, the SEC is conducting a formal private investigation into Sonus’historical stock option granting practices. If the Company is subject toadverse findings, it could be required to pay damages or penalties or haveother remedies imposed, including criminal penalties, which could adverselySonus’ business, financial position or results of operations.

Sonus includes standardintellectual property indemnification provisions in its product agreements inthe ordinary course of business. Pursuant to its product agreements, Sonus willindemnify, hold harmless, and reimburse the indemnified party for lossessuffered or incurred by the indemnified party, generally business partners orcustomers, in connection with certain patent, copyright or other intellectualproperty infringement claims by third parties with respect to Sonus products. Otheragreements with Sonus’ customers provide indemnification for claims relating toproperty damage or personal injury resulting from the performance of servicesby Sonus or its subcontractors. Historically, Sonus’ costs to defend lawsuitsor settle claims relating to such indemnity agreements have been insignificant.Accordingly, the estimated fair value of these indemnification provisions isimmaterial.

The Internal RevenueService has notified the Company that its payroll tax returns for the yearsended December 31, 2004, 2005 and 2006 have been selected for audit inconnection with its stock option review. In connection with the restatement ofits financial statements, Sonus has recorded approximately $1.6 million ofaccrued liabilities for additional tax, penalties and interest related toadjustments resulting from errors in stock option accounting. Sonus could berequired to pay additional tax, penalties or interest, or have other remediesimposed, which could adversely impact its business, financial position orresults of operations.

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**(6) Subsequent Event**

On August 7, 2007, Sonus announced that itsPresident and Chief Operating Officer, who is also a member of the Board ofDirectors, would be leaving the Company effective August 10, 2007. Theseparation arrangement requires Sonus to make a lump sum payment to thisofficer of approximately $902,000 six months from the date of separation andcontinue to pay health care benefits for 18 months from the date ofseparation. The stock options held by this officer will continue to vest duringthe 18 months from the date of separation and are exercisable for up to 24 monthsfrom the date of separation. In the third quarter of 2007, Sonus expects torecord a charge totaling approximately $2.4 million associated with therequired separation payments, other benefits and unamortized stock-basedcompensation associated with the unvested stock options held by this officer asof the date of separation.

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

*This Management’s Discussion and Analysis of FinancialCondition and Results of Operations contains forward-looking statements, whichare 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 future events orcircumstances. Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of various factors,including the factors set forth in Item 1A. “Risk Factors” in this QuarterlyReport on Form 10-Q. This discussion should be read in conjunctionwith the unaudited condensed consolidated financial statements and relatednotes for the periods specified. Further reference should be made to our AnnualReport on Form 10-K for the year ended December 31, 2006.*

**Overview**

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

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

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. Our revenues and resultsof operations may vary significantly and unexpectedly from quarter to quarteras a result of long sales cycles, our expectation that customers will tend tosporadically place large orders with short lead times and the application ofcomplex revenue recognition rules to certain transactions, which mayresult in customer shipments and orders from multiple quarters being recognizedas revenue in one quarter. We expect to recognize revenues from a limitednumber of customers for the foreseeable future.

Since our inceptionthrough December 31, 2003, we incurred significant losses. At June 30,2007, we had an accumulated deficit of $739.2 million. Although we achievedprofitability on an annual basis in fiscal years 2006 and 2005, we incurred netlosses in the first and second quarters of 2007 and may incur additional lossesin future quarters and years. We have a lengthy sales cycle for our productsand, accordingly, we expect to incur sales and other expenses before we realizethe related revenues. We expect to continue to incur significant sales andmarketing, research and development and general and administrative expenses,many of which are fixed prior to the beginning of any particular fiscal periodand, as a result, we will need to generate significant revenues to maintainprofitability.

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**Acquisition ofZynetix Limited**

On April 13, 2007, wecompleted the acquisition of Zynetix Limited (“Zynetix”), a privately-helddesigner of innovative Global System for Mobile Communications (“GSM”)infrastructure solutions located in the United Kingdom. In consideration, wepaid the selling shareholders £3,000,000 on the acquisition date (U.S. $5.9million as of the acquisition date), and £1,330,583 on June 11, 2007 (U.S.$2.6 million as June 11, 2007). We also paid $0.3 million of transactioncosts related to this acquisition. The Share Purchase Agreement also includestwo additional potential payments to the selling shareholders: (1) £1,500,000(U.S. $3.0 million as of the acquisition date) payable on May 1, 2008; and(2) 175,000 shares of our common stock deliverable on April 30, 2009,contingent upon the business achieving certain predetermined financial and businessmetrics. The operating results of Zynetix have been included in our condensedconsolidated financial statements for the period subsequent to its acquisition.

**Stock-BasedCompensation**

On January 1,2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R),*Share-Based Payment* (“SFAS 123R”). SFAS123R supersedes APB Opinion 25 (“APB 25”), *Accountingfor Stock Issued to Employees,* and provided the required disclosuresin accordance with SFAS No. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”). In transitioning to SFAS 123R, we usedthe proscribed modified prospective transition method. Under the modifiedprospective transition method, the unrecognized expense of awards not yetvested at the date of adoption will be recognized in net income in the periodsafter the date of adoption using the same valuation method, Black-Scholes, and assumptionsdetermined under the original provisions of SFAS 123. We recorded $14.6 million and $2.7 million of stock-basedcompensation in the Condensed Consolidated Statements of Operations for thethree months ended June 30, 2007 and 2006, respectively, and $23.5 millionand $5.0 million for the six months ended June 30, 2007 and 2006,respectively. These amounts are included in the following expense categories(in thousands):

| ** **                  | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Product cost of  revenue    |       | $                                               | 188        |                                          | $          | 10 |   | $ | 278 |   | $ | 25 |   |
| Service cost of  revenue    |       | 1,023                                           |       | 199                                           |       | 1,605 |   | 483 |   |
| Research and  development   |       | 6,482                                           |       | 633                                           |       | 9,691 |   | 1,420 |   |
| Sales and  marketing        |       | 5,699                                           |       | 1,166                                         |       | 9,221 |   | 1,676 |   |
| General and  administrative |       | 1,225                                           |       | 735                                           |       | 2,691 |   | 1,438 |   |
|                        |       | $                                               | 14,617     |                                          | $          | 2,743 |   | $ | 23,486 |   | $ | 5,042 |   |

 

In addition, we included in inventory approximately$405,000 and $32,000 of stock-based compensation at June 30, 2007 and December 31,2006.

At June 30, 2007, there was $23.1 million ofunrecognized compensation cost related to share-based awards, which is expectedto be recognized over a weighted average period of approximately three years.At June 30, 2007, we had $1.2 million of additional stock-basedcompensation expense to be recorded over the remaining ESPP purchase period.

During December 2006, in order to remedy theunfavorable personal tax consequences for those who have not exercised stockoptions after December 31, 2005 subject to Section 409A, we entered into agreements with ourdirectors and executives who are designated as Section 16 filers with theSecurities and Exchange Commission. Our agreement with our directors andexecutives originally had a vesting requirement, but was amended in the firstquarter of 2007 to eliminate such vesting requirement. This resulted inadditional stock-based compensation expense of $1.2 million in the firstquarter of 2007.

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Our registration statements on Form S-8were unavailable for use during a portion of fiscal 2006 and 2007. As a result,we extended the contractual terms of vested stock options held by formerexecutives and other former employees aggregating approximately 833,000 and 1.7million during the three and six months ended June 30, 2007, respectively.During the fourth quarter of 2006, we extended the contractual terms ofapproximately 756,000 vested stock options held by former executives and otherformer employees. Modifications of stock options subsequent to the departure offormer employees were initially recorded as stock-based compensation expense inaccordance with FAS 123R. Subsequently, the options were reclassified tocurrent liabilities under the provisions of Emerging Issues Task Force (“EITF”)Issue No. 00-19, *Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock* (“EITF 00-19”). Under EITF 00-19, changes in fairvalue calculated at the end of each reporting period until final settlementusing the Black-Scholes valuation model are expensed in our consolidatedstatement of operations in the period of change. We recorded additionalstock-based compensation of $7.2 million and $10.8 million in the three and sixmonths ended June 30, 2007, respectively, associated with modifications ofstock options. We also recorded $0.2 million and $0.9 million in the three andsix months ended June 30, 2007, respectively, of Other expense as a resultof changes in the fair value of the liability awards. We are accounting forthese liability awards as derivative financial instruments, and accordingly,changes in fair value are reported as Other expense. Any changes to the fairvalues of these options in future periods until settlement will be expensed inour consolidated statement of operations in the period of change.

During the first quarter of 2007, as a result of ourinability to issue any securities under our registration statement on Form S-8,we extended the contractual terms of approximately 185,000 vested stock optionsheld by current employees which were due to expire. We accounted for themodifications to extend the contractual term of the awards for currentemployees in accordance with SFAS 123R, and recorded expense of $0.8 million inthe six months ended June 30, 2007.

In addition we were unableto issue shares under our ESPP as scheduled on February 28, 2007. As aresult, the Company made multiple modifications to the ESPP in order to delaythe issuance of shares until after we became current in our SEC reportingobligations. In addition, we delayed the commencement of the next scheduledESPP period from March 1, 2007 to April 1, 2007. The modifications tothe ESPP resulted in additional stock-based compensation expense of $2.8million and $5.6 million in the three and six months ended June 30, 2007,respectively, and will result in an additional $3.3 million during thethree months ending September 30, 2007.

**Critical AccountingPolicies and Estimates**

Management’sdiscussion and analysis of financial condition and results of operations is basedupon our condensed consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. We base our estimates and judgments on historical experience,knowledge of current conditions and beliefs of what could occur in the futuregiven available information. We consider the following accounting policies tobe both those most important to the portrayal of our financial condition andthose that require the most subjective judgment. If actual results differsignificantly from management’s estimates and projections, there could be amaterial effect on our financial statements. The significant accountingpolicies that we believe are the most critical include the following:

·       Revenuerecognition;

·       Deferredrevenue;

·       Allowancefor doubtful accounts;

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·       Inventoryreserves;

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

·       Stock-basedcompensation;

·       Acquisitions;

·       Goodwilland identifiable intangible assets; and

·       Accountingfor income taxes.

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

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

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

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

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

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

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

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

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

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

***Warranty Reserve.******  ***Our productsare covered by a standard warranty of 90 days for software and one year forhardware or a warranty for longer periods under certain customer contracts. Inaddition, certain customer contracts include warranty-type provisions forepidemic or similar product failures, generally for the contractual period orthe life of the product in accordance with published telecommunicationsstandards**.**We accrue for warranty obligationswhen the occurrence of such obligation is probable and the amount of suchobligation is reasonably estimable. We have not incurred significant costsrelated to such obligations. Our customers typically purchase maintenance andsupport contracts, which encompass our warranty obligations. Our estimates ofwarranty obligations are primarily based on historical information and futureforecasts.

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

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

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

***Loss Contingenciesand Reserves.******  ***We are subject to ongoing businessrisks arising in the ordinary course of business that affect the estimationprocess of the carrying value of assets, the recording of 

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liabilities and thepossibility of various loss contingencies. Under SFAS No. 5, *Accounting for Contingencies*, an estimatedloss contingency is accrued when it is probable that a liability has beenincurred or an asset has been impaired and the amount of loss can be reasonablyestimated. We regularly evaluate current information available to determinewhether such amounts should be adjusted and record changes in estimates in theperiod they become known.

***Stock-basedCompensation.*****  **On January 1,2006, we adopted SFAS 123R, using the modified prospective transition method. Weaccount for all stock-based compensation awards to consultants and othernon-employees in accordance with the Financial Accounting Standards Board (“FASB”)Emerging Issues Task Force Issue No. 96-18, *Accountingfor Equity Instruments that are Issued to Other than Employees for Acquiring orin Conjunction with Selling Goods or Services,* and SFAS 123, asamended by SFAS No. 148, *Accounting for Stock-BasedCompensation—Transition and Disclosure*(prior to January 1,2006), or in accordance with SFAS 123R (subsequent to January 1, 2006). Wefollowed FASB Interpretation No. 28, *Accounting for StockAppreciation Rights and Other Variable Stock Option or Award Plans—anInterpretation of APB Opinions No. 15 and 25,*in therecognition of stock-based compensation expense measured under APB 25 (prior toJanuary 1, 2006) and the straight-line method in the recognition ofstock-based compensation expense under SFAS 123 (prior to January 1, 2006)and SFAS 123R (subsequent to December 31, 2005). Under both APB 25 andSFAS 123R, the requisite service period over which stock-based compensation isexpensed generally equals the vesting periods of the awards.

***Acquisitions.***   Inaccordance with the purchase method of accounting, the fair values of assetsacquired and liabilities assumed are determined and recorded as of the date ofthe acquisition. We utilize independent valuation specialists to assist us indetermining the fair values of identifiable intangible assets acquired in orderto determine the portion of the purchase price allocable to these assets. Coststo acquire the business, including transaction costs, are allocated to the fairvalue of net assets acquired. Any excess of the purchase price over theestimated fair value of the net assets acquired is recorded as goodwill.

***Goodwill andPurchased Intangible Assets.***   At June 30,2007, we had goodwill and net purchased intangible assets of $7.8 million and$2.9 million, respectively. Goodwill and intangible assets with indefinitelives are tested annually for impairment in accordance with the goodwillprovisions of SFAS No. 142, *Goodwill and OtherIntangible Assets* (“SFAS 142”). Intangible assets with estimatedlives and other long-lived assets are reviewed for impairment when events orchanges in circumstances indicate that the carrying amount of an asset or assetgroup may not be recoverable in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*(“SFAS 144”). Recoverability of intangible assets with estimated lives andother long-lived assets is measured by comparing the carrying amount of theasset or asset group to future net undiscounted pretax cash flows expected tobe generated by the asset or asset group. If these comparisons indicate that anasset is not recoverable, we will recognize an impairment loss for the amountby which the carrying value of the asset or asset group exceeds the relatedestimated fair value. Estimated fair value is based on either discounted futurepretax operating cash flows or appraised values, depending on the nature of theasset. Considerable judgment is required to estimate discounted futureoperating cash flows. Judgment is also required in determining whether an eventhas occurred that may impair the value of goodwill or identifiable intangibleor other long-lived assets. Factors that could indicate that an impairment mayexist include significant underperformance relative to plan or long-termprojections, strategic changes in business strategy, significant negativeindustry or economic trends, a significant change in circumstances relative toa large customer, a significant decline in our stock price for a sustainedperiod and a decline in our market capitalization to below net book value. Wemust make assumptions about future cash flows, future operating plans, discountrates and other factors in the models and valuation reports. To the extentthese future projections and estimates change, the estimated amounts ofimpairment could differ from current estimates.

***Accounting forIncome Taxes.***   Our provision for income taxesis comprised of a current and a deferred portion. The current income taxprovision is calculated as the estimated taxes payable or refundable on tax 

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

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

We have not provided for U.S. income taxes on theundistributed earnings of non-U.S. subsidiaries, as we plan to permanentlyreinvest these amounts.

Effective January 1, 2007, we adopted FASBInterpretation No. 48, *Accounting for Uncertaintyin Income Taxes—an interpretation of FASB Statement No. 109* (“FIN48”). The Interpretation prescribes a recognition threshold and a measurementattribute for the financial statement recognition and measurement of taxpositions taken or expected to be taken in a tax return. For those benefits to berecognized, a tax position must be more likely than not to be sustained uponexamination by taxing authorities.

We assessed all materialpositions taken in any income tax return, including all significant uncertainpositions, in all tax years that are still subject to assessment or challengeby relevant taxing authorities. Assessing an uncertain tax position begins withthe initial determination of the position’s sustainability and is measured atthe largest amount of benefit that is greater than 50 percent likely of beingrealized upon ultimate settlement. As of each balance sheet date, unresolveduncertain tax positions must be reassessed, and we will determine whether (i) thefactors underlying the sustainability assertion have changed and (ii) theamount of recognized tax benefit is still appropriate. The recognition andmeasurement of tax benefits requires significant judgment. Judgments concerningthe recognition and measurement of a tax benefit might change as newinformation becomes available.

***Three and Six Months Ended June 30, 2007 and 2006***

***Revenue.******  ***Revenue forthe three and six months ended June 30, 2007 and 2006 was as follows (inthousands):

| ** **    | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **    | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Product       |       | $                                               | 52,171     |                                          | $          | 48,853 |   | $ | 103,798 |   | $ | 93,395 |   |
| Service       |       | 23,322                                          |       | 15,627                                        |       | 42,841 |   | 31,080 |   |
| Total revenue |       | $                                               | 75,493     |                                          | $          | 64,480 |   | $ | 146,639 |   | $ | 124,475 |   |

 

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Product revenue is comprised of sales of our voiceinfrastructure products, including our GSX9000Ôand GSX4000Ô Open Services Switches, PSX CallRouting Server, SGX Signaling Gateway, ASX Feature Server, the Sonus InsightÔManagement System and related product offerings. Product revenue for the threeand six months ended June 30, 2007 increased 6.8% and 11.1%, respectively,from the comparable prior year periods. The increase in product revenue in bothcurrent year periods was primarily the result of increased product sales andshipments, including the successful completion of the deployment of ourproducts into new and expanded customer networks.

Service revenue is primarily comprised of hardware andsoftware maintenance and support, network design, installation and otherprofessional services. Service revenue increased 49.2% in the three monthsended June 30, 2007 and 37.8% in the six months ended June 30, 2007,compared to the same prior year periods. The increase in the three months endedJune 30, 2007 was primarily the result of higher maintenance andinstallation revenue; the increase in the six months ended June 30, 2007was primarily attributable to higher maintenance, installation and residentengineering revenue.

AT&T contributed more than 10% of our revenue inboth the three and six months ended June 30, 2007. Cingular Wireless (partof AT&T as of January 1, 2007) contributed more than 10% of ourrevenue in both the three and six months ended June 30, 2006. Forpresentation purposes, AT&T (in fiscal 2007) and Cingular Wireless (infiscal 2006) are reported as the same customer in year to year comparisons.

International revenue was approximately 25% and 5% ofrevenue for the three months ended June 30, 2007 and 2006, respectively,and 21% and 14% of revenue for the six months ended June 30, 2007 and2006, respectively. We expect that international revenue will remain uneven asa percentage of revenue from quarter to quarter.

Our deferred product revenue was $34.6 million and$32.7 million at June 30, 2007 and December 31, 2006, respectively. Ourdeferred service revenue was $52.0 million and $61.5 million at June 30,2007 and December 31, 2006, respectively. Our deferred revenue balance mayfluctuate as a result of the timing of revenue recognition, customer payments,maintenance contract renewals, contractual billing rights, customercreditworthiness and maintenance revenue deferrals included in multiple elementarrangements. At June 30, 2007 and December 31, 2006, deferredrevenue and accounts receivable excluded $21.7 million and $12.4 million,respectively, related to products shipped and billed to customers for whichrevenue is recognized as cash is collected, or for which title had not passedto the customer as of the period end date.

***Cost of Revenue/Gross Profit.******  ***Our cost ofrevenue consists primarily of amounts paid to third-party manufacturers forpurchased materials and services, royalties, manufacturing and professionalservices personnel and related costs and inventory obsolescence. Cost ofrevenue and gross profit as a percentage of revenue for the three and sixmonths ended June 30, 2007 and 2006 were as follows (in thousands, exceptpercentages):

| ** **                                    | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Cost of product                               |       | $                                               | 23,561     |                                          | $          | 16,199 |   | $ | 40,643 |   | $ | 32,082 |   |
| Cost of service                               |       | 9,563                                           |       | 6,987                                         |       | 18,142 |   | 13,716 |   |
| Total cost of revenue                         |       | $                                               | 33,124     |                                          | $          | 23,186 |   | $ | 58,785 |   | $ | 45,798 |   |
| Gross profit margin (% of respective revenue) |       |                                            |       |                                          |       |   |   |   |   |
| Product                                       |       | 54.8                                            | %          | 66.8                                          | %          | 60.8 | % | 65.6 | % |
| Service                                       |       | 59.0                                            | %          | 55.3                                          | %          | 57.7 | % | 55.9 | % |
| Total gross  profit margin                    |       | 56.1                                            | %          | 64.0                                          | %          | 59.9 | % | 63.2 | % |

 

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The decrease in product gross profit as a percentageof revenue was primarily due to product mix. We believe that our product grossprofit over time will remain in our long-term financial model of 58% to 62%. Theincrease in service gross profit as a percentage of service revenue wasprimarily due to higher service revenue relative to our fixed service costs. Ourservice cost of revenue is relatively fixed in advance of any particularquarter and, therefore, changes in service revenue will have a significantimpact on service gross profit percentage.

***Research andDevelopment Expenses.******  ***Research and development expensesconsist primarily of salaries and related personnel expenses and prototypecosts related to the design, development, testing and enhancement of ourproducts. Research and development expenses were $22.4 million for the threemonths ended June 30, 2007, an increase of $9.5 million, or 73.3%, from$12.9 million in the same period of fiscal 2006. Research and developmentexpenses were $41.0 million for the six months ended June 30, 2007, anincrease of $15.0 million, or 58.0%, from $26.0 million in the six months endedJune 30, 2006. The current year increases primarily reflect an increase insalary and related expenses associated with increased headcount and stock-basedcompensation. Stock-based compensation costs accounted for $5.8 million and$8.3 million of increased research and development expenses in the three andsix months ended June 30, 2007, compared to the same prior year periods. Someaspects of our 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 are tailoring our investments to meet therequirements of our customers and market.

***Sales and MarketingExpenses.******  ***Sales and marketing expenses consistprimarily of salaries and related personnel costs, commissions, travel andentertainment expenses, promotions, customer evaluations inventory and othermarketing and sales support expenses. Sales and marketing expenses were $21.2million for the three months ended June 30, 2007, an increase of $5.6million, or 35.6%, compared to $15.6 million in the same prior year period. Salesand marketing expenses were $44.3 million for the six months ended June 30,2007, an increase of $14.6 million, or 49.2%, from $29.7 million in the comparableprior year period.  The current yearincreases primarily reflect an increase in salaries, commissions and travelexpenses associated with increased headcount related to the expansion of ourworldwide sales and support coverage and higher sales levels, stock-basedcompensation expense and evaluation equipment expenses. Stock-basedcompensation costs accounted for $4.5 million and $7.5 million of increasedsales and marketing expenses in the three and six months ended June 30,2007, compared to the same prior year periods.

***General andAdministrative Expenses.******  ***General andadministrative expenses consist primarily of salaries and related personnelcosts for executive and administrative personnel, recruiting expenses,allowance for doubtful accounts and professional fees. General andadministrative expenses were $14.2 million for the three months ended June 30,2007, an increase of $7.0 million, or 95.9%, compared to $7.2 million in thesame prior year period. General and administrative expenses for the six monthsended June 30, 2007 were $28.3 million, an increase of $14.1 million, or98.7%, compared to $14.2 million in the six months ended June 30, 2006. Theincrease in both the three and six month current year periods primarilyreflects higher professional fees, including $9.9 million and $14.1 million,respectively, of professional fees and other costs associated with our stockoption review and resulting restatement, stock compensation expense and salaryand related expenses associated with increased headcount, partially offset by adecrease in directors and officers insurance premiums. Stock-based compensationexpense accounted for $0.5 million and $1.3 million of increased general and administrativeexpenses in the three and six months ended June 30, 2007, compared to thesame prior year periods.

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***Interest Income,net.******  ***Interest income consists of interestearned on our cash equivalents, marketable debt securities and long-terminvestments. Interest expense in the current year periods primarily relates tointerest on capital lease obligations. Interest expense in the prior yearperiods includes interest incurred on a convertible subordinated note andcapital lease obligations. Interest income, net of interest expense, was $4.4million and $9.1 million, respectively, for the three and six months ended June 30,2007, and $3.8 million and $7.1 million, respectively, for the three and sixmonths ended June 30, 2006. This increase is primarily attributable tohigher balances available for investment and higher interest rates on ourinvested funds.

***Other Expense.******  ***We recorded $0.2 million and$0.9 million of expense in the three and six months ended June 30, 2007,to reflect the change in fair value of stock options modified to extend theirexpiration dates subsequent to the departure of the former employees who arethe optionees affected.

***Income Taxes.******  ***We provide forincome taxes during interim periods based on the estimated effective tax ratefor the full fiscal year, and record a cumulative adjustment to the taxprovision in an interim period in which a change in the estimated annualeffective tax rate is determined. Our effective tax rate, including discreteitems, was 37.8% for both the three and six months ended June 30, 2007,compared to 4.3% and 7.5%, respectively, for the three and six months endedJune 30, 2006. The income tax benefit of $4.2 and $6.6 million in thethree and six months ended June 30, 2007, respectively, primarily reflectsa current benefit for federal, state and foreign taxes. The income tax benefitfor the six months ended June 30, 2007 also includes a discrete expense of$52,000 which consists of $46,000 related to the tax effect of certain stockoption activity as required by SFAS 123R and $6,000 related to interest accruedon uncertain tax positions. The income tax provision of $0.4 million and $1.2million for the three and six months ended June 30, 2006, respectively,reflects a current provision for federal, state and foreign taxes. In addition,we maintained a full valuation allowance against our domestic deferred taxassets for these periods. At December 31, 2006, the Company released themajority of its deferred tax asset valuation allowance. The effective tax rate,including discrete items, could be volatile depending on the nature and timingof the dispositions of incentive stock options, the exercise of nonqualifiedstock options and the resolution of uncertain tax positions.

**Off-balance SheetArrangements**

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

**Liquidity andCapital Resources**

At June 30, 2007, our principal sources ofliquidity were our cash, cash equivalents, marketable debt securities andlong-term investments that totaled $344.7 million.

Our operating activities provided $0.3 million of cashin the six months ended June 30, 2007, compared to $5.4 million in thesame prior year period. Non-cash adjustments to our net loss primarily relatedto stock-based compensation, deferred income taxes, depreciation andamortization of property and equipment, the increase in fair value of modifiedstock options held by former employees and amortization of purchased intangibleassets. These amounts were offset by increases of $10.6 million, $5.7 millionand $1.3 million in inventory, other operating assets and accounts receivable,respectively. The increase in inventory levels is primarily due to a buildup ofstock in anticipation of increased sales demand in the second half of thefiscal year. Decreases in deferred revenue and accrued expenses, deferred rentand accrued restructuring expenses used $7.4 million and $6.9 million of cash,respectively. The decrease in deferred revenue is primarily attributable tolower levels of deferred service revenue compared to December 31, 2006.The decrease in accrued expenses, deferred rent and accrued restructuringexpenses is primarily attributable to lower income taxes payable, employeecompensation and related costs, and 

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accrued royalties,partially offset by the accumulation of employee stock purchase plancontributions resulting from our inability to issue shares of our common stockthrough the Employee Stock Purchase Plan (“ESPP”) and increased sales and othertaxes payable. Higher accounts payable levels provided $6.5 million of cash.Cash provided by operating activities in the six months ended June 30,2006 came from net income, after adjustments for non-cash items includingstock-based compensation and depreciation and amortization of property andequipment, coupled with $4.2 million of lower inventory levels. These amountswere partially offset by decreases of $6.7 million and $3.7 million in deferredrevenue and accounts payable, respectively, and higher levels of accountsreceivable and other operating assets aggregating $13.0 million.

Our investing activities provided $17.9 million ofcash in the six months ended June 30, 2007, primarily comprised of $33.6million of net maturities of marketable debt securities and long-terminvestments, partially offset by $8.8 million spent to acquire Zynetix Limitedand $7.1 million of investments in property and equipment. In the six months endedJune 30, 2006, our net investment in marketable debt securities andlong-term investments was $129.4 million, and we used $5.2 million of cash topurchase property and equipment.

Our financing activities used $0.7 of cash in the sixmonths ended 30, 2007, of which $0.3 million was used to pay notes payable tothe shareholders of Zynetix, a liability we assumed in connection with ouracquisition of Zynetix, $0.3 million was used to pay tax withholdingobligations related to the net share settlement in December 31, 2006 of arestricted stock award and $0.1 million was used for payments on our to capitalleases for office equipment. Due to the stock option review and relatedrestatement, which we recently completed, we had been unable to issue shares ofour common stock through either the ESPP or to allow any exercises ofoutstanding options to purchase our common stock during the six months ended June 30,2007. Our financing activities provided $3.7 million of cash in the six monthsended June 30, 2006, the result of $13.7 million of proceeds from the saleof common stock in connection with our ESPP and the exercise of stock options,partially offset by the repayment of our $10.0 million convertible subordinatednote.

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

**Recent AccountingPronouncements**

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

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met. We are currentlyevaluating the impact of SFAS 159 on our consolidated results of operations andfinancial condition.

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

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

In June 2006, theFASB issued FASB Interpretation No. 48, Accounting for Uncertainty inIncome Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”),which clarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with FASB Statement No. 109, *Accounting for Income Taxes.*FIN 48 prescribes a two-stepprocess to determine the amount of tax benefit to be recognized. First, the taxposition must be evaluated to determine the likelihood that it will besustained upon external examination. If the tax position is deemedmore-likely-than-not to be sustained, the tax position is then assessed todetermine the amount of benefit to recognize in the financial statements. Theamount of the benefit that may be recognized is the largest amount that has agreater than 50% likelihood of being realized upon ultimate settlement. Werecorded an increase to the accumulated deficit of $0.1 million to reflect thecumulative effect of the adoption of FIN 48 on January 1, 2007.

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

We are exposed to avariety of market risks, including changes in interest rates affecting thereturn on our investments and foreign currency fluctuations. We do not believethat a hypothetical 10% adverse movement in interest rates and foreign currencyexchange rates would have a materially different impact than what was disclosedin our Annual Report on Form 10-K for the fiscal year ended December 31,2006.

**Item 4. Controlsand Procedures**

**Disclosure Controlsand Procedures**

Our management, with the participation of ourprincipal executive officer and principal financial officer, has evaluated theeffectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Securities and Exchange Act of 1934 (the Exchange Act)), as of June 30,2007, which included an evaluation of disclosure controls and proceduresapplicable to the period covered by the filing of this periodic report. Theterm “disclosure controls and procedures,” as defined in Rule 13a-15(e),means controls and other procedures of a company that are designed to ensurethat information required to be disclosed by a company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms. 

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Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is accumulated and communicatedto the company’s management, including its principal executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure.

In our *Management’s Report on Internal Control overFinancial Reporting*filed with our Annual Report on Form 10-Kfor the year ended December 31, 2006, we reported material weaknesses inour internal control over financial reporting (as defined in Rule 13a-15(f) underthe Exchange Act). During the quarter ended June 30, 2007, we continued todesign enhancements to our controls and implemented a limited number of changesto address the reported material weaknesses, as defined by the Public CompanyAccounting Oversight Board. As a result of these material weaknesses, whichwere not remediated as of June 30, 2007, we have concluded that ourdisclosure controls and procedures were not effective as of June 30, 2007.

**Changes in InternalControl over Financial Reporting**

During the fiscal quarterended June 30, 2007, we made changes that have materially affected, or arereasonably likely to materially affect our internal control over financialreporting as follows:

***Inadequate monitoring of foreign locations:***

·       Designed a formal closingchecklist and internal management representation letter to improve andstandardize the financial closing and review process at foreign locations.

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

·       Hiredan additional Sales Controller; and

·       Created and implemented arevenue closing checklist to ensure key contract terms for each customer are identifiedand reviewed on a timely basis;

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

·       Hireda new Property and Equipment Accountant; and

·       Improved segregation ofduties control related to bank signatories.

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

***Risks and Inherent Limitations***

Prior to the complete remediation of these materialweaknesses, there remains risk that the processes and procedures on which wecurrently rely will fail to be sufficiently effective, which could result inmaterial misstatement of our financial position or results of operations andrequire a restatement. Moreover, because of the inherent limitations in allcontrol systems, no evaluation of controls—even when we conclude the controlsare operating effectively—can provide absolute assurance that all controlissues, including instances of fraud, if any, have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and breakdowns can occur because of a simple error or mistake.Additionally, controls can be circumvented by the individual acts of somepersons, by collusion of two or more people, or by management override of thecontrols. The design of any system of controls also is based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. 

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Over time, our controlsystems, as we develop them, may become inadequate because of changes inconditions, or the degree of compliance with the policies or procedures maydeteriorate. Because of the inherent limitations in a cost-effective controlsystem, misstatements due to error or fraud may occur and not be detected andcould be material to our financial statements.

The certifications of ourprincipal executive officer and principal financial officer required inaccordance with Rule 13a-14(a) under the Exchange Act and Section 302of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this QuarterlyReport on Form 10-Q. The disclosures set forth in this Item 4contain information concerning the evaluation of our disclosure controls andprocedures, and changes in internal control over financial reporting, referredto in paragraph 4 of the certifications. Those certifications should be read inconjunction with this Item 4 for a more complete understanding of the matterscovered by the certifications.

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**PART II - OTHERINFORMATION**

**Item 1. LegalProceedings**

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

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

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

On January 6, 2006, a purchaser of our commonstock filed a complaint in the United States District Court for the District ofMassachusetts that is essentially identical to the Consolidated AmendedComplaint previously filed against the defendants. The Court has appointed thePublic Employees’ Retirement System of Mississippi as lead plaintiff. The leadplaintiff has filed an Amended Consolidated Complaint. The defendants filed on April 19,2007 a motion to dismiss the Amended Consolidated Complaint. There is no assurancewe will prevail in such a motion or defending this action. A judgment or asettlement of the claims against the defendants could have a material impact onour financial results. It is too early to determine the ultimate outcome orpotential range of loss, if any.

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

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

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

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

On November 14, 2006, a purported shareholderderivative lawsuit was filed in the United District Court for the District ofMassachusetts against us and certain of our officers and directors, naming usas a nominal defendant. Other purported shareholders filed virtually identicalcomplaints. The suits claim that certain of our officers and directors breachedtheir fiduciary duties to our stockholders and to us in connection with ourannounced stock option review. The complaints are derivative in nature and donot 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. By order dated December 18, 2006, the Court consolidated theactions. The plaintiffs have filed a consolidated complaint. The defendantsfiled on March 19, 2007 a motion to dismiss the consolidated complaint. TheCourt held a hearing on July 11, 2007, and took the motion underadvisement. We believe that we have substantial legal and factual defenses tothe derivative claims, which we intend to pursue vigorously. There is noassurance we will prevail in defending these actions. We cannot predict theultimate outcome of this litigation or any potential impact on our results ofoperations or financial position.

On January 19, 2007, a purported shareholderderivative lawsuit was filed in the Superior Court Department of MiddlesexCounty of Massachusetts against certain of our directors and officers, also 

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naming us as a nominaldefendant. Another purported shareholder filed a virtually identical complaint.The suits assert similar claims and seek relief similar to the derivative suitsfiled in federal court. On May 7, 2007, the plaintiffs filed aconsolidated complaint. On June 6, 2007, the defendants moved to dismissthe consolidated complaint. The Court has scheduled a hearing on the motion forAugust 14, 2007. We believe that we have substantial legal and factualdefenses to the derivative claims, which we intend to pursue vigorously. Thereis no assurance we will prevail in defending these actions. We cannot predictthe ultimate outcome of this litigation or any potential impact on our resultsof operations or financial position.

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

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

The Internal RevenueService has notified us that our payroll tax returns for the years ended December 31,2004, 2005 and 2006 have been selected for audit in connection with our stockoption review. In connection with the restatement of our financial statements,we have recorded approximately $1.6 million of accruals for additional tax,penalties and interest related to adjustments resulting from errors in stockoption accounting. We could be required to pay additional tax, penalties orinterest, or have other remedies imposed, which could adversely impact ourbusiness, financial position or results of operations.

**Item 1A. RiskFactors**

*Investing in our commonstock involves a high degree of risk. You should carefully consider the risksdescribed below before buying our common stock. If any of the following risksactually occurs, the trading price of our common stock could decline and youmay lose all or part of your investment.*

***The investigation of our historical stock optionpractices and the restatement of our prior financial statements required us toincur substantial expenses and diverted our management’s attention from ourbusiness, which may impact*** our business, financial position and results of operations andthe trading price of our common stock.

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

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

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***Matters related to the investigation into ourhistorical stock option granting practices and the restatement of our financialstatements may result in additional litigation, regulatory proceedings andgovernment enforcement actions for which we may be required to pay damages orpenalties or have other remedies imposed.***

Our historical stockoption granting practices and the restatement of our financial statements haveexposed us to greater risks associated with litigation, regulatory proceedingsand government enforcement action. For more information regarding our currentlitigation and related inquiries, please see Part II, Item 1 “LegalProceedings” as well as the other risk factors related to litigation set forthin this section. We have provided the results of our internal review andindependent investigation to the SEC, which has notified us of a formal orderof private investigation. We have responded to requests for documents andadditional information and we intend to continue to cooperate with the SEC. Noassurance can be given regarding the outcomes from litigation, regulatoryproceedings or government enforcement actions relating to our past stock optionpractices. The resolution of these matters will be time-consuming, expensive,and may distract management from the conduct of our business. Furthermore, ifwe are subject to adverse findings in litigation, regulatory proceedings orgovernment enforcement actions, we could be required to pay damages orpenalties or have other remedies imposed, which could harm our business,financial condition, results of operations and cash flows.

***We have identified material weaknesses in our internalcontrol over financial reporting, which, if not remedied effectively, couldhave an adverse effect on the trading price of our common stock and impair ourability to timely file our SEC reports and otherwise seriously harm ourbusiness.***

Through, in part, thedocumentation, testing and assessment of our internal control over financialreporting pursuant to the rules promulgated by the SEC under Section 404of the Sarbanes-Oxley Act of 2002 and Item 308 of Regulation S-K, managementhas concluded that our disclosure controls and procedures and our internalcontrol over financial reporting had material weaknesses as of December 31,2006. We have taken certain actions 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. Prior to the elimination ofthese material weaknesses, there remains risk that the transitional controls onwhich we currently rely will fail to be sufficiently effective, which couldresult in a material misstatement of our financial position or results ofoperations and require a restatement. In addition, even if we are successful instrengthening our controls and procedures, such controls and procedures may notbe adequate to prevent or identify irregularities or facilitate the fairpresentation of our financial statements or SEC reporting.

***Failure or circumvention of our controls andprocedures could impair our ability to report accurate financial results andcould seriously harm our business.***

As described in Item 4 ofthis Form 10-Q, we have made significant changes in our internalcontrol over financial reporting and our disclosure controls and procedures. Anysystem of controls, however well designed and operated, is based in part oncertain assumptions and can provide only reasonable, and not absolute,assurances that the objectives of the system are met. The failure orcircumvention of our controls, policies and procedures could impair our abilityto report accurate financial results and could have a material adverse effecton our business, results of operations and financial position.

***We face risks related to securities litigation thatcould result in significant legal expenses and settlement or damage awards.***

We have been named as a defendant in a number ofsecurities class action and derivative lawsuits. We are generally obliged, tothe extent permitted by law, to indemnify our current and former directors andofficers who are named as defendants in these lawsuits. Defending againstexisting and potential litigation 

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may require significantattention and resources of management. Regardless of the outcome, suchlitigation will result in significant legal expenses. If our defenses areultimately unsuccessful, or if we are unable to achieve a favorable settlement,we could be liable for large damage awards that could have a material adverseeffect on our business, results of operations and financial position.

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

***The limitations of our director and officer liabilityinsurance may require us to pay significant legal expenses and settlement ordamage awards.***

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

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

From August 9, 2006through August 2, 2007, we were not current in our SEC filings. If we areunable to remain current in our SEC filings, we will not be able to have aregistration statement under the Securities Act of 1933, covering a publicoffering of securities, declared effective by the SEC, and we will not be ableto make offerings pursuant to existing registration statements (includingregistration statements on Form S-8 covering employee stock plans),or pursuant to certain “private placement” rules of the SEC underRegulation D to any purchasers not qualifying as “accredited investors.”  Inaddition, our affiliates will not be able to sell our securities pursuant to Rule 144under the Securities Act. Finally, we will not be eligible to use a “short form”registration statement on Form S-3 until September 1, 2008 andwe have lost our status as a “well known seasoned issuer,” including theregistration advantages associated with such status. These restrictions mayimpair our ability to raise capital in the public markets should we desire todo so, and to attract and retain key employees.

***Our common stock may be delisted from the NASDAQGlobal Select Market and transferred to the National Quotation Service Bureau (“PinkSheets”), which may, among other things, reduce the price of our common stockand the levels of liquidity available to our stockholders.***

On August 2, 2007, we filed the Quarterly Reporton Form 10-Q for the quarter ended June 30, 2006 (the “SecondQuarter Form 10-Q”), the Quarterly Report on Form 10-Qfor the quarter ended September 30, 2006 (the “Third Quarter Form 10-Q”),the Annual Report on Form 10-K for the year ended December 31,2006 (the “2006 Form 10-K”) and the Quarterly Report on Form 10-Qfor the quarter ended March 31, 2007 (the “First Quarter Form 10-Q”)with the SEC. We consider that the filing of these reports has remedied ournon-compliance with Marketplace Rule 4310(c)(14), subject to NASDAQ’saffirmative completion of its compliance protocols and its notification to usaccordingly. However, if NASDAQ disagrees with our position or if the SECdisagrees with the manner in which we have accounted for and reported, or notreported, the financial impact of past stock option grants, there 

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could be further delays infiling subsequent SEC reports or other actions that might result in thedelisting of our common stock from the NASDAQ Global Select Market.

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

***Recent rulemaking by the Financial AccountingStandards Board requires us to expense equity compensation given to ouremployees and may reduce our ability to effectively utilize equity compensationto attract and retain employees.***

We historically have used stock options as asignificant component of our employee compensation program in order to alignemployees’ interests with the interests of our stockholders, encourage employeeretention, and provide competitive compensation packages. The FinancialAccounting Standards Board has adopted changes that require companies to recorda charge to earnings for employee stock option grants and other equityincentives effective January 1, 2006, which we have adopted. By causing usto incur significantly increased compensation costs, such accounting changesmay cause us to reduce the availability and amount of equity incentivesprovided to employees, which may make it more difficult for us to attract,retain and motivate key personnel.

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

***We expect that a majority of our revenues will begenerated from a limited number of customers and we will not be successful ifwe do not grow our customer base.***

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

·       acquisitionsof or by our customers;

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

·       potentialcustomer concerns with selecting an emerging telecommunications equipmentvendor;

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

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

·       newproduct introductions by our competitors;

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·       failureof our products to perform as expected; or

·       difficultieswe may incur in meeting customers’ delivery requirements.

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

***Our business has been adversely affected bydevelopments in the telecommunications industry and these developments maycontinue to affect our revenues and operating results.***

From our inception through the year 2000, thetelecommunications market experienced rapid growth spurred by a number offactors, including deregulation in the industry, entry of a large number of newemerging service providers, growth in data traffic and the availability ofsignificant capital from the financial markets. Commencing in 2001, thetelecommunications industry experienced a reversal of some of these trends,marked by dramatic reductions in capital expenditures, financial difficulties,and, in some cases, bankruptcies of service providers. These conditions causeda substantial, unexpected reduction in demand for telecommunications equipment,including our products.

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

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

·       ourrevenues could be unexpectedly reduced; and

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

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

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

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

***The market for voice infrastructure products for thepublic network is new and evolving and our business will suffer if it does notdevelop as we expect.***

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

***If we do not anticipate and meet specific customerrequirements or if our products do not interoperate with our customers’existing networks, we may not retain current customers 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. 

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Prospective customers mayrequire product features and capabilities that our current products do not have.The introduction of new or enhanced products also requires that we carefullymanage the transition from older products in order to minimize disruption incustomer ordering patterns and ensure that adequate supplies of new productscan be delivered to meet anticipated customer demand. If we fail to developproducts and offer services that satisfy customer requirements, or toeffectively manage the transition from older products, our ability to create orincrease demand for our products would be seriously harmed and we may losecurrent 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 customers have substantial negotiatingleverage, which may require that we agree to terms and conditions that may havean adverse effect on our business.***

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

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

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

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

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

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

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needto develop versions of our products that comply with local standards. Furthermore,international operations are subject to other inherent risks, including:

·       relianceon distributors and resellers;

·       greaterdifficulty collecting accounts receivable and longer collection cycles;

·       difficultiesand costs of staffing and managing international operations;

·       theimpact of differing technical standards outside the United States;

·       theimpact of recessions in economies outside the United States;

·       changesin regulatory requirements and currency exchange rates;

·       certificationrequirements;

·       reducedprotection for intellectual property rights in some countries;

·       potentiallyadverse tax consequences; and

·       political and economicinstability.

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

Our revenues andoperating results may vary significantly from quarter to quarter due to anumber of factors, many of which are outside of our control and any of whichmay cause our stock price to fluctuate. Generally, purchases by serviceproviders of telecommunications equipment from manufacturers have beenunpredictable and clustered, rather than steady, as the providers build outtheir networks. The primary factors that may affect our revenues and operatingresults include the following:

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

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

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

·       thetiming of revenue recognition;

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

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

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

·       themix of product configurations sold;

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

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

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

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

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

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

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

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

We have incurred significant losses since inceptionand, at June 30, 2007, had an accumulated deficit of $739.2 million. Althoughwe achieved profitability on an annual basis in fiscal 2006, fiscal 2005 andfiscal 2004, we have incurred a net loss in certain quarters and may incur additionallosses in future quarters and years. Our revenues may not grow and we may nevergenerate sufficient revenues to sustain profitability.

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

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

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

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

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

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

Competition in the telecommunications market isintense. This market has historically been dominated by large incumbenttelecommunications equipment companies, such as Alcatel-Lucent, NEC, NortelNetworks, Nokia Siemens and Ericsson, all of which are our direct competitors. Wealso face competition from other large telecommunications and networkingcompanies, including Cisco Systems, some of which have entered our market byacquiring companies that design competing products. Alcatel and Lucent recentlycompleted their merger. Siemens has combined its networking business with Nokia’snetworking business. Other competitors may merge, intensifying competition. Additionalcompetitors with significant financial resources also may enter our markets andfurther intensify competition.

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

To competeeffectively, we must deliver innovative products that:

·       provideextremely high reliability and voice quality;

·       scaleeasily and efficiently;

·       interoperatewith existing network designs and other vendors’ equipment;

·       provideeffective network management;

·       areaccompanied by comprehensive customer support and professional services;

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

·       meetprice competition from low cost equipment providers.

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

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

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

·       lossof, or delay in, revenues;

·       lossof customers and market share;

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

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

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·       costly and time-consuminglegal actions by our customers.

***Because our products are deployed in large, complexnetworks around the world, failure to establish a support infrastructure andmaintain required support levels could seriously harm our business.***

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

·       lossof customers and market share;

·       afailure to attract new customers in new geographies;

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

·       network performancepenalties.

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

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

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

Our business depends upon highly skilled engineering,sales, marketing and customer support personnel. Any failure to hire or retainneeded qualified personnel could impair our growth. We face increased risk associated with employee

retention due to restrictionsimposed on our employees’ ability to exercise stock options, delays in stockpurchases under our Employee Stock Purchase Plan and the adverse tax impact of Section 409Aon our employees’ stock options—all of which resulted from our review ofhistorical stock granting practices and the restatement of our financialstatements.

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

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

We may become subject toemployment claims in connection with employee terminations. In addition,companies in our industry whose employees accept positions with competitors mayclaim that their competitors have engaged in unfair hiring practices. Theseclaims may result in material litigation. We could incur substantial costsdefending ourselves or our employees against those claims, regardless of theirmerits. In addition, defending ourselves from those types of claims coulddivert our management’s 

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attentionfrom our operations. If we are found liable in connection with any employmentclaim, we may incur significant costs that could adversely impact our financialposition and results of operations.

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

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

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

We and our contract manufacturer currently purchaseseveral key components of our products, including commercial digital signalprocessors, from single or limited sources. We purchase these components on apurchase order basis. If we overestimate our component requirements, we couldhave excess inventory, which would increase our costs. If we underestimate ourrequirements, we may not have an adequate supply, which could interruptmanufacturing of our products and result in delays in shipments and revenues.

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

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

We have incorporated third-party licensed technology into ourcurrent products. From time to time, we may be required to license additionaltechnology from third parties to develop new products or product enhancements. Third-party licenses may not be available orcontinue to be available to us on commercially reasonable terms. The inabilityto maintain or re-license any third-party licenses required in our currentproducts or to obtain any new third-partylicenses to develop new products and product enhancements 

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couldrequire us to obtain substitute technology of lower quality or performancestandards or at greater cost, and delay or prevent us from making theseproducts or enhancements, any of which could seriously harm the competitivenessof our products.

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

Our solutionsinclude the integration of products supplied by strategic partners, who offercomplementary products and services. We rely on these strategic partners in thetimely and successful deployment of our solutions to our customers. If theproducts provided by these partners have defects or do not operate as expectedor if we do not effectively integrate and support products supplied by thesestrategic partners, then we may have difficulty with the deployment of oursolutions that may result in:

·       lossof, or delay in, revenues;

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

·       networkperformance penalties.

In addition tocooperating with our strategic partners on specific customer projects, we alsomay compete in some areas with these same partners. If these strategic partnersfail to perform or choose not to cooperate with us on certain projects, inaddition to the effects described above, we could experience:

·       lossof customers and market share; and

·       a failure to attract newcustomers 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 not protect our proprietary rights as fully as in the United States. Ifcompetitors are able to use our technology, our ability to compete effectivelycould be harmed.

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

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

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

·       redesignthose products that use any allegedly infringing technology.

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

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

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

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

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

·       reducesignificantly our cash and investments;

·       incurdebt or assume liabilities;

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

·       incursignificant amortization expenses related to purchased intangible assets; or

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

Our integration ofany acquired products, technologies or businesses will also involve 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;

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

·       integrationof internal controls and financial systems.

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

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

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

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

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

·       fundongoing operations and capital requirements;

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

·       developnew products; or

·       respondto competitive pressures.

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

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

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

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

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

·       theaddition or loss of any major customer;

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·       consolidationin the telecommunications industry; changes in the financial condition oranticipated capital expenditure purchases of any existing or potential majorcustomer;

·       quarterlyvariations in our operating results;

·       changesin financial estimates by securities analysts;

·       speculationin the press or investment community;

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

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

·       securitiesand other litigation;

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

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

·       worldwide economicinstability.

***Provisions of our charter documents and Delawarelaw  have anti-takeover effects thatcould prevent a change of control.***

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

**Item 2. UnregisteredSales of Equity Securities and Use of Proceeds.**

***Sales of Unregistered Securities***

None.

***Purchases of Equity Securities by the Issuer andAffiliated Purchasers***

Wehave not announced any currently effective authorization to repurchase sharesof our common stock. However, upon vesting of restricted stock awards,employees are permitted to return to us a portion of the newly vested shares tosatisfy the tax withholding obligations that arise in connection with such vesting.The following table summarizes repurchases of our common stock during thesecond quarter of fiscal 2007, which represent shares returned to satisfy taxwithholding obligations:

| **Period**                                 | ** ** | ** ** | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of  Shares Purchased  as Part of  Publicly  Announced Plans  or Programs** | ** ** | **Approximate Dollar  Value of Shares that May  Yet be Purchased Under  the Plans or Programs** | ** ** |
|--------------------------------------------|------------|------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| April 1,  2007 to April 30, 2007 |       |       | 14,302     |                                             |       |                                         | $          | 7.73                                                                                                                         |       |                                                                                                                                                   |       | — |   |   |   | — |   |   |
| May 1, 2007  to May 31, 2007     |       |       | —     |                                             |       |                                         | —     |                                                                                                                         |       |                                                                                                                                                   | —     |   |   |   | — |   |   |
| June 1, 2007  to June 30, 2007   |       |       | —     |                                             |       |                                         | —     |                                                                                                                         |       |                                                                                                                                                   | —     |   |   |   | — |   |   |
| Total                                      |       |       | 14,302     |                                             |       |                                         | $          | 7.73                                                                                                                         |       |                                                                                                                                                   |       | — |   |   |   | — |   |   |

 

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**Item6. Exhibits**

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

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

| Dated: August 9, 2007 |   | SONUS NETWORKS, INC. |
|----------------------------|--------|----------------------|
|                       |   | By:                  |   | /s/ Ellen B. Richstone |
|                       |   |                 |   | Ellen B. Richstone  Chief Financial Officer (Principal Financial Officer) |
|                       |   | By:                  |   | /s/ Paul K. McDermott |
|                       |   |                 |   | Paul K. McDermott  Vice President of Finance, Corporate Controller and Principal Accounting  Officer (Principal Accounting Officer) |

 

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**EXHIBITINDEX**

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

 

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