**UNITED STATES**SECURITIES AND EXCHANGE COMMISSION

**Washington,D.C. 20549**

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**FORM 10-Q**

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

**Forthe quarterly period ended September 30, 2005**

**CommissionFile Number 000-30229**

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**SONUS NETWORKS, INC.**

(Exact name of Registrantas specified in its charter)

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

 

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

(Address of principalexecutive offices, including zip code)

**(978) 614-8100**

(Registrant’s telephonenumber, including area code)

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Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

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

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

As of October 31,2005, there were 249,378,820 shares of $0.001 par value per share, common stockoutstanding.

 

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**SONUSNETWORKS, INC.FORM 10-QQUARTER ENDED SEPTEMBER 30, 2005TABLE OF CONTENTS**
|                                             | ** ** | ** **                                                                                                                         | ** ** | **Page** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I—FINANCIAL  INFORMATION** |       |                                                                                                                               |       |     |
| Item 1:                                     |       | Financial  Statements                                                                                                              |       |     |       |   |
|                                        |       | Condensed Consolidated  Balance Sheets as of September 30, 2005 and December 31, 2004  (unaudited)                       |       | 1        |       |   |
|                                        |       | Condensed Consolidated  Statements of Operations for the Three and Nine Months Ended  September 30, 2005 and 2004 (unaudited) |       | 2        |       |   |
|                                        |       | Condensed Consolidated  Statements of Cash Flows for the Nine Months Ended September 30, 2005  and 2004 (unaudited)           |       | 3        |       |   |
|                                        |       | Notes to Condensed  Consolidated Financial Statements (unaudited)                                                                  |       | 4        |       |   |
| Item 2:                                     |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                        |       | 16       |       |   |
| Item 3:                                     |       | Quantitative and Qualitative  Disclosures About Market Risk                                                                        |       | 37       |       |   |
| Item 4:                                     |       | Controls and Procedures                                                                                                            |       | 37       |       |   |
| **PART II—OTHER  INFORMATION**    |       |                                                                                                                               |       |     |
| Item 1:                                     |       | Legal Proceedings                                                                                                                  |       | 40       |       |   |
| Item 6:                                     |       | Exhibits                                                                                                                           |       | 42       |       |   |
|                                        |       | Signatures                                                                                                                         |       | 43       |       |   |

 

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**PART I—FINANCIAL INFORMATION**

**Item 1: Financial Statements**

**SONUS NETWORKS, INC.Condensed ConsolidatedBalance Sheets(In thousands, except share data)(Unaudited)**

| ** **                                                                                                                                                                                                           | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                           | ** ** |                         | ** ** | ** **                  |       |   | ** ** | ** ** |   |
| **Current assets:**                                                                                                                                                                                                  |       |                         |       | ** **                  |       |   |   | ** ** |   |
| Cash and cash  equivalents                                                                                                                                                                                           |       |                         | $          | 134,789                     | ** ** |   |   | $ | 121,931 | ** ** |   |
| Marketable debt  securities                                                                                                                                                                                          |       |                         | 182,735    | ** **                  |       |   | 170,145 | ** ** |   |
| Accounts receivable, net                                                                                                                                                                                             |       |                         | 42,690     | ** **                  |       |   | 32,486 | ** ** |   |
| Inventory, net                                                                                                                                                                                                       |       |                         | 30,288     | ** **                  |       |   | 28,346 | ** ** |   |
| Other current assets                                                                                                                                                                                                 |       |                         | 12,637     | ** **                  |       |   | 10,891 | ** ** |   |
| Total current assets                                                                                                                                                                                                 |       |                         | 403,139    | ** **                  |       |   | 363,799 | ** ** |   |
| **Property and equipment,**  net                                                                                                                                                                                     |       |                         | 14,894     | ** **                  |       |   | 8,217 | ** ** |   |
| **Long-term investments**                                                                                                                                                                                            |       |                         | 7,363      | ** **                  |       |   | 21,029 | ** ** |   |
| **Other assets**                                                                                                                                                                                                     |       |                         | 720        | ** **                  |       |   | 783 | ** ** |   |
| Total                                                                                                                                                                                                                |       |                         | $          | 426,116                     | ** ** |   |   | $ | 393,828 | ** ** |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                       | ** ** |                         | ** ** | ** **                  |       |   | ** ** | ** ** |   |
| **Current liabilities:**                                                                                                                                                                                             |       |                         |       | ** **                  |       |   |   | ** ** |   |
| Accounts payable                                                                                                                                                                                                     |       |                         | $          | 12,697                      | ** ** |   |   | $ | 8,654 | ** ** |   |
| Accrued expenses                                                                                                                                                                                                     |       |                         | 14,489     | ** **                  |       |   | 18,240 | ** ** |   |
| Accrued restructuring  expenses                                                                                                                                                                                      |       |                         | 193        | ** **                  |       |   | 186 | ** ** |   |
| Current portion of  deferred revenue                                                                                                                                                                                 |       |                         | 80,968     | ** **                  |       |   | 65,105 | ** ** |   |
| Convertible subordinated  note                                                                                                                                                                                       |       |                         | 10,000     | ** **                  |       |   | — | ** ** |   |
| Current portion of long-term  liabilities                                                                                                                                                                            |       |                         | 45         | ** **                  |       |   | 30 | ** ** |   |
| Total current  liabilities                                                                                                                                                                                           |       |                         | 118,392    | ** **                  |       |   | 92,215 | ** ** |   |
| **Long-term deferred revenue,**  less current portion                                                                                                                                                                |       |                         | 32,392     | ** **                  |       |   | 25,960 | ** ** |   |
| **Long-term liabilities,**  less current portion                                                                                                                                                                     |       |                         | 538        | ** **                  |       |   | 613 | ** ** |   |
| **Convertible subordinated note**                                                                                                                                                                                    |       |                         | —     | ** **                  |       |   | 10,000 | ** ** |   |
| Total liabilities                                                                                                                                                                                                    |       |                         | 151,322    | ** **                  |       |   | 128,788 | ** ** |   |
| **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, 251,601,576 and 249,755,118 shares  issued and 249,304,666 and 247,458,208 shares outstanding at  September 30, 2005 and December 31, 2004 |       |                         | 252        | ** **                  |       |   | 250 | ** ** |   |
| Additional paid-in  capital                                                                                                                                                                                          |       |                         | 1,055,548  | ** **                  |       |   | 1,049,142 | ** ** |   |
| Accumulated deficit                                                                                                                                                                                                  |       |                         | (780,739   | )                           |       |   | (784,085 | ) |   |
| Treasury stock, at cost;  2,296,910 common shares at September 30, 2005 and December 31,  2004                                                                                                        |       |                         | (267       | )                           |       |   | (267 | ) |   |
| Total stockholders’  equity                                                                                                                                                                                     |       |                         | 274,794    | ** **                  |       |   | 265,040 | ** ** |   |
| Total                                                                                                                                                                                                                |       |                         | $          | 426,116                     | ** ** |   |   | $ | 393,828 | ** ** |   |

 

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

1

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

| ** **                                              | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                              | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenues:**                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                                 |       | $                                                    | 29,107     |                                                | $          | 36,064 |   | $ | 92,904 |   | $ | 92,896 |   |
| Service                                                 |       | 16,550                                               |       | 10,698                                              |       | 44,456 |   | 32,759 |   |
| Total revenues                                          |       | 45,657                                               |       | 46,762                                              |       | 137,360 |   | 125,655 |   |
| **Cost of revenues**  (1):                              |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                                 |       | 17,410                                               |       | 6,296                                               |       | 39,657 |   | 24,151 |   |
| Service                                                 |       | 6,073                                                |       | 4,173                                               |       | 16,993 |   | 12,659 |   |
| Total cost of revenues                                  |       | 23,483                                               |       | 10,469                                              |       | 56,650 |   | 36,810 |   |
| **Gross  profit**                                       |       | 22,174                                               |       | 36,293                                              |       | 80,710 |   | 88,845 |   |
| **Operating expenses:**                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Research and development (1)                            |       | 11,787                                               |       | 8,975                                               |       | 33,902 |   | 26,826 |   |
| Sales and marketing (1)                                 |       | 10,834                                               |       | 10,539                                              |       | 31,365 |   | 26,034 |   |
| General and administrative (1)                          |       | 5,455                                                |       | 6,638                                               |       | 18,732 |   | 17,210 |   |
| Stock-based compensation                                |       | 11                                                   |       | 91                                                  |       | 15 |   | 606 |   |
| Amortization of purchased intangible assets             |       | —                                               |       | 601                                                 |       | — |   | 1,801 |   |
| Total operating expenses                                |       | 28,087                                               |       | 26,844                                              |       | 84,014 |   | 72,477 |   |
| **(Loss)  income from operations**                      |       | (5,913                                               | )          | 9,449                                               |       | (3,304 | ) | 16,368 |   |
| Interest expense                                        |       | (121                                                 | )          | (117                                                | )          | (370 | ) | (360 | ) |
| Interest income                                         |       | 2,690                                                |       | 1,150                                               |       | 6,787 |   | 2,806 |   |
| **(Loss)  income before income taxes**                  |       | (3,344                                               | )          | 10,482                                              |       | 3,113 |   | 18,814 |   |
| (Benefit)  provision for income taxes                   |       | (640                                                 | )          | 214                                                 |       | (233 | ) | 598 |   |
| **Net  (loss) income**                                  |       | $                                                    | (2,704     | )                                                   | $          | 10,268 |   | $ | 3,346 |   | $ | 18,216 |   |
| **Net  (loss) income per share—basic and diluted** |       | $                                                    | (0.01      | )                                                   | $          | 0.04 |   | $ | 0.01 |   | $ | 0.07 |   |
| **Weighted average shares  outstanding:**               |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                   |       | 248,801                                              |       | 246,198                                             |       | 248,312 |   | 245,394 |   |
| Diluted                                                 |       | 248,801                                              |       | 251,707                                             |       | 253,221 |   | 252,776 |   |

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(1)          Excludesnon-cash, stock-based compensation expense as follows: 

| Cost of revenues           |   | $         — |   | $           5 |   | $         — |   | $         15 |   |
|----------------------------|--------|---------------------------------------------------------------|--------|----------------------------------------------------------------------|--------|---------------------------------------------------------------|--------|-----------------------------------------------------------|--------|
| Research and development   |   | —                                                        |   | 38                                                                   |   | —                                                        |   | 200                                                       |   |
| Sales and marketing        |   | 11                                                            |   | 32                                                                   |   | 15                                                            |   | 295                                                       |   |
| General and administrative |   | —                                                        |   | 16                                                                   |   | —                                                        |   | 96                                                        |   |
|                       |   | $         11     |   | $         91            |   | $         15     |   | $      606                  |   |

 

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

2

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**SONUSNETWORKS, INC.Condensed Consolidated Statements of Cash Flows(In thousands)(Unaudited)**

| ** **                                                                                   | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| **Cash flows from operating activities:**                                                    |       |                                                |       |   |   |
| Net income                                                                                   |       | $                                                   | 3,346      |   | $ | 18,216 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                                                |       |   |   |
| Depreciation                                                                                 |       | 5,256                                               |       | 4,179 |   |
| Stock-based  compensation                                                                    |       | 15                                                  |       | 606 |   |
| Amortization of purchased  intangible assets                                                 |       | —                                              |       | 1,801 |   |
| Changes in operating assets and liabilities:                                                 |       |                                                |       |   |   |
| Accounts receivable                                                                          |       | (10,204                                             | )          | (11,648 | ) |
| Inventory                                                                                    |       | (1,942                                              | )          | (13,827 | ) |
| Other current assets                                                                         |       | (1,155                                              | )          | (5,926 | ) |
| Accounts payable                                                                             |       | 4,043                                               |       | 7,851 |   |
| Accrued expenses and  accrued restructuring expenses                                         |       | (4,390                                              | )          | (4,528 | ) |
| Deferred revenue                                                                             |       | 22,295                                              |       | 989 |   |
| Net cash provided by  (used in) operating activities                                         |       | 17,264                                              |       | (2,287 | ) |
| **Cash flows from investing activities:**                                                    |       |                                                |       |   |   |
| Purchases of property and  equipment                                                         |       | (11,271                                             | )          | (6,308 | ) |
| Maturities of  available-for-sale marketable debt securities                                 |       | 146,400                                             |       | 152,761 |   |
| Purchases of  available-for-sale marketable debt securities                                  |       | (151,660                                            | )          | (154,229 | ) |
| Maturities of  held-to-maturity marketable debt securities and long-term investments         |       | 38,316                                              |       | 20,672 |   |
| Purchases of  held-to-maturity marketable debt securities and long-term investments          |       | (31,980                                             | )          | (30,583 | ) |
| Increase in restricted  cash                                                                 |       | (591                                                | )          | — |   |
| Other assets                                                                                 |       | 63                                                  |       | 430 |   |
| Net cash used in  investing activities                                                       |       | (10,723                                             | )          | (17,257 | ) |
| **Cash flows from financing activities:**                                                    |       |                                                |       |   |   |
| Sale of common stock in  connection with employee stock purchase plan                        |       | 4,516                                               |       | 1,721 |   |
| Proceeds from exercise of  stock options                                                     |       | 1,877                                               |       | 1,104 |   |
| Payments of long-term  liabilities                                                           |       | (76                                                 | )          | (151 | ) |
| Net cash provided by  financing activities                                                   |       | 6,317                                               |       | 2,674 |   |
| **Net  increase (decrease) in cash and cash equivalents**                                    |       | 12,858                                              |       | (16,870 | ) |
| **Cash and cash equivalents,  beginning of period**                                          |       | 121,931                                             |       | 133,715 |   |
| **Cash and  cash equivalents, end of period**                                                |       | $                                                   | 134,789    |   | $ | 116,845 |   |
| **Supplemental disclosure of cash flow  information:**                                       |       |                                                |       |   |   |
| Cash paid for interest                                                                       |       | $                                                   | 244        |   | $ | 241 |   |
| Cash paid for taxes                                                                          |       | $                                                   | 713        |   | $ | 668 |   |
| Tax refunds received                                                                         |       | $                                                   | 454        |   | $ | — |   |
| Non-cash purchases of property and equipment                                                 |       | $                                                   | 662        |   | $ | — |   |

 

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

3

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

**(1) Description of Business**

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

**(2) Summary ofSignificant Accounting Policies**

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

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

The accompanying unaudited condensed consolidatedfinancial statements have been prepared by Sonus pursuant to the rules andregulations of the United States Securities and Exchange Commission(SEC) regarding interim financial reporting. Accordingly, they do notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States of America for complete financialstatements and should be read in conjunction with the audited financialstatements included in Sonus’ Annual Report on Form 10-K for theyear ended December 31, 2004.

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

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

Certain balances in thecondensed consolidated financial statements as of December 31, 2004 andfor the period ended September 30, 2004 have been adjusted to conform tothe current year presentation.

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

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting periods. Significant estimates and judgments relied upon in preparingthese financial statements include revenue recognition for multiple elementarrangements, allowances for doubtful accounts, estimated fair value ofinvestments, inventory reserves, expected future cash flows used to evaluatethe recoverability of long-lived assets, restructuring and other relatedcharges, contingencies associated with revenue contracts, contingentliabilities, and recoverability of Sonus’ net deferred tax assets and relatedvaluation allowance. Although Sonus regularly assesses these estimates, actualresults could differ materially from these estimates. Changes in estimates arerecorded in the period in which they become known. Sonus bases its estimates onhistorical experience and various other assumptions that it believes to bereasonable under the 

4

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

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

***circumstances.Actual results may differ from Sonus’ estimates if past experience or otherassumptions do not turn out to be substantially accurate.***

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

Cash equivalents are stated at cost, whichapproximates market value, and have remaining maturities of three months orless at 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 all periods presented. The unrealized losses related to thesesecurities at September 30, 2005 are not considered to be a permanentdecline in the market value of such securities. There have been no materialrealized gains or losses to date. Current marketable debt securities includeheld-to-maturity investments with remaining maturities of less than one year atthe date of purchase and available-for-sale investments that are expected to besold in the current period or to be used in current operations. Long-terminvestments have remaining maturities of one to five years as of the balancesheet date.

As of September 30,2005 and December 31, 2004, marketable debt securities consisted of thefollowing, in thousands:

| ** **                               | ** ** | **September 30, 2005** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **Amortized  Cost**              | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Market  Value** | ** ** |
| *Short-term  marketable debt securities* |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:                      |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| State municipal  obligations             |       | $                                | 150,175    |   |   | $ | — |   |   |   | $ | — |   |   | $ | 150,175 |   |
| Held-to-maturity:                        |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government  agency notes            |       | 6,552                            |       |   | — |   |   |   | (8 | ) |   | 6,544 |   |
| Corporate debt  securities               |       | 18,914                           |       |   | — |   |   |   | (132 | ) |   | 18,782 |   |
| Commercial paper                         |       | 7,094                            |       |   | — |   |   |   | (3 | ) |   | 7,091 |   |
|                                     |       | $                                | 182,735    |   |   | $ | — |   |   |   | $ | (143 | ) |   | $ | 182,592 |   |
| *Long-term  marketable debt securities*  |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:                        |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government  agency notes            |       | $                                | 5,568      |   |   | $ | — |   |   |   | $ | (75 | ) |   | $ | 5,493 |   |
| Corporate debt  securities               |       | 1,795                            |       |   | — |   |   |   | (22 | ) |   | 1,773 |   |
|                                     |       | $                                | 7,363      |   |   | $ | — |   |   |   | $ | (97 | ) |   | $ | 7,266 |   |

 

5

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

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

| ** **                               | ** ** | **December 31, 2004** | ** ** |
|------------------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **Amortized  Cost**             | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Market  Value** | ** ** |
| *Short-term marketable debt  securities* |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:                      |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| State municipal obligations              |       | $                               | 144,548    |   |   | $ | — |   |   |   | $ | — |   |   | $ | 144,548 |   |
| Held-to-maturity:                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government  agency notes            |       | 5,600                           |       |   | 1 |   |   |   | — |   |   | 5,601 |   |
| Corporate debt  securities               |       | 19,997                          |       |   | — |   |   |   | (103 | ) |   | 19,894 |   |
| Commercial paper                         |       | —                          |       |   | — |   |   |   | — |   |   | — |   |
|                                     |       | $                               | 170,145    |   |   | $ | 1 |   |   |   | $ | (103 | ) |   | $ | 170,043 |   |
| *Long-term marketable debt  securities*  |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government  agency notes            |       | $                               | 5,566      |   |   | $ | — |   |   |   | $ | (9 | ) |   | $ | 5,557 |   |
| Corporate debt  securities               |       | 15,463                          |       |   | — |   |   |   | (190 | ) |   | 15,273 |   |
|                                     |       | $                               | 21,029     |   |   | $ | — |   |   |   | $ | (199 | ) |   | $ | 20,830 |   |

 

As of September 30,2005, Sonus had $591,000 in restricted cash, which is used to collateralizestandby letters of credit. Restricted cash is included in Other Current Assetson the Condensed Consolidated Balance Sheet.

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

The financial instruments that potentially subjectSonus to concentrations of credit risk are cash, cash equivalents, marketablesecurities, accounts receivables and long-term investments. Sonus has nooff-balance sheet arrangements such as foreign exchange contracts, optionscontracts or other foreign hedging arrangements as of September 30, 2005.During the three months ended September 30, 2005, Sonus entered intoforeign exchange contracts to hedge against currency fluctuations related to aparticular account receivable denominated in Japanese Yen which were completedby September 30, 2005. Sonus’ cash, cash equivalent and investmentportfolio holdings are diversified among five financial institutions.

Thefollowing customers contributed 10% or more of Sonus’ revenues in the three andnine months ended September 30,2005 and 2004:

| ** **    | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,**      | ** ** |
|---------------|------------|------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Customer:** | ** ** | ** **                                           | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| A             |       |                                                 | 33         | %                                                        |       |   | * |   |   |   | 29 | % |   |   | 10 | % |   |
| B             |       |                                                 | *          |                                                     |       |   | 38 | % |   |   | * |   |   |   | 16 |   |   |
| C             |       |                                                 | *          |                                                     |       |   | * |   |   |   | * |   |   |   | 10 |   |   |
| D             |       |                                                 | *          |                                                     |       |   | * |   |   |   | * |   |   |   | 10 |   |   |
| E             |       |                                                 | *          |                                                     |       |   | 27 | % |   |   | * |   |   |   | 18 |   |   |
|               |            |                                                      |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

*                    Representsless than 10% of revenues.

6

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

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

One customer at September 30,2005 and two customers at December 31, 2004, each accounted for 10% ormore of Sonus’ accounts receivable balance, representing an aggregate of 49%and 53% of total accounts receivable, respectively. Sonus performs ongoingcredit evaluations of its customers and generally does not require collateralon accounts receivable. Sonus maintains allowances for potential credit lossesand such losses have been within management’s expectations.

International revenues,primarily attributable to Japan and Europe, were 21% and 6% of total revenuesfor the three months ended September 30, 2005 and 2004, respectively, andwere 20% and 15% of total revenues for the nine months ended September 30,2005 and 2004, respectively. All international sales are denominated in U.S.dollars. The effect of foreign currency gains or losses is not material as of September30, 2005 and December 31, 2004.

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

***(e) AccountsReceivable***

Accountsreceivable consist of the following, in thousands:

| ** **                       | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Earned accounts  receivable      |       |                         | $          | 28,572                      |       |   |   | $ | 9,088 |   |   |
| Unearned accounts  receivable    |       |                         | 14,474     |                        |       |   | 23,807 |   |   |
| Accounts  receivable, gross      |       |                         | 43,046     |                        |       |   | 32,895 |   |   |
| Allowance for  doubtful accounts |       |                         | (356       | )                           |       |   | (409 | ) |   |
| Accounts receivable, net         |       |                         | $          | 42,690                      |       |   |   | $ | 32,486 |   |   |

 

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

***(f) Inventory***

Inventoryconsists of the following, in thousands:

| ** **                                             | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| On-hand  final assemblies and finished goods inventory |       |                         | $          | 15,446                      |       |   |   | $ | 18,725 |   |   |
| Unearned inventory                                     |       |                         | 17,483     |                        |       |   | 14,054 |   |   |
| Evaluation  inventory                                  |       |                         | 3,907      |                        |       |   | 6,107 |   |   |
| Inventory, gross                                       |       |                         | 36,836     |                        |       |   | 38,886 |   |   |
| Excess, obsolete  and evaluation reserve               |       |                         | (6,548     | )                           |       |   | (10,540 | ) |   |
| Inventory, net                                         |       |                         | $          | 30,288                      |       |   |   | $ | 28,346 |   |   |

 

7

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

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

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

Sonus values inventory atthe lower of cost on a first-in, first-out basis or fair market value andprovides inventory reserves based on excess and obsolete inventory determinedprimarily by future demand forecasts and records adjustments to such reservesthrough charges to cost of revenues. Sonus also records a full inventoryreserve for evaluation equipment at the time of shipment to customers as acharge to sales and marketing expense as Sonus’ experience with this type ofinventory indicates it is probable that the value of the inventory will not berealizable. If these evaluation shipments should convert to revenue, Sonusrecords a benefit to sales and marketing expense and records the full cost ofrevenues in the period of revenue recognition.

***(g) Deferred Revenue***

Deferredrevenue consists of the following, in thousands:

| ** **                         | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Maintenance and  support contracts |       |                         | $          | 65,543                      |       |   |   | $ | 44,859 |   |   |
| Customer deposits                  |       |                         | 33,343     |                        |       |   | 22,399 |   |   |
| Unearned revenue                   |       |                         | 14,474     |                        |       |   | 23,807 |   |   |
| Total deferred  revenue            |       |                         | 113,360    |                        |       |   | 91,065 |   |   |
| Less current  portion              |       |                         | (80,968    | )                           |       |   | (65,105 | ) |   |
|                               |       |                         | $          | 32,392                      |       |   |   | $ | 25,960 |   |   |

 

Maintenance and supportcontracts are recognized ratably over the life of the maintenance and supportperiod. Customer deposits represent payments received in advance of revenuerecognition. Unearned revenue represents billings for which payment has notbeen received and revenue recognition criteria have not been met. As of September 30,2005 and December 31, 2004, deferred revenue and accounts receivableexcluded $7.7 million and $6.5 million related to products shippedand billed to customers which are collectible under extended payment terms orfor which revenue is recognized as cash is collected.

***(h) Revenue Recognition***

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

Many of Sonus’ sales involve complex contractual,multiple element arrangements. When a sale includes multiple elements, such asproducts, maintenance and/or professional services, Sonus recognizes 

8

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

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

revenue using the residualmethod. Revenues associated with undelivered elements that are considered notessential to the functionality of the product and for which VSOE has beenestablished, are deferred based on the VSOE value and any remaining arrangementfee is then allocated to, and recognized as, product revenue. VSOE isdetermined based upon the price charged when the same element is soldseparately or established by the relevant pricing authority. If Sonus cannotestablish VSOE for each undelivered element, including specified upgrades, itdefers revenue on the entire arrangement until VSOE for all undeliveredelements is known or all elements are delivered and all other revenuerecognition criteria are met.

Maintenance and support services are recognizedratably over the life of the service period, ranging from one to five years. Maintenanceand support services include telephone support, return and repair support andunspecified rights to product upgrades and enhancements.

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

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

Sonus sells the majority of its products directly toend-users. For products sold by resellers and distributors, Sonus typicallyrecognizes revenue on a sell-through basis utilizing information provided toSonus from its resellers and distributors. To date, no revenues have beenrecognized on a sell-in basis due to the limited history of shipments toresellers and distributors.

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 revenues include customer deposits and amountsassociated with maintenance contracts. Deferred revenues expected to berecognized as revenue more than one year of the balance sheet date are classifiedas long-term deferred revenues.

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

***(i) Stock-based Compensation***

Sonus uses the intrinsic value method to account forall of its employee stock-based compensation and uses the fair valuemethod to account for all non-employee stock-based compensation. Underthe intrinsic value method, compensation associated with stock options andawards to employees is determined as the excess, if any, of the current fairvalue of the underlying common stock on the date compensation is measured overthe price an employee must pay to exercise the option or award. Under the fairvalue method, compensation associated with stock options and awards isdetermined based on the estimated fair value of the option or award itself,measured using either current market data or an established option pricingmodel. The measurement date for options and awards is generally the date ofgrant.

9

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

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

The following table showsSonus’ pro forma net (loss) income and net (loss) income per share if accountedunder SFAS 123 for the three and nine months ended September 30, 2005 and2004, in thousands except per share data:

| ** **                                                                                                                           | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net (loss)  income, as reported                                                                                                      |       | $                                                    | (2,704     | )                                                   | $          | 10,268 |   | $ | 3,346 |   | $ | 18,216 |   |
| Plus: Employee  stock-based compensation expense included in net (loss) income under  intrinsic value method related to options |       | 11                                                   |       | 65                                                  |       | 15 |   | 530 |   |
| Less: Employee  stock-based compensation under fair value method                                                                     |       | (8,458                                               | )          | (12,104                                             | )          | (26,696 | ) | (35,137 | ) |
| Pro forma net  loss                                                                                                                  |       | $                                                    | (11,151    | )                                                   | $          | (1,771 | ) | $ | (23,335 | ) | $ | (16,391 | ) |
| **Basic and diluted net (loss) income per share—**                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| As reported                                                                                                                          |       | $                                                    | (0.01      | )                                                   | $          | 0.04 |   | $ | 0.01 |   | $ | 0.07 |   |
| Pro forma                                                                                                                            |       | $                                                    | (0.04      | )                                                   | $          | (0.01 | ) | $ | (0.09 | ) | $ | (0.07 | ) |

 

***(j) Comprehensive Net Income (Loss)***

Sonus applies SFAS No. 130,*Reporting Comprehensive Income*.The comprehensive net (loss) income for the three and nine months ended September 30,2005 and 2004 does not significantly differ from the reported net (loss) income.

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

SFAS No. 131, *Disclosures about Segments of an Enterprise andRelated Information*, established standards for reporting informationregarding operating segments and established standards for related disclosuresabout products and services and geographic areas. Operating segments areidentified as components of an enterprise about which separate discretefinancial information is available for evaluation by the chief operatingdecision maker in making decisions regarding resource allocation and assessingperformance. To date, the chief operating decision maker has made suchdecisions and assessed performance at the company level as one segment.

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

Basic net (loss) income per share is computed bydividing the net income for the period by the weighted average number of sharesof unrestricted common stock outstanding during the period. Diluted net (loss)income per share is computed by dividing the net (loss) income for the periodby the weighted average number of shares of unrestricted common stock anddilutive potential common shares outstanding based on the average market priceof Sonus’ common stock (under the treasury stock method). Dilutive potentialcommon shares consist of restricted common stock and common stock issuable uponthe exercise of stock options and conversion of a convertible subordinatednote.

10

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

**(2) Summary of SignificantAccounting Policies (Continued)**

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

| ** **                                                         | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average  common shares outstanding                        |       | 248,801                                              |       | 246,322                                             |       | 248,312 |   | 245,849 |   |
| Less weighted  average restricted common shares outstanding        |       | —                                               |       | 124                                                 |       | — |   | 455 |   |
| Weighted average  shares used in basic per share calculation  |       | 248,801                                              |       | 246,198                                             |       | 248,312 |   | 245,394 |   |
| Add effect of  dilutive potential common shares                    |       | —                                               |       | 5,509                                               |       | 4,909 |   | 7,382 |   |
| Weighted average shares  used in diluted per share calculation     |       | 248,801                                              |       | 251,707                                             |       | 253,221 |   | 252,776 |   |

 

Excludedfrom the shares used in the calculations above are options to purchase sharesof common stock and shares of common stock issuable upon conversion of aconvertible subordinated note representing an aggregate of 9,422,290 shares forthe three months ended September 30, 2004, and 11,145,862 shares and5,529,290 shares for the nine months ended September 30, 2005 and 2004 astheir effects would have been anti-dilutive.

***(m) Warranty Reserve***

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

In addition, certain ofSonus’ customer contracts include provisions under which Sonus may be obligatedto pay penalties generally for the contractual period or for the life of theproduct if Sonus’ products fail or do not perform in accordance with specifications.Sonus accrues for such contingent obligations when the occurrence of suchobligation is probable and the amount of such obligation is reasonablyestimable. Sonus has not incurred significant costs related to such provisions.Sonus periodically assesses the adequacy of its recorded warranty liabilitiesand adjusts the amounts as necessary. Increases in product failure rates,material usage or service delivery costs may result in increases to Sonus’warranty reserve and its gross profit could be adversely affected. As of September 30,2005 and December 31, 2004 Sonus had $330,000 and $0 of warranty reservesrecorded.

11

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

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

***(n) Recent Accounting Pronouncements***

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs, an amendment of AccountingResearch Bulletin (ARB) No. 43, Chapter 4.*SFAS No. 151amends the guidance in ARB No 43, Chapter 4, “Inventory Pricing” to clarifythat abnormal amounts of idle facility expense, freight, handling costs, andwasted material (spoilage) should be recognized as current-periodcharges. In addition, SFAS No. 151 requires that allocation of fixedproduction overhead to the costs of conversion be based on the normal capacityof the production facilities. The provisions of SFAS No. 151 areeffective for fiscal years beginning after June 15, 2005. Sonus isevaluating the provisions of SFAS No. 151 and presently does notbelieve that its adoption will have a material impact on its financialcondition, results of operations or cash flows.

In December 2004, theFASB issued SFAS 123(R), *Share-BasedPayment*, which revises SFAS No. 123, *Accounting for Stock-Based Compensation*. supersedesAPB Opinion No. 25, *Accounting forStock Issued to Employees* and its related interpretations, andamends SFAS No. 95, *Statement of CashFlows*. SFAS 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe income statement based on their fair values at the date of grant. Pro formadisclosure is no longer an alternative. SFAS 123(R) is effective forfiscal years beginning after June 15, 2005. Sonus is required to adoptSFAS 123(R) on January 1, 2006. SFAS 123(R) permitspublic companies to adopt its requirements using one of two methods: a “modifiedprospective” method, in which compensation cost is recognized beginning withthe effective date (a) based on the requirements of SFAS 123(R) forall share-based payments granted after the effective date, and (b) basedon the requirements of SFAS 123 for all awards granted to employees priorto the effective date of SFAS 123(R) that remain unvested on theeffective date; or a “modified retrospective” method, which includes the requirementsof the modified prospective method described above, but also permits entitiesto restate based on the amounts previously recognized under SFAS 123 forpurposes of pro forma disclosures either (a) all prior periods presentedor (b) prior interim periods of the year of adoption. Sonus has not yetdetermined which method to use in adopting SFAS 123(R). Sonus isevaluating SFAS 123(R) and has not yet determined the amount of stockoption expense that will be incurred in future periods as a result of theadoption of SFAS 123(R). The adoption of SFAS 123(R) will haveno impact on Sonus’ net cash flows or overall financial position.

**(3) Restructuring Charges**

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

12

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

**(3) Restructuring Charges(Continued)**

**2002 RestructuringAccrual**

Thefollowing table summarizes the activity during the nine months ended September 30,2005 relating to Sonus’ accrual for fiscal 2002 restructuring actions, inthousands:

| ** **                   | ** ** | **December 31,  2004  accrual  balance** | ** ** | **Cash  payments** | ** ** | **September 30,  2005  accrual  balance** | ** ** | **Current  portion** | ** ** | **Long-term  portion** | ** ** |   |
|------------------------------|------------|-----------------------------------------------|------------|--------------------|------------|------------------------------------------------|------------|----------------------|------------|------------------------|------------|--------|
| Consolidation of  facilities |       |                                          | $          | 799                |       |                                           |       | $                    | (138       | )                      |       |   | $ | 661 |   |   |   | $ | 193 |   |   |   | $ | 468 |   |   |
|                              |            |                                               |            |                    |            |                                                |            |                      |            |                        |            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theremaining cash expenditures relating to the consolidation of excess facilitiesare expected to be paid through 2008.

**(4) Contingencies**

In November 2001, a purchaser of Sonus’ commonstock filed a complaint in the United States District Court for the SouthernDistrict of New York against Sonus, two of its officers and the leadunderwriters alleging violations of the federal securities laws in connectionwith Sonus’ initial public offering (IPO) and seeking unspecified monetarydamages. The purchaser seeks to represent a class of persons who purchasedSonus’ common stock between the IPO on May 24, 2000 and December 6,2000. An amended complaint was filed in April 2002. The amended complaintalleges that Sonus’ registration statement contained false or misleadinginformation or omitted to state material facts concerning the alleged receiptof undisclosed compensation by the underwriters and the existence ofundisclosed arrangements between underwriters and certain purchasers to makeadditional purchases in the after market. The claims against Sonus are assertedunder Section 10(b) of the Securities Exchange Act of 1934 and Section 11of the Securities Act of 1933 and against the individual defendants underSections 11 and 15 of the Securities Act and Sections 10(b) and 20(a) ofthe Exchange Act. Other plaintiffs have filed substantially similar classaction cases against approximately 300 other publicly traded companies andtheir IPO underwriters which, along with the actions against Sonus, have beentransferred to a single federal judge for purposes of coordinated casemanagement. On July 15, 2002, Sonus, together with the other issuers namedas defendants in these coordinated proceedings, filed a collective motion todismiss the consolidated amended complaints on various legal grounds common toall or most of the issuer defendants. The plaintiffs voluntarily dismissed theclaims against many of the individual defendants, including those Sonusofficers named in the complaint. On February 19, 2003, the court granted aportion of the motion to dismiss by dismissing the Section 10(b) claimsagainst certain defendants including Sonus, but denied the remainder of themotion as to the defendants. In June 2003, a special committee of Sonus’Board of Directors authorized Sonus to enter into a proposed settlement withthe plaintiffs on terms substantially consistent with the terms of a Memorandumof Understanding negotiated among representatives of the plaintiffs, the issuerdefendants and the insurers for the issuer defendants. On February 15,2005, the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. On August 31,2005, the court approved the terms of the proposed settlement, as modified. Thesettlement is subject to class certification and final approval by the court. Ahearing has been scheduled on April 24, 2006 for final approval. Theproposed settlement would 

13

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

**(4)Contingencies (Continued)**

not require any settlementpayment by Sonus, therefore Sonus does not expect that the settlement wouldhave a material impact on its business or financial results.

Beginning in July 2002, several purchasers ofSonus’ common stock filed complaints in the United States District Courtfor the District of Massachusetts against Sonus, certain officers and directorsand a former officer under Sections 10(b) and 20(a) and Rule 10b-5of the Securities Exchange Act of 1934 (Class Action Complaints). Thepurchasers seek to represent a class of persons who purchased Sonus’ commonstock between December 11, 2000 and January 16, 2002, and seekunspecified monetary damages. The Class Action Complaints were essentiallyidentical and alleged that Sonus made false and misleading statements about itsproducts and business. On March 3, 2003, the plaintiffs filed aConsolidated Amended Complaint. On April 22, 2003, Sonus filed a motion todismiss the Consolidated Amended Complaint on various grounds. On May 11,2004, the court held oral argument on the motion, at the conclusion of whichthe court denied Sonus’ motion to dismiss. The plaintiffs filed a motion forclass certification on July 30, 2004. . On February 16, 2005, thecourt certified the class and appointed a class representative. On March 9,2005, the court appointed the law firm of Moulton & Gans as leadcounsel. After the court requested additional briefing on the adequacy of theclass representative, the class representative withdrew. Lead counsel thenfiled a motion to substitute a new plaintiff as the class representative. On May 19,2005, the court held a hearing on the motion and took the matter underadvisement. On August 15, 2005, the court issued an order decertifying theclass and requiring the parties to submit a joint report informing the courtwhether the cases have been settled and whether defendants would be seeking torecover attorney’s fees from the plaintiffs. On September 30, 2005, theplaintiffs filed motions to voluntarily dismiss their complaints with prejudice.On October 5, 2005, the court entered an order dismissing the cases. On October 21,2005, the defendants filed a motion seeking the recovery of attorneys’ feesfrom plaintiffs. The plaintiffs have until December 5, 2005 to respond tothe motion.

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against Sonus and certain of itscurrent officers and directors. On June 28, 2004, the court consolidatedthe claims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the SecuritiesExchange Act of 1934 and Sections 11, 12(a), and 15 of the Securities Act of1933, relating to Sonus’ restatement of its financial results for 2001, 2002,and the first three quarters of 2003. Specifically, the complaint alleges thatSonus issued a series of false or misleading statements to the marketconcerning Sonus’ revenues, earnings and financial condition. Plaintiffscontend that such statements caused Sonus’ stock price to be artificiallyinflated. The complaint seeks unspecified damages on behalf of a purportedclass of purchasers of Sonus’ common stock during the period from March 28,2002, through March 26, 2004. On January 28, 2005, Sonus filed amotion to dismiss the Section 10(b) and 12(a) claims and joinedthe motion to dismiss the Section 11 claim filed by the individualdefendants. On June 1, 2005, the court held a hearing on the motion andallowed the plaintiff to file an amended complaint. The plaintiff filed anAmended Complaint that included the same claims and substantially similarallegations as set forth in the prior Complaint. On September 12, 2005,the defendants filed motions to dismiss this Amended Complaint. The Court hasscheduled a hearing on the motions for December 10, 2005. Sonus believesthat it has substantial legal and factual defenses to the claims, which itintends to pursue vigorously. There is no assurance Sonus will prevail indefending these actions. A 

14

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

**(4)Contingencies (Continued)**

judgment or a settlementof the claims against the defendants could have a material impact of Sonus’financial results.

In February 2004, three purported shareholderderivative lawsuits were filed in the United States District Court for theDistrict of Massachusetts against Sonus and certain of its officers anddirectors, naming Sonus as a nominal defendant. Also in February 2004, twopurported shareholder derivative lawsuits were filed in the business litigationsession of the superior court of Suffolk County of Massachusetts against Sonusand certain of its directors and officers, also naming Sonus as a nominaldefendant. The suits claim that certain of Sonus’ officers and directors breachedtheir fiduciary duties to Sonus’ 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 Sonus’ obligations underthe 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. The defendants renewed their motions to dismiss. The court hasscheduled a hearing on the motions for December 10, 2005. There is noassurance Sonus will prevail in defending these actions. Sonus does not expectthese shareholder derivative claims will have a material impact on itsfinancial results.

In December 2004, a purchaser of Sonus’ commonstock filed a complaint in the circuit court in Will County, Illinois,against Sonus, one of its officers, and a former officer allegingmisrepresentation and fraud in connection with the plaintiff’s purchase ofSonus stock. The Complaint seeks unspecified damages. Sonus filed a motion todismiss the complaint. On May 5, 2005, the plaintiff filed an amendedcomplaint. On October 26, 2005, the court held a hearing on the motionduring which he dismissed the federal claims without prejudice and dismissedthe state claims without prejudice and leave to refile within 28 days. If theplaintiff does not refile within 28 days then the state claims will bedismissed with prejudice. The court scheduled a status hearing for December 1,2005. Sonus does not expect that this claim will have a material impact on its financialresults.

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

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

*This Management’s Discussion and Analysis of FinancialCondition and Results of Operations contains forward-looking statements,which are subject to a number of risks and uncertainties. These forward-lookingstatements are based on our current expectations, assumptions, estimates andprojections about our industry and ourselves, and we do not undertake anobligation to update our forward-looking statements to reflect futureevents or circumstances. Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of variousfactors, including the factors set forth in “Cautionary Statements” in theQuarterly Report on Form 10-Q. This discussion should be read inconjunction with the unaudited condensed consolidated financial statements andrelated notes for the periods specified. Further reference should be made toour Annual Report on Form 10-K for the year ended December 31,2004 and our Quarterly Report on Form 10-Q for the quarter ended June 30,2005, both on file with the SEC.*

**Overview**

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

In 2004 and continuing into 2005, there was increasedinterest and activity in the market for packet-based voice infrastructureproducts. While it remains uncertain as to the speed and extent of the adoptionof carrier packet voice infrastructure products by large carriers, we believethat over time the market opportunity for packet voice solutions is substantial.This has shown in our order activity as in the fourth quarter of fiscal 2004 weachieved record orders and in the first nine months of fiscal 2005 orders wereconsistent with revenue. For the three and nine months ended September 30,2005, revenues were $45.7 million and $137.4 million, respectively, compared to$46.8 million and $125.7 million for the three and nine months ended September 30,2004, respectively, and total deferred revenue increased to $113.4 millionat September 30, 2005 from $91.1 million at December 31, 2004. Thisvariability in our quarterly revenue and operating results is caused primarilyby the uneven ordering pattern of our customers and the timing of revenuerecognition, including network installations, product delays and customeracceptance.

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 periodicallyplace large orders with short lead times and the application of complex revenuerecognition rules to certain transactions, which may result in customershipments and orders from multiple quarters being recognized as revenue in onequarter. We expect to recognize revenues from a limited number of customers forthe foreseeable future.

From our inception throughDecember 31, 2003, we incurred significant losses. As of September 30,2005, we had an accumulated deficit of $780.7 million. Although we achievedprofitability in the second quarter of 2005 and in each quarter and on anannual basis in fiscal year 2004, we incurred a net loss for the first andthird quarters of 2005 and may incur additional losses in future quarters andyears. We have a lengthy sales cycle for our products and, accordingly, weexpect to incur sales and other expenses before we realize the 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.

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**CriticalAccounting Policies and Estimates**

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

·       Revenuerecognition

·       Deferredrevenue

·       Allowancefor doubtful accounts

·       Inventoryreserves

·       Warranty,litigation, and other loss contingency reserves

·       Stock-basedcompensation, and

·       Accountingfor income taxes

A full discussion of these accounting policies isincluded in our 2004 Annual Report on Form 10-K filed with theSecurities and Exchange Commission and we refer the reader to that discussion.The following information regarding critical accounting policies has beenupdated since our 10-K:

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

Many of our sales involve complex contractual,multiple element arrangements. When a sale includes multiple elements, such asproducts, maintenance and/or professional services, we recognize revenue usingthe residual method. Revenues associated with undelivered elements that areconsidered not essential to the functionality of the product and for which VSOEhas been established, are deferred based on the VSOE value and any remainingarrangement fee is then allocated to, and recognized as, product revenue. VSOEis determined based upon the price charged when the same element is soldseparately or established by the relevant pricing authority. If we cannotestablish VSOE for each undelivered element, including specified upgrades, wedefer revenue on the entire arrangement until VSOE for all undelivered elementsis known or all elements are delivered and all other revenue recognitioncriteria are met.

Maintenance and support services are recognizedratably over the life of the service period, ranging from one to five years.Maintenance and support services include telephone support, return and repairsupport and unspecified rights to product upgrades and enhancements.

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Installation service revenues which are considered tobe perfunctory are generally recognized when the service is complete. Other professionalservices for which VSOE has been established are typically recognized based onthe proportional performance as the services are delivered.

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

We sell the majority of our products directly toend-users. For products sold through resellers and distributors, we typicallyrecognize revenue on a sell-through basis utilizing information provided to usfrom our resellers and distributors. To date, no revenues have been recognizedon a sell-in basis due to the limited history of shipments to resellers anddistributors.

We record deferred revenue for product delivered orservices performed for which collection of the amount billed is either probableor has been collected but other revenue recognition criteria have not beensatisfied. Deferred revenues include customer deposits and amounts associatedwith maintenance contracts. Deferred revenues expected to be recognized asrevenue more than one year of the balance sheet date are classified aslong-term deferred revenues.

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.

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

***Allowance forDoubtful Accounts.******  ***We establish billing terms at thetime we negotiate purchase agreements with our customers. We continuallymonitor for timely payments and potential collection issues. Allowance fordoubtful accounts is estimated based on our detailed assessment of thecollectibility of specific customer accounts. While we believe that ourallowance for doubtful accounts is adequate and that the judgment applied isappropriate, if there is a deterioration of a customer’s creditworthiness oractual defaults are higher than our historical experience, the actual resultscould differ from these estimates. While such credit losses have historicallybeen within our expectations and the allowances we established, we can provideno assurance that we will continue to experience the same credit loss ratesthat we have in the past. If the financial condition of our customers were todeteriorate, resulting in an impairment of their ability to make payment,additional allowances may be required. We defer revenue recognition for customersfor which we believe collection is less than probable. Our failure toaccurately estimate the losses for doubtful accounts or receive payments on atimely basis could have a material adverse effect on our business, financialcondition and results of operations.

***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 andreturns of defective product, and record charges to cost of revenues. We assesssuch demand forecasts and return history on at least a quarterly basis. If werecord a charge to reduce inventory to its estimated net realizable value, wedo 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.

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

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

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

In addition, certain of our customer contracts includeprovisions under which we may be obligated to pay penalties generally for thecontractual period or for the life of the product if our products fail or donot perform in accordance with specifications. We accrue for such contingentobligations when the occurrence of such obligation is probable and the amountof such obligation is reasonably estimable. We have not incurred significantcosts related to such provisions. We periodically assess the adequacy of ourrecorded warranty liabilities and adjust the amounts as necessary. Increases inproduct failure rates, material usage or service delivery costs may result in increasesto our warranty reserve and our gross profit could be adversely affected. As ofSeptember 30, 2005 and December 31, 2004 we had $330,000 and $0 of warrantyreserves recorded.

***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. While we believe that the amounts accruedfor estimated royalties are adequate, the amounts required to ultimately settleroyalty obligations may be different.

***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. Weintend to defend these matters vigorously, although the ultimate outcome ofthese items is uncertain and the potential loss, if any, may be significantlydifferent than the amounts we have previously accrued.

***Accounting forIncome Taxes.******  ***As a result of net operating lossesincurred in prior years in most jurisdictions in which we operate, a netoperating loss in the first and third fiscal quarters of 2005, and uncertaintyas to the extent, jurisdiction and timing of profitability in future periods,we have continued to record a full valuation allowance against net deferred taxassets, which was approximately $94 million as of September 30, 2005.The establishment and amount of the valuation allowance requires significantestimates and judgment and can materially affect our results of operations. Ifthe realization of deferred 

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tax assets in the futureis considered more likely than not, an adjustment to the valuation reserve forthe deferred tax asset would be made. A portion of the release of the valuationallowance will increase net income in the period such determination was made.In addition, approximately $26 million of the valuation allowance relates totax benefits from stock option compensation. A substantial portion of the taxbenefit of that item, when realized, will result in an increase in additionalpaid-in capital. Our effective tax rate may vary from period to period based onchanges in estimated taxable income or loss in each jurisdiction, changes tothe valuation allowance, statutory minimum tax rates or changes to federal,state or foreign tax laws, future expansion into areas with varying country,state, and local income tax rates including statutory minimum tax rates,deductibility of certain costs and expenses by jurisdiction and as a result ofacquisitions.

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

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

***Restructuring and Other Related Charges.******  ***We establishedexit plans for each of the restructuring activities which took place in 2001and 2002 and accounted for these plans in accordance with Emerging Issues TaskForce (EITF) Issue No. 94-3, *LiabilityRecognition for Certain Employee Benefits and Other Costs to Exit an Activity(including Certain Costs incurred in a Restructuring)*. These exitplans required that we make estimates as to the nature, timing and amount ofthe exit costs that we specifically identified. The consolidation of facilitiesrequired us to make estimates, which included contractual rental commitments orlease buy-outs for office space being vacated and related costs and leaseholdimprovement write-downs, offset by estimated sub-lease income. We haveremaining accrued exit costs of $661,000 as of September 30, 2005, whichrelate to remaining lease payments. SFAS No. 146, *Accounting for Costs Associated with Exit or DisposalActivities*, was effective for exit or disposal activities that areinitiated after December 31, 2002. SFAS No. 146 requires that aliability for a cost that is associated with an exit or disposal activity berecognized when the liability is incurred. A liability is recognized when theseverance amounts relate to prior services rendered, the payment of the amountis probable and the amount can be reasonably estimated.

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***Three and Nine Months Ended September 30, 2005and 2004***

***Revenues.******  ***Revenues forthe three and nine months ended September 30, 2005 and 2004 were asfollows, in thousands:

| ** **     | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **     | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenues:**  |       |                                                 |       |                                                |       |   |   |   |   |
| Product        |       | $                                                    | 29,107     |                                                | $          | 36,064 |   | $ | 92,904 |   | $ | 92,896 |   |
| Service        |       | 16,550                                               |       | 10,698                                              |       | 44,456 |   | 32,759 |   |
| Total revenues |       | $                                                    | 45,657     |                                                | $          | 46,762 |   | $ | 137,360 |   | $ | 125,655 |   |

 

Product revenues comprise sales of our voiceinfrastructure products, including our GSX9000TM Open Services Switch, PSX, SGX,ASX, Sonus InsightTM Management System and related product offerings. Productrevenues for the three months ended September 30, 2005 decreased 19% fromthe comparable period in fiscal 2004. Product revenues for the nine monthsended September 30, 2005 were consistent with the comparable period infiscal 2004. The decrease for the three months ended September 30, 2005 isprimarily due to the renegotiation of bundled maintenance and supportarrangements with two customers resulting in a deferral of product revenue of$4.7 million for the three months ended September 30, 2005. Themaintenance and support renegotiation also resulted in a decrease in grossmargin in the amount of $4.7 million and earnings per share of $0.02. The $4.7million of deferred revenue will be recognized as service revenue oversubsequent quarters as services are delivered. The consistency for the ninemonths ended September 30, 2005 is primarily due to the timing of revenuerecognition, which in part is dependent upon completion of certain customerdeployments and obligations as of the end of a fiscal quarter and the impact ofan increase in orders in the fourth quarter of 2004 and first quarter of 2005,offset by the $4.7 reduction of revenue noted above.

Service revenues primarily comprise hardware andsoftware maintenance, network design, installation and other professionalservices. Service revenues for the three and nine months ended September 30,2005 increased 55% and 36%, respectively, from the comparable periods in fiscal2004. These increases were primarily a result of higher maintenance revenuesdue to our growing installed product base and an increase in installationrevenue. For the nine months ended September 30, 2005, service revenueswere partially offset by lower resident engineering revenue.

Cingular Wireless, Global Crossing, QwestCommunications, Softbank Broadband and Verizon Global Networks each contributed10% or more of our revenues during one or more of the periods for the three andnine months ended September 30, 2005 and 2004.

International revenues, primarily attributable toJapan and Europe, were 21% and 6% of total revenues for the three months ended September 30,2005 and 2004, respectively, and were 20% and 15% of total revenues for thenine months ended September 30, 2005 and 2004, respectively.

Our deferred product revenue was $47.8 million and$46.2 million as of September 30, 2005 and December 31, 2004,respectively. Our deferred service revenue was $65.6 million and $44.9 millionas of September 30, 2005 and December 31, 2004, respectively. Ourdeferred revenue balance may fluctuate as a result of the timing of revenuerecognition, customer payments, maintenance contract renewals, contractualbilling rights, customer creditworthiness and maintenance revenue deferrals includedin multiple element arrangements. As of September 30, 2005 and December 31,2004, deferred revenue and accounts receivable excluded $7.7 million and $6.5million, respectively, related to products shipped and billed to customerswhich are collectible under extended payment terms or for which revenue isrecognized as cash is collected.

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***Cost of Revenues/Gross Profit.******  ***Ourcost of revenues consists primarily of amounts paid to third-partymanufacturers for purchased materials and services, royalties, manufacturingand professional services personnel and related costs, and inventoryobsolescence. Cost of revenues and gross profit as a percentage of revenues forthe three and nine months ended September 30, 2005 and 2004 were asfollows (in thousands, except percentages):

| ** **                                             | ** ** | **Three months ended  September  30,** | ** ** | **Nine months ended  September  30,** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                                   | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cost of revenues:**                                  |       |                                                       |       |                                                      |       |   |   |   |   |
| Product                                                |       | $                                                          | 17,410     |                                                      | $          | 6,296 |   | $ | 39,657 |   | $ | 24,151 |   |
| Service                                                |       | 6,073                                                      |       | 4,173                                                     |       | 16,993 |   | 12,659 |   |
| Total cost of revenues                                 |       | $                                                          | 23,483     |                                                      | $          | 10,469 |   | $ | 56,650 |   | $ | 36,810 |   |
| **Gross profit margin****(% of respective revenues):** |       |                                                       |       |                                                      |       |   |   |   |   |
| Product                                                |       | 40                                                         | %          | 83                                                        | %          | 57 | % | 74 | % |
| Service                                                |       | 63                                                         |       | 61                                                        |       | 62 |   | 61 |   |
| Total gross profit  margin                             |       | 49                                                         | %          | 78                                                        | %          | 59 | % | 71 | % |

 

The decreases in product gross profit as a percentageof product revenues for the three and nine months ended September 30, 2005were primarily due to customer and product mix and a renegotiation ofmaintenance and support arrangements with two customers resulting in areduction in product revenue and gross margin of $4.7 million in the thirdquarter of 2005. We expect that over time our product gross margins will beconsistent with our long-term financial model of 58-62%. The increase inservice gross profit as a percentage of service revenues was primarily due toan increase in our service revenues, partially offset by increased investmentin our service organization to support the expansion of our installed base. Ourservice cost of revenues is predominantly fixed in nature 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 costs and prototype costsrelated to the design, development, testing and enhancement of our products.Research and development expenses were $11.8 million for the three monthsended September 30, 2005, an increase of $2.8 million, or 31%, from$9.0 million for the same period in fiscal 2004. Research and developmentexpenses were $33.9 million for the nine months ended September 30,2005, an increase of $7.1 million, or 26%, from $26.8 million for thesame period in fiscal 2004. These increases primarily reflect an increase insalary and related expenses associated with increased headcount and additionaldepreciation expenses associated with new capital expenditures. Some aspects ofour research and development efforts require significant short-termexpenditures, the timing of which can cause significant variability in ourexpenses. We believe that rapid technological innovation is critical to ourlong-term success and we intend to continue to make substantial investments toenhance our products and technologies to meet the requirements of our customersand market. We believe that our research and development expenses for thefourth quarter of fiscal 2005 will increase from the third quarter of fiscal2005 primarily as a result of increases in salary and related expensesassociated with increased headcount, and depreciation expenses associated withnew capital expenditures. The additional investments are directed primarily towardthe growth of our access, wireless and international businesses as well as theexpansion of our research and development operations in India.

***Sales and MarketingExpenses.******  ***Sales and marketing expenses consistprimarily of salaries and related personnel costs, commissions, travel andentertainment expenses, promotions, customer evaluations and other marketingand sales support expenses. Sales and marketing expenses were $10.8 millionfor the three months ended September 30, 2005, an increase of $295,000, or3%, from $10.5 million for the same period in fiscal 2004. Sales andmarketing expenses were $31.4 million for the nine months ended September 30,2005, an increase of $5.4 million, or 20%, from $26.0 million for thesame period in fiscal 2004. The 

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increases for the threeand nine months ended September 30, 2005 primarily reflect an increase insalaries and travel expenses associated with increased headcount related to theexpansion of our access, wireless and international sales opportunities,partially offset by a decrease in evaluation equipment expenses. We believethat our sales and marketing expenses for the fourth quarter of fiscal 2005will increase from the third quarter of fiscal 2005 related to commission andevaluation equipment expenses. The magnitude of the increase will be dependentupon our level of revenues in the fourth quarter as commission expensesfluctuate primarily based on revenue levels.

***General and AdministrativeExpenses.******  ***General and administrative expensesconsist primarily of salaries and related personnel costs for executive andadministrative personnel, recruiting expenses, professional fees and directorsand officers insurance. General and administrative expenses were$5.5 million for the three months ended September 30, 2005, adecrease of $1.2 million, or 18%, from $6.6 million for the same period infiscal 2004. General and administrative expenses were $18.7 million forthe nine months ended September 30, 2005, an increase of $1.5 million, or9%, from $17.2 million for the same period in fiscal 2004. The decreasefor the three months ended September 30, 2005 primarily reflects adecrease in directors and officers insurance costs and a reduction in bonusexpenses, partially offset by an increase in salary and related expensesassociated with increased headcount. The increase for the nine months ended September 30,2005 primarily reflects an increase in professional fees incurred to performthe assessment and audit of our internal control over financial reportingrequired under Section 404 of the Sarbanes-Oxley Act of 2002 for2005 and to remedy identified material weaknesses in our internal controlenvironment and an increase in salary and related expenses associated withincreased headcount, partially offset by a decrease in directors and officersinsurance costs. We believe that our general and administrative expenses forthe fourth quarter of fiscal 2005 will increase from the third quarter due tocontinued costs associated with improvements we are making in our internalcontrol environment to address material weaknesses.

***Stock-basedCompensation Expenses.******  ***Stock-basedcompensation expenses include the amortization of stock compensation chargesresulting from the granting of stock options, including the telecomtechnologies, inc. (TTI) stock options assumed by us, stock awards to TTIemployees under the 2000 Retention Plan, sales of restricted common stock andgranting of stock options to non-employees. Stock-based compensationexpenses were $11,000 and $15,000 for the three and nine months ended September 30,2005, respectively, compared to $91,000 and $606,000 for the three and ninemonths ended September 30, 2004, respectively. The decreases are due todeferred stock-based compensation being fully amortized as of December 31,2004, partially offset by expense for a grant to a non-employee in the secondquarter of 2005.

***Amortization ofPurchased Intangible Assets.******  ***In fiscal2001, we acquired certain intellectual property, in-process research anddevelopment and intangible assets in connection with our acquisitions of TTIand Linguateq, Inc. As of December 31, 2004, the purchased intangibleassets were fully amortized, therefore there was no amortization expense forthe three and nine months ended September 30, 2005. Amortization ofpurchased intangible assets was $601,000 and $1.8 million for the three andnine months ended September 30, 2004, respectively.

***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 arrangements. Interest income, net ofinterest expense, was $2.6 million for the three months ended September 30,2005, an increase of $1.6 million from $1.0 million for the same period infiscal 2004. Interest income, net of interest expense, was $6.4 million for thenine months ended September 30, 2005, an increase of $4.0 million from$2.4 million for the same period in fiscal 2004. These increases primarilyreflect the benefit of an increase in the yield on our portfolio due to anincreasing interest rate environment.

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***Income Taxes.******  ***(Benefit)provision for income taxes was $(640,000) and $214,000 for the three monthsended September 30, 2005 and 2004, respectively, and $(233,000) and$598,000 for the nine months ended September 30, 2005 and 2004,respectively. The income tax (benefit) provision in all periods is primarilyattributable to foreign income taxes and state income taxes in the U.S. Duringthe three months ended September 30, 2005, we received****arefund of approximately $450,000 related to foreign income taxes paid in prioryears that was recorded as a reduction to expense.

**Liquidity and Capital Resources**

At September 30, 2005, our principal sources ofliquidity were our cash, cash equivalents, marketable debt securities andlong-term investments that totaled $324.9 million.

Our cash generated from operating activities was$17.3 million for the nine months ended September 30, 2005 ascompared to net cash used in operating activities of $2.3 million for thesame period in fiscal 2004. This increase was primarily due to an increase indeferred revenue and decreases in inventory and other current assets, partiallyoffset by lower net income for the nine months ended September 30, 2005 ascompared to the prior year and a decrease in accounts payable.

Net cash used in investing activities was$10.7 million for the nine months ended September 30, 2005, ascompared to $17.3 million for the same period in fiscal 2004. Net cash used ininvesting activities for the nine months ended September 30, 2005primarily reflects capital expenditures of $11.3 million. Net cash used ininvesting activities for the nine months ended September 30, 2004primarily reflects net purchases of marketable debt securities and long-terminvestments of $11.4 million and capital expenditures of $6.3 million.We expect to incur approximately $3-4 million in additional capitalexpenditures in the remainder of 2005.

Net cash provided by financing activities was$6.3 million for the nine months ended September 30, 2005, ascompared to $2.7 million for the same period in fiscal 2004. The net cashprovided by financing activities for both periods resulted primarily from thesale of common stock in connection with our employee stock purchase plan andproceeds from the exercise of stock options.

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

***Recent Accounting Pronouncements***

In November 2004, theFASB issued SFAS No. 151, *InventoryCosts, an Amendment of Accounting Research Bulletin (ARB) No. 43, Chapter4.*SFAS No. 151 amends the guidance in ARB No. 43,Chapter 4, “Inventory Pricing” to clarify that abnormal amounts of idlefacility expense, freight, handling costs, and wasted material (spoilage)should be recognized as current-period charges. In addition,SFAS No. 151 requires that allocation of fixed production overhead tothe costs of conversion be based on the normal capacity of the productionfacilities. The provisions of SFAS No. 151 are effective for fiscalyears beginning after June 15, 2005. We are evaluating the provisions ofSFAS No. 151 and presently do not believe that its adoption will havea material impact on our financial condition, results of operations or cashflows.

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In December 2004, theFASB issued SFAS 123(R), *Share-BasedPayment*, which revises SFAS No. 123, *Accounting for Stock-Based Compensation*.supersedes APB Opinion No. 25, *Accountingfor Stock Issued to Employees* and its related interpretations, andamends SFAS No. 95, *Statement of CashFlows*. SFAS 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe income statement based on their fair values at the date of grant. Pro formadisclosure is no longer an alternative. SFAS 123(R) is effective forfiscal years beginning after June 15, 2005. Sonus is required to adoptSFAS 123(R) on January 1, 2006. SFAS 123(R) permitspublic companies to adopt its requirements using one of two methods: a “modifiedprospective” method, in which compensation cost is recognized beginning withthe effective date (a) based on the requirements of SFAS 123(R) forall share-based payments granted after the effective date, and (b) basedon the requirements of SFAS 123 for all awards granted to employees priorto the effective date of SFAS 123(R) that remain unvested on theeffective date; or a “modified retrospective” method, which includes therequirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underSFAS 123 for purposes of pro forma disclosures either (a) all priorperiods presented or (b) prior interim periods of the year of adoption.Sonus has not yet determined which method to use in adopting SFAS 123(R).Sonus is evaluating SFAS 123(R) and has not yet determined the amountof stock option expense that will be incurred in future periods as a result ofthe adoption of SFAS 123(R). The adoption of SFAS 123(R) willhave no impact on Sonus’ net cash flows or overall financial position.

**Cautionary Statements**

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

***We have identified material weaknesses in ourdisclosure controls and procedures and our internal control over financialreporting, which, if not remedied effectively, could have an adverse effect onthe trading price of our common stock and otherwise seriously harm ourbusiness.***

Management has concludedthat our disclosure controls and procedures and our internal control overfinancial reporting had material weaknesses as of December 31, 2004. Althoughwe have taken certain actions during 2005 to address those material weaknesses,our inability to remedy such material weaknesses promptly and effectively couldhave a material adverse effect on our business, results of operations andfinancial condition, as well as impair our ability to meet our quarterly andannual reporting requirements in a timely manner. These effects could in turnadversely affect the trading price of our common stock. Prior to theremediation of these material weaknesses, there remains risk that thetransitional controls on which we currently rely will fail to be sufficientlyeffective, which could result in a material misstatement of our financialposition or results of operations. 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 fraud or facilitate thefair presentation of our financial statements, SEC reporting or otherdisclosures.

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

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

***We face risks related to securities litigation thatcould have a material adverse effect on our business, financial position andresults of operations.***

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

***The limitations of our director and officer liabilityinsurance may materially harm our business and financial condition.***

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

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

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

If we fail to keep currentin our SEC filings, our common stock may be delisted from the NASDAQ NationalMarket and subsequently would trade on the Pink Sheets. The trading of ourcommon stock on the Pink Sheets may reduce the price of our common stock andthe levels of liquidity available to our stockholders. Our delisting from theNASDAQ National Market and transfer to the Pink Sheets may also result in othernegative implications, including the potential loss of confidence by suppliers,customers and employees, the loss of institutional investor interest and fewerbusiness development opportunities.

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***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 andcontinuing into 2005, the telecommunications industry experienced a reversal ofsome of these trends, marked by dramatic reductions in capital expenditures,financial difficulties, and, in some cases, bankruptcies experienced by serviceproviders. These conditions caused a substantial, unexpected reduction indemand for telecommunications equipment, including our products.

We expect the developmentsdescribed above to continue to affect our business in the following 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.

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

To date, we haveshipped our products to a limited number of customers. We expect that in theforeseeable future, the majority of our revenues will continue to depend onsales of our products to a limited number of customers. One customercontributed more than 10% of our revenues for the first nine months of fiscal2005, which represented an aggregate of 29% of total revenues. Two and fourcustomers each contributed more than 10% of our revenues for fiscal 2004 and2003, respectively, which represented an aggregate of 29% and 57% of totalrevenues, respectively. Our future success will depend on our ability toattract additional customers beyond our current limited number. The growth ofour customer base could be adversely affected by:

·       acquisitionof or by our customers;

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

·       potentialcustomer concerns with selecting an emerging telecommunications equipmentvendor;

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

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

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·       newproduct introductions by our competitors;

·       failureof our products to perform as expected; or

·       difficultieswe may incur in meeting customers’ delivery requirements.

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

***The market for voice infrastructure products for thenew public network is new and evolving and our business will suffer if it doesnot develop as we expect.***

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

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

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

***Our large 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 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 impact our financial position in theperiod affected.

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

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

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

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

Internationalrevenues, primarily attributable to Japan and Europe, were approximately $26.8million for the first nine months of fiscal 2005, and $28.8 million forfiscal 2004 and we intend to expand our sales in international markets. Thisexpansion will require significant management attention and financial resourcesto successfully develop direct and indirect international sales and supportchannels. In addition, we may not be able to develop international marketdemand for our products, which could impair our ability to grow our revenues.We have limited experience marketing, distributing and supporting our productsinternationally and, to do so, we expect that we will need to develop versionsof our products that comply with local standards. Furthermore, internationaloperations are subject to other inherent risks, including:

·       relianceon distributors and resellers;

·       greaterdifficulty collecting accounts receivable and longer collection cycle;

·       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.

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

We have incurredsignificant losses since inception and, as of September 30, 2005, had anaccumulated deficit of $780.7 million. Although we achieved profitability inthe second quarter of fiscal 2005 and in each quarter and on an annual basis infiscal year 2004, we incurred a net loss in the first and third quarters offiscal 2005 and may incur additional losses in future quarters and years. Ourrevenues may not grow and we may never generate sufficient revenues to returnto or sustain profitability.

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

Our revenues andoperating results may vary significantly from quarter to quarter due to a numberof factors, many of which are outside of our control and any of which may causeour stock price to fluctuate. Generally, purchases by service providers oftelecommunications equipment from manufacturers have been unpredictable andclustered, rather than steady, as the providers build out their networks. Theprimary factors that may affect our revenues and operating results include thefollowing:

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

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

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

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

·       thetiming of revenue recognition;

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

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

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

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***We are 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 or marketingof new products and enhancements. The introduction of new products by ourcompetitors, the market acceptance of products based on new or alternativetechnologies or the emergence of new industry standards could render ourexisting or future products obsolete. If the standards adopted are differentfrom those that we have chosen to support, market acceptance of our productsmay be significantly reduced or delayed. If our products become technologicallyobsolete, we may be unable to sell our products in the marketplace and generaterevenues.

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

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

Many of our current and potential competitors havesignificantly greater selling and marketing, technical, manufacturing,financial and other resources. Further, some of our competitors sellsignificant amounts of other products to our current and prospective customers.Our competitors’ broad product portfolios, coupled with already existingrelationships, may cause our customers to buy our competitors’ products or harmour ability to attract new customers.

To competeeffectively, we must deliver innovative products that:

·       provideextremely high reliability and voice quality;

·       scaleeasily and efficiently;

·       interoperatewith existing network designs and other vendors’ equipment;

·       provideeffective network management;

·       areaccompanied by comprehensive customer support and professional services; and

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

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

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

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

·       lossof, or delay in, revenues;

·       lossof customers and market share;

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

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

·       costly and time-consuminglegal actions by our customers.

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

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

·       lossof customers and market share;

·       afailure to attract new customers in new geographies;

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

·       network performancepenalties.

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

We have made significant changes in our seniormanagement team recently including the hiring of a Vice President, CorporateController and Principal Accounting Officer in August 2005, a VicePresident of Internal Operations in March 2005, and a Chief FinancialOfficer in December 2004. Because of these significant changes, ourmanagement team may not be able to work together effectively to successfullydevelop and implement our business strategies and financial operations. 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.

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

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

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

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

***We depend upon contract manufacturers and anydisruption in these relationships may cause us to fail to meet the demands ofour customers and damage our customer relationships.***

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

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

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

We currently do not havelong-term supply contracts with our component suppliers and they are notrequired to supply us with products for any specified periods, in any specifiedquantities or at any set price, except as may be specified in a particularpurchase order. In the event of a disruption or delay in supply, or inabilityto obtain products, we may not be able to develop an alternate source in atimely manner or at 

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favorableprices, or at all. A failure to find acceptable alternative sources could hurtour ability to deliver high-quality products to our customers and negativelyaffect our operating margins. In addition, reliance on our suppliers exposes usto potential supplier production difficulties or quality variations. Ourcustomers rely upon our ability to meet committed delivery dates, and anydisruption in the supply of key components would seriously adversely affect ourability to meet these dates and could result in legal action by our customers,loss of customers or harm our ability to attract new customers.

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

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

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

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

·       lossof, or delay in, revenues;

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

·       networkperformance penalties.

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

·       lossof customers and market share; and

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

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

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

In addition, wehave received inquiries from other patent holders and may become subject toclaims that we infringe their intellectual property rights. Any partiesasserting that our products infringe upon 

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theirproprietary rights could force us to license their patents for substantialroyalty payments or to defend ourselves and possibly our customers or contractmanufacturers in litigation. These claims and any resulting licensingarrangement or lawsuit, if successful, could subject us to significant royaltypayments or liability for damages and invalidation of our proprietary rights. Anypotential intellectual property litigation also could force us to do one ormore of the following:

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

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

·       redesignthose products that use any allegedly infringing technology.

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

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

We intend to considerinvesting in, or acquiring, complementary products, technologies or businesses.In the event of future investments or acquisitions, we could:

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

·       incurdebt or assume liabilities;

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

·       incursignificant amortization expenses related to purchased intangible assets; or

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

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

·       problemsand unanticipated costs associated with combining the purchased products, technologiesor 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 prior experience;and

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

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

***Recent rulemaking by the Financial AccountingStandards Board will require 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 usedstock options as a significant component of our employee compensation programin order to align employees’ interests with the interests of our stockholders,encourage employee retention, and provide competitive compensation packages.The Financial Accounting Standards Board has adopted changes that will requirecompanies to record a charge to earnings for employee stock option 

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grantsand other equity incentives beginning January 1, 2006. By causing us toincur significantly increased compensation costs, such accounting changes maycause us to reduce the availability and amount of equity incentives provided toemployees, which may make it more difficult for us to attract, retain andmotivate key personnel.

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

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

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

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

·       fundongoing operations and capital requirements;

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

·       developnew products; or

·       respondto competitive pressures.

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

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

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

·       changesin our listing status on the NASDAQ Stock Market;

·       theaddition or loss of any major customer;

·       consolidationin the telecommunications industry;

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

·       quarterlyvariations in our operating results;

·       changesin financial estimates by securities analysts;

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·       speculationin the press or investment community;

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

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

·       securitiesand other litigation;

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

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

·       worldwide economicinstability.

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

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

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

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

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

We are exposed to a variety of market risks, includingchanges in interest rates affecting the return on its investments and foreigncurrency fluctuations. We have established procedures to manage our exposure tofluctuations in interest rates and foreign currency exchange rates.

We generally place ourmarketable debt securities in high-quality debt instruments, primarily U.S.Government, state government and corporate obligations with contractualmaturities of less than one year. Beginning in the third quarter of 2005, weentered into foreign exchange contracts to hedge against currency fluctuationsrelated to a particular account receivable denominated in Japanese Yen whichwere closed as of September 30, 2005. We have not experienced any materiallosses from our marketable security investments and therefore believe that ourpotential interest rate exposure is not material. As we continue to expandinternationally, we will continue to evaluate the impact of foreign currencyexchange risk on our results of operations.

**Item 4: Controls and Procedures**

Our management, with the participation of our ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof our disclosure controls and procedures (as defined in Rule 13a-15(e)under the Securities Exchange Act of 1934 (the Exchange Act)) as of September 30,2005, which included an evaluation of disclosure controls and proceduresapplicable to the period covered by the filing of this periodic report. Wepreviously reported ten material weaknesses in our internal control overfinancial reporting (as defined in Rule 13a-15(f) under theExchange Act), which were described in Item 9A and Management’s Report onInternal Control Over Financial Reporting in our Annual Report on Form 10-Kfor the year ended December 31, 2004. As a result of these materialweaknesses in our internal control 

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over financial reporting,we have concluded that our disclosure controls and procedures were noteffective as of September 30, 2005.

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

·       Weimplemented system-based detail sub-ledgers related to revenue, deferredrevenue, cost of revenue and inventory transactions to help ensure thatbalances are properly summarized and posted to our general ledger.

·       Weimplemented a quote and proposal review and approval process intended toprovide an enhanced level of management and cross-functional review forcustomer quotes and proposals before submission to our customers, capture therelevant data to identify all commitments made to customers for our financialreporting and define, automate and document the required approvals.

·       Weenhanced our controls over cash receipts, including the implementation of alockbox and reassignment of responsibilities to help ensure that all cash isaccurately and timely recorded.

·       Weestablished an IT Audit and Security function to help provide assurance thatchanges to financial applications are properly authorized and tested and thataccess to our information systems and financial applications are appropriatelyrestricted.

·       Wecontinued to enhance the level of analysis and supporting documentation foramounts reported in the financial statements.

·       Wecontinued to enhance our processes and procedures to help ensure that inventoryvaluation accounts are properly analyzed and that any resulting adjustingentries are accurately and timely recorded in our general ledger.

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

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

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

We are currently implementing an enhanced internalcontrols environment intended to address the material weaknesses in ourinternal control over financial reporting and to remedy the ineffectiveness ofour disclosure controls and procedures. While this implementation phase isunderway, we are relying on extensive manual procedures, including regular reviewsand the significant utilization of external professionals, to assist us withmeeting the objectives otherwise fulfilled by an effective internal controlsenvironment. We expect to establish and implement a policy-based systemof internal controls. While we are undertaking the implementation of this newinternal controls environment, there remains risk that the transitionalcontrols on which we are currently relying will fail to be sufficientlyeffective. We also note, however, that an internal control system, no matterhow well conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the internal control system are met. Further,the design of an internal control system must include an assessment of thecosts and related risks associated 

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with the control and thepurpose for which it was intended. Because of the inherent limitations in allinternal control systems, no evaluation of internal controls can provideabsolute assurance that all control issues including instances of fraud, ifany, have been detected. These inherent limitations include the realities thatjudgments in decision-making can be faulty, and breakdowns can occurbecause of simple error or mistake. Additionally, internal controls can becircumvented by the individual acts of some person, by collusion of two or morepeople, or by management override of the controls. The design of any system ofinternal controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions.Over time, our internal control systems, as we develop them, may becomeinadequate because of changes in conditions, or the degree of compliance withthe policies or procedures may deteriorate. Because of the inherent limitationsin a cost-effective control system, misstatements due to error or fraud mayoccur and not be detected and could be material to our financial statements.

The certifications of our Chief Executive Officer andChief Financial Officer required in accordance with Rule 13a-14(a) underthe Exchange Act are attached as exhibits to this Quarterly Report on Form 10-Q.The disclosures set forth in this Item 4 contain information concerning theevaluation of our disclosure controls and procedures, and changes in ourinternal control over financial reporting, referred to in paragraph 4 ofthose certifications. Those certifications should be read in conjunction withthis Item 4 for a more complete understanding of the matters covered by thecertifications.

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**PART II—OTHER INFORMATION**

**Item 1: Legal Proceedings**

In November 2001, a purchaser of our common stockfiled a complaint in the United States District Court for the Southern Districtof New York against us, two of our officers and the lead underwriters allegingviolations of the federal securities laws in connection with our initial publicoffering (IPO) and seeking unspecified monetary damages. The purchaser seeks torepresent a class of persons who purchased our common stock between the IPO on May 24,2000 and December 6, 2000. An amended complaint was filed in April 2002.The amended complaint alleges that our registration statement contained falseor misleading information or omitted to state material facts concerning thealleged receipt of undisclosed compensation by the underwriters and theexistence of undisclosed arrangements between underwriters and certainpurchasers to make additional purchases in the after market. The claims againstus are asserted under Section 10(b) of the Securities Exchange Act of1934 and Section 11 of the Securities Act of 1933 and against theindividual defendants under Sections 11 and 15 of the Securities Act andSections 10(b) and 20(a) of the Exchange Act. Other plaintiffs have filedsubstantially similar class action cases against approximately 300 otherpublicly traded companies and their IPO underwriters which, along with theactions against us, have been transferred to a single federal judge forpurposes of coordinated case management. On July 15, 2002, we, togetherwith the other issuers named as defendants in these coordinated proceedings,filed a collective motion to dismiss the consolidated amended complaints onvarious legal grounds common to all or most of the issuer defendants. Theplaintiffs voluntarily dismissed the claims against many of the individualdefendants, including our officers named in the complaint. On February 19,2003, the court granted a portion of the motion to dismiss by dismissing the Section 10(b)claims against certain defendants including us, but denied the remainder of themotion as to the defendants. In June 2003, a special committee of ourBoard of Directors authorized us to enter into a proposed settlement with theplaintiffs on terms substantially consistent with the terms of a Memorandum ofUnderstanding negotiated among representatives of the plaintiffs, the issuerdefendants and the insurers for the issuer defendants. On February 15,2005, the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. On August 31,2005, the court approved the terms of the proposed settlement, as modified. Thesettlement is subject to class certification and final approval by the court. Ahearing has been scheduled on April 24, 2006 for final approval. Theproposed settlement would not require any settlement payment by Sonus,therefore Sonus does not expect that the settlement would have a materialimpact on its business or financial results.

Beginning in July 2002, several purchasers of ourcommon stock filed complaints in the United States District Court for theDistrict of Massachusetts against us, certain officers and directors and aformer officer under Sections 10(b) and 20(a) and Rule 10b-5of the Securities Exchange Act of 1934 (Class Action Complaints). Thepurchasers seek to represent a class of persons who purchased our common stockbetween December 11, 2000 and January 16, 2002, and seek unspecifiedmonetary damages. The Class Action Complaints were essentially identicaland alleged that we made false and misleading statements about our products andbusiness. On March 3, 2003, the plaintiffs filed a Consolidated AmendedComplaint. On April 22, 2003, we filed a motion to dismiss theConsolidated Amended Complaint on various grounds. On May 11, 2004, thecourt held oral argument on the motion, at the conclusion of which the courtdenied our motion to dismiss. The plaintiffs filed a motion for classcertification on July 30, 2004, . On February 16, 2005, the courtcertified the class and appointed a class representative. On March 9,2005, the court appointed 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 

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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 October 21,2005, the defendants filed a motion seeking the recovery of attorneys’ feesfrom plaintiffs. The plaintiffs have until December 5, 2005 to respond tothe motion.

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against us and certain of our currentofficers and directors. On June 28, 2004, the court consolidated theclaims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the Securities ExchangeAct of 1934 and Sections 11, 12(a), and 15 of the Securities Act of 1933,relating to our restatement of our financial results for 2001, 2002, and thefirst three quarters of 2003. Specifically, the complaint alleges that weissued a series of false or misleading statements to the market concerning ourrevenues, earnings, and financial condition. Plaintiffs contend that suchstatements caused our stock price to be artificially inflated. The complaintseeks unspecified damages on behalf of a purported class of purchasers of ourcommon stock during the period from March 28, 2002, through March 26,2004. On January 28, 2005, we filed a motion to dismiss the Section 10(b) and12(a) claims and joined the motion to dismiss the Section 11 claimfiled by the individual defendants. On June 1, 2005, the court held ahearing on the motion and allowed the plaintiff to file an amended complaint. Theplaintiff filed an Amended Complaint that included the same claims andsubstantially similar allegations as set forth in the prior Complaint. On September 12,2005, the defendants filed motions to dismiss this Amended Complaint. The Courthas scheduled a hearing on the motions for December 10, 2005. We believethat we have substantial legal and factual defenses to the claims, which weintend to pursue vigorously. There is no assurance we will prevail in defendingthese actions. A judgment or a settlement of the claims against the defendantscould have a material impact of Sonus’ financial results.

In February 2004, three purported shareholderderivative lawsuits were filed in the United States District Court for theDistrict of Massachusetts against us and certain of our officers and directors,naming us as a nominal defendant. Also in February 2004, two purportedshareholder derivative lawsuits were filed in the business litigation sessionof the superior court of Suffolk County of Massachusetts against us and certainof our directors and officers, also naming us as a nominal defendant. The suitsclaim that certain of our officers and directors breached their fiduciaryduties to our stockholders and to us. The complaints are derivative in natureand do not seek relief from us. However, we have entered into indemnificationagreements in the ordinary course of business with certain of the defendantofficers and directors and may be obligated throughout the pendency of theseactions to advance payment of legal fees and costs incurred by the defendantspursuant to our obligations under the indemnification agreements or applicableDelaware law. On September 27, 2004, the state court granted our motion todismiss. On October 26, 2004, the plaintiffs filed a notice appealing thestate court’s dismissal of the actions. On June 24, 2005, the plaintiffswithdrew the appeal and dismissed the case with prejudice. In the federalactions, on June 28, 2004, the court consolidated and stayed the threeactions. On October 12, 2004, the lead plaintiff filed a consolidatedamended complaint. On June 1, 2005, the court held a hearing on the motionand allowed the plaintiff to file an amended complaint. On July 1, 2005,the plaintiff filed and amended complaint. The defendants renewed their motions todismiss. The court has scheduled a hearing on the motions for December 10,2005. There is no assurance we will prevail in defending these actions. Sonusdoes not expect these shareholder derivative claims will have a material impacton its financial results.

In December 2004, a purchaser of our common stockfiled a complaint in the circuit court in Will County, Illinois, againstus, one of our officers, and a former officer alleging misrepresentation andfraud in connection with the plaintiff’s purchase of our stock. The Complaintseeks unspecified damages. We filed a motion to dismiss the complaint. On May 5,2005, the plaintiff filed an amended complaint. On October 26, 2005, thecourt held a hearing on the motion during which he dismissed the federal claims

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without prejudice anddismissed the state claims without prejudice and leave to refile within 28 days.If the plaintiff does not refile within 28 days then the state claims will bedismissed with prejudice. The court scheduled a status hearing for December 1,2005. Sonus does not expect that this claim will have a material impact on itsfinancial results.

Sonus includes standardintellectual property indemnification provisions in its product agreements inthe ordinary course of business. Pursuant to Sonus’ product agreements, Sonuswill indemnify, hold harmless, and reimburse the indemnified party for lossessuffered or incurred by the indemnified party, generally business partners orcustomers, in connection with certain patent, copyright or other intellectualproperty infringement claims by third parties with respect to Sonus’ products.Other agreements with Sonus’ customers provide indemnification for claimsrelating to property damage or personal injury resulting from the performanceof services by Sonus or its subcontractors. Historically, Sonus’ costs todefend lawsuits or settle claims relating to such indemnity agreements havebeen insignificant. Accordingly, the estimated fair value of theseindemnification provisions is immaterial.

**Item 6: Exhibits**
| Exhibit Number | ** ** | ** **                                                                                                                                                                                           | ** ** | **Description** |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.28               |       | Office Lease Agreement, dated July 19, 2005,  between Sonus Networks, Inc. and Pearson Fund III, L.P. with  respect to property located at 1130 East Arapaho Road, Richardson, Texas. |
| 10.29(a)            |       | Employment letter dated  August 11, 2005, by and between the Registrant and Paul K. McDermott.                                                                                                  |
| 31.1                |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Rule 13a-14(a) of  the Securities Exchange Act of 1934.                                                    |
| 31.2                |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Rule 13a-14(a) of  the Securities Exchange Act of 1934.                                                    |
| 32.1                |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Rule 13a-14(b) of  the Securities Exchange Act of 1934.                                                    |
| 32.2                |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Rule 13a-14(b) of  the Securities Exchange Act of 1934.                                                    |

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(a)           Incorporated byreference from the Registrant’s Form 8-K (file No. 000-30229)filed August 15, 2005 with the SEC.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theRegistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized. 
| Dated: November 8, 2005 | SONUS NETWORKS, INC. |
|------------------------------|---------------------------|
|                         | By:                       | /s/ ELLEN B. RICHSTONE |
|                         |                      | Ellen B. Richstone |
| * *                     | * *                  | *Chief Financial Officer (Principal Financial  Officer)* |
|                         | SONUS NETWORKS, INC. |
|                         | 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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**EXHIBIT INDEX**
| Exhibit Number | ** ** | ** **                                                                                                                                                                                           | ** ** | **Description** |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.28               |       | Office Lease Agreement, dated July 19, 2005,  between Sonus Networks, Inc. and Pearson Fund III, L.P. with  respect to property located at 1130 East Arapaho Road, Richardson, Texas. |
| 10.29(a)            |       | Employment letter dated  August 11, 2005, by and between the Registrant and Paul K. McDermott.                                                                                                  |
| 31.1                |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Rule 13a-14(a) of  the Securities Exchange Act of 1934.                                                    |
| 31.2                |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Rule 13a-14(a) of  the Securities Exchange Act of 1934.                                                    |
| 32.1                |       | Certification of Sonus  Networks, Inc. Chief Executive Officer pursuant to Rule 13a-14(b) of  the Securities Exchange Act of 1934.                                                    |
| 32.2                |       | Certification of Sonus  Networks, Inc. Chief Financial Officer pursuant to Rule 13a-14(b) of  the Securities Exchange Act of 1934.                                                    |

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(a)           Incorporated byreference from the Registrant’s Form 8-K (file No. 000-30229)filed August 15, 2005 with the SEC.

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