**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

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

**Forthe quarterly period ended March 31, 2007**

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

**CommissionFile Number 000-30229**

**SONUS NETWORKS, INC.**

(Exact name of Registrantas specified in its charter)

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

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

(Address of principalexecutive offices, including zip code)

**(978) 614-8100**

(Registrant’s telephonenumber, including area code)

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

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

Indicate by check 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 o No x

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

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

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

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

 

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**Explanatory Note**

In this Form 10-Q (“Form 10-Q”),we are restating our consolidated financial statements as for the three monthsended March 31, 2006. Immediately prior to the filing of this Form 10-Q,we filed a Quarterly Report on Form 10-Q for the quarter ended June 30,2006, a Quarterly Report on Form 10-Q for the quarter ended September 30,2006 and an Annual Report on Form 10-K (“Form 10-K”) forthe year ended December 31, 2006. In our Form 10-K filed withthe Securities and Exchange Commission we restated our consolidated financialstatements as of December 31, 2005 and for each of the years ended December 31,2005 and 2004 and each of the quarters in 2005 and the three months ended March 31,2006.

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

The restatement ofour consolidated financial statements reflects:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

*May 2000 IPOThrough Late 2004*

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

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

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

We also lacked a consistentor documented practice for entering grant information into the accounting andequity records and how and when such stock option grants were communicated toemployees.

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*Late 2004 ThroughCurrent*

In response to a restatement of our consolidated financialstatements completed in July 2004, material weaknesses identified in ourinternal control over financial reporting and the hiring of new members ofsenior management, including a new CFO in January 2005, we commenced inlate 2004 and continuing into 2006, implementing a number of improvements toour stock option granting practices and controls. Notwithstanding these improvements, we continued to have issues withinadequate documentation and processes resulting in revised measurement datesfor certain grants through 2005.

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

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

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

*Measurement DateMethodology*

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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

 

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

 

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

*Tax-RelatedAdjustments*

*Withholding Taxes*

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

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thedisqualification of the ISO status of stock options totaled approximately $1.0million from 2001 through 2005 and approximately $0.2 million in the threemonths ended March 31, 2006.

*Section 409A*

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

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

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

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

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

*Income Taxes*

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

*Other Adjustments*

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

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**SONUSNETWORKS, INC.FORM 10-QQUARTER ENDED MARCH 31, 2007TABLE OF CONTENTS**

|                                        | ** ** |                                                                                                                                    | ** ** | **Page** |
|----------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I  FINANCIAL INFORMATION** |       |                                                                                                                               |
| Item 1.                                |       | Financial Statements                                                                                                               |       |     |
|                                   |       | Condensed Consolidated Balance Sheets as of  March 31, 2007 and December 31, 2006 (unaudited)                            |       | 10       |
|                                   |       | Condensed Consolidated Statements of Operations for  the Three Months Ended March 31, 2007 and 2006 (as restated) (unaudited) |       | 11       |
|                                   |       | Condensed Consolidated Statements of Cash Flows for  the Three Months Ended March 31, 2007 and 2006 (as restated) (unaudited) |       | 12       |
|                                   |       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                                  |       | 13       |
| Item 2.                                |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                        |       | 38       |
| Item 3.                                |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                        |       | 51       |
| Item 4.                                |       | Controls and Procedures                                                                                                            |       | 51       |
| **PART II  OTHER INFORMATION**    |       |                                                                                                                               |
| Item  1.                               |       | Legal  Proceedings                                                                                                                 |       | 54       |
| Item  1A.                              |       | Risk  Factors                                                                                                                      |       | 57       |
| Item 6.                                |       | Exhibits                                                                                                                           |       | 72       |
|                                   |       | Signatures                                                                                                                         |       | 73       |
|                                   |       | Exhibit Index                                                                                                                 |       | 74       |
|                                        |            |                                                                                                                                    |            |          |  |  |

 

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**PART I- FINANCIAL INFORMATIONItem 1. Financial Statements**

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

| ** **                                                                                                                                                                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                           | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                                                           | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| Current assets:                                                                                                                                                                      |       |               |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                            |       | $                  | 53,380     |                  |       | $ | 44,206 |   |   |
| Marketable debt securities                                                                                                                                                           |       | 267,740            |       |                  | 256,485    |   |   |
| Accounts receivable, net                                                                                                                                                             |       | 59,711             |       |                  | 70,726     |   |   |
| Inventory, net                                                                                                                                                                       |       | 26,999             |       |                  | 22,266     |   |   |
| Deferred income taxes                                                                                                                                                                |       | 24,212             |       |                  | 21,808     |   |   |
| Other current assets                                                                                                                                                                 |       | 18,389             |       |                  | 18,523     |   |   |
| Total current assets                                                                                                                                                                 |       | 450,431            |       |                  | 434,014    |   |   |
| Property and  equipment, net                                                                                                                                                         |       | 18,987             |       |                  | 19,051     |   |   |
| Long-term  investments                                                                                                                                                               |       | 44,933             |       |                  | 60,189     |   |   |
| Deferred income  taxes                                                                                                                                                               |       | 47,003             |       |                  | 52,613     |   |   |
| Other assets                                                                                                                                                                         |       | 24,557             |       |                  | 23,737     |   |   |
|                                                                                                                                                                                 |       | $                  | 585,911    |                  |       | $ | 589,604 |   |   |
| **Liabilities and stockholders’ equity**                                                                                                                                        | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| Current liabilities:                                                                                                                                                                 |       |               |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                     |       | $                  | 19,872     |                  |       | $ | 17,219 |   |   |
| Accrued expenses                                                                                                                                                                     |       | 33,067             |       |                  | 43,653     |   |   |
| Accrued restructuring expenses                                                                                                                                                       |       | —             |       |                  | 61         |   |   |
| Current portion of deferred revenue                                                                                                                                                  |       | 58,544             |       |                  | 60,383     |   |   |
| Current portion of long-term liabilities                                                                                                                                             |       | 2,550              |       |                  | 501        |   |   |
| Total current liabilities                                                                                                                                                            |       | 114,033            |       |                  | 121,817    |   |   |
| Long-term deferred  revenue                                                                                                                                                          |       | 32,092             |       |                  | 33,787     |   |   |
| Long-term  liabilities, net of current portion                                                                                                                                       |       | 3,133              |       |                  | 1,467      |   |   |
| Total liabilities                                                                                                                                                                    |       | 149,258            |       |                  | 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, 262,065,332 shares issued and 259,768,422 shares outstanding at  both March 31, 2007 and December 31, 2006 |       | 262                |       |                  | 262        |   |   |
| Additional paid-in capital                                                                                                                                                           |       | 1,168,940          |       |                  | 1,160,853  |   |   |
| Accumulated deficit                                                                                                                                                                  |       | (732,261           | )          |                  | (728,233   | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                 |       | (21                | )          |                  | (82        | ) |   |
| Treasury stock, at cost; 2,296,910 common shares at  March 31, 2007 and December 31, 2006                                                                                  |       | (267               | )          |                  | (267       | ) |   |
| Total stockholders’ equity                                                                                                                                                      |       | 436,653            |       |                  | 432,533    |   |   |
|                                                                                                                                                                                 |       | $                  | 585,911    |                  |       | $ | 589,604 |   |   |

 

See notes to the condensed consolidated financial statements.

10

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

| ** **                                             | ** ** | **Three months ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                             | ** ** | **March 31,**               | ** ** |
| ** **                                             | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| ** **                                             | ** ** | ** **                       | ** ** | **(As Restated,** | ** ** |
| ** **                                             | ** ** | ** **                       | ** ** | **See Note 2)** | ** ** |
| Revenue:                                               |       |                             |       |   |   |   |   |
| Product                                                |       | $                                | 51,627     |   |   | $ | 44,542 |   |   |
| Service                                                |       | 19,519                           |       |   | 15,453 |   |   |
| Total revenue                                          |       | 71,146                           |       |   | 59,995 |   |   |
| Cost of revenue:                                       |       |                             |       |   |   |   |   |
| Product                                                |       | 17,082                           |       |   | 15,883 |   |   |
| Service                                                |       | 8,579                            |       |   | 6,729 |   |   |
| Total cost of revenue                                  |       | 25,661                           |       |   | 22,612 |   |   |
| Gross profit                                           |       | 45,485                           |       |   | 37,383 |   |   |
| Operating expenses:                                    |       |                             |       |   |   |   |   |
| Research and development                               |       | 18,698                           |       |   | 13,076 |   |   |
| Sales and marketing                                    |       | 23,050                           |       |   | 14,025 |   |   |
| General and administrative                             |       | 14,062                           |       |   | 6,980 |   |   |
| Total operating expenses                               |       | 55,810                           |       |   | 34,081 |   |   |
| Income (loss)  from operations                         |       | (10,325                          | )          |   | 3,302 |   |   |
| Interest expense                                       |       | (4                               | )          |   | (137 | ) |   |
| Interest income                                        |       | 4,624                            |       |   | 3,442 |   |   |
| Other income  (expense), net                           |       | (680                             | )          |   | — |   |   |
| Income (loss)  before income taxes                     |       | (6,385                           | )          |   | 6,607 |   |   |
| Income tax  benefit (provision)                        |       | 2,407                            |       |   | (791 | ) |   |
| Net income (loss)                                      |       | $                                | (3,978     | ) |   | $ | 5,816 |   |   |
| Net income (loss)  per share:                          |       |                             |       |   |   |   |   |
| Basic and diluted                                      |       | $                                | (0.02      | ) |   | $ | 0.02 |   |   |
| Shares used in  computing net income (loss) per share: |       |                             |       |   |   |   |   |
| Basic                                                  |       | 259,768                          |       |   | 250,064 |   |   |
| Diluted                                                |       | 259,768                          |       |   | 254,591 |   |   |

 

See notes to the condensed consolidated financial statements.

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

| ** **                                                                                         | ** ** | **Three months ended** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                         | ** ** | **March 31,**               | ** ** |
| ** **                                                                                         | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| ** **                                                                                         | ** ** | ** **                       | ** ** | **(As Restated,** | ** ** |
| ** **                                                                                         | ** ** | ** **                       | ** ** | **See Note 2)** | ** ** |
| Cash flows from operating activities:                                                              |       |                             |       |   |   |   |   |
| Net income (loss)                                                                                  |       | $                                | (3,978     | ) |   | $ | 5,816 |   |   |
| Adjustments to reconcile  net income (loss) to cash flows provided by operating activities:        |       |                             |       |   |   |   |   |
| Depreciation and  amortization of property and equipment                                           |       | 3,026                            |       |   | 2,313 |   |   |
| Stock-based  compensation                                                                          |       | 8,869                            |       |   | 2,299 |   |   |
| Loss on disposal  of property and equipment                                                        |       | —                           |       |   | 6 |   |   |
| Increase in fair  value of modified stock options held by former employees                         |       | 682                              |       |   | — |   |   |
| Deferred income  taxes                                                                             |       | 3,206                            |       |   | — |   |   |
| Changes in operating  assets and liabilities:                                                      |       |                             |       |   |   |   |   |
| Accounts  receivable                                                                               |       | 11,015                           |       |   | 39,011 |   |   |
| Inventory                                                                                          |       | (4,654                           | )          |   | 3,823 |   |   |
| Other operating  assets                                                                            |       | 1,439                            |       |   | (4,783 | ) |   |
| Accounts payable                                                                                   |       | 1,424                            |       |   | (3,991 | ) |   |
| Accrued expenses,  deferred rent and accrued restructuring expenses                                |       | (10,483                          | )          |   | (3,571 | ) |   |
| Deferred revenue                                                                                   |       | (3,534                           | )          |   | (19,883 | ) |   |
| Net cash provided  by operating activities                                                         |       | 7,012                            |       |   | 21,040 |   |   |
| Cash flows from investing activities:                                                              |       |                             |       |   |   |   |   |
| Purchases of  property and equipment                                                               |       | (1,681                           | )          |   | (2,328 | ) |   |
| Maturities of available-for-sale  marketable debt securities                                       |       | 6,953                            |       |   | 25,500 |   |   |
| Purchases of  available-for-sale marketable debt securities                                        |       | (10,703                          | )          |   | (12,825 | ) |   |
| Maturities of  held-to-maturity marketable debt securities and long-term investments               |       | 75,800                           |       |   | 22,950 |   |   |
| Purchases of  held-to-maturity marketable debt securities and long-term investments                |       | (68,049                          | )          |   | (166,991 | ) |   |
| Decrease in  restricted cash                                                                       |       | 11                               |       |   | 250 |   |   |
| Net cash provided  by (used in) investing activities                                               |       | 2,331                            |       |   | (133,444 | ) |   |
| Cash flows from financing activities:                                                              |       |                             |       |   |   |   |   |
| Sale of common  stock in connection with employee stock purchase plan                              |       | —                           |       |   | 2,311 |   |   |
| Proceeds from  exercise of stock options                                                           |       | —                           |       |   | 4,821 |   |   |
| Payment of  withholding tax obligations related to net share settlement of restricted  stock award |       | (189                             | )          |   | — |   |   |
| Principal payments  of capital lease obligations                                                   |       | (41                              | )          |   | (12 | ) |   |
| Net cash provided  by (used in) financing activities                                               |       | (230                             | )          |   | 7,120 |   |   |
| Effect of exchange rate  changes on cash and cash equivalents                                      |       | 61                               |       |   | (86 | ) |   |
| Net increase (decrease)  in cash and cash equivalents                                              |       | 9,174                            |       |   | (105,370 | ) |   |
| Cash and cash  equivalents, beginning of period                                                    |       | 44,206                           |       |   | 155,679 |   |   |
| Cash and cash  equivalents, end of period                                                          |       | $                                | 53,380     |   |   | $ | 50,309 |   |   |
| Supplemental disclosure of cash flow information:                                                  |       |                             |       |   |   |   |   |
| Interest paid                                                                                      |       | $                                | 11         |   |   | $ | 12 |   |   |
| Income taxes paid                                                                                  |       | $                                | 1,744      |   |   | $ | 905 |   |   |
| Supplemental disclosure of non-cash investing  activities:                                         |       |                             |       |   |   |   |   |
| Non-cash purchases  of property and equipment                                                      |       | $                                | 1,196      |   |   | $ | 1,081 |   |   |
| Property and  equipment acquired as part of a facility lease                                       |       | $                                | —     |   |   | $ | 50 |   |   |
| Property and  equipment acquired under capital lease                                               |       | $                                | 53         |   |   | $ | — |   |   |
| Supplemental disclosure of non-cash financing  activities:                                         |       |                             |       |   |   |   |   |
| Modifications of  stock options—reclassification  from equity to liability award              |       | $                                | 702        |   |   | $ | — |   |   |

 

See notes to the condensed consolidated financial statements.

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

**(1) Description ofBusiness**

SonusNetworks, Inc. (“Sonus” or the “Company”) was incorporated in 1997 and isa leading provider of voice infrastructure solutions for wireline and wirelessservice providers. Sonus offers a new generation of carrier-classinfrastructure equipment and software that enables voice services to bedelivered over packet-based networks.

**(2) Restatement ofConsolidated Financial Statements**

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

As a result of the Audit Committee Investigation, theCompany performed a review of stock option grant measurement dates recorded forfinancial reporting purposes. The Company determined that during the periodfrom May 2000 through December 31, 2005, the Company i) appliedincorrect measurement dates in the accounting for certain stock options and ii)incorrectly accounted for certain stock options that should have been recordedusing variable accounting. Accordingly, the Company has restated itsaccumulated deficit as of January 1, 2006 and its consolidated financialstatements for the three months ended March 31, 2006 to record additionalstock-based compensation to correctly account for its stock options and relatedtax adjustments. The Company has also corrected other previously unrecordedmisstatements not related to the accounting for stock options previously deemedto be immaterial.

Thefollowing table reconciles net income and accumulated deficit  as previously reported to the restatedamounts (in thousands):

| ** **                                                                              | ** ** | **Net Income  Three Months  Ended  March 31, 2006** | ** ** | **Accumulated  Deficit as of  January 1, 2006** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| As previously  reported                                                                 |       |                                                                    | $          | 5,744                                                               |       |   |   | $ | (775,717 | ) |   |
| Changes in net  income and accumulated deficit                                          |       |                                                                    |       |                                                                |       |   |   |   |   |
| Stock-based compensation adjustments related to  revised measurement dates              |       |                                                                    | (11        | )                                                                   |       |   | (52,861 | ) |   |
| Stock-based compensation  adjustments related to the application of variable accounting |       |                                                                    | —     |                                                                |       |   | (1,222 | ) |   |
| Tax-related adjustments                                                                 |       |                                                                    | (174       | )                                                                   |       |   | (1,030 | ) |   |
| Other adjustments                                                                       |       |                                                                    | 257        |                                                                |       |   | (1,212 | ) |   |
| Income tax benefit                                                                      |       |                                                                    | —     |                                                                |       |   | 955 |   |   |
| Total change in  net income and accumulated deficit                                     |       |                                                                    | 72         |                                                                |       |   | (55,370 | ) |   |
| As restated                                                                             |       |                                                                    | $          | 5,816                                                               |       |   |   | $ | (831,087 | ) |   |

 

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*Stock-BasedCompensation Adjustments Related to Revised Measurement Dates*

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

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

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

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

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

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

(3)         If the stock option grantwas approved by UWC and the Company did not have clear prior evidence of thedate the principal terms of the grant were communicated to the recipients, thedate of receipt of the last signature for the UWC provided there was clearevidence of the date the last signature was received was determined to be themost likely measurement date. 

14

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Measurement dates forapproximately 2% of the total number of grants were determined based on thismethod.

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

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

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

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

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

In applying thisframework, the Company revised the measurement dates for many grants whichresulted in exercise prices that were less than the fair market value of thestock on the revised measurement dates. This outcome results in a stock-basedcompensation charge in accordance with APB 25. Adjustments related to revisedmeasurement dates resulted in the Company recognizing additional stock-basedcompensation expense from 2000 through 2005 of approximately $52.9 million.

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

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

Subsequent to theenactment of the new NIC regulations in 1999, the Company granted stock optionsto its UK employees. The Company entered into agreements whereby the employeewould be required to reimburse the Company for the taxes. Under the guidance ofIssue 15 of Emerging Issues Task Force (“EITF”) Issue No. 00-23, *Issues Related to the Accounting for Stock Compensation under APBOpinion No. 25 and FASB Interpretation No. 44,* variable accountingis required for stock option grants when a cash 

15

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paymentcontingent upon exercise is not fixed. Accordingly, an employee obligation toreimburse the employer for the amount of NIC taxes triggered by an exercisecauses a variable exercise price for the grant, and thus, the options issued to UK employeesresulted in the Company recording additional stock-based compensation expensefrom 2000 through 2005 totaling approximately $1.2 million.

*Tax-RelatedAdjustments*

*Withholding Taxes*

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

*Section 409A*

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

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

In order to remedy the unfavorable personal taxconsequences for those who have not exercised stock options subject to Section 409A,the Company intends to provide holders of these options the opportunity toamend their affected options. In December 2006, the Company entered intoagreements with its directors and executive officers under which the Companywill amend any affected stock options to increase the exercise price to thequoted market price on the revised measurement date and either provide cashpayment in 2008 or issue restricted stock in 2007, at the Company’s discretion,to the option holder based on the difference in exercise price between therevised measurement date and original grant date. In February 2007, theCompany determined it would provide a cash payment or restricted stock for thechange in exercise price for the directors and officers. Certain directors andofficers agreed to waive such 

16

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cash payment or restrictedstock from the Company for the difference in exercise price of certain affectedstock options. The Company’s agreement with its directors and executivesresulted in additional stock-based compensation expense of approximately$16,000 in the Company’s consolidated financial statements in the fourthquarter of 2006 and resulted in additional stock-based compensation expense ofapproximately $1.2 million in the three months ended March 31, 2007.

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

*Income Taxes*

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

*Other Adjustments*

The restatement of prioryear financial statements includes adjustments for other errors identified insubsequent periods. Such errors were not previously recorded as the Companyconcluded the amount of any such errors, both individually and in theaggregate, were not material to the consolidated financial statements of anyperiod. These errors related to the timing of revenue recognition, therecording of cost of goods sold and certain operating expenses. Cash flowstatement adjustments included such items as the reclassification of $3.2million between inventory and other assets to reflect unearned inventory forwhich revenue will be deferred for more than one year from the balance sheetdate.

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***Statement of Operations Adjustments***

The following tablereconciles the amounts previously reported in the Company’s consolidatedstatement of operations for the three months ended March 31, 2006 to thecorresponding restated amounts, which reflect the restatement adjustmentspreviously described (in thousands, except per share data):

| **Three Months Ended March 31, 2006** | ** ** | ** ** | ** ** | **As Previously  Reported** | ** ** | **Stock-based  Compensation and  Tax-Related  Adjustments** | ** ** | **Other  Adjustments** | ** ** | **As Restated** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|----------------------------------|------------|------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| Revenue:                                                       |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Product                                                        |       |       | $          | 44,383                           |       |                                                             |       | $                      | —     |                 |       |   | $ | 159 |   |   |   | $ | 44,542 |   |   |
| Service                                                        |       |       | 15,589     |                             |       |                                                             | —     |                   |       |                 | (136       | ) |   |   | 15,453 |   |   |
| Total revenue                                                  |       |       | 59,972     |                             |       |                                                             | —     |                   |       |                 | 23         |   |   |   | 59,995 |   |   |
|                                                           |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Cost of revenue:                                               |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Product                                                        |       |       | 15,853     |                             |       |                                                             | 5          |                   |       |                 | 25         |   |   |   | 15,883 |   |   |
| Service                                                        |       |       | 7,381      |                             |       |                                                             | 8          |                   |       |                 | (660       | ) |   |   | 6,729 |   |   |
| Total cost of revenue                                          |       |       | 23,234     |                             |       |                                                             | 13         |                   |       |                 | (635       | ) |   |   | 22,612 |   |   |
| Gross profit                                                   |       |       | 36,738     |                             |       |                                                             | (13        | )                      |       |                 | 658        |   |   |   | 37,383 |   |   |
|                                                           |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Operating expense:                                             |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Research and development                                       |       |       | 12,891     |                             |       |                                                             | 20         |                   |       |                 | 165        |   |   |   | 13,076 |   |   |
| Sales and marketing                                            |       |       | 13,898     |                             |       |                                                             | 37         |                   |       |                 | 90         |   |   |   | 14,025 |   |   |
| General and administrative                                     |       |       | 6,719      |                             |       |                                                             | 115        |                   |       |                 | 146        |   |   |   | 6,980 |   |   |
| Total operating expenses                                       |       |       | 33,508     |                             |       |                                                             | 172        |                   |       |                 | 401        |   |   |   | 34,081 |   |   |
|                                                           |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Income from  operations                                        |       |       | 3,230      |                             |       |                                                             | (185       | )                      |       |                 | 257        |   |   |   | 3,302 |   |   |
| Interest expense                                               |       |       | (137       | )                                |       |                                                             | —     |                   |       |                 | —     |   |   |   | (137 | ) |   |
| Interest income                                                |       |       | 3,442      |                             |       |                                                             | —     |                   |       |                 | —     |   |   |   | 3,442 |   |   |
|                                                           |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Income before  income taxes                                    |       |       | 6,535      |                             |       |                                                             | (185       | )                      |       |                 | 257        |   |   |   | 6,607 |   |   |
| Income tax  provision                                          |       |       | (791       | )                                |       |                                                             | —     |                   |       |                 | —     |   |   |   | (791 | ) |   |
| Net income                                                     |       |       | $          | 5,744                            |       |                                                             |       | $                      | (185       | )                    |       |   | $ | 257 |   |   |   | 5,816 |   |   |
|                                                           |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Net income per share:                                          |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Basic and diluted                                              |       |       | $          | 0.02                             |       |                                                             |       | $                      | —-    |                 |       |   | $ | —- |   |   |   | $ | 0.02 |   |   |
|                                                           |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Shares used in computing  net income per share:                |       |       |       |                             |       |                                                             |       |                   |       |                 |       |   |   |   |   |   |   |
| Basic                                                          |       |       | 250,064    |                             |       |                                                             | —     |                   |       |                 | —     |   |   |   | 250,064 |   |   |
| Diluted                                                        |       |       | 254,459    |                             |       |                                                             | 132        |                   |       |                 | —     |   |   |   | 254,591 |   |   |

 

18

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***Statement of Cash Flows Adjustments***

Thefollowing table reconciles the amounts previously reported in the Company’sconsolidated statement of cash flows for the three months ended March 31,2006 to the corresponding restated amounts, which reflect the restatementadjustments previously described (in thousands):

| ** **                                                                           | ** ** | **As Previously  Reported** | ** ** | **Stock-based  Compensation  and Tax-Related  Adjustments** | ** ** | **Other  Adjustments** | ** ** | **As Restated** | ** **   |
|--------------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------------------------------------------|------------|------------------------|------------|----------------------|--------------|
| Cash flows from operating  activities:                                               |       |                             |       |                                                             |       |                   |       |                 |         |   |   |   |   |   |   |
| Net income                                                                           |       |                             | $          | 5,744                                                            |       |                   |       | $                    | (185         | ) |   |   | $ | 257 |   |   | $ | 5,816 |   |
| Adjustments to  reconcile net income to cash flows from operating activities:        |       |                             |       |                                                             |       |                   |       |                 |         |   |   |   |   |   |   |
| Depreciation and amortization of property and  equipment                             |       |                             | 2,293      |                                                             |       |                   |       |                 |         |   | 20 |   |   | 2,313 |   |
| Stock-based compensation                                                             |       |                             | 1,903      |                                                             |       |                   | 396        |                 |         |   | — |   |   | 2,299 |   |
| Loss on disposal of property and equipment                                           |       |                             | 6          |                                                             |       |                   | —     |                 |         |   | — |   |   | 6 |   |
| Changes in current  assets and liabilities:                                          |       |                             |       |                                                             |       |                   |       |                 |         |   |   |   |   |   |   |
| Accounts receivable                                                                  |       |                             | 39,071     |                                                             |       |                   | —     |                 |         |   | (60 | ) |   | 39,011 |   |
| Inventory                                                                            |       |                             | 713        |                                                             |       |                   | —     |                 |         |   | 3,110 |   |   | 3,823 |   |
| Other operating assets                                                               |       |                             | (857       | )                                                                |       |                   | —     |                 |         |   | (3,926 | ) |   | (4,783 | ) |
| Accounts payable                                                                     |       |                             | (4,072     | )                                                                |       |                   | —     |                 |         |   | 81 |   |   | (3,991 | ) |
| Accrued expenses, deferred rent and accrued  restructuring expenses                  |       |                             | (3,926     | )                                                                |       |                   | (211       | )                    |         |   | 566 |   |   | (3,571 | ) |
| Deferred revenue                                                                     |       |                             | (19,920    | )                                                                |       |                   | —     |                 |         |   | 37 |   |   | (19,883 | ) |
| Cash flows provided by operating activities                                          |       |                             | 20,955     |                                                             |       |                   | —     |                 |         |   | 85 |   |   | 21,040 |   |
|                                                                                 |       |                             |       |                                                             |       |                   |       |                 |         |   |   |   |   |   |   |
| Cash flows from investing  activities:                                               |       |                             |       |                                                             |       |                   |       |                 |         |   |   |   |   |   |   |
| Purchases of property and equipment                                                  |       |                             | (2,328     | )                                                                |       |                   | —     |                 |         |   | — |   |   | (2,328 | ) |
| Maturities of available-for-sale marketable debt  securities                         |       |                             | 25,500     |                                                             |       |                   | —     |                 |         |   | — |   |   | 25,500 |   |
| Purchases of available-for-sale marketable debt  securities                          |       |                             | (12,825    | )                                                                |       |                   | —     |                 |         |   | — |   |   | (12,825 | ) |
| Maturities of held-to-maturity marketable debt  securities and long-term investments |       |                             | 22,950     |                                                             |       |                   | —     |                 |         |   | — |   |   | 22,950 |   |
| Purchases of held-to-maturity marketable debt  securities and long-term investments  |       |                             | (166,991   | )                                                                |       |                   | —     |                 |         |   | — |   |   | (166,991 | ) |
| Decrease in restricted cash                                                          |       |                             | 250        |                                                             |       |                   | —     |                 |         |   | — |   |   | 250 |   |
| Decrease in other assets                                                             |       |                             | 85         |                                                             |       |                   | —     |                 |         |   | (85 | ) |   | — |   |
| Cash flows used in investing activities                                              |       |                             | (133,359   | )                                                                |       |                   | —     |                 |         |   | (85 | ) |   | (133,444 | ) |
|                                                                                 |       |                             |       |                                                             |       |                   |       |                 |         |   |   |   |   |   |   |
| Cash flows from financing  activities:                                               |       |                             |       |                                                             |       |                   |       |                 |         |   |   |   |   |   |   |
| Sale of common stock in connection with employee  stock purchase plan                |       |                             | 2,311      |                                                             |       |                   | —     |                 |         |   | — |   |   | 2,311 |   |
| Proceeds from exercise of stock options                                              |       |                             | 4,821      |                                                             |       |                   | —     |                 |         |   | — |   |   | 4,821 |   |
| Principal payments of capital lease obligations                                      |       |                             | (12        | )                                                                |       |                   | —     |                 |         |   | — |   |   | (12 | ) |
| Cash flows provided by financing activities                                          |       |                             | 7,120      |                                                             |       |                   | —     |                 |         |   | — |   |   | 7,120 |   |
| Effect of exchange  rate changes on cash and cash equivalents                        |       |                             | (86        | )                                                                |       |                   | —     |            |    |   | — |   |   | (86 | ) |
|                                                                                 |       |                             |       |                                                             |       |                   |       |                 |         |   |   |   |   |   |   |
| Net decrease in  cash and cash equivalents                                           |       |                             | (105,370   | )                                                                |       |                   | —     |                 |         |   | — |   |   | (105,370 | ) |
| Cash and cash  equivalents, beginning of period                                      |       |                             | 155,679    |                                                             |       |                   | —     |                 |         |   | — |   |   | 155,679 |   |
| Cash and cash  equivalents, end of period                                            |       |                             | $          | 50,309                                                           |       |                   |       | $                    | —       |   |   |   | $ | — |   |   | $ | 50,309 |   |

 

19

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| **Three months ended March 31, 2006 (continued)** | ** ** | ** ** | ** ** | **As Previously  Reported** | ** ** | **Stock-based  Compensation  and Tax-  Related  Adjustments** | ** ** | **Other  Adjustments** | ** ** | **As Restated** | ** ** |
|---------------------------------------------------------------------------------|------------|------------|------------|----------------------------------|------------|--------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| Supplemental disclosure  of cash flow information:                              |       |       |       |                             |       |                                                               |       |                   |       |                 |       |   |   |   |   |   |   |
| Interest paid                                                                   |       |       | $          | 12                               |       |                                                               |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 12 |   |   |
| Income taxes paid                                                               |       |       | $          | 905                              |       |                                                               |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 905 |   |   |
| Supplemental disclosure  of non-cash investing activities:                      |       |       |       |                             |       |                                                               |       |                   |       |                 |       |   |   |   |   |   |   |
| Non-cash purchases of property and equipment                                    |       |       | $          | 1,081                            |       |                                                               |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 1,081 |   |   |
| Property and  equipment acquired as part of a facility lease                    |       |       | $          | 50                               |       |                                                               |       | $                      | —     |                 |       |   | $ | — |   |   |   | $ | 50 |   |   |

 

**(3) Summary ofSignificant Accounting Policies**

Theaccompanying condensed consolidated financial statements reflect theapplication of certain significant accounting policies as described in thisnote and elsewhere in the accompanying condensed consolidated financialstatements 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.

Theaccompanying condensed consolidated financial statements include the accountsof Sonus and its wholly owned subsidiaries. All intercompany transactions andbalances have been eliminated in consolidation.

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

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

20

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***(c) Cash Equivalents, Marketable Debt Securities andLong-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 March 31, 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 ofone to five years as of the balance sheet date.

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

| ** **                      | ** ** | **March 31, 2007** | ** ** |
|---------------------------------|------------|------------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**          | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| *Marketable debt securities*    |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| State and municipal obligations |       |                         | $          | 31,900 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 31,900 |   |
| Held-to-maturity:               |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       |                         | 96,077     |   |   |   | 17 |   |   |   | (67 | ) |   | 96,027 |   |
| Corporate debt securities       |       |                         | 40,834     |   |   |   | 9 |   |   |   | (38 | ) |   | 40,805 |   |
| Commercial paper                |       |                         | 98,929     |   |   |   | 4 |   |   |   | (323 | ) |   | 98,610 |   |
|                            |       |                         | $          | 267,740 |   |   |   | $ | 30 |   |   |   | $ | (428 | ) |   | $ | 267,342 |   |
| *Long-term investments*         |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:               |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       |                         | $          | 40,421 |   |   |   | $ | 40 |   |   |   | $ | (6 | ) |   | $ | 40,455 |   |
| Corporate debt securities       |       |                         | 4,512      |   |   |   | 2 |   |   |   | (5 | ) |   | 4,509 |   |
|                            |       |                         | $          | 44,933 |   |   |   | $ | 42 |   |   |   | $ | (11 | ) |   | $ | 44,964 |   |

 

21

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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 March 31, 2007 and December 31, 2006,Sonus had $330,000 and $341,000, respectively, of restricted cash, which isused to collateralize standby letters of credit. Restricted cash is included inOther current assets in the Condensed Consolidated Balance Sheets.

Inconnection with the move to Westford, Massachusetts in January 2007, theCompany 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-Balance SheetRisk, 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 March 31, 2007.

Thefollowing customers each contributed at least 10% of Sonus’ revenue for thethree months ended March 31, 2007 and 2006:

| ** **   | ** ** | **Three months ended** | ** ** |
|--------------|------------|----------------------------------|------------|
| ** **   | ** ** | **March 31,**               | ** ** |
| **Customer** | ** ** | ** **                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| A            |       |                             | 43         | % |   |   | * |   |   |
| B       |       |                             | *          |   |   |   | 18 | % |   |
| C       |       |                             | *          |   |   |   | 12 | % |   |
| D            |       |                             | *          |   |   |   | 11 | % |   |
|              |            |                                  |            |  |  |  |  |  |  |  |  |

----

*                    Representsless than 10% of revenue.

At March 31, 2007 and December 31, 2006, twocustomers and three customers, respectively, each accounted for at least 10% ofSonus’ accounts receivable balance, representing a total of approximately 50%and 45% of the Company’s total accounts receivable balances. Sonus performsongoing credit evaluations of its customers and generally does not requirecollateral on accounts receivable. Sonus maintains an allowance for doubtfulaccounts and such losses have been within management’s expectations.

22

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Thefollowing table shows the percentage of revenue by geographic region for thethree months ended March 31, 2007 and 2006:

| ** **                      | ** ** | **Three months ended  March 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------------|------------|
| ** **                      | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| United States                   |       |                                             | 83         | % |   |   | 77 | % |   |
| Japan                           |       |                                             | 7          |   |   |   | 11 |   |   |
| Other Asia  Pacific             |       |                                             | *          |   |   |   | 9 |   |   |
| Europe, Middle  East and Africa |       |                                             | 6          |   |   |   | 3 |   |   |
| Other                           |       |                                             | 4          |   |   |   | * |   |   |
|                            |       |                                             | 100        | % |   |   | 100 | % |   |

 

----

*                    Representsless than 1% of revenue.

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

In2006, Sonus consolidated its manufacturing to a single manufacturer. Failure tomanage these consolidation activities could result in a disruption in thesupply of its products and in delays in the fulfillment of the Company’scustomer orders.

***(e) Accounts Receivable***

Accountsreceivable consist of the following (in thousands):

| ** **                       | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Earned accounts  receivable      |       |                     | $          | 47,550                      |       |   |   | $ | 42,086 |   |   |
| Unearned accounts  receivable    |       |                     | 12,514     |                        |       |   | 29,232 |   |   |
| Accounts receivable, gross       |       |                     | 60,064     |                        |       |   | 71,318 |   |   |
| Allowance for  doubtful accounts |       |                     | (353       | )                           |       |   | (592 | ) |   |
| Accounts  receivable, net        |       |                     | $          | 59,711                      |       |   |   | $ | 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):

| ** **                                             | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| On-hand final assemblies and finished goods  inventory |       | $                        | 17,645     |                        |       | $ | 15,738 |   |   |
| Unearned inventory                                     |       | 29,856                   |       |                        | 27,166     |   |   |
| Evaluation inventory                                   |       | 5,347                    |       |                        | 4,380      |   |   |
| Current  inventory, gross                              |       | 52,848                   |       |                        | 47,284     |   |   |
| Excess, obsolete and evaluation reserve                |       | (6,800                   | )          |                        | (5,969     | ) |   |
| Inventory, net                                         |       | 46,048                   |       |                        | 41,315     |   |   |
| Less current portion                                   |       | (26,999                  | )          |                        | (22,266    | ) |   |
| Long-term portion  (included in Other assets)          |       | $                        | 19,049     |                        |       | $ | 19,049 |   |   |

 

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

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

Sonusprovides inventory reserves based on excess and obsolete inventory determinedprimarily by future demand forecasts, recording any adjustments to suchreserves through charges to cost of revenue. Sonus also records a fullinventory reserve for evaluation equipment at the time of shipment to itscustomers as a charge to sales and marketing expense as it is probable that theinventory will not be realizable. If these evaluation shipments are laterpurchased by Sonus’ customers, Sonus reclassifies amounts previously charged tosales and marketing expense to cost of revenue in the period when all revenuerecognition criteria are met.

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

Property and equipment are stated at cost, net ofaccumulated depreciation. Expenditures for maintenance and repairs are chargedto expense as incurred. Depreciation is computed using the straight-line methodover the estimated useful lives of the related assets, which range from two tofive years. Leasehold improvements are amortized over the lesser of the leaseterm or five years. When an item is sold or retired, the cost and relatedaccumulated depreciation or amortization is eliminated, and the resulting gainor loss, if any, is recognized in income (loss) from operations in the CondensedConsolidated Statements of Operations.

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***(h)   Other Assets***

Otherassets consist of the following (in thousands):

| ** **           | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------|------------|--------------------------|------------|-----------------------------|------------|
| Prepaid  commissions |       |                     | $          | 2,083                       |       |   |   | $ | 3,103 |   |   |
| Prepaid royalties    |       |                     | 1,649      |                        |       |   | 336 |   |   |
| Deposits             |       |                     | 1,776      |                        |       |   | 1,249 |   |   |
| Unearned  inventory  |       |                     | 19,049     |                        |       |   | 19,049 |   |   |
|                 |       |                     | $          | 24,557                      |       |   |   | $ | 23,737 |   |   |

 

***(i)    Accrued Expenses***

Accruedexpenses consist of the following (in thousands):

| ** **                               | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Employee  compensation and related costs |       |                     | $          | 17,483                      |       |   |   | $ | 21,715 |   |   |
| Employee stock  purchase plan            |       |                     | 2,889      |                        |       |   | 1,966 |   |   |
| Professional fees                        |       |                     | 4,144      |                        |       |   | 4,223 |   |   |
| Royalties                                |       |                     | 1,286      |                        |       |   | 2,640 |   |   |
| Income taxes  payable                    |       |                     | 152        |                        |       |   | 7,239 |   |   |
| Sales taxes  payable                     |       |                     | 671        |                        |       |   | 761 |   |   |
| Other taxes                              |       |                     | 4,333      |                        |       |   | 3,486 |   |   |
| Other                                    |       |                     | 2,109      |                        |       |   | 1,623 |   |   |
|                                     |       |                     | $          | 33,067                      |       |   |   | $43,653 |   |   |

 

***(j)    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 established by the relevant pricing authority. If Sonuscannot establish VSOE for each undelivered element, including specifiedupgrades, it defers revenue on the entire arrangement until VSOE for allundelivered elements is known or all elements are delivered and all otherrevenue recognition criteria are met.

25

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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 defersrecognition of incremental direct costs, such as cost of goods, royalties,commissions and third-party installation costs, until satisfaction of thecriteria for recognition of the related revenue.

***(k)   Deferred Revenue***

Deferredrevenue consists of the following (in thousands):

| ** **                         | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Maintenance and  support contracts |       | $                        | 50,300     |                        |       | $ | 41,077 |   |   |
| Customer deposits                  |       | 27,822                   |       |                        | 23,861     |   |   |
| Unearned revenue                   |       | 12,514                   |       |                        | 29,232     |   |   |
| Total deferred revenue             |       | 90,636                   |       |                        | 94,170     |   |   |
| Less current  portion              |       | (58,544                  | )          |                        | (60,383    | ) |   |
| Long-term portion                  |       | $                        | 32,092     |                        |       | $ | 33,787 |   |   |

 

Revenue frommaintenance and support contracts is recognized ratably over the life of themaintenance and support period. Customer deposits represent payments receivedin advance of revenue recognition. Unearned revenue represents billings forwhich payment has not been received and revenue recognition criteria have notbeen met. At March 31, 2007 and December 31, 2006, both deferredrevenue and accounts receivable excluded $16.9 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.

***(l)    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, officers, directors (including those directors who are not employeesor officers of the Company), consultants and advisors of the Company and itssubsidiaries.

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 

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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 two year offering period, subsequent to the purchase, theoffering 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 Statement of Financial Accounting Standards (“SFAS”) No. 123R,*Share-based Payment* (“SFAS 123R”), andFinancial Accounting Standards Board (“FASB”) Technical Bulletin 97-1, *Accounting under Statement 123 for Certain Employee Stock PurchasePlans 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 marked to market at each interim reporting date and thechanges in fair value are recorded as other income or expense. Sonus recorded $0.7 millionof Other expense for the three months ended March 31, 2007 as a result ofchanges in the fair value 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 $8.9 million and $2.3 million ofstock-based compensation for the three months ended March 31, 2007 and2006, respectively. These amounts are included as components of the followingexpense categories in the Condensed Consolidated Statements of Operations (inthousands):

| ** **                  | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                  | ** ** | ** **                                       | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Product cost of  revenue    |       | $                                                | 90         |   |   | $ | 15 |   |   |
| Service cost of  revenue    |       | 582                                              |       |   | 283 |   |   |
| Research and  development   |       | 3,209                                            |       |   | 787 |   |   |
| Sales and  marketing        |       | 3,522                                            |       |   | 512 |   |   |
| General and  administrative |       | 1,466                                            |       |   | 702 |   |   |
|                        |       | $                                                | 8,869      |   |   | $ | 2,299 |   |   |

 

In addition, Sonus included in inventory approximately$277,000 of stock-based compensation at March 31, 2007.

At March 31, 2007,there was $19.6 million of unrecognized compensation cost related toshare-based awards, which is expected to be recognized over a weighted averageperiod of approximately three years.

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***Valuation Assumptions***

Thegrant-date fair value of options to purchase common stock granted in the threemonths ended March 31, 2007 and 2006 was estimated using the Black-Scholesvaluation model with the following assumptions:

| ** **                   | ** ** | **Three months  ended  March 31,** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|
| ** **                   | ** ** | **2007**                                     | ** ** | **2006** | ** ** |
| Risk-free  interest rate     |       | 4.64                                         | %          | 4.55 | % |
| Expected dividend  yield     |       | —                                       |       | — |   |
| Expected  volatility         |       | 57.50                                        | %          | 85.00 | % |
| Weighted average  volatility |       | 57.50                                        | %          | 85.00 | % |
| Expected life (years)        |       | 4.5                                          |       | 4.5 |   |

 

Based on the above assumptions, the weighted averagefair value of stock options granted during the three months ended March 31,2007 and 2006 was $3.83 and $3.31, 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  March 31,** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|
| ** **                   | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Risk-free  interest rate     |       | 3.59%–5.10                                  | %          | 1.8%–4.8 | % |
| Expected dividend  yield     |       | —                                           |       | — |   |
| Expected  volatility         |       | 50.77%-79.12                                     | %          | 56.0%-126.0 | % |
| Weighted average  volatility |       | 57.50                                            | %          | 85.5 | % |
| Expected life (years)        |       | 0.5–2.0                                     |       | 0.5–2.0 |   |

 

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 three months ended March 31, 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                                              |       | 1,412,895  |       |                       | $          | 7.47                                       |       |                                                                 |       |                                                     |       |   |   |   |   |   |
| Exercised                                            |       | —     |       |                       | —     |                                       |       |                                                                 |       |                                                     |       |   |   |   |   |
| Canceled                                             |       | (89,933    | )          |                       | $          | 4.90                                       |       |                                                                 |       |                                                     |       |   |   |   |   |   |
| Outstanding at  March 31, 2007                  |       | 40,523,739 |       |                       | $          | 4.87                                       |       |                                                                 |       | 6.41                                                     |       |   |   | $ | 136,062 |   |   |
| Vested or  expected to vest at   March 31, 2007 |       | 39,895,365 |       |                       | $          | 4.86                                       |       |                                                                 |       | 6.36                                                     |       |   |   | $ | 134,398 |   |   |
| Exercisable at  March 31, 2007                  |       | 33,604,806 |       |                       | $          | 4.78                                       |       |                                                                 |       | 5.87                                                     |       |   |   | $ | 116,877 |   |   |

 

The total intrinsic value of options exercised duringthe three months ended March 31, 2006 was $2.1 million. There were nooptions exercised during the three months ended March 31, 2007. The totalfair value of options vested during the three months ended March 31, 2007and 2006 was $6.1 million and $1.7 million, respectively.

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, as more fully describedin Note 2, “Restatement of Consolidated Financial Statements,” 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. For more information, refer to Note 2, “Restatement ofConsolidated Financial Statements.”  TheCompany’s agreement with its directors and executive officers resulted in additionalstock-based compensation expense of approximately $1.2 million in the Company’sconsolidated 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. During the fourth quarter of 2006 and the first quarterof 2007, the Company extended the contractual terms of approximately 756,000and 833,000 vested stock options, respectively, held by former executives andother former employees. The Company accounted for the modifications to extendthe contractual term of the awards for former executives and other formeremployees in accordance with SFAS 123R. Based on the guidance in SFAS 123R andrelated FASB Staff Positions, after the modification those stock options heldby former executives and other former employees became subject to theprovisions of other applicable GAAP. Specifically, based on the provisions ofEITF 00-19, certain of those stock option awards were reclassifiedas current liabilities. Therefore, at the end of each reporting period theCompany will determine the fair value of those awards utilizing theBlack-Scholes valuation model and will recognize any change in fair value inthe Company’s consolidated statement of operations in the period of change untilthe awards are exercised, expire, or are otherwise settled. As a result of themodification, the Company recorded additional stock-based compensation ofapproximately $2.1 million in the fourth quarter of 2006 and $3.6 million inthe first quarter of 2007. The Company also recorded an aggregate fair value ofapproximately $1.1 million and $2.6 million in current liabilities as of December 31,2006 and March 31, 2007, respectively. The Company recorded Other expenseof approximately $39,000 in the fourth quarter of 2006 and approximately $0.7million in the first quarter of 2007 as a result of changes in the fair valueof 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 thecontractual term of the awards for current employees in accordance with SFAS123R. As a result of the modification, the Company recorded additionalstock-based compensation of approximately $0.8 million in the first quarter of2007.

The Company was not able to issue shares under theESPP as scheduled on February 28, 2007, delaying the issuance of sharesuntil after it became current in it SEC reporting obligations. The Company alsodelayed the commencement of the next scheduled ESPP purchase period fromMarch 1, 2007 to April 1, 2007. The modifications to the ESPPresulted in additional stock-based compensation expense beginning in the firstquarter of 2007 of approximately $1.2 million, with additional stock-basedcompensation expense of approximately $1.7 million to be recorded over theremaining ESPP purchase period of the modifications.

Theactivity related to the Company’s outstanding restricted stock awards for thethree months ended March 31, 2007 is as follows:

| ** **                                   | ** ** | **Shares** | ** ** | **Weighted Average  Grant-date  Fair Value** | ** ** |
|----------------------------------------------|------------|------------|------------|--------------------------------------------------------|------------|
| Nonvested balance  at December 31, 2006 |       | 330,000    |       |                                                   | $          | 4.60 |   |   |
| Granted                                      |       | —     |       |                                                   | —     |   |   |
| Vested                                       |       | —     |       |                                                   | —     |   |   |
| Nonvested balance at  March 31, 2007    |       | 330,000    |       |                                                   | $          | 4.60 |   |   |

 

There were no shares of restricted common stockissued, repurchased or forfeited during the three months ended March 31,2007 and 2006.

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

Sonus’comprehensive income (loss) for the three months ended March 31, 2007 and2006 is as follows (in thousands):

| ** **                                | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                | ** ** | ** **                                       | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Net income (loss)                         |       | $                                                | (3,978     | ) |   | $ | 5,816 |   |   |
| Foreign currency  translation adjustments |       | 61                                               |       |   | 6 |   |   |
| Comprehensive income  (loss)              |       | $                                                | (3,917     | ) |   | $ | 5,822 |   |   |

 

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

Operating segmentsare identified 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.

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

Net income (loss) per share is computed in accordancewith SFAS No. 128, *Earnings per Share*.Basic net income (loss) per share is computed by dividing net income (loss) bythe weighted average number of 

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shares of common stockoutstanding during the period. For periods in which the Company reports netincome, diluted net income per share is determined by using the weightedaverage number of common and dilutive common equivalent shares outstanding duringthe period unless the effect is antidilutive. Potential dilutive common sharesconsist of common stock issuable upon the exercise of stock options andpurchases of common shares under the Company’s ESPP using the treasury stockmethod.

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

| ** **                                        | ** ** | **Three months ended  March 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                        | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                        | ** ** | ** **                                       | ** ** | **(As Restated,  See Note 2)** | ** ** |
| Weighted average  shares outstanding—basic   |       | 259,768                                          |       |   | 250,064 |   |   |
| Potential dilutive  common shares                 |       | —                                           |       |   | 4,527 |   |   |
| Weighted average shares  outstanding—diluted |       | 259,768                                          |       |   | 254,591 |   |   |

 

The calculationabove for the three months ended March 31, 2006 excludes options topurchase shares of common stock and shares of common stock issuable uponconversion of a convertible subordinated note aggregating 20,412,837 shares, astheir effect would be antidilutive.

***(p)   Warranty Reserve***

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

In addition,certain of Sonus’ customer contracts include provisions under which Sonus maybe obligated to pay penalties generally for the contractual period or for thelife of the product if Sonus’ products fail or do not perform in accordancewith specifications. Sonus accrues for such contingent obligations when theoccurrence of such obligation is probable and the amount of such obligation isreasonably estimable. Sonus has not incurred significant costs related to suchprovisions. Sonus periodically assesses the adequacy of its recorded warrantyliabilities and adjusts the amounts as necessary. At both March 31, 2007and December 31, 2006, Sonus had $45,000 of warranty reserves recorded.

***(q)   Income Taxes***

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 accountingfor uncertainty in income taxes recognized in a company’s financial statementsin accordance with FASB Statement No. 109, *Accountingfor Income Taxes*. FIN 48 prescribes a two-step process todetermine the amount of tax benefit to be recognized. First, the tax positionmust be evaluated to determine the likelihood that it will be sustained uponexternal examination. If the tax position is deemed more-likely-than-not to besustained, the tax position is then assessed to determine the amount of benefitto recognize in the financial statements. The 

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amount of the benefit thatmay be recognized is the largest amount that has a greater than 50% likelihoodof 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 taxbenefits, which was accounted for as an increase to the accumulated deficit. Inaddition, the Company has $7.1 million of federal and state unrecognized taxbenefits consisting 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 March 31,2007, the total amount of accrued interest and penalties was $34,000. TheCompany accounts for interest and penalties related to uncertain tax positionsas part of its provision for federal and state income taxes.

The Company and itssubsidiaries file income tax returns in the U.S. federal jurisdiction, as wellas various states and foreign jurisdictions. Generally, the tax years 2003through 2006 remain open to examination by the major taxing jurisdictions towhich we are subject. The Company’s federal net operating losses generatedprior to 2003 could be adjusted on examination even though the year in whichthe loss was generated is otherwise closed by the statute of limitations. In2006, the Massachusetts Department of Revenue (“Mass. DOR”) commenced anexamination of the Company’s Massachusetts state income tax returns for 2002and 2003. We extended the statute for the 2002 tax year to allow for additionaltime to complete this audit. As of March 31, 2007, the Mass. DOR had notproposed any significant adjustments to the Company’s tax positions.

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

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS 159”). SFAS 159 permits an entity tomeasure certain financial assets and financial liabilities at fair value. UnderSFAS 159, entities that elect the fair value option will report unrealizedgains and losses in earnings at each subsequent reporting date. The fair valueoption may be elected on an instrument-by-instrument basis, with a fewexceptions, as long as it is applied to the instrument in its entirety. SFAS159 establishes presentation and disclosure requirements, but does 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.

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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 misstatements and insteadelect to record a cumulative-effect adjustment. Sonus applied the provisions ofSAB 108 in the quarter ended March 31, 2007. The application of SAB 108 hadno impact on the Company’s consolidated results of operations or financialcondition.

**(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 by March 31,2007.

Thefollowing table summarizes the activity related to this initiative during thethree months ended March 31, 2007 (in thousands):

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

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2006, the court held ahearing on a motion to approve the final settlement and took the matter underadvisement. On December 5, 2006, the Court of Appeals for the SecondCircuit reversed the court’s October 2004 order certifying a class. OnJune 25, 2007, the Court entered an order terminating the settlement. Accordingly,the Company is unable to determine the ultimate outcome or potential range ofloss, if any.

Beginning in July 2002, several purchasers of theCompany’s common stock filed complaints in the United States District Court forthe District of Massachusetts against Sonus, certain officers and directors anda former officer under Sections 10(b) and 20(a) and Rule 10b-5of the Exchange Act (the “Class Action Complaints”). The purchasers seekto represent a class of persons who purchased the Company’s common stockbetween December 11, 2000 and January 16, 2002, and seek unspecifiedmonetary damages. The Class Action Complaints were essentially identicaland alleged that Sonus made false and misleading statements about its productsand business. On March 3, 2003, the plaintiffs filed a ConsolidatedAmended Complaint. On April 22, 2003, 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 lead plaintiff.The lead plaintiff has filed an Amended Consolidated Complaint. The defendantsfiled on April 19, 2007 a motion to dismiss the Amended ConsolidatedComplaint. There is no assurance Sonus will prevail in such a motion ordefending this action. A judgment or a settlement of the claims against thedefendants could have a material impact on the Company’s financial results. Itis too early to determine the ultimate outcome or potential range of loss, ifany.

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

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plaintiff to file anamended complaint. The plaintiff filed an amended complaint that included thesame claims and substantially similar allegations as set forth in the initialcomplaint. On September 12, 2005, the defendants filed motions to dismissthis amended complaint. On December 10, 2005, the court held a hearing onthe motions and took the matter under advisement. On May 10, 2006, thecourt issued an order granting the defendants’ motions in part and denying themotions in part. The court dismissed the Section 12(a)(2) claimsagainst all the defendants and the Section 10(b) and Section 11claims against the individual defendants. The court denied the motions as tothe Section 10(b) and Section 11 claims against Sonus and Section 15claims against the individual defendants. The plaintiff has filed a motion forclass certification, which the defendants have opposed. The court held ahearing on February 28, 2007 on plaintiff’s motion for class certificationand took the matter under advisement. The Company believes that it hassubstantial legal and factual defenses to the claims, which it intends topursue vigorously. Sonus expects to incur significant legal fees in defendingthis action. At this time, Sonus is unable to determine the ultimate outcome orpotential range of loss, if any.

In February 2004, three purported shareholderderivative lawsuits were filed in the United States District Court for theDistrict of Massachusetts against Sonus and certain of its officers and directors,naming Sonus 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 Sonus andcertain of its directors and officers, also naming Sonus as a nominal defendant.The suits claim that certain of Sonus’ officers and directors breached theirfiduciary duties to the Company’s stockholders and to the Company. Thecomplaints 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. On September 27,2004, the state court granted Sonus’ motion to dismiss. On October 26,2004, the plaintiffs filed a notice appealing the state court’s dismissal ofthe actions. On June 24, 2005, the plaintiffs withdrew the appeal 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. Sonus does not expect that thisclaim will have a material impact on its financial statements.

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

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On June 14, 2006, C2 Communications sued AT&T, Inc.,Verizon Communications, Inc., Qwest, Bellsouth 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.”  Sonus has 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 Sonus. There can be no assurance that other defendants who have purchasedSonus products will not seek indemnification from Sonus. The court issued ascheduling order with a trial date of August 4, 2008. Sonus believes thatthe defendants have substantial legal and factual defenses to the infringementclaim, which the Company intends to pursue vigorously on behalf of thedefendants for whom Sonus agrees or is required to assume defense of thelitigation. However, there is no assurance any of the defendants will prevailin defending this action. There also can be no assurance that Sonus will not berequired to indemnify any of the defendants from any judgment of infringementrendered against them. Sonus may be required to devote significant time andresources in connection with assuming the defense of the claim of infringementon behalf of the defendants for whom Sonus has agreed to assume defense of thelitigation. An adverse outcome with respect to the claim and Sonus’indemnification could have a material adverse impact on Sonus’ business,operating results and financial condition. Sonus cannot predict the ultimateoutcome of this litigation or any potential impact on the Company’s operatingresults or financial position.

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

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

As announced on March 19, 2007, the SEC isconducting a formal private investigation into Sonus’ historical stock optiongranting practices. If the Company is subject to adverse findings, it could be 

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required to pay damages orpenalties or have other remedies imposed, including criminal penalties, whichcould adversely Sonus’ business, financial position or results of operations.

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

TheInternal Revenue Service has notified the Company that its payroll tax returnsfor the years ended December 31, 2004, 2005 and 2006 have been selectedfor audit in connection with its stock option review. In connection with therestatement of its financial statements, Sonus has recorded approximately $1.6million of accruals for additional tax, penalties and interest related toadjustments resulting from errors in stock option accounting. For moreinformation about stock-based compensation, including the financial statementimpact from the restatement, see Note 2, “Restatement of Consolidated FinancialStatements” and Note 3, “Summary of Significant Accounting Policies” item (1) “Stock-basedCompensation” of the Notes to Condensed Consolidated Financial Statementsincluded in this Quarterly Report on Form 10-Q. 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.

**(6) SubsequentEvents**

On April 13, 2007, Sonus completed theacquisition of Zynetix Limited (“Zynetix”), a privately-held designer ofinnovative Global System for Mobile Communications (“GSM”) infrastructuresolutions located in the United Kingdom. In consideration, Sonus paid theselling shareholders £3,000,000 on the acquisition date (U.S. $5.9 millionas of the acquisition date) and £1,330,583 on June 11, 2007 (U.S. $2.6million as of June 11, 2007). The Share Purchase Agreement also 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 Sonus common stock deliverable on April 30,2009, contingent upon the business achieving certain predetermined financialand business metrics.

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

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

The following informationhas been adjusted to reflect the restatement of the our financial results,which is more fully described in the “Explanatory Note” preceding Part I,Item 1 and in Note 2, “Restatement of Consolidated Financial Statements”in Notes to Condensed Consolidated Financial Statements of this Form 10-Q.The net of tax impact of the restatement on our results of operations amountedto $0.1 million of additional net income for the three months ended March 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 March 31,2007, we had an accumulated deficit of $732.3 million. Although we achievedprofitability on an annual basis in fiscal years 2006 and 2005, we incurred netlosses for the first and third quarters of fiscal 2005 and in the first quarterof 2007 and may incur additional losses in future quarters and years. We have alengthy sales cycle for our products and, accordingly, we expect to incur salesand other expenses before we realize the 

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relatedrevenues. We expect to continue to incur significant sales and marketing,research and development and general and administrative expenses, many of whichare fixed prior to the beginning of any particular fiscal period and, as aresult, we will need to generate significant revenues to maintainprofitability.

**Recent Developments**

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

**Stock-BasedCompensation**

On January 1, 2006, we adopted Statement ofFinancial Accounting Standards (“SFAS”) No. 123R, *Share-BasedPayment* (“SFAS 123R”). SFAS 123R supersedes APB Opinion 25 (“APB 25”),*Accounting for Stock Issued to Employees,*and provided the required disclosures in accordance with SFAS No. 123, *Accounting for Stock-Based Compensation* (“SFAS 123”). Intransitioning to SFAS 123R, we used the proscribed modified prospectivetransition method. Accordingly, periods prior to adoption have not beenrestated to conform to SFAS 123R and are not directly comparable to periodsafter adoption.

Underthe modified prospective transition method, the unrecognized expense of awardsnot yet vested at the date of adoption shall be recognized in net income in theperiods after the date of adoption using the same valuation method,Black-Scholes, and assumptions determined under the original provisions of SFAS123. We recorded $8.9 millionand $2.3 million of stock-based compensation in the Condensed Consolidated Statementsof Operations for the three months ended March 31, 2007 and 2006,respectively. These amounts are included in the following expense categories(in thousands):

| ** **                  | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Product cost of  revenue    |       | $                                                | 90         |   | $ | 15 |   |
| Service cost of  revenue    |       | 582                                              |       | 283 |   |
| Research and  development   |       | 3,209                                            |       | 787 |   |
| Sales and  marketing        |       | 3,522                                            |       | 512 |   |
| General and  administrative |       | 1,466                                            |       | 702 |   |
|                        |       | $                                                | 8,869      |   | $ | 2,299 |   |

 

In addition, we included in inventory approximately$277,000 of stock-based compensation at March 31, 2007.

The recording of stock-based compensation expense forthe three months ended March 31, 2007 in the Condensed Consolidated Statementsof Operations adversely impacted net income by $8.9 million, and adverselyimpacted basic and diluted earnings per share by $0.03. The recording ofstock-based compensation expense for the three months ended March 31, 2006in the Condensed Consolidated Statements of Operations resulted in a decreaseto net income of $2.3 million and a decrease to basic and diluted earnings pershare of $0.01.

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At March 31, 2007, there was $19.6 million ofunrecognized compensation cost related to share-based awards, which is expectedto be recognized over a weighted average period of three years.

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

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, as more fully describedin Note 2, “Restatement of Consolidated Financial Statements,” weentered into agreements with our directors and executives who are designated asSection 16 filers with the Securities and Exchange Commission. For moreinformation, refer to Note 2, “Restatement of Consolidated Financial Statements.”  Our agreement with our directors andexecutives resulted in additional stock-based compensation expense ofapproximately $1.2 million in the Company’s consolidated financial statementsin the first quarter of 2007.

Our registration statements on Form S-8were unavailable for use during a portion of fiscal 2006 and 2007. As a result,during the fourth quarter of 2006 and first quarter of 2007, approximately756,000 and 833,000 of such options held by departing former executives andformer other employees, respectively, due to expire were extended. For modificationsof stock options subsequent to the departure of former employees, they wereinitially recorded as stock-based compensation expense in accordance with FAS 123R.Subsequently, the options were reclassified to current liabilities under theprovisions of Emerging Issues Task Force (“EITF”) Issue No. 00-19, *Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock* (“EITF 00-19”). UnderEITF 00-19, changes in fair value calculated at the end of each reportingperiod until final settlement using the Black-Scholes valuation model areexpensed in the Company’s consolidated statement of operations in the period ofchange. The Company recorded additional stock-based compensation ofapproximately $3.6 million in the first quarter of 2007 associated withmodifications of stock options and recorded approximately $0.7 million of Otherexpense as a result of changes in the fair value of the liability awards. Anychanges to the fair values of these options in future periods until settlementwill be expensed in the Company’s consolidated statement of operations in theperiod of change.

In addition to the stock option modifications, theCompany was not able to issue shares under the ESPP as scheduled on February 28,2007, delaying the issuance of shares until after it became current in it SECreporting obligations. In addition, the Company delayed the commencement of thenext scheduled ESPP period from March 1, 2007 to April 1, 2007. Themodifications to the ESPP resulted in additional stock-based compensationexpense beginning in the first quarter of 2007 of approximately $1.2 million,with additional stock-based compensation expense of approximately $1.7 millionto be recorded over the remaining service period of the modifications.

For more information aboutstock-based compensation, including the financial statement impact from therestatement, see “Explanatory Note” preceding Part I, Item 1, Note 2,“Restatement of Consolidated Financial Statements” and Note 3, “Summary ofSignificant Accounting Policies”, Item 1, Stock-based 

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Compensationin the Notes to the Condensed Consolidated Financial Statements of this Form 10-Qand “Critical Accounting Policies” below.

**Critical AccountingPolicies and Estimates**

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

·       Revenuerecognition;

·       Deferredrevenue;

·       Allowancefor doubtful accounts;

·       Inventoryreserves;

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

·       Stock-basedcompensation; and

·       Accountingfor income taxes.

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

Many of our sales involve complex contractual, multiple-elementarrangements. When a sale includes multiple elements, such as products,maintenance and/or professional services, we recognize revenue using theresidual method as we have not established VSOE of fair value for our productsor specified features/upgrades. Revenue associated with undelivered elementsthat are not considered essential to the functionality of the product and forwhich VSOE of fair value has been established, is deferred based on the VSOE offair 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 pricingauthority. The Company’s Pricing Committee has the relevant authority forestablishing pricing for products and services. If we cannot establish VSOE offair value for any undelivered element, including specified features andupgrades, we defer revenue on the entire arrangement until VSOE of fair valuefor all undelivered elements is known or all elements are delivered and allother revenue recognition criteria are met.

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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 is acceptedby 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.

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.

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

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

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

***Loss Contingenciesand Reserves.******  ***We are subject to ongoing businessrisks arising in the ordinary course of business that affect the estimationprocess of the carrying value of assets, the recording of liabilities and thepossibility of various loss contingencies. Under SFAS No. 5, *Accounting for Contingencies*, 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.*****  **Prior toJanuary 1, 2006, we accounted for all of employee and non-employeedirector stock-based compensation awards using the intrinsic value method underAccounting Principles Board Opinion No. 25, *Accounting for StockIssued to Employees* (“APB 25”), and provided the requireddisclosures in accordance with SFAS 123. On January 1, 2006, we adoptedSFAS 123R, using the modified prospective transition method. We account for allstock-based compensation awards to consultants and other non-employees inaccordance with the Financial Accounting Standards Board (“FASB”) EmergingIssues 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,*inthe recognition of stock-based compensation expense measured under APB 25(prior to January 1, 2006) and the straight-line method in the recognitionof stock-based compensation expense under SFAS 123 (prior to January 1,2006) and SFAS 123R (subsequent to December 31, 2005). Under both APB 25and SFAS 123R, the requisite service period over which stock-based compensationis expensed generally equals the vesting periods of the awards.

Under SFAS 123R, our stock-based compensation isaffected by our stock price as well as valuation assumptions, including thevolatility of our stock price, expected term of the option, risk-free interestrate and expected dividends. We utilize the Black-Scholes valuation model forestimating the fair value on the date of grant of employee stock options. Prior to January 1, 2006, we used historicalvolatility to estimate the grant-date fair value of stock options. Starting on January 1,2006, we changed our method to a combination of historical and impliedvolatility. We believe that a combination of historical and implied volatilityresults in a more accurate estimate of the grant-date fair value of employeestock options because it more appropriately reflects the market’s expectationsof future volatility. Historical volatility during the period associated withthe expected term of our stock options over the past few years included aperiod of time 

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duringor subsequent to our initial public offering when our stock price experiencedabnormally high volatility levels, which we believe is unlikely to be indicativeof future stock price behavior. However, we have not placed sole reliance onimplied volatility as options in our common stock that are actively traded onthe open market generally have a term of two years or less - substantiallyshorter than our stock option’s expected term.

In connection with the restatement of our consolidatedfinancial statements, we determined that during the period from May 2000through December 31, 2005, the Company i) applied incorrect measurementdates in the accounting for certain stock options and ii) incorrectly accountedfor certain stock options that should have been recorded using variableaccounting. The correction of these errors related to stock option accountingresulted in additional cumulative stock-based compensation charges ofapproximately $54.1 million from 2000 through 2005.

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

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

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

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

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

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

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

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

Measurement dates for approximately 6% of the totalnumber of grants were determined based on the next date that the twoCompensation Committee members were physically present at a 

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Board-level meeting and approximately 15% when atleast 90% of the stock option grant was entered into the Company’s stock optionadministration system.

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

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

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

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

 

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The additional (less)cumulative stock-based compensation by year from 2000 through 2005 undercategories two, three and four of our framework based upon the low, average andhigh closing prices during those periods is as follows (in millions):

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

 

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

 

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

 

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

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

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

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

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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 tobe recognized, 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 Months Ended March 31, 2007 and 2006***

***Revenue.******  ***Revenue forthe three months ended March 31, 2007 and 2006 was as follows (inthousands):

| ** **     | ** ** | **Three months ended  March 31,** | ** ** |
|----------------|------------|--------------------------------------------------|------------|
| ** **     | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Product        |       | $                                                | 51,627     |   | $ | 44,542 |   |
| Service        |       | 19,519                                           |       | 15,453 |   |
| Total revenues |       | $                                                | 71,146     |   | $ | 59,995 |   |

 

Product revenue is comprised of sales of our voiceinfrastructure products, including our GSX9000Ôand GSX4000ÔOpenServices Switches, PSX Call Routing Server, SGX Signaling Gateway, ASX FeatureServer, the Sonus InsightÔ Management Systemand related product offerings. Product revenue for the three months ended March 31,2007 increased 15.9%, from the comparable prior year period. The increase inproduct revenue 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 26.3% in the three monthsended March 31, 2007, compared to the same prior year period. The increasein the current year period was primarily the result of higher maintenance,installation and resident engineering revenue.

AT&T (including AT&T, Bellsouth and CingularWireless in fiscal 2007), Level 3, Global Crossing and Qwest CommunicationsInternational, Inc. each contributed more than 10% of our revenue in atleast one of the three month periods ended March 31, 2007 and 2006.

International revenue was approximately 17% and 23% ofrevenue for the three months ended March 31, 2007 and 2006, respectively. Weexpect that international revenue will remain uneven as a percentage of revenuefrom quarter to quarter.

Our deferred product revenue was $31.4 million and $32.7million at March 31, 2007 and December 31, 2006, respectively. Ourdeferred service revenue was $59.2 million and $61.5 million at 

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March 31, 2007 and December 31,2006, respectively. Our deferred revenue balance may fluctuate as a result ofthe timing of revenue recognition, customer payments, maintenance contractrenewals, contractual billing rights, customer creditworthiness and maintenancerevenue deferrals included in multiple element arrangements. At March 31,2007 and December 31, 2006, deferred revenue and accounts receivableexcluded $16.9 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.

***Cost of Revenue/Gross Profit.******  ***Our cost ofrevenue consists primarily of amounts paid to third-party manufacturersfor purchased materials and services, royalties, manufacturing and professionalservices personnel and related costs and inventory obsolescence. Cost ofrevenue and gross profit as a percentage of revenue for the three months ended March 31,2007 and 2006 were as follows (in thousands, except percentages):

| ** **                                     | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                     | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Cost of revenue                                |       |                                             |       |   |   |
| Product                                        |       | $                                                | 17,082     |   | $ | 15,883 |   |
| Service                                        |       | 8,579                                            |       | 6,729 |   |
| Total cost of revenue                          |       | $                                                | 25,661     |   | $ | 22,612 |   |
| Gross profit margin (%  of respective revenue) |       |                                             |       |   |   |
| Product                                        |       | 66.9                                             | %          | 64.3 | % |
| Service                                        |       | 56.0                                             | %          | 56.5 | % |
| Total gross  profit margin                     |       | 63.9                                             | %          | 62.3 | % |

 

The increase in product gross profit as a percentageof revenue was primarily due to customer and product mix. Our product grossprofit remained higher than our long-term financial model of 58% to 62%. We canprovide no assurance that this favorable customer and product mix willcontinue, and we expect that over time our gross margins will return to levelsconsistent with our long-term financial model. The decrease in service grossprofit as a percentage of service revenue was primarily due to increasedinvestment in our service organization to support the expansion of ourinstalled base and higher stock-based compensation. Our service cost of revenueis relatively fixed in advance of any particular quarter and, therefore,changes in service revenue will have a significant impact on service grossprofit 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 $18.7 million for the threemonths ended March 31, 2007, an increase of $5.6 million, or 43.0%, from$13.1 million for the same period in fiscal 2006. This increase primarilyreflects an increase in salary and related expenses associated with increasedheadcount and stock-based compensation. Some aspects of our research anddevelopment efforts require significant short-term expenditures, the timing ofwhich can cause significant variability in our expenses. We believe that rapidtechnological innovation is critical to our long-term success, and we intend tocontinue to make substantial investments to enhance our products andtechnologies to meet the requirements of our customers and market.

***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 $23.1 millionfor the three months ended March 30, 2007, an increase of $9.1 million, or64.3%, from $14.0 million for the same period in fiscal 2006. Thisincrease primarily reflects an increase in salaries, commissions and travelexpenses associated with increased headcount related to the expansion of our 

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worldwide sales andsupport coverage and higher sales levels, stock-based compensation expense andevaluation equipment expenses.

***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 $14.1 million for the three months ended March 31,2007, an increase of $7.1 million, or 101.5%, from $7.0 million for thesame period in fiscal 2006. The increase primarily reflects higher professionalfees, including $4.2 million of professional fees and other costs associatedwith our stock option review and resulting restatement, stock compensationexpense and salary and related expenses associated with increased headcount,partially offset by a decrease in directors and officers insurance premiums.

***Interest Income,net.******  ***Interest income consists of interestearned on our cash equivalents, marketable debt securities and long-terminvestments. Interest expense consists of interest incurred on a convertiblesubordinated note and capital lease obligations. Interest income, net ofinterest expense, was $4.6 million for the three months ended March 31,2007, compared to $3.3 million for the same period in fiscal 2006. Thisincrease is primarily attributable to higher balances available for investmentand higher interest rates on our invested funds.

***Other Expense.******  ***We recorded $0.7 million ofexpense in the three months ended March 31, 2007, to reflect the change infair value of stock options modified to extend their expiration datessubsequent to the departure of the former employees who are the optioneesaffected.

***Income Taxes.******  ***Weprovide for income taxes during interim periods based on the estimatedeffective tax rate for the full fiscal year, and record a cumulative adjustmentto the tax provision in an interim period in which a change in the estimatedannual effective tax rate is determined. Our effective tax rate, includingdiscrete items, was 37.7% for the three months ended March 31, 2007, and 12.0%for the three months ended March 31, 2006. The income tax benefit of $2.5million for the three months ended March 31, 2007 primarily reflects acurrent benefit for federal, state and foreign taxes. The income tax provisionof $0.8 million for the three months ended March 31, 2006 reflects acurrent provision for federal, state and foreign taxes.

In the near term, weexpect our annual effective tax rate for the remaining quarters of 2007 toremain relatively consistent with the first quarter’s rate, excluding theeffect of discrete items recorded as a result of the adoption of SFAS 123R andFIN 48. The effective tax rate, including the discrete items, could be volatiledepending on the nature and timing of the dispositions of incentive stockoptions, the exercise of nonqualified stock options and the resolution ofuncertain 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 March 31, 2007, our principal sources ofliquidity were our cash, cash equivalents, marketable debt securities andlong-term investments that totaled $366.1 million.

Our operating activities provided $7.0 million of cashin the three months ended March 31, 2007, compared to $21.0 million in thesame prior year period. Cash provided by operating activities in the threemonths ended March 31, 2007 came from non-cash adjustments to our net lossfor stock-based compensation, deferred income taxes, depreciation andamortization of property and equipment and the increase in fair value ofmodified stock options held by former employees. These non-cash adjustments 

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were further benefitedfrom decreases in accounts receivable and other operating assets of $11.0million and $1.4 million, respectively, as well as $1.4 million of higheraccounts payable. These amounts were partially offset by decreases of $10.5million in accrued expenses, deferred rent and accrued restructuring expensesand $3.5 million in deferred revenue, coupled with $4.7 million of higherinventory levels. Cash provided by operating activities in the three monthsended March 31, 2006 came from net income, after adjustments for non-cashitems including depreciation and amortization, stock-based compensation andlosses on the disposal of property and equipment. Lower accounts receivable andinventory levels provided $39.0 million and $3.8 million, respectively, of cash.These amounts were partially offset by decreases of $19.9 million to deferredrevenue, $4.0 million to accounts payable and $3.6 million to accrued expenses,deferred rent and accrued restructuring expenses, coupled with a $4.8 millionincrease in other operating assets.

Our investing activities provided $2.3 million of cashin the three months ended March 31, 2007, primarily comprised of $4.0million of net maturities of marketable debt securities and long-terminvestments, partially offset by $1.7 million of investments in property andequipment. In the three months ended March 31, 2006, our net investment inmarketable debt securities and long-term investments was $131.4 million, and weused $2.3 million of cash to purchase property and equipment.

Our financing activities used $230,000 of cash in thethree months ended March 31, 2007, of which $189,000 was used to paywithholding obligations related to the net share settlement inDecember 2006 of a restricted stock award and $41,000 was used to paylong-term liabilities related to capital leases for office equipment. Due tothe ongoing stock option review and related restatement, we were unable toissue shares of our common stock through either the Employee Stock PurchasePlan (“ESPP”) or to allow any exercises of outstanding options to purchase ourcommon stock during the quarter. Our financing activities provided $7.1 millionof cash in the three months ended March 31, 2006, derived from theproceeds from the sale of common stock in connection with our ESPP and theexercise of stock options.

Based on our currentexpectations, we believe our current cash, cash equivalents, marketable debtsecurities and long-term investments will be sufficient to meet our anticipatedcash needs for working capital and capital expenditures for at 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 aremet. We are currently evaluating the impact of SFAS 159 on our consolidatedresults of operations and financial condition.

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In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements* (“SFAS 157”). SFAS157 provides a single definition of fair value, along with a framework formeasuring it, and requires additional disclosure about using fair value tomeasure assets and liabilities. SFAS 157 emphasizes that fair value measurementis market-based, not entity-specific, and establishes a fair value hierarchy inwhich the highest priority is quoted prices in active markets. Under SFAS 157,fair value measurements are disclosed according to their level within thishierarchy. While SFAS 157 does not add any new fair value measurements, it doeschange current practice in certain ways, including requiring entities toinclude their own credit standing when measuring their liabilities. SFAS 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years. We are currently evaluatingthe impact of SFAS 157 on our consolidated results of operations and financialcondition.

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

In June 2006, theFASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109*(“FIN 48”), which clarifies the accounting for uncertainty in income taxesrecognized in a company’s financial statements in accordance with FASBStatement No. 109, *Accounting for Income Taxes.*FIN 48 prescribes a two-step process to determine the amount of taxbenefit to be recognized. First, the tax position must be evaluated todetermine the likelihood that it will be sustained upon external examination. Ifthe tax position is deemed more-likely-than-not to be sustained, the taxposition is then assessed to determine the amount of benefit to recognize inthe financial statements. The amount of the benefit that may be recognized isthe largest amount that has a greater than 50% likelihood of being realizedupon ultimate settlement. We recorded an increase to the accumulated deficit of$0.1 million to reflect the cumulative 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 March 31,2007, 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. Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under 

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the Exchange Act is accumulatedand communicated to the company’s management, including its principal executiveand principal financial officers, as appropriate to allow timely decisionsregarding required disclosure.

In our *Management’sReport on Internal Control over Financial Reporting*filed with ourAnnual Report on Form 10-K for the year ended December 31,2006, we reported material weaknesses in our internal control over financialreporting (as defined in Rule 13a-15(f) under the Exchange Act).During the quarter ended March 31, 2007, we continued to designenhancements to our controls and implemented a limited number of changes toaddress the reported material weaknesses. As a result of these materialweaknesses, which were not remediated as of March 31, 2007, we have concludedthat our disclosure controls and procedures were not effective as of March 31,2007.

Public AccountingOversight Board Auditing Standard No. 2 defines a material weakness as asignificant deficiency, or combination of significant deficiencies, that resultsin there being more than a remote likelihood that a material misstatement ofthe annual or interim financial statements will not be prevented or detected.

**Changes in InternalControl over Financial Reporting**

During the fiscal quarter ended March 31, 2007,we made changes that have materially affected, or are reasonably likely tomaterially affect our internal control over financial reporting as follows:

***Inadequate revenuerecognition procedures and controls:***

·       Transferredthe Director of Internal Audit to Worldwide Sales Controller and hired anadditional Sales Controller;

·       Refinedour procedures for assessing vendor specific objective evidence of fair valueof the service elements of our customer arrangements on a quarterly basis;

·       Formallydocumented certain processes to ensure consistent understanding and applicationof our revenue recognition practices; and

·       Implementedcertain controls in our accounting system to help ensure the completeness ofall sales order records.

***Inadequatefinancial statement preparation and review procedures:***

·       Hireda new Director of Tax;

·       Beganthe implementation and testing of a new commission payment application systemto ensure the completeness, accuracy and proper financial statementpresentation of commission transactions in our general ledger and financialstatements;

·       Beganthe implementation and testing of new procedures for recording for property,plant and equipment to ensure that historical property, plant and equipmentrecords and the related accumulated depreciation are valid, complete andrecorded accurately;

·       Designeda new manual spreadsheet policy to ensure the integrity and control over keymanual spreadsheets is maintained; and

·       Hiredan External Reporting Manager, an Accounts Payable Supervisor, a BillingAccountant and a Staff Accountant to supplement the resources of the FinanceDepartment.

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***Inadequatepurchasing controls:***

·       Implemented a process totimely review and monitor vendor contract obligations to ensure all royalty,maintenance and support arrangements are properly understood, documented andaccurately recorded in the general ledger and financial statements; and

·       Continued to improve thecommunication process among the finance, customer service, manufacturing andlegal functions to ensure all pertinent information related to vendor contractobligations is identified and timely recorded in the financial statements.

***Inadequate controlsover the accounting for stock-based compensation:***

·       Hireda new Stock Option Administrator to enhance the effectiveness of the policies,procedures and controls related to stock option transactions; and

·       Formalized writtenprocedures for documenting, approving, granting and communicating stock-basedawards to employees, consultants and directors.

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

***Risks and Inherent Limitations***

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

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

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**PART II - OTHER INFORMATION**

**Item1. Legal Proceedings**

In November 2001, apurchaser of our common stock filed a complaint in the United States DistrictCourt for the Southern District of New York against us, two of our officers andthe lead underwriters alleging violations of the federal securities laws inconnection with our initial public offering (“IPO”) and seeking unspecifiedmonetary damages. The purchaser seeks to represent a class of persons whopurchased our common stock between the IPO on May 24, 2000 and December 6,2000. An amended complaint was filed in April 2002. The amended complaintalleges that our registration statement contained false or misleadinginformation or omitted to state material facts concerning the alleged receiptof undisclosed compensation by the underwriters and the existence ofundisclosed arrangements between the underwriters and certain purchasers tomake additional purchases in the after market. The claims against us areasserted under Section 10(b) of the Securities Exchange Act of 1934(the “Exchange Act”) and Section 11 of the Securities Act of 1933 andagainst the individual defendants under Sections 11 and 15 of the SecuritiesAct and Sections 10(b) and 20(a) of the Exchange Act. Otherplaintiffs have filed substantially similar class action cases againstapproximately 300 other publicly traded companies and their IPO underwriterswhich, along with the actions against us, have been transferred to a singlefederal 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 our common stock filed complaints in the United StatesDistrict Court for the District of Massachusetts against us, certain officersand directors and a former officer under Sections 10(b) and 20(a) andRule 10b-5 of the Exchange Act (the “Class Action Complaints”).The purchasers seek to represent a class of persons who purchased our commonstock between December 11, 2000 and January 16, 2002, and seekunspecified monetary damages. The Class Action Complaints were essentiallyidentical and alleged that we made false and misleading statements about ourproducts and business. On March 3, 2003, the plaintiffs filed aConsolidated Amended Complaint. On April 22, 2003, we filed a motion todismiss the Consolidated Amended Complaint on various grounds. On May 11,2004, the court held oral argument on the motion, at the conclusion of whichthe court denied our motion to dismiss. The plaintiffs filed a motion for classcertification on July 30, 2004. On February 16, 2005, the courtcertified the class and appointed a class representative. On March 9,2005, the court appointed 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 andrequiring the parties to submit a joint report informing the court whether thecases have been settled and whether defendants would be seeking to recoverattorney’s fees from the plaintiffs. On September 30, 2005, the plaintiffsfiled 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 our motion for recovery of attorneys’ fees.

On January 6, 2006, apurchaser of our common stock filed a complaint in the United States DistrictCourt for the District of Massachusetts that is essentially identical to theConsolidated Amended Complaint previously filed against the defendants. TheCourt has appointed the Public Employees’ Retirement System of Mississippi aslead plaintiff. The lead plaintiff has filed an Amended Consolidated Complaint.The defendants filed on April 19, 2007 a motion to dismiss the AmendedConsolidated Complaint. There is no assurance we will prevail in such a motionor defending this action. A judgment or a settlement of the claims against thedefendants could have a material impact on our financial results. It is tooearly to determine the ultimate outcome or potential range of loss, if any.

Beginning in February 2004,a number of purported shareholder class action complaints were filed in theUnited States District Court for the District of Massachusetts against us andcertain of our current officers and directors. On June 28, 2004, the courtconsolidated the claims. On December 1, 2004, the lead plaintiff filed aconsolidated amended complaint. The complaint asserts claims under the federalsecurities laws, specifically Sections 10(b) and 20(a) of theExchange Act and Sections 11, 12(a), and 15 of the Securities Act, relating toour restatement of our financial results for 2001, 2002, and the first three quartersof 2003. Specifically, the complaint alleges that we issued a series of falseor misleading statements to the market concerning our revenues, earnings, andfinancial condition. Plaintiffs contend that such statements caused our stockprice to be artificially inflated. The complaint seeks unspecified damages onbehalf of a purported class of purchasers of our common stock during the periodfrom March 28, 2002 through March 26, 2004. On January 28, 2005,we 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) andSection 11 claims against the individual defendants. The court denied themotions as to the Section 10(b) and Section 11 claims against usand Section 15 claims against the individual defendants. The plaintiff hasfiled a motion for class certification, which the defendants have opposed. Thecourt held a hearing on February 28, 2007 on plaintiff’s motion for classcertification and took the matter under advisement. We believe that we havesubstantial legal and factual defenses to the claims, which we intend to pursuevigorously. We expect to incur significant legal fees in defending this action.At this time, we are unable to determine the ultimate outcome or potentialrange 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 us and certain of ourofficers and directors, naming us 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 us and certain of our directors and officers, also naming us as anominal defendant. The suits claim that certain of our officers and directorsbreached their fiduciary duties to our stockholders and to us. The complaintsare derivative in nature and do not seek relief from us. However, we haveentered into indemnification agreements in the ordinary course of business withcertain of the defendant officers and directors and may 

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

In December 2004, apurchaser of our common stock filed a complaint in the circuit court in WillCounty, Illinois, against us, one of our officers, and a former officer allegingmisrepresentation and fraud in connection with the plaintiff’s purchase of ourstock. The complaint seeks unspecified damages. We filed a motion to dismissthe complaint. On May 5, 2005, the plaintiff filed an amended complaint. OnOctober 26, 2005, the court held a hearing on the motion during which itdismissed the federal claims without prejudice and dismissed the state claimswithout prejudice. On November 23, 2005, the plaintiff filed a secondamended complaint with essentially the same allegations as in the priorcomplaints. The defendants renewed their motions to dismiss with respect to thesecond amended complaint. On March 9, 2006, the court held a hearing onthe defendants’ motions during which the court entered an order dismissing thesecond amended complaint with prejudice. On April 17, 2006, the plaintifffiled a notice of appeal of the dismissal order. In order to avoid the costs ofan appeal, we agreed to settle the matter for a de minimus amount. On June 23,2006, the court entered an order dismissing the case.

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.” We have agreed, subject to certain conditions, to assume thedefense of Qwest, Global Crossing and Level 3 in this litigation to the extentthe claim results from their use of products purchased from us. There can be noassurance that other defendants who have purchased our products will not seekindemnification from us. The court issued a scheduling order with a trial dateof August 4, 2008. We believe that the defendants have substantial legaland factual defenses to the infringement claim, which we intend to pursuevigorously on behalf of the defendant for whom we agree or are required toassume defense of the litigation. However, there is no assurance any of thedefendants will prevail in defending this action. There also can be noassurance that we will not be required to indemnify any of the defendants fromany judgment of infringement rendered against them. We 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 shareholder derivative lawsuit was filed in the United DistrictCourt for the District of Massachusetts against us and certain of our officersand directors, naming us as a nominal defendant. Other purported shareholdersfiled virtually identical complaints. The suits claim that certain of ourofficers and directors breached their fiduciary duties to our stockholders andto us in connection with our announced stock option review. The complaints arederivative in nature and do not 

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

On January 19, 2007,a purported shareholder derivative lawsuit was filed in the Superior CourtDepartment of Middlesex County of Massachusetts against certain of ourdirectors and officers, also naming us 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 Courtscheduled a hearing on the motion for August 14, 2007. We believe that wehave substantial legal and factual defenses to the derivative claims, which weintend to pursue vigorously. There is no assurance we will prevail in defendingthese actions. We cannot predict the ultimate outcome of this litigation or anypotential impact on our results of operations or financial position.

As announced on March 19,2007, the SEC is conducting a formal private investigation into our historicalstock option granting practices. If we are subject to adverse findings, wecould be required to pay damages or penalties or have other remedies imposed,including criminal penalties, which could adversely our business, financialposition or results of operations.

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

The Internal Revenue Servicehas 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. For more information about stock-based compensation,including the financial statement impact from the restatement, see Note 2, “Restatementof Consolidated Financial Statements” and Note 3, “Summary of SignificantAccounting Policies” item (1) “Stock-based Compensation” of the Notes toCondensed Consolidated Financial Statements included in this Quarterly Reporton Form 10-Q. We could be required to pay additional tax, penaltiesor interest, or have other remedies imposed, which could adversely impact ourbusiness, financial position or results of operations.

**Item1A. Risk Factors**

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

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

Our internal review andour Audit Committee’s investigation into our historical stock option practicesand accounting have required us to incur substantial expenses for legal,accounting, tax and other professional services, have diverted management’sattention from our business, and could in the future harm our business,financial condition and results of operations.

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

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

Our historical stockoption granting practices and the restatement of our financial statements haveexposed us to greater risks associated with litigation, regulatory proceedingsand government enforcement action. For more information regarding our currentlitigation and related inquiries, please see Part I, Item 3 “LegalProceedings” as well as the other risk factors related to litigation set forthin this section. We have provided the results of our internal review 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, regulatory proceedingsor government enforcement actions relating to our past stock option practices. Theresolution of these matters will be time-consuming, expensive, and may distractmanagement from the conduct of our business. Furthermore, if we are subject toadverse findings in litigation, regulatory proceedings or governmentenforcement actions, we could be required to pay damages or penalties or haveother remedies imposed, which could harm our business, financial condition,results of operations and cash flows.

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

Through, in part, thedocumentation, testing and assessment of our internal control over financialreporting pursuant to the rules promulgated by the SEC under Section 404of the Sarbanes-Oxley Act of 2002 and Item 308 of Regulation S-K, Managementhas concluded that our disclosure controls and procedures and our internalcontrol over financial reporting had material weaknesses as of December 31,2006. 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.

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***Failure or circumvention of our controls andprocedures could 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 have a materialadverse effect on 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 may require significant attention andresources of management. Regardless of the outcome, such litigation will resultin significant legal expenses. If our defenses are ultimately unsuccessful, orif we are unable to achieve a favorable settlement, we could be liable forlarge damage awards that could have a material adverse effect on our business,results of operations and financial position.

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

***The limitations 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 August 2, 2008 and wehave lost our status as a “well known seasoned issuer,” including theregistration advantages associated with such status. These restrictions mayimpair our ability to raise capital in the public markets should we desire todo so, and to attract and retain key employees.

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***Our common 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 this Quarterly Report on Form 10-Qfor the quarter ended March 31, 2007 (the “First Quarter Form 10”)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 could befurther delays in filing subsequent SEC reports or other actions that mightresult in the delisting of our common stock from the NASDAQ Global SelectMarket.

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

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

***Recent 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 employee

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

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

***We expect that 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 have shipped our products to a limitednumber of customers. We expect that in the foreseeable future, the majority ofour revenues will continue to depend on sales of our products to a limitednumber of customers. Three customers each contributed more than 10% of ourrevenues in fiscal 2006, or approximately 43% of our revenues in the aggregate.One customer contributed approximately 28% of our revenues in fiscal 2005. Twocustomers each contributed more than 10%, or approximately 29% in theaggregate, of our revenues in fiscal 2004. Our future success will depend onour ability to attract additional customers beyond our current limited number.The growth of our customer base could be adversely affected by:

·       acquisitionsof or by our customers;

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

·       potentialcustomer concerns with selecting an emerging telecommunications equipmentvendor;

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

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

·       newproduct introductions by our competitors;

·       failureof our products to perform as expected; or

·       difficultieswe may incur in meeting customers’ delivery requirements.

The loss of any of our significantcustomers or any substantial reduction in orders or contractual commitmentsfrom these customers could materially and adversely affect our financialposition and results of operations. If we do not expand our customer base toinclude additional customers that deploy our products in operational commercialnetworks, our business, operating results and financial position could bematerially 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 

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

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

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

·       ourrevenues could be unexpectedly reduced; and

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

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

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

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

***The market 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 newcustomers.***

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. Prospectivecustomers may require product features and capabilities that our currentproducts do not have. The introduction of new or enhanced products alsorequires that we carefully manage the transition from older products in orderto minimize disruption in customer ordering patterns and ensure that adequatesupplies of new products can be delivered to meet anticipated customer demand. Ifwe fail to develop products and offer services that satisfy customerrequirements, or to effectively manage the transition from older products, ourability to create or increase demand for our products would be seriously harmedand we may lose current and prospective customers.

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

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

Large telecommunicationsproviders have substantial purchasing power and leverage in negotiating contractualarrangements with us. These customers may require us to develop additionalfeatures and require penalties for failure to deliver such features. As we seekto sell more products to this class of customer, we may be required to agree tosuch terms and conditions, which may affect the timing of revenue recognitionand amount of deferred revenues and may adversely affect our financial positionin the applicable period affected.

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

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

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

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

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

·       relianceon distributors and resellers;

·       greaterdifficulty collecting accounts receivable and longer collection cycles;

·       difficultiesand costs of staffing and managing international operations;

·       theimpact of differing technical standards outside the United States;

·       theimpact of recessions in economies outside the United States;

·       changesin regulatory requirements and currency exchange rates;

·       certificationrequirements;

·       reducedprotection for intellectual property rights in some countries;

·       potentiallyadverse tax consequences; and

·       political and economicinstability.

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

Our revenues and operating results may varysignificantly from quarter to quarter due to a number of factors, many of whichare outside of our control and any of which may cause our stock price tofluctuate. Generally, purchases by service providers of telecommunicationsequipment from manufacturers have been unpredictable and clustered, rather thansteady, as the providers build out their networks. The primary factors that mayaffect our revenues and operating results 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 of existingcontractual commitments;

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

·       thetiming of revenue recognition;

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

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

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

·       themix of product configurations sold;

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

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

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

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

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

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

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

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

We have incurred significant losses since inception and,at March 31, 2007, had an accumulated deficit of $732.3 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 incuradditional losses in future quarters and years. Our revenues may not grow andwe may never generate sufficient revenues to sustain profitability.

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

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

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

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

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

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

Competition in the telecommunications market isintense. This market has historically been dominated by large incumbenttelecommunications equipment companies, such as Alcatel-Lucent, NEC, 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.

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Tocompete effectively, we must deliver innovative products that:

·       provideextremely high reliability and voice quality;

·       scaleeasily and efficiently;

·       interoperatewith existing network designs and other vendors’ equipment;

·       provideeffective network management;

·       areaccompanied by comprehensive customer support and professional services;

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

·       meetprice competition from low cost equipment providers.

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

***Becauseour products are sophisticated and designed to be deployed in complexenvironments, they may have errors or defects that we find only after fulldeployment, which could seriously harm our business.***

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

·       lossof, or delay in, revenues;

·       lossof customers and market share;

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

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

·       costly and time-consuminglegal actions by our customers.

***Becauseour products are deployed in large, complex networks around the world, failureto establish a support infrastructure and maintain required support levelscould seriously harm our business.***

Ourproducts are deployed in large and complex networks around the world. Ourcustomers expect us to establish a support infrastructure and maintaindemanding support standards to ensure that their networks maintain high levelsof availability and performance. To support the continued growth of ourbusiness, our support organization will need to provide service and support ata high level throughout the world. If we are unable to provide the expectedlevel of support and 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.

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***We have experienced changes in our seniormanagement which 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 wefail to hire and retain needed personnel, the implementation of our businessplan could slow or our future growth could halt.***

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

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

***If we are subject to employment claims, we couldincur substantial 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. These claimsmay result in material litigation. We could incur substantial costs defendingourselves or our employees against those claims, regardless of their merits. Inaddition, defending ourselves from those types of claims could divert ourmanagement’s attention from our operations. If we are found liable inconnection with any employment claim, we may incur significant costs that couldadversely impact our financial position and results of operations.

***We dependupon a single contract manufacturer and any disruption in this relationship maycause us to fail to meet the demands of our customers and damage our customerrelationships.***

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

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***We andour contract manufacturer rely on single or limited sources for supply of somecomponents of our products and if we fail to adequately predict ourmanufacturing requirements or if our supply of any of these components isdisrupted, we will be unable to ship our products.***

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

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

***If we arenot able to obtain necessary licenses of third-party technology atacceptable prices, or at all, our products could become obsolete.***

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

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

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

·       lossof, or delay in, revenues;

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

·       networkperformance penalties.

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

·       lossof customers and market share; and

·       a failure to attract newcustomers or achieve market acceptance for our products.

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***Ourability to compete and our business could be jeopardized if we are unable toprotect our intellectual property or become subject to intellectual propertyrights claims, which could require us to incur significant costs.***

We rely on a combinationof patent, copyright, trademark and trade secret laws and restrictions ondisclosure to protect our intellectual property rights. Despite our efforts toprotect our proprietary rights, unauthorized parties may attempt to copy or otherwiseobtain and use our products or technology. Monitoring unauthorized use of ourproducts is difficult and we cannot be certain that the steps we have takenwill prevent unauthorized use of our technology, particularly in foreigncountries where the laws may not protect our proprietary rights as fully as inthe United States. If competitors are able to use our technology, our abilityto compete effectively could be harmed.

Inaddition, we have received inquiries from other patent holders and may become subjectto claims 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 regardingintellectual property rights, regardless of their success, would betime-consuming, expensive to resolve and would divert our management’s time andattention.

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 thedefense of Qwest, Global Crossing and Level 3 in this litigation to the extentthe claim results from their use of products purchased from us. There can be noassurance that other defendants who have purchased our products will not seekindemnification from us. We believe that the defendants have substantial legaland factual defenses to the infringement claim, which we intend to pursuevigorously on behalf of the defendant for whom we agree or are required toassume defense of the litigation. However, there is no assurance any of thedefendants will prevail in defending this action. There also can be noassurance that we will not be required to indemnify any of the defendants fromany judgment of infringement rendered against them. We will be required todevote significant time and resources in connection with assuming the defenseof the claim of infringement on behalf of the defendants for whom we haveagreed to assume defense of the litigation. An adverse outcome with respect tothe claim and our indemnification could have a material adverse impact on ourbusiness, operating results and financial condition.

***Any investments or acquisitions we make coulddisrupt our 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;

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·       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.

Ourintegration of any acquired products, technologies or businesses will alsoinvolve numerous risks, including:

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

·       diversionof management’s attention from our core business;

·       adverseeffects on existing business relationships with suppliers and customers;

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

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

·       integrationof internal controls and financial systems.

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

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

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

***We mayseek to raise additional capital in the future, which may not be available tous, and if it is available, may dilute the ownership of our common stock.***

In April andSeptember 2003, we completed public offerings of 20,000,000 and 17,000,000shares, respectively, of our common stock resulting in the dilution of ourexisting investors’ percentage ownership of our common stock. In the future, wemay seek to raise additional funds through public or private debt or equityfinancings in order to:

·       fundongoing operations and capital requirements;

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

·       developnew products; or

·       respondto competitive pressures.

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

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

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

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

Themarket for technology stocks has been and will likely continue to be extremelyvolatile. The following factors could cause the market price of our commonstock to fluctuate significantly:

·       theaddition or loss of any major customer;

·       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.

***Provisionsof our charter documents and Delaware law have anti-takeover effects that couldprevent a change of control.***

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

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**Item6. Exhibits**

|        | **Exhibit Number** | ** ** | ** ** | **Description**                                                                                            |
|--------|-------------------------|------------|------------|------------------------------------------------------------------------------------------------------------|
|   | 10.1                    | (a)        |       | Summary of 2007  Executive Incentive Compensation Plan.                                                    |
|   | 31.1                    |       |       | Certification of  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |
|   | 31.2                    |       |       | Certification of  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |
|   | 32.1                    |       |       | Certification of  Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |
|   | 32.2                    |       |       | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |
|        |                         |            |            |                                                                                                            |  |  |

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(a)           Incorporated byreference from the Registrant’s Form 8-K (File No. 000-30229)filed April 2, 2007 with the SEC.

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**SIGNATURES**

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

| Dated: August 2, 2007 | SONUS NETWORKS, INC. |
|----------------------------|----------------------|
|                       | By:                  | /s/ Ellen B. Richstone |
|                       |                 | Ellen B. Richstone  Chief Financial Officer (Principal Financial Officer) |
|                       | By:                  | /s/ Paul K. McDermott |
|                       |                 | Paul K. McDermott  Vice President of Finance, Corporate Controller and Principal Accounting  Officer (Principal Accounting Officer) |

 

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**EXHIBITINDEX**

|        | **Exhibit Number** | ** ** | ** ** | **Description**                                                                                                        |
|--------|-------------------------|------------|------------|------------------------------------------------------------------------------------------------------------------------|
|   | 10.1                    | (a)        |       | Summary of 2007  Executive Incentive Compensation Plan.                                                                |
|   | 31.1                    |       |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley   Act  of 2002. |
|   | 31.2                    |       |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.             |
|   | 32.1                    |       |       | Certification of Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.             |
|   | 32.2                    |       |       | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.             |
|        |                         |            |            |                                                                                                                        |  |  |

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(a)           Incorporated byreference from the Registrant’s Form 8-K (File No. 000-30229)filed April 2, 2007 with the SEC.

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