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**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

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**FORM 10-K**

**FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO****SECTIONS** **13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

|  | **ANNUAL REPORT PURSUANT TO SECTION** **13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JULY** **31, 2004, OR** |
|--|--------------------------------------------------------------------------------------------------------------------------------------------------------|

|   |                                                                                                   |
|--------|--------------------------------------------------------------------------------------------------------|
|        | **TRANSITION REPORT PURSUANT TO SECTION** **13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |

 

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**Commission File Number: 000-26763**

**NET2PHONE, INC.****(Exact name of registrant as specified in its charter)**

| **Delaware**                          | **22-3559037**          |
|---------------------------------------|-------------------------|
| **(State or other jurisdiction**      | **(I.R.S. Employer**    |
| **of incorporation or organization)** | **Identification No.)** |

**520 Broad Street****Newark, New Jersey 07102****(Address of principal executive offices, including zip code)**

**(973) 438-3111****(Registrant’s telephone number, including area code)**

**Securities registered pursuant to Section** **12(b) of the Act:** **None**          

**Securities registered pursuant to Section** **12(g) of the Act:** **Common Stock, par value $0.01 per share (Title of Class)**

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form10-K or any amendment to this Form 10-K. 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes  No 

The aggregate market value of registrant’s    common stock held by non-affiliates of the registrant on January 31,    2004 (the last business day of the registrant’s most recently completed    second fiscal quarter), was approximately $316.6 million. On such date,    the last sale price of registrant’s common stock was $6.33 per share.

The number of shares outstanding    of each of the registrant’s classes of common stock, as of October 7,    2004, was 47,498,630 shares of common stock and 28,911,750 shares of Class    A common stock. (The number of outstanding shares of Class A common stock    does not include 6.9 million shares we expect to issue as of the date    definitive agreements are executed between Net2Phone, Inc. and IDT Corporation    as described in more detail in Note 14 to the Consolidated Financial Statements    included herein.)

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**DOCUMENTS INCORPORATED BY REFERENCE**

Certain sections of the registrant’s Proxy Statement to be filed in connection with the 2004 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K where indicated.

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|--|
|  |
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**NET2PHONE, INC.****ANNUAL REPORT ON FORM 10-K****TABLE OF CONTENTS**

|                          |                                                                                                                          | **Page     Number** |
|-------------------------------|-------------------------------------------------------------------------------------------------------------------------------|---------------------|
|                          |                                                                                                                          |                     |
|                          |                                                                                                                          |                |
| PART I                        | 1                                                                                                                             |
|                          |                                                                                                                          |                |
| Item 1.                       | Business                                                                                                                      | 1                   |
| Item 2.                       | Properties                                                                                                                    | 33                  |
| Item 3.                       | Legal Proceedings                                                                                                             | 33                  |
| Item 4.                       | Submission of Matters to a Vote of Security Holders                                                                           | 34                  |
|                          |                                                                                                                          |                |
| PART II                       | 35                                                                                                                            |
|                          |                                                                                                                          |                |
| Item 5.                       | Market for          Registrant’s Common Equity, Related Stockholder Matters and Issuer    Purchases of Equity Securities | 35                  |
| Item 6.                       | Selected Financial Data                                                                                                       | 36                  |
| Item 7.                       | Management’s    Discussion and Analysis of Financial Condition and Results of Operations                                 | 36                  |
| Item 7A.                      | Quantitative and Qualitative Disclosures About Market Risk                                                                    | 51                  |
| Item 8.                       | Financial Statements and Supplementary Data                                                                                   | 52                  |
| Item 9.                       | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                                          | 52                  |
| Item 9A.                      | Controls and Procedures                                                                                                       | 52                  |
| Item 9B.                      | Other Information                                                                                                             | 52                  |
|                          |                                                                                                                          |                |
| PART III                      | 53                                                                                                                            |
|                          |                                                                                                                          |                |
| Item 10.                      | Directors and Executive Officers of the Registrant                                                                            | 53                  |
| Item 11.                      | Executive Compensation                                                                                                        | 53                  |
| Item 12.                      | Security Ownership of Certain Beneficial Owners and Management                                                                | 53                  |
| Item 13.                      | Certain Relationships and Related Transactions                                                                                | 54                  |
| Item 14.                      | Principal Accounting Fees and Services                                                                                        | 54                  |
|                          |                                                                                                                          |                |
| PART IV                       | 55                                                                                                                            |
|                          |                                                                                                                          |                |
| Item 15.                      | Exhibits and Financial Statement Schedules                                                                                    | 55                  |
|                          |                                                                                                                          |                |
| INDEX TO FINANCIAL STATEMENTS | F-1                                                                                                                           |
|                          |                                                                                                                          |                |
| SIGNATURES                    | S-1                                                                                                                           |

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**PART      I**

This Annual Report on Form 10-K      includes “forward-looking statements.” The words “may,” “will,” “should,” “continue,” “future,” “potential,” “believe,” “expect,” “anticipate,” “project,” “plan,” “intend,” “seek,” “estimate” and      similar expressions identify forward-looking statements. We caution you      that any forward-looking statements made by us are not guarantees of future      performance and that a variety of factors, including those discussed below,      could cause our actual results and experience to differ materially from      the anticipated results or other expectations expressed in our forward-looking      statements. Please see “Risk Factors” below for detailed information      about the uncertainties and other factors that may cause actual results      to materially differ from the views stated in such forward-looking statements.      All forward-looking statements and risk factors included in this Annual      Report are made as of the date hereof, based on information available to      us as of the date hereof, and we assume no obligation to update any forward-looking      statement or risk factor.

Our fiscal year ends on July 31      of each calendar year. Each reference to a fiscal year in this Annual Report      refers to the fiscal year ending July 31 of the calendar year indicated      (for example, fiscal 2004 refers to the fiscal year ended July 31,      2004). Unless the context requires otherwise, references to “we,” “us,” “our,” “Net2Phone” and      the “Company” refer to Net2Phone, Inc. and its consolidated subsidiaries.

| **Item            1.**     ***Business*** |
|--------------------------------------------------------------------|

|                 |
|----------------------|
| **Company Overview** |

We are a leading provider of Voice      over Internet Protocol, or VoIP, communications services. We began operations      in 1995 as a division of IDT Corporation, or IDT, and were incorporated      in Delaware as a separate subsidiary of IDT in October 1997. Since we began      operations in 1995, we have evolved from a pioneer in developing PC-to-telephone      calling services over the Internet to a next generation provider of high      quality voice and enhanced communication services throughout the world,      including cable telephony services. We utilize our VoIP technology to transmit      digital voice communications over managed data networks and the Internet.      Since 1996, we have carried billions of VoIP minutes worldwide.

Our corporate structure is primarily      organized around two wholly owned operating subsidiaries:

|   | • | *Net2Phone Global Services*delivers          VoIP telephone services to businesses and consumers directly and through          its global distribution network of over 500 resellers in over 130 countries,          capitalizing on the growth, quality, flexibility and cost advantages          of VoIP technologies. |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   |   |                                                                                                                                                                                                                                                                                 |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Net2Phone Cable Telephony*offers          broadband operators a complete suite of services enabling them to deliver          residential phone service to their customers having comparable features          and functionality to that offered by traditional telephone companies. |

Substantially all of our revenue has been, and is currently, derived  from Net2Phone Global Services. Through Net2Phone Global Services, we offer a variety of VoIP-based communications  products and services to consumers, enterprises and telecommunications providers around the world. During the past  thirty months, we have focused Net2Phone Global Services on higher margin opportunities in deregulating  telecommunications markets.  Additionally, we have eliminated low margin services, such as disposable calling  cards in the U.S., and significantly reduced our workforce.  Although these measures have resulted in consistent  quarterly declines in revenue until recently, our gross margin has exceeded 40 percent for the past thirteen quarters  and our expenses have significantly declined. While we have never generated income from operations (other than as a result  of a litigation settlement in 2003) and Net2Phone Global Services reported significant segment losses prior to fiscal 2003,  Net2Phone Global Services has achieved increasing segment income over the past two fiscal years.  For more information  regarding our segment operating results, see Note 21 of the Notes to our Consolidated Financial Statements included  elsewhere in this Annual Report.

We are actively marketing cable      telephony services to a wide array of cable operators in the U.S., Europe      and Latin America who we believe may be more likely to buy our services      than to build their own cable telephony service. On October 22, 2003,      following a successful trial period, Net2Phone Cable Telephony signed its      first customer contract with Liberty Cablevision of Puerto Rico, Inc.,      which is an affiliate of one of our strategic investors, Liberty Media Corporation, to exclusively      deploy and manage Liberty Cablevision of Puerto Rico’s residential      cable telephony offering. In May 2004, Liberty Cablevision of Puerto Rico      expanded its offering to reach its entire footprint of over 300,000 homes      passed. Since signing our first cable customer in 2003, several other cable      operators have selected us to provide their customers with cable telephony.      As of October 13, 2004, Net2Phone Cable Telephony has over 7,000 cable      telephony subscribers.

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Our strategic investors include      IDT, a global telecommunications, media and technology company, and Liberty      Media Corporation, a global media company. IDT and Liberty Media together      own NTOP Holdings, L.L.C., which, as of October 7, 2004, holds an      aggregate of 37.8 percent of our outstanding capital stock and 54.9 percent      of our aggregate voting power. IDT is currently the controlling member      of NTOP Holdings, through which it effectively controls us. In November      of 2003, we closed an underwritten common stock offering, through which,      in addition to the 11.5 million shares purchased by the public and      our underwriters, 1.25 million shares were purchased by each of IDT      and Liberty Media. Including the 1.25 million shares IDT purchased      in the offering and an additional 0.3 million shares of our common      stock held directly by IDT, as of October 7, 2004, IDT controls 56.3      percent of our aggregate voting power. We have also entered into a Memorandum      of Understanding with IDT, described in more detail in Note 14 of our Consolidated      Financial Statements included herein, which calls for us to issue an additional      6.9 million shares of our Class A common stock to IDT upon entering      into definitive telecommunications services agreements with IDT. Assuming      these 6.9 million shares are issued, IDT will control 61.4 percent      of our aggregate voting power based on our outstanding stock on October 7,      2004.

| **Industry Overview** |
|-----------------------|

The VoIP industry has grown dramatically      from the early days of calls made through personal computers. Technology      research firm JupiterResearch predicts that VoIP telephony services will      grow to about 400,000 U.S. households by the end of 2004, and to 12.1 million      U.S. households by 2009. VoIP is an alternative technology that can replace      services provided by the traditional telephone network. VoIP technology      translates voice into data packets, transmits the packets over data networks      and reconverts them into voice at the destination. Unlike traditional telephone      networks, VoIP does not use dedicated circuits for each telephone call;      instead, the same VoIP network can be shared by multiple users for voice,      data and video simultaneously. This type of data network is more efficient      than a dedicated circuit network because the data network is not restricted      by the one-call, one-line limitation of a traditional telephone network.      This improved efficiency creates cost savings that can be passed on to      the consumer in the form of lower rates or retained by the VoIP provider.

The growth of VoIP has been and      continues to be driven primarily by:

|   | • | increasing consumer demand          worldwide for lower cost phone service; |
|--------|--------|-----------------------------------------------------------------------------|

|   |   |                                                                                                                                                             |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | improved quality and reliability          of VoIP calls fueled by technological advances, increased network development          and greater bandwidth capacity; |

|   |   |                                                                                                                      |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------|
|   | • | continuing domestic and          international deregulation, opening new market opportunities for VoIP          services; |

|   |   |                                                                                                                                                    |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | new product innovations          that allow VoIP providers to offer services not currently offered by          traditional phone service companies; and |

|   |   |                                                                                                                                |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------|
|   | • | growing demand for long          distance communication services driven by the increased mobility of          the global workforce. |

As a result of these developments,      consumers, enterprises and telecommunications providers are continuing      to embrace offerings from VoIP providers, such as those offered by us.      Consumers, particularly in emerging markets, are increasingly using VoIP-enabled      services, such as calling cards and Internet Protocol, or IP, telephones,      to realize significant cost savings on long distance calls. Enterprises      are significantly reducing telephony expenses by using VoIP to link users      within offices and around the world. VoIP enables telecommunications providers      to reduce their network costs and to deliver new products and services      that cannot be supported by traditional networks.

|      *Cable            Telephony Market* |
|-------------------------------------------------------------------|

Telephony represents a significant      revenue growth opportunity for cable operators. In-Stat/MDR projects that      the number of cable telephony subscribers worldwide will grow to over 19 million      in 2007. In-Stat/MDR further projects that worldwide cable telephony services      revenue will increase from $3.7 billion in 2003 to

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over $6 billion in 2007. The following    table provides an estimate of worldwide cable telephony subscribers through    2007 (subscribers in thousands):

|                   |   | **2001** |   | **2002** |   | **2003** |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   |
|------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
|                   |   |          |        |     |        |          |   |          |        |     |        |          |   |          |        |   |  |  |   |  |  |   |
| North          America |   |     | 1,745  |     |   | 2,430    |   |     | 2,795  |     |   | 3,420    |   |     | 4,115  |   |   | 5,060 |   |   | 5,830 |   |
| Europe                 |   |     | 3,710  |     |   | 5,370    |   |     | 5,935  |     |   | 6,670    |   |     | 7,455  |   |   | 8,140 |   |   | 8,680 |   |
| Rest          of World |   |     | 550    |     |   | 935      |   |     | 1,440  |     |   | 2,235    |   |     | 3,130  |   |   | 4,185 |   |   | 5,420 |   |
|                   |   |          |        |     |        |          |   |          |        |     |        |          |   |          |        |   |  |  |   |  |  |   |
| Total Subscribers      |   |     | 6,005  |     |   | 8,735    |   |     | 10,170 |     |   | 12,325   |   |     | 14,700 |   |   | 17,385 |   |   | 19,930 |   |
|                   |   |          |        |     |        |          |   |          |        |     |        |          |   |          |        |   |  |  |   |  |  |   |

Source: In-Stat/MDR, November 2003;    subscribers include those receiving cable telephony through traditional circuit-switched    and VoIP services.

With the addition of cable telephony,      cable operators can offer their subscribers a bundle of telephone, television      and high speed Internet services, referred to as the “triple play” of      voice, video and data services. We believe cable operators will accelerate      the bundling of telephone service into their existing video and data offerings      in order to:

|   | • | generate a new source of          revenue; |
|--------|--------|--------------------------------------------|

|   |   |                        |
|--------|--------|-----------------------------|
|   | • | improve customer retention; |

|   |   |                                                                                                                                        |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | compete with local residential          telephone providers that bundle high speed DSL Internet access with          telephone service; and |

|   |   |                                                                                                                                                                                 |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | compete with satellite          television services, some of which are partnering with residential          telephone providers to provide a bundled voice, video and data offering. |

Cable operators currently have      two distinct technologies that they can employ to offer cable telephony      services: constant bit rate technology and VoIP technology. Constant bit      rate technology utilizes the circuit-switched network currently used in      traditional phone service. VoIP technology permits cable operators to implement      and offer telephony services comparable to those offered by traditional      telephone service providers, at costs below those associated with constant      bit rate technology. VoIP cable telephony services can use the public Internet      to carry voice traffic or can employ a fully managed network. VoIP cable      telephony services that use the public Internet can suffer from the data      loss and transmission delays associated with the Internet. In contrast,      by using a fully managed VoIP network that does not rely on the public      Internet, VoIP operators, such as Net2Phone Cable Telephony, can give voice      calls priority over data and video traffic or even reserve a dedicated      channel for phone service on a cable operator’s network and significantly      improve call quality. Several cable operators including Cablevision, Time      Warner Cable, Comcast and Cox Communications have announced deployment      of VoIP-based cable telephony as a new product offering.

VoIP technology enables cable operators      to provide a comprehensive residential telephony solution, which we believe      has several key benefits relative to traditional circuit-switched networks,      including:

|   | • | comparable reliability,          enhanced services and functionality; |
|--------|--------|-----------------------------------------------------------------------|

|   |   |                           |
|--------|--------|--------------------------------|
|   | • | simpler and faster deployment; |

|   |   |                                         |
|--------|--------|----------------------------------------------|
|   | • | lower initial deployment          costs; and |

|   |   |                                                                                          |
|--------|--------|-----------------------------------------------------------------------------------------------|
|   | • | lower cost structure providing          an ability to offer competitive pricing to customers. |

Cable operators seeking to offer      cable telephony by developing an in-house service must integrate several      additional components with their existing systems, which requires substantial      capital expense and technical expertise. Cable operators developing an      in-house service must often engage in hiring, retraining and process reengineering      to support telephony services. Full service VoIP telephony companies, such      as Net2Phone, can provide cable operators the ability to outsource their      cable telephony services, thereby reducing cable operators’ costs,      time to market and risks associated with developing and maintaining an      in-house cable telephony service.

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| **Our Products and Services** |
|-------------------------------|

|                                                                       |
|----------------------------------------------------------------------------|
|      ***Net2Phone              Global Services*** |

We offer a variety of VoIP-based      telecommunications products and services to consumers, enterprises and      telecommunications providers around the world, primarily through local      resellers. Our centrally managed platform supports a full range of consumer      and corporate hardware products and services that enhance quality, lower      costs and improve ease of use and management. The devices and calling cards      we offer allow users to access our VoIP platform to make low cost calls      to anywhere in the world. Below are the key products and services offered      by Net2Phone Global Services:

|   | • | *Enterprise Solutions.*We          provide a suite of VoIP products and services targeting small and medium-sized          enterprises. Our Max Private Voice Network, or Max PVN, allows business          customers to utilize their existing broadband connections to place          free calls among their corporate offices and their primary business          contacts, such as customers and suppliers. Our Max PVN and several          of our other products also allow enterprises to access our VoIP platform          to make low cost VoIP calls to anywhere in the world. Our Maxline product          extension is designed for inbound calling to a device located anywhere          in the world using a US Toll-free, US local or UK toll free direct          inward dial, or DID, phone number. The Maxline product was designed          to offer enterprise customers around the world the opportunity to create          an American (or UK) presence in order to open up new business opportunities          and markets. |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Calling Cards and Prefix            Dialing.*We sell rechargeable calling cards in the U.S. and internationally            directly and through our resellers. We offer calling cards in over            130 countries that can be used to access our VoIP platform to make            low cost local, long distance or international calls. We also offer            a calling card that enables users to access our VoIP platform from            25 countries to make low cost calls. Additionally, we offer dial-around            numbers, called “prefix codes,” similar to the “10-10” service            prevalent in the U.S. |

|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Public Call Centers            and Internet Cafes.*We offer public call centers and Internet            cafes the ability to sell VoIP services. Public call centers and            Internet cafes are popular in emerging markets where telecommunications            infrastructure is limited and consumers rarely have freely available            access to a telephone or the Internet. Our product and service offerings            to public call centers and Internet cafes include devices to support            end users and a billing software platform that allows call centers            and Internet cafes to create their own rate tables, bill in their            local currencies and print out customized bills with their company’s            information. |

|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Broadband Telephony,            including VoiceLine*SM. We sell devices that can be            plugged into a high speed connection anywhere in the world and allow            users to be reached at the telephone number assigned to such devices.            The devices also allow users to access our VoIP platform to make            phone calls to anywhere in the world. Our VoiceLine service allows            high-speed data providers to offer their subscribers residential            broadband telephony solutions. |

|   |   |                                                                                                                                                                                                                                                                                                                    |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Carrier Services.*We          sell wholesale minutes through our VoIP network to other telecommunications          providers. Through our VoIP network, we offer carriers what we believe          is a low cost, high quality alternative for the transport and termination          of voice and fax communications. |

|   |   |                                                                                                 |
|--------|--------|------------------------------------------------------------------------------------------------------|
|   | • | *PC-to-Phone.*We          provide our PC-to-phone service to consumers globally through our website. |

We are also evaluating and developing      new products and service offerings to serve our target markets including:      VoIP over wireless fidelity, or WiFi, integration and interoperability      between our VoIP services and mobile devices, expanding our suite of enterprise      services and operator code dialing services.

|      ***Net2Phone              Cable Telephony*** |
|----------------------------------------------------------------------------|

Taking advantage of our experience      and leadership in VoIP services, we have developed a fully outsourced VoIP      service offering that enables cable operators to provide VoIP-based residential      telephone services. We believe our offering provides comparable features      and functionality to that provided by traditional phone companies. Our      platform utilizes a fully managed network and does not need to carry voice

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traffic over the public Internet,    which may suffer from data loss and transmission delays, allowing us and    our customers to provide voice quality equivalent to that provided by traditional    phone companies.

We offer cable operators the ability      to provide cable telephony services to their customers faster and with      less expense than if they were to develop their own cable telephony service.      Our service offerings allow cable operators to bundle telephony services      with their video and data offerings. The cable operator can use its own      brand, deliver a single bill and provide direct customer support to its      customers. We support the back office platform, switching and transport      of voice traffic, ongoing operations and secondary technical support to      deliver a fully managed VoIP service.

We work with cable operators to      deploy an integrated, tested and operational telephony service, including      customized operations support systems, network interfaces, carrier interconnects,      telecommunications methods and procedures and real-time service assurance,      including 24 x 7 network operations center support. Our service offering      includes two primary products, CableLineSM and VoiceLineSM:

| *CableLine*SM |
|---------------|

Our CableLine service resembles      traditional telephony in terms of service, quality, enhanced features,      functionality and reliability, and is engineered to conform with PacketCable      technical specifications set by CableLabs, a consortium of cable operators      in the U.S. CableLine’s accompanying network management toolset enables      fully managed end-to-end VoIP cable telephony service, guaranteeing quality      from call inception through termination. Throughout each point in the network — the      local cable HFC network, the IXC segment and the local termination — our      CableLine solution delivers end-to-end guaranteed call quality, network      availability and service management. CableLine is comprised of three components:

|      *Planning            and Deployment Services* |
|-----------------------------------------------------------------------------|

We customize our service offering      to capitalize on cable operators’ existing systems and processes.      Our team works with cable operators’ engineers to design an optimal      VoIP architecture that interfaces with the public switched telephone network,      or PSTN. We project traffic volume and capacity requirements on the cable      operators’ facilities, the PSTN and IP networks to develop a system      that can handle peak demands across each segment. We also develop and document      business processes and provide training and support to cable operators      during the cable telephony service launch and on an ongoing basis.

|      *Switching            and Service Assurance Platform* |
|-------------------------------------------------------------------------------------|

The switching and service assurance      platform provides the infrastructure required to support VoIP cable telephony      and consists of the following elements:

|   | • | *Call Management Server            Platform.*Our call management server platform provides the features            and functions typically delivered by a hardware-based switch, known            as a CLASS 5 switch, but at a significantly lower cost. The software-based            solution allows us to process a call and deliver it through the most            efficient, cost effective and high quality route, provide CLASS 5            feature support (for example, caller ID, call waiting, distinctive            ring and three-way calling), interface to the PSTN for termination            and origination and provide network generated announcements. |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Record Keeping Server.*The          record-keeping server is a real-time event messaging, collection, correlation          and distribution database developed by us. The database stores the          information generated by the call management server platform and the          real-time assurance platform described below. The record-keeping server          can be accessed by cable operator and Net2Phone operations personnel          through a Web-based or software interface to analyze call information,          which can then be employed to improve network functions and prevent          possible future network problems. The record keeping server also stores          all the usage information required for customer support, billing, back          office and management functions. |

|   |   |                                                                                                                                                                                                                                                                                                                                                                   |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Real-time Service Assurance            Platform.*The real-time assurance platform continually monitors            the call management server platform and originates and terminates            test calls across each cable, PSTN and IP entry and exit point to            sample call quality and network availability.This information is            collected and |

 

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|   |   | programmed by the cable operator and Net2Phone        personnel to generate real-time alarms if actual performance metrics        exceed predetermined thresholds. The result is that cable operators and        Net2Phone can monitor call traffic and diagnose and resolve network problems        in real-time, often before the telephone user notices any problem.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   | • | *Cable Voice Operations            Support System.*The cable voice operations support system, which            we have developed, consists of a web-based portal and a software            client interface to access, control, monitor and manage the cable            telephony service. Once the proper administrative controls have been            established in the cable voice operations support system, customer            service and back office personnel use this system to access data            required to provide customer support and track billing and accounts            payable. Additionally, we and cable operator management can use the            system interfaces to access management reports such as overall network            quality, end-user customer service response times, billing history            and calling patterns and destinations. |

|                                                                         |
|------------------------------------------------------------------------------|
|      *Telecommunications            Administration* |

For some of our customers, and      depending on the market, we order, provide and administer circuits for      each phone line, and we establish agreements with both local and long distance      telecommunications providers to terminate calls. We also acquire and manage      a database of telephone numbers to assign to users in every geographic      region of our customers. We believe IDT will be one of our significant      suppliers of telecommunications services to our cable telephony business.      For more information see “—Telecommunications Services Memorandum      of Understanding with IDT” elsewhere in this Annual Report. Some of      our customers may elect to manage these administrative functions directly,      or we may outsource these services.

| *VoiceLine*SM |
|---------------|

We also offer VoiceLine, a broadband      phone service that uses Session Initiation Protocol, or SIP, signalling,      which empowers edge devices, such as multimedia terminal adapters, to establish      and manage voice calls on all types of high-speed data networks. VoiceLine allows high-speed data      providers to offer their subscribers residential broadband telephony solutions.      The VoiceLine service is a centrally managed and hosted telephony solution      that supports local, long distance and international calling. It provides      an end user with a local phone number for inbound calling, and comes with      a full set of features and functionality, including call waiting, caller      ID, three-way conference calling and voice mail. Our VoiceLine service      can also seamlessly integrate its front and back office systems, including      its billing platform, into the operator’s infrastructure. This allows      the operator to provision accounts, provide customer support, and create      a unified bill for high-speed data, telecommunications and other services.      Additional features include web-based tools allowing subscribers to manage      their telephony features online, manage their accounts, and check their      voice mail.

| *Liberty Cablevision            of Puerto Rico Agreement and Deployment* |
|--------------------------------------------------------------------------|

On October 22, 2003, we entered      into a six-year agreement with Liberty Cablevision of Puerto Rico under      which we are providing Liberty Cablevision of Puerto Rico with our cable      telephony services. Liberty Cablevision of Puerto Rico passes, or could      potentially serve, a total of approximately 300,000 homes and serves approximately      120,000 customers in 37 municipalities principally located in the Eastern,      Central and Northern regions of the island of Puerto Rico.

Under the terms of the agreement,      Liberty Cablevision of Puerto Rico maintains ownership of the customer,      service brand and first level customer and technical support, while we      support the back office platform, switching and transport of voice traffic,      ongoing operations and secondary technical support to deliver a fully managed      VoIP service. We track and monitor voice quality and network performance      metrics from start to finish and provide Liberty Cablevision of Puerto      Rico with a full view into telephone calls routed over its network.

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Liberty Cablevision of Puerto Rico      pays us an up-front license fee and an on-going monthly maintenance fee      for each cable telephony subscriber line ordered by it. In addition, Liberty      Cablevision of Puerto Rico reimburses us for equipment, as well as the      telecommunications costs we incur, such as long distance and call termination      fees, to provide the telephony service, plus a margin. Under the agreement,      we commit to maintain defined quality levels. If we fail to do so, Liberty      Cablevision of Puerto Rico will be entitled to service credits. As of October      13, 2004, there are over 7,000 Liberty Cablevision of Puerto Rico subscribers      to our CableLine service.

| **Our Competitive Advantages** |
|--------------------------------|

We believe we have several core      competitive advantages that will allow us to maintain and expand our position      as a leading provider of VoIP services.

*Leadership and Experience in        VoIP.*     We pioneered the development and        commercial introduction of VoIP services and have a globally recognized        brand name in the VoIP industry. We have a proven track record of quickly        deploying and successfully managing our VoIP services around the world,        across a variety of networks and technologies. Currently, our top sixteen        engineering personnel responsible for integrating and deploying our services        have an aggregate of over 240 years of telecommunications engineering        experience, much of it gained at Bell Labs and IBM research laboratories.        Over our nine-year history, our research and development team has created        innovative new products, feature enhancements and applications to improve        the performance and quality of our services. Our cable telephony service        capitalizes on the call management and monitoring platform developed        for Net2Phone Global Services and the lessons learned in developing VoIP        services around the world.

*Platform to Deliver Centrally        Managed, High Quality and Low Cost Voice Services.*     We        provide our services through our centrally managed platform, which aggregates,        provisions, rates, routes, monitors and bills phone calls in real-time.        Our platform allows us to offer a comprehensive array of services meeting        the varied needs of consumer, enterprise, cable and carrier customers.        Through our platform, we track and manage calls to optimize voice quality.        Our services support multiple technical standards and work on both dial-up        and high-speed Internet connections. Furthermore, using a fully managed        network that does not use the public Internet, Net2Phone CableLine processes        calls to deliver them through the most efficient, cost effective and        high quality routes, resulting in voice quality equivalent to that offered        by traditional telephone companies. Our centrally managed platform allows        us to increase the number of end users of our services, without significant        additional capital expenditures generally associated with network build-outs.

*Strategic Relationships.*     We      have established and expect to expand our strategic relationships with      cable operators, equipment suppliers and telecommunications companies.      Through our relationships with companies such as IDT, we are able to obtain      access to high quality telecommunications services and networks at competitive      prices. We believe our cable telephony platform, combined with our strategic      relationships with companies such as IDT, together create a compelling      and highly competitive cable telephony service offering.

*Global Distribution Channels.*     Net2Phone      Global Services has developed and continues to expand and improve its global      distribution channel that delivers low cost, high quality VoIP services      to resellers around the globe. We deliver VoIP telephone services to businesses      and consumers in over 130 countries through our global distribution network      of over 500 resellers and other distribution channels. As countries continue      to liberalize the regulation of their telecommunications services, we can      employ our distribution network and capitalize on our existing reseller      relationships to partner with incumbent telecommunications providers, well      capitalized new entrants, large systems integrators or significant sales      and marketing organizations.

*Financial Strength.*     We      have a strong balance sheet, with $132.8 million in cash, cash equivalents,      and marketable securities as of July 31, 2004, which includes $21.3 million      in restricted cash, cash equivalents and marketable securities. Our financial      strength allows us to pursue new VoIP opportunities, such as the cable      telephony market, while at the same time growing our existing core business      lines in targeted areas. In addition, our financial strength allows us      to offer cable operators flexible strategic, operational and economic alternatives      for deploying cable telephony in their territories.

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| **Our Strategy** |
|------------------|

Our strategy is to become the leading provider of VoIP telephony products and services in the markets we serve. The following are key elements of our strategy:

*Capitalize on the Growth of VoIP      Services and the Cable Telephony Market.*     We      believe Net2Phone Global Services and Net2Phone Cable Telephony are well      positioned to take advantage of the expected growth of the VoIP services      and cable telephony markets. Technology research firm JupiterResearch predicts      that VoIP telephony services will grow to about 400,000 U.S. households      by the end of 2004, and to 12.1 million U.S. households by 2009.

*Target Small to Mid-sized Cable      Operators in the U.S. and International Cable Operators.*     Net2Phone      Cable Telephony targets small to mid-sized cable operators in the U.S.      and operators of all sizes in Europe and Latin America, who we believe      may be more likely to buy our services than to build their own cable telephony      service. These cable operators may not have the significant technical and      financial resources required to develop an internal cable telephony solution,      such as the personnel to support network operations, engineering, support      and project management. We believe our service and our expertise in VoIP      reduces cable operators’ costs, time to market and risks associated      with developing and maintaining an in-house cable telephony service.

*Offer Flexible Deployment and      Economic Alternatives.*     Net2Phone Cable      Telephony offers cable operators a choice of strategic deployment and economic      alternatives for our cable telephony offering. Depending on the particular      market and financial position of each operator, we tailor our offer to      fit within the business objectives and the available resources of each      cable telephony opportunity. We can develop and integrate specific features      and applications into our service, such as voice-mail, voice-activated      dialing and Internet-based account management, which the operator can then      offer to its subscribers to meet the operator’s strategic objectives.      For resource and capital constrained operators, we offer alternatives that      require a lower amount of human resources and financial investment by the      operator.

*Focus Net2Phone Global Services      on Opportunities in Emerging Markets and New Service Offerings.*     Net2Phone      Global Services targets international markets undergoing telecommunications      deregulation, which we believe will provide high margin opportunities.      We plan to continue to enhance our global distribution chain by securing      new resellers with strong local sales and marketing channels. Our plan      is to develop and integrate new services into our existing managed platform.

| **Sales and Marketing** |
|-------------------------|

|                                                          |
|---------------------------------------------------------------|
|      ***Net2Phone Global Services*** |

Net2Phone Global Services sells and    markets our services through three divisions, each designed to focus on a    specific market. The International Communication Services Division sells    our services to resellers across the globe that have access to consumers    and small to mid-sized businesses. Our Consumer Division sells our direct-to-consumer    VoIP services. The Carrier Services Division sells wholesale minutes on our    VoIP network to other telecommunications providers.

*International Communications Services.*     Our    International Communications Services Division primarily contracts with resellers    around the world, who in turn sell our services to retailers, businesses,    Internet cafés and others in their local markets. Our experience in    building a global distribution chain and integrating our services in the    emerging international telecommunications environment assists us in effectively    entering markets as they open to competition.

We initiate and manage relationships    with our international resellers through a global marketing and sales force    of 29 employees and additional consultants and sales representatives located    in the U.S., South America, Europe, the Middle East and Asia. Although our    resellers are generally responsible for all sales and marketing expenses,    we assist in managing their marketing efforts. We are focusing our marketing    efforts towards selecting resellers in markets undergoing telecommunications    deregulation over the next three years.

 

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Using our platform, resellers can    quickly and easily sell our products in their own countries. We enable our    resellers to generate calling card accounts, create rate tables to support    different markets, provide customized billing in multiple currencies and    languages and offer customer support tools.

*Consumer Division.*     Our Consumer Division is comprised of broadband telephony, calling card services in the U.S. and our PC-to-phone service.

|   | • | *Calling Cards:*We          market our rechargeable pre-paid calling cards in the U.S. through          traditional direct-response advertising in domestic publications. In          addition, many customers enroll for calling card services on our web          site. We also market through loyalty programs as well as through e-mail-based          programs to existing customers, and other on-line advertising. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   |   |                                                                                                                                                                |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | *Broadband Telephony:*We offer our broadband telephony service, including our VoiceLineSM product line, directly to consumers from our web site, www.net2phone.com. |

|   |   |                                                                                                |
|--------|--------|-----------------------------------------------------------------------------------------------------|
|   | • | *PC-to-Phone Service:*We provide our PC-to-phone service to consumers globally through our website. |

*Carrier Services Division.*     We    sell wholesale minutes on our VoIP network to other telecommunications providers    through our internal sales force. We have de-emphasized our traditional carrier    services, and to that end, we have attempted to limit our activity to selected    carriers, particularly those with which we have bilateral carrier ageements.    IDT was our largest traditional carrier customer in fiscal 2004, representing    approximately 33.8 percent of our carrier revenue and, together with its    affiliates, 7.2 percent of our total revenue.

|      ***Net2Phone Cable Telephony*** |
|---------------------------------------------------------------|

Net2Phone Cable Telephony targets    small to mid-sized cable operators in the U.S. and operators of all sizes    in Europe and Latin America, who we believe may not have the significant    technical and financial resources required to develop and maintain an internal    cable telephony service. Our offering can be deployed over all or part of    a cable operator’s two-way digital cable systems.

Our sales process combines business case development with a proposed technical architectural design. The timing of this process is variable and driven principally by the cable operator’s own strategic priorities.

We offer cable operators a range    of services, strategic deployment and economic alternatives. We expect our    cable telephony agreements to have terms of up to five years. Our primary    business model, what we have previously called our hosted service, has the    operator outsourcing the planning, development and aspects of the ongoing    operation of cable telephony to us. We have seen limited interest in our    franchise model, under which we buy back from the cable operator its cable    telephony rights and subscribers at pre-negotiated periods and valuations.    Under our hosted model, the cable operator collects revenue from its customers    and pays us a fee on a per subscriber basis for providing our integrated    services as well as ongoing maintenance and support fees. In some situations,    this per subscriber fee is supplemented by, or, if the economic terms warrant,    replaced by, a revenue sharing arrangement. In addition, in certain cases    the cable operator reimburses us for our telecommunications costs plus a    margin. These costs include the set up and ongoing management of local and    long distance interconnection and termination, the costs of any dedicated    circuits    and the recurring cost of maintaining phone numbers and other support services,    such as 911 and operator assisted calling. In most cases, the cable operator    is responsible for sales and marketing, customer activation, customer support,    billing and collection, plant engineering and service technicians and any    regulatory costs associated with offering cable telephony. In some cases    we are responsible for some of these services and the related expenses. In    most cases, the cable operator is also responsible for the capital expense    associated with the cost of new service installation, the cost of equipment    deployed at the subscriber’s premises and the upgrade to its existing    cable modem termination server. We bear the capital and operating expenses    for the planning, design, procurement, deployment and operation of the VoIP    cable    telephony infrastructure. Our capital expenditures include the hardware and    software costs of integrating our services and systems with the operator’s    systems. Some operators may choose to purchase equipment directly from third    parties.

Our fees on a particular contract will depend on a number of variables, including the size of the cable operator’s telephony footprint, its ability to sell cable telephony services to its customers, the complexity of

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the deployment, whether we or the operator is funding the purchase of certain equipment and whether we are providing telecommunications administration services.

| **Telecommunications Services Memorandum of Understanding with IDT** |
|----------------------------------------------------------------------|

On October 29, 2003, we entered    into a binding memorandum of understanding with IDT for the provision of    telecommunications services to Net2Phone Cable Telephony. The memorandum    of understanding memorializes IDT’s agreement to provide Net2Phone CableTelephony,    directly or through its subsidiaries, with local and inter-exchange network    access, termination, origination and other related services, including sales    and marketing assistance and an agreement by IDT not to compete in the cable    and broadband telephony market. IDT is a competitive local exchange carrier    and an inter-exchange carrier and its network includes switching facilities    in several U.S. cities and additional points of presence in various countries,    allowing us to co-locate our equipment and connect to IDT’s network    at those points. We have agreed to issue to IDT 6.9 million shares of    our Class A common stock at the time we enter into definitive agreements.    When issued, the stock will be held in escrow and released to IDT in equal    installments over five years. The stock held in escrow will secure IDT’s    performance of its obligations under the agreement.

The memorandum of understanding requires    us and IDT to use good faith efforts to enter into definitive agreements    relating to these services. We are continuing to negotiate definitive agreements.    The definitive agreements will have an indefinite term, however, either party    may terminate the agreement upon 180 days notice, beginning 180 days prior    to the fifth anniversary of the agreement. The memorandum of understanding    was approved by an independent committee of our board of directors.

For more information relating to our relationship with IDT, please see Note 14 to our financial statements included elsewhere in this Annual Report.

Although we intend to use IDT as    one of our primary providers for telecommunications services related to offering    cable telephony, we have sole discretion to use other telecommunications    services providers. We have used and may continue to use other providers    in cases where they offer more competitive rates, in situations where IDT    is not able to deliver the services we require or for other reasons as we    deem strategically, operationally or financially appropriate.

| **Our Infrastructure** |
|------------------------|

|                                                               |
|--------------------------------------------------------------------|
|      ***Our Centrally Managed Platform*** |

We have a centrally managed platform    consisting of reliable and flexible data management, monitoring, control    and billing systems, which support all of our products and services. We have    invested substantial resources to develop and implement our sophisticated    real-time call management information system. Key elements of this system    include: customer provisioning, customer access, fraud control, network security,    call routing, call monitoring, media processing and normalization, call reliability    and detailed call records.

Our platform monitors our process    of digitizing and compressing voice into packets and transmitting these packets    over data networks around the world. All call signaling is routed to a managed    softswitch, which is a software-based system that manages call admission,    call control, call rating and event recording and routes calls to an appropriate    endpoint. Unless the recipient is using an Internet telephony on-line device,    the packets are sent to a gateway where they are reassembled and the call    is transferred to the PSTN and directed to a regular telephone anywhere in    the world. We have hubs in the U.S., United Kingdom and Hong Kong which terminate    voice traffic within particular regions. Our billing and back office systems    manage and enroll customers and bill calls as they originate and terminate    on the system.

|      ***Network Operations Center*** |
|---------------------------------------------------------------|

Our Network Operations Center is    located at our headquarters in Newark, New Jersey, and employs a staff of    14 people with experience in both voice and data operations to provide twenty    four hour support to our operations and customers around the world. We use    various tools to monitor and manage all elements of telephone calls in real-time.    Additionally, our Network Operations Center provides technical support to    troubleshoot equipment and network problems.

 

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|      ***Customer and Technical Support*** |
|--------------------------------------------------------------------|

We provide customer service on various    levels to different customers. Within the International Communications Services    division of our Net2Phone Global Services business, we provide customer service    and technical support directly to our resellers. The resellers provide their    own support directly to their sub-resellers and end users. U.S. consumers    who access our services directly through the web site receive customer service    and technical support through multilingual telephone communication, web-based    customer service as well as e-mail support. We utilize multiple call centers    globally to provide better support to our worldwide customer base.

Net2Phone Cable Telephony provides    cable operators with the tools, documentation and software to deliver first    level customer and technical support to their subscribers. We do not interface    directly with cable operator’s subscribers. We provide advanced technical    support to the cable operators directly.

|      ***Back Office Systems*** |
|---------------------------------------------------------|

In order to improve efficient management    of product offerings, we have added new reporting tools that provide a direct    view into the network’s performance. We have also created a multi-level    technical support interface, allowing resellers to view both their account    activity as well as the activities of their sub-resellers and end users.    We also support the user interface for foreign currency, allowing resellers    to charge their users in their currencies while the partners pay us in U.S.    currency.

|      ***Interconnection Agreements*** |
|----------------------------------------------------------------|

We are party to service agreements    with several telecommunications providers, including Regional Bell Operating    Companies, competitive local exchange carriers, foreign post, telephone and    telegraph companies, Internet backbone providers and others. Pursuant to    these agreements, we can transport VoIP packets to our hubs and terminate    calls throughout the world.

| **Key Suppliers** |
|-------------------|

We expect that IDT will be a significant supplier of telecommunications services to support our cable telephony business. For a more complete discussion of this agreement, see “—Telecommunications Services Memorandum of Understanding with IDT.”

We rely on one of our vendors, LG    Electronics, to manufacture approximately fifty percent of the hardware devices    sold by Net2Phone Global Services’ primarily through its International Communications Services division.    We do not have a contract with LG Electronics, and, therefore, LG Electronics    could stop providing us with these products with little or no prior notice.    While we believe our relationship with LG Electronics is stable, we can provide    no assurance that this relationship will continue to be good, or continue    at all. While we believe we could replace LG Electronics if necessary, this    could take a period of time during which our hardware sales could be materially    impacted, and this could impact our ability to service some of our customers    for this period of time.

We also rely on one of our vendors,    Level3 Communications, Inc., to deliver a suite of local telecommunications    services, including local phone numbers, access to the PSTN, operator assistance,    directory listings and assistance, E911 emergency services and local number    portability. By using Level3, we gain access to its telephone numbering resources,    which expands the availability of our telephony products to cable operators.

| **Competition** |
|-----------------|

|                                                          |
|---------------------------------------------------------------|
|      ***Net2Phone Global Services*** |

|                                                                 |
|----------------------------------------------------------------------|
|      *International Communication Services* |

Internationally, the competitive    marketplace varies from region to region. In markets where telecommunications    has been fully deregulated, the competition continues to increase. Generally,    newly deregulated markets strive to allow new entrants to establish a foothold    and offer competitive services

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relatively easily. Our competitors    include both government-owned and incumbent phone companies and emerging    competitive carriers. As consumers and telecommunications providers have    come to understand the benefits that may be realized from transmitting voice    over the Internet, a substantial number of companies have emerged to provide    VoIP services. The principal competitive factors in the market include: price,    quality of service, distribution, customer service, reliability, network    capacity, the availability of enhanced communications services and brand    recognition.

|      *Consumer Division* |
|---------------------------------------------------|

The long distance market in the United    States is highly competitive. There are several much larger and numerous    similar-sized and smaller competitors, and we expect to face continuing competition    based on price and service offerings from existing competitors. The principal    competitive factors in the market include: price, quality of service, distribution,    customer service, reliability, network capacity and the availability of enhanced    communications services. Some of our competitors include AT&T, MCI, Sprint,    IDT and Regional Bell Operating Companies, all of whom offer services and    products competitive with ours on the above factors, including offering their    own pre-paid calling cards.

Some providers, such as Go2Call and    DeltaThree, Inc., offer similar PC-to-phone services to ours. Other providers,    such as Vonage Holdings Corp., Packet 8, AT&T, Verizon and Primus, compete    with our VoiceLine service offering, and may become competitive with our    International Communications Services offerings.

|      *Carrier Services Division* |
|-----------------------------------------------------------|

Wholesale Internet telephony service    providers, such as Teleglobe Corp. and iBasis, Inc. compete with our carrier    services, and could become meaningful competitors to our International Communications    Services group. We also compete with other wholesale communications providers,    such as MCI, Global Crossing, IDT, Qwest Communications and Sprint.

|      ***Net2Phone Cable Telephony*** |
|---------------------------------------------------------------|

Our ability to sell our cable telephony services may be limited by the fact that cable operators have and may in the future elect to develop and maintain their own internal cable telephony services instead of buying services from us.

We compete with other providers who    currently market cable telephony services directly to consumers and cable    operators. These companies may be able to offer services similar to ours,    or features that we may be unable to provide, and may offer services at prices    lower than we intend to charge.

Other companies aggregate a series    of elements to deploy cable telephony systems that could be competitive to    ours. These systems include combinations of softswitches, announcement servers    and gateways, but these vendors do not offer telecommunications administration,    record keeping servers or interconnections with the public switched telephone    network. We can and may partner with some of these vendors to incorporate    some of their elements into our offering as we use available components to    complete our solution.

We and cable operators seeking to    provide telephony services directly to customers will face competition for    subscribers from incumbent local exchange carriers, such as Verizon, Qwest,    SBC Communications and competitive local exchange carriers that offer similar    services. We expect that competition for telephony services will be primarily    on the basis of price, quality, features, customer service and the ability    to offer a bundled service offering of voice, data and video. Some local    exchange carriers, alone or together with partners such as satellite television    providers, are or may become capable of providing bundled service offerings    of voice, high speed internet and video similar to those which cable operators    may provide. These providers may be able to provide this bundled service    offering at lower prices or with greater reliability than cable operators,    which in turn may adversely affect demand for our product.

 

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| **Research and Development** |
|------------------------------|

We operate two research and development facilities    in our West Long Branch and Brick, New Jersey locations, where our employees are involved    in research and development and related activities. These employees have technical expertise    which covers areas including software, hardware, switching, security, voice compression, protocols,    web applications, PC development, interactive voice response systems, next-generation    signaling, firewalls and network address translations, engineering real-time    online transactions, billing, network and call management and conferencing    network monitoring and cable systems. This staff is devoted to the improvement    and enhancement of our existing product and service offerings, as well as    to the development of new products and services. Our future success will    depend, in part, on our ability to improve existing technology, to retain    services of talented employees and to develop new products and services that    incorporate    leading technology.

Software development costs are our primary research and development expenditures. Such costs, which totaled $8.2 million in fiscal 2004, $5.4 million in fiscal 2003, and $11.2 million in fiscal 2002, are included in selling, general and administrative expenses.

| **Regulation** |
|----------------|

The use of the Internet and private    IP networks to provide voice communications services, is a relatively recent    market development. Although the provision of such services is currently    largely unregulated within the United States, the United States Congress    is considering several bills that would, if passed, impose new and additional    regulations on providers of VoIP services, including us. In addition, several    foreign governments have adopted or proposed laws and/or regulations that    could be interpreted to restrict or prohibit the provision of VoIP services.    Other countries, however, have begun to open their markets to competition    from new Internet-based voice services. More aggressive regulation of the    Internet in general, and Internet telephony providers and services specifically,    may materially and adversely affect our business, financial condition, operating    results and future prospects, particularly if increased numbers of governments    impose regulations restricting the use and sale of IP telephony services.    This additional regulation could have a material adverse effect on both our    Net2Phone Global Services and Net2Phone Cable Telephony subsidiaries.

|      ***United States*** |
|---------------------------------------------------|

In an April 10, 1998 Report    to Congress, the Federal Communications Commission (FCC) declined to conclude    that IP telephony services constitute telecommunications services and instead    indicated that it would undertake a subsequent examination of the question    whether certain forms of phone-to-phone Internet telephony are information    services or telecommunications services. The FCC indicated that, in the future,    it would consider the extent to which phone-to-phone Internet telephony providers    could be considered “telecommunications carriers” such that they    could be subject to the regulations governing traditional telephone companies    such as the imposition of access charges. The FCC stated that, although it    did not have a sufficient record upon which to make a definitive ruling,    the record suggested that, to the extent that certain forms of phone-to-phone    IP telephony appear to possess the same characteristics as traditional telecommunications    services and to the extent the providers of those services obtain the same    circuit-switched access as obtained by interexchange carriers, the FCC may    find it reasonable that they pay similar access charges. The FCC also recognized,    however, that it would consider whether it should forbear from imposing any    of the rules that would apply to phone-to-phone Internet telephony providers    as “telecommunications carriers.” To date, the FCC has not imposed    broad-based regulatory charges or traditional common carrier regulation upon    providers of Internet communications services, but it has begun regulating    this area on a limited basis as outlined below.

Although the FCC treats providers    of Internet telephony services no differently from providers of other information    and enhanced services that are exempt from payment of interstate access and    other fees and charges, this decision may be reconsidered in the future.    For instance, on April 19, 2001, in Docket No. CC 01-92, the FCC adopted    a proposal to begin a fundamental examination of all forms of intercarrier    compensation — the payments among telecommunications carriers resulting    from their interconnecting networks. The FCC could adopt an intercarrier    compensation mechanism and other regulations that could result in an increase    in the cost    of the local transmission facilities necessary to complete our calls or a

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decrease in the costs of such facilities    to traditional long distance telephone companies. An increase in our rates    as a result of new FCC regulations could have a material adverse effect on    our ability to compete with other carriers.

Among the VoIP-related proceedings    recently before the FCC was a petition filed by AT&T on October 18,    2002, seeking a declaratory ruling from the FCC that would prevent incumbent    local exchange carriers, or ILECs, from imposing traditional circuit-switched    access charges on AT&T’s phone-to-phone IP services. On April 21,    2004 the FCC ruled on AT&T’s petition that AT&T’s particular    phone-to-phone service was a regulated telecommunications service and was    therefore subject to access charges. On February 5, 2003 pulver.com    filed a petition with the FCC seeking a declaratory ruling that its “Free    World Dialup,” (which facilitates point-to-point broadband Internet    protocol voice communications), is neither telecommunications nor a telecommunications    service. On February 19, 2004 the FCC issued an order holding that Free    World Dialup is more properly classified as an information service and not    subject to regulations governing traditional telecommunications providers.    In another proceeding, Vonage filed a petition for declaratory ruling requesting    that the FCC find an Order of the Minnesota Public Utilities Commission (MNPUC)    requiring Vonage to comply with state laws governing providers of traditional    telephone service to be preempted because Vonage’s broadband Internet    telephony service is an information service. As of October 14, 2004, the    FCC has not ruled on this petition.

On March 10, 2004, the FCC opened    a proceeding (Docket No. 04-36) to examine several regulatory and policy    issues regarding the regulation of IP-enabled services (such as VoIP), technologies,    and providers. This proceeding could result in the FCC determining, for instance,    that certain types of Internet telephony should be regulated like basic telecommunications    services. Thus, Internet telephony could no longer be exempt from access    charges, which reimburse local carriers for use of their local telephone    network and other telecommunications related fees and regulatory obligations.    The FCC could also conclude that Internet telephony providers should contribute    to the Universal Service Fund, which provides support to ensure universal    access to telephone service. The imposition of access charges, regulatory    fees, or universal service contributions would substantially increase our    costs of serving our customers in the U.S. The imposition of regulation and    contribution requirements might also negatively affect the incentives for    companies to continue to develop IP technologies to offer VoIP services.    It is also possible that the FCC might adopt a regulatory framework that    is    unique to IP telephony providers or one where IP telephony providers are    subject to reduced regulatory requirements. The FCC may also decline to preempt    state regulation over IP-enabled services which may prompt imposition of    additional regulation of VoIP on the state level. We cannot predict what    regulations,    or the extent of regulation, if any, the FCC may impose. The FCC has, however,    explained that it intends to rely wherever possible on competition and apply    discrete regulatory requirements only where such requirements are necessary    to fulfill important policy objectives. We cannot predict when the FCC will    issue a final decision, the outcome of the decision, or the result of any    subsequent proceedings or actions that may arise out of the FCC’s decision.

Other aspects of our services may    be subject to state or federal regulation, such as regulations relating to    the confidentiality of data and communications, copyright issues, taxation    of services, licensing, 911 emergency access and access requirements under    the Communications Assistance for Law Enforcement Act, or CALEA. For instance,    in a Further Notice of Proposed Rulemaking released February 20, 2002,    the FCC has undertaken an examination of whether emergency 911 requirements    should be extended to packet-based networks and services. Net2Phone Cable    Telephony is  currently enabling 911 for Liberty Cablevision    of Puerto Rico. Both Net2Phone Global Services and Net2Phone Cable Telephony    may enable emergency access services for other cable    clients or directly to consumer services. We expect to continue to develop technologies that may be able to    support emergency access and enhanced emergency services.

On August 9, 2004, the FCC released    a Notice of Proposed Rulemaking, or NPRM, to examine the applicability of    CALEA on VoIP and broadband services. In the CALEA NPRM, the FCC made certain    tentative conclusions that if adopted could impose CALEA obligations on VoIP    and broadband services and providers such as Net2Phone and Net2Phone’s    cable clients. Net2Phone has cooperated with law enforcement to ensure that    our network enables these authorities to accomplish lawful interception of    our services. However, complying with the full panoply of CALEA requirements    may impose additional substantial costs on Net2Phone.

 

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In July 2004, the Internal Revenue    Service issued an Advance Notice of Proposed Rulemaking to examine proposing    regulations that would revise the existing Federal Excise Tax requirements    to reflect changes in communications technologies that could impact us. Additionally,    there are several amendments to the Internet Tax Freedom Act, or ITFA, pending    in the federal legislature that aim to expressly exclude VoIP from the tax    freedom enjoyed by Internet services under the ITFA. There are also at least    two states (one of them New Jersey, where we have our headquarters) that    have passed legislation that could be interpreted to impose taxes on VoIP    services    such as ours.

Moreover, state governments and their    regulatory authorities may assert jurisdiction over the provision of intra-state    IP communications services where they believe that their telecommunications    regulations are broad enough to cover regulation of IP services. Various    state regulatory authorities have initiated proceedings to examine the regulatory    status of Internet telephony services. While a majority of state commissions    have not imposed traditional telecommunications regulatory requirements on    IP telephony at this time, some states have issued rulings that may be interpreted    differently. For instance, a state court in Colorado has ruled that the use    of the Internet to provide certain intrastate services does not exempt an    entity from paying intrastate access charges. Prior to imposing any regulatory    burdens on VoIP providers, however, the Colorado Public Utilities Commission,    or CPUC, opened a docket to investigate whether it has jurisdiction to regulate    VoIP services. On December 17, 2003, the CPUC closed its investigatory    docket pending the outcome of the FCC’s various VoIP-related proceedings.    The New York State Public Service Commission, or NYPSC, has ruled that another    company’s particular IP telephony services may be considered telecommunications    services subject to access charges. The NYPSC has to date, however, declined    to issue a broad regulatory policy related to all types of VoIP services.    On May 24, 2004, the NYPSC found that another provider’s particular    broadband VoIP service was a telecommunications service subject to New York    telecommunications regulations. On July 16, 2004, a federal district    court issued a preliminary injunction against the NYPSC pending outcome of    relevant FCC proceedings. Following an investigative workshop held by the    Florida Public Service Commission on VoIP, the Florida Legislature passed    a bill that exempts VoIP from regulation, but some local exchange companies    have attempted to interpret the new law as leaving open the issue of access    charges. On October 16, 2003, a Federal court in Minnesota issued a    permanent injunction against the MNPUC preventing the MNPUC from imposing    state regulations on another provider’s VoIP services offered over broadband    connections.

There are approximately 30 states    and U.S. territories that have examined or are in the process of examining    the regulatory status of VoIP to some extent. We have received letters from    California, Washington, Wisconsin and Florida directing us to register as    a telecommunications provider. We have responded to these letters by asserting    that we are an information service and not a telecommunications provider    and, therefore, are not subject to regulation under their laws. If the states    require us to register as a telecommunications provider, we may become subject    to significant additional fees and charges, although we may decide to challenge    these charges or the regulations establishing them. There can be no assurance    that these states, or others that may contact us in this regard, will accept    our position or that our challenges will be successful.

|      ***VoIP over Broadband, such as Cable Modem Services*** |
|---------------------------------------------------------------------------------------|

The regulatory status of cable VoIP    could be affected by the state and federal legislative efforts and the FCC    and court decisions in the proceedings discussed above. Net2Phone’s    ability to provide cable telephony services to cable operators may also be    influenced by federal and state regulations specific to Internet over cable    (also known as cable modem services). The FCC has deemed cable modem services    to be unregulated information services that do not contain a separate telecommunications    component. Additionally, the FCC has found that information services are    interstate in nature, thus falling out of the regulatory purview of the states.    On October 6,    2003, the U.S. Court of Appeals for the Ninth Circuit issued its opinion    in Brand X Internet Services v. FCC, reversing the FCC’s prior ruling    that cable modem services do not contain a separate telecommunications component    and remanded the issue back to the FCC for further proceedings consistent    with the court’s decision. The court’s decision was based on procedural    grounds. The FCC, U.S. Solicitor General, and several cable companies have    appealed the Ninth Circuit’s ruling to the U.S Supreme Court. We cannot    predict whether the Supreme Court will hear the appeal. Until the FCC acts    on the Ninth Circuit

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ruling, the regulatory status of    cable modem services remains unchanged. Presently, the decision may add uncertainty    to the regulatory treatment of cable facilities used to provide information    services such as VoIP and as to whether states may attempt to impose any    regulations on the telecommunications component of cable modem services.

The FCC is engaged in several other proceedings to examine the regulatory treatment of cable modem services and other broadband technologies such as DSL that may indirectly affect the market for our cable telephony service. Although the FCC has maintained apro-competitive regulatory policy for cable modem and broadband services, Net2Phone cannot predict the impact that market forces and regulatory developments might have on its business and operations related to our cable telephony solutions.

On the state and local levels, regulators    may try to impose additional franchise fees and requirements on cable operators    seeking to offer cable telephony within the state. While federal laws limit    the extent of state and local regulation over cable networks used to offer    telecommunications services, states may nevertheless attempt regulation.    The FCC is also examining the role, if any, of state and local governmental    authorities in regulating cable modem and broadband services in general.    Where state or local regulators impose additional requirements on cable providers    that offer voice or cable modem services, this may create disincentives for    cable operators to deploy these services and, in turn, materially decrease    market demand for Net2Phone’s cable telephony solution.

As state governments, courts, and    regulatory authorities continue to examine the regulatory status of Internet    telephony services, they could render decisions or adopt regulations affecting    providers of Internet telephony services or requiring such providers to pay    intrastate access charges or to make contributions to universal service funding.    Should the FCC determine to regulate IP services, states may, if not preempted    by federal regulation, decide to follow the FCC’s lead and impose additional    obligations as well. We cannot predict the actions that federal, state, and    local regulators may take or what impact such actions would have on our business.

|      ***International*** |
|---------------------------------------------------|

The regulatory treatment of IP communications    outside the United States varies significantly from country to country. Net2Phone    operates on a global scale. The regulations we are subject to in many jurisdictions    change from time to time, and they may be difficult to obtain in a timely    manner and to interpret as applied to new technologies. This is especially    true for developing markets. Additionally, in our experience, the enforcement    of these regulations does not always track the letter of the law. Accordingly,    although we devote considerable resources to maintaining compliance with    these regulations, we cannot be certain that we are in compliance with all    of the    relevant regulations at any given point in time.

While some countries prohibit IP    telecommunications, others have determined that IP services offer a viable    alternative to traditional telecommunications services. As the Internet telephony    market has expanded, regulators have begun to reconsider whether to regulate    Internet telephony services. Some countries currently impose little or no    regulation on Internet telephony services. Other countries, however, are    beginning to take a more structured approach to regulating VoIP. For instance,    in 2002 the European Union, or EU, adopted several directives that revamp    the existing EU telecommunications policies and regulations (Directives).    The EU Directives, collectively referred to as the New Regulatory Framework    (NRF), require Member States to adopt laws that implement the provisions    of the NRF and that promote its key objectives, which include fostering competition    and innovation, liberalizing markets and simplifying market entry; promoting    the single European market and the interest of citizens.

While the European Commission (EC)    monitors and supervises the Member States of the EU to ensure they properly    apply the provisions of the Directives, the primary responsibility for implementing    the provisions of specific EU legislation lies with the legislatures and    regulatory authorities of the Member States. Accordingly, although Member    States are required to adhere to the EU laws, Member States may not take    a uniform approach toward a particular service such as VoIP. Moreover, one    of the key tenants of the NRF is technological neutrality, which means that    a given service should in theory be subject to the same kind of regulation,    regardless of the technological platform or network over which the service    is delivered. The level of regulation in a given situation will depend principally    on market analysis conducted by each regulatory

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authority. The heaviest regulatory    burden will fall on providers that are found to hold a dominant position    on the relevant market. Certain consumer protection, quality of service and    public safety obligations may be imposed on providers of publicly available    voice services, even if the providers do not hold a dominant position onthe market.

There is considerable uncertainty    as to how this last aspect of the NRF would apply to providers of VoIP services    such as Net2Phone. Currently, we intend to offer our cable telephony platform,    and other services, in several EU countries, including France, Belgium, Luxemburg    and Ireland. Under the new regulatory framework, we cannot guarantee that    these or other EU Member States where we may elect to do business will refrain    from imposing additional regulations on our VoIP services as they implement    and interpret the NRF. The EU and several Member States, including Ireland,    have issued consultation documents requesting industry comments on the applicability    of aspects of the NRF to various VoIP services in their respective countries.    Net2Phone cannot predict the outcome of these consultations or the manner    in which Member States will implement the NRF with respect to VoIP services    such as ours.

Other countries, including those    in which the governments prohibit or limit competition for traditional voice    telephony services, generally do not permit Internet telephony services or    strictly limit the terms under which those services may be provided. Still    other countries regulate Internet telephony services like traditional voice    telephony services, requiring Internet telephony companies to, among other    things, apply for the same types of licenses and pay the same regulatory    fees as traditional telecommunications service providers in those countries.    While some countries subject IP telephony providers to reduced regulations,    others have moved towards liberalization of the IP communications sector    and have lifted bans on provision of IP communications services. We believe    that while increased prohibitions and restrictions could materially threaten    our ability to provide services, the lifting of prohibitive regulations in    a country generally will enable us to expand our services and presence in    that country. On the other hand, in countries where there exists substantial    regulatory uncertainty with respect to VoIP, limited and narrowly tailored    regulation    may enable providers such as Net2Phone to enter these markets with greater    certainty. We cannot predict how a regulatory or policy change of a particular    country might affect the provision of our services.

In some cases where access to some    of our services has been blocked by government-controlled telecommunications    companies, we have tried to negotiate agreements with those governments to    provide our services. We intend to continue to do the same where similar    situations may arise. No assurances can be given, however, that we will be    successful in such negotiations or that we will be able to provide alternative    means of accessing our services that will not be blocked by foreign governments    or government-controlled telecommunications companies. The varying and continually    changing regulatory landscape of Internet telephony in the countries in which    we currently provide or may provide services may adversely and materially    affect our business, financial condition and results of operations. We believe    that our experience negotiating this complicated and ever-changing regulatory    environment gives us a competitive advantage over other, less experienced    competitors attempting to access these international markets.

In addition, as we expand into additional    foreign countries, some countries may conclude that we are required to qualify    to do business in their country, that we are otherwise subject to regulation,    or that we are prohibited from conducting our business in such countries.    Our failure to qualify as a foreign corporation in certain jurisdictions,    or to comply with foreign laws and regulations, may materially and adversely    affect our business.

Moreover, our resellers in various    foreign countries may be or may become subject to various regulatory requirements.    We cannot be certain that our partners are currently in compliance with every    regulatory or other legal requirement in their respective countries, or that    they will be able to comply with existing or future requirements. Failure    of our resellers to comply with these requirements could materially and adversely    affect our business.

|      ***Regulation of the Internet*** |
|----------------------------------------------------------------|

In addition to regulations addressing    Internet telephony, cable modem and broadband services, other regulatory    issues relating to the Internet in general could affect our ability to provide    our services. Congress has adopted legislation that regulates certain aspects    of the Internet, including online content, user privacy,

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taxation, liability for third-party    activities and jurisdiction. In addition, a number of initiatives pending    in Congress and state legislatures would prohibit or restrict advertising    or sale of certain products and services on the Internet, which may have    the effect of raising the cost of doing business on the Internet generally.    The European Union has also enacted several directives relating to the Internet,    one of which addresses online commerce. In 2002, the European Union adopted    a privacy directive that establishes certain requirements with respect to,    among other things, the confidentiality, processing and retention of personally    identifiable subscriber information and usage patterns. The potential effect,    if any, of these data protection rules on the development of our business    remains uncertain.

Federal, state, local and foreign    governmental organizations are considering other legislative and regulatory    proposals that would regulate the Internet. We cannot predict whether new    taxes will be imposed on our services both nationally and internationally,    and depending on the type of taxes imposed, whether and how our services    would be affected thereafter. Increased regulation of the Internet may decrease    its growth and hinder technological development, which may negatively impact    the cost of doing business via the Internet or otherwise materially adversely    affect our business, financial condition and results of operations.

|      ***Other Regulations that May Affect Our Services*** |
|------------------------------------------------------------------------------------|

We are also subject to federal and    state laws and regulations regarding consumer protection and disclosure regulations.    Changes in these rules could substantially increase the cost of doing business    nationally and in any particular state. Authorities having jurisdiction may    bring claims against us pursuant to the relevant consumer protection laws    in the event we do not meet our legal requirements. The FCC also requires    service providers that enable users to place toll-free calls from payphones    in the United States to compensate the payphone operator for each call placed    from a payphone. Changes in FCC payphone compensation rules and/or the failure    of Net2Phone to properly compensate payphone operators for use of their payphones    could subject us to legal actions, or otherwise negatively affect our revenues.

In addition to specific telecommunications    regulation, we are subject to other laws. For example, the Office of Foreign    Asset Control of the U.S. Department of the Treasury, or OFAC, administers    the United States’ sanctions against certain countries. OFAC rules restrict    many business transactions with such countries and, in some cases, require    that licenses be obtained for such transactions. Companies that export products    or services out of the United States are also subject to the export regulations    of the Bureau of Industry and Security (BIS) of the U.S. Department of Commerce.    Failure to obtain proper authority from these regulators could expose us    to legal and criminal liability.

| **Intellectual Property** |
|---------------------------|

We rely on a combination of patents, trademarks, domain name registrations and trade secret laws and contractual restrictions to enforce our rights in our intellectual property against others.

|      ***Patents*** |
|---------------------------------------------|

We currently own, directly or through    wholly owned subsidiaries, twenty seven (27) patents issued in the United    States and twenty eight (28) foreign patents, plus over thirty other applications    pending in both the U.S. and abroad. Five U.S. patents related to VoIP are:    (1) U.S. Patent Number 6,137,792 (Patent ‘792); (2) U.S. Patent Number    6,389,038 (Patent ‘038); (3) U.S. Patent Number 6,108,704 (Patent ‘704);    (4) U.S. Patent Number 6,513,066 (Patent ‘066); and (5) U.S. Patent    Number 6,009,469 (Patent ‘469). Patent ‘792 relates to a method    and system for enabling data transmission over a bypass circuit-switched    network between two computers connected to a public packet-switched network,    such as the Internet. Patent ‘038 relates to a method and system for    combining plural independently addressable packets into a larger packet,    called a SuperPacket, which improves the utilization of a telecommunications    channel,    and helps reduce latency. Patents ‘704, ‘066 and ‘469 relate    to a protocol for establishing point-to-point communications over a packet    switched network, such as the Internet, in which protocol addresses are dynamically    assigned. Because these patents relate to our core business, we believe the    patents have value. Patent ‘792 was issued on October 24, 2000    and expires June 14, 2016. Patent ‘038 was issued May 14,    2002 and expires January 21, 2020. Patent ‘704 was issued on August 22,    2000 and expires September 24, 2015. Patent ‘066 was issued on    January 28,

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2003 and expires September 24, 2015. Patent ‘469 was issued on December 28, 1999 and expires September 3, 2005.

The ability to make, use, sell or    offer for sale our products and services is important to our business. We    are aware that patents have been granted to others based on fundamental technologies    in the Internet telephony area. It is possible that certain patent infringement    claims might be asserted successfully against us in the future. A party making    an infringement claim could secure a substantial monetary award or obtain    injunctive relief that could effectively block our ability to provide services    or products in the United States or abroad. If any of these risks materialize,    we could be forced to suspend operations, to pay significant amounts to defend    our rights and/or secure an expensive license. A substantial amount of the    attention of our management may be diverted from our ongoing business. Moreover,    because patent applications in the United States are not publicly disclosed    when    filed, third parties may have filed applications that, if issued as patents,    could result in claims against us in the future. These claims could materially    adversely affect our ability to operate and our financial condition and results    of operations. We may be able to use our own patents against such claims,    for example, if cross-licenses are warranted.

|      ***Trademarks*** |
|------------------------------------------------|

We own 44 registered trademarks in the United States and more than 100 foreign registered trademarks.

Our most important mark is NET2PHONE.    We have made a significant investment in protecting this mark, and we believe    it has achieved recognition in the U.S. and abroad. We are currently engaged    in an international filing program to file trademark applications for trademark    registrations of the mark NET2PHONE in a number of foreign countries. There    can be no assurance that we will be able to secure registration and maintain    protection for NET2PHONE in all the countries where we deem it important    to do so. Competitors of ours or other third parties may adopt marks similar    to our mark NET2PHONE, thereby interfering with our efforts to build brand    identity and possibly leading to customer confusion.

We have encountered trademark oppositions    challenging our registration and use of the NET2PHONE mark in several countries.    We have also encountered refusals to registration from local trademark offices    in several foreign countries, typically based on the asserted grounds that    the mark is descriptive/non-distinctive or that it conflicts with a prior    registered mark. In addition, in a limited number of situations, third parties    have challenged our marks. Our practice is to oppose vigorously such challenges,    and we have generally been successful.

Unlike patents, which have a limited duration, our trademarks will continue to be registered so long as we pay the required fees and the company does nothing to lose its rights, such as permit others to use the same mark.

|      ***Domain Names*** |
|--------------------------------------------------|

We have registered many Internet    domain names that contain the term NET2PHONE. We cannot assure you that we    will be successful in obtaining all of the domain names that we would like    to have, either because of unwarranted expense, inability to register the    domain due to registrar requirements that we cannot meet, or because of third    parties who previously registered the relevant domain name. We have encountered    several instances of third parties who have registered the term NET2PHONE    within a domain name. We have generally had success in obtaining the transfer    of those domains that we deemed important to our business from such third    parties by agreement, institution of accepted domain name dispute resolution    proceedings or other means, but we cannot assure you that we will be successful    in the future in obtaining all domains that we deem important. Finally, there    are many variations of the word NET2PHONE, and it is difficult, if not impossible,    to register each variation, or to pursue all pirates who register such variations.    Because we are in large part an Internet business, we may be materially and    adversely affected by the unauthorized use of the word NET2PHONE, or of a    substantially similar word, in a domain name owned by a third party.

 

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|      ***Confidentiality Agreements*** |
|----------------------------------------------------------------|

All key employees have signed confidentiality    agreements, and it is our standard practice to require newly hired employees    and, when appropriate, independent consultants, to execute confidentiality    agreements. These agreements provide that the employee or consultant may    not use or disclose    confidential    company    information    except in the performance of his or her duties for the company, or in other    limited circumstances. These agreements also state that, to the extent rights    in any invention conceived of by the employee or consultant while employed    by us do not vest in the company automatically by operation of law, the employee    or consultant is required to assign his or her rights to us. The steps taken    by us may not, however, be adequate to prevent the misappropriation of our    proprietary rights or technology.

| **Employees** |
|---------------|

As of July 31, 2004, we employed    249 individuals full-time, three individuals part-time, and 11 individuals    on a temporary basis. These employees include approximately 86 in technical    support, 40 in marketing and sales, 34 in management and finance, 70 in operations    and 33 in research and development. Our employees are not represented by    a union, and we consider our employee relations to be good. We have never    experienced a work stoppage.

| **Revenues and Assets by Geographic Area** |
|--------------------------------------------|

For the year ended July 31,    2004, 55 percent of our revenue was derived from international customers,    and 45 percent from customers in the United States. Substantially all our    long-lived assets are located in the United States. For more detailed information    concerning our geographic segments, see Note 22 to our financial statements    included elsewhere in this Annual Report.

| **Key Customers** |
|-------------------|

IDT is our largest carrier customer,    representing approximately 33.8 percent of our carrier revenue and, together    with its affiliates, 7.2 percent of our total revenue for fiscal 2004. One    of IDT’s affiliates, Union Telecard Alliance, was also a customer during    fiscal 2004, representing approximately 1.3 percent of our revenue for this    period.

| **Executive Officers** |
|------------------------|

The following are the executive officers    of Net2Phone as of October 14, 2004. On September 22, 2004, our    Board of Directors appointed Liore Alroy, effective October 31, 2004, to    the position of Chief Executive Officer of Net2Phone, Inc. Stephen M. Greenberg,    our current Chief Executive Officer and Vice Chairman of the Board, will    resign as CEO, effective October 31, 2004, but will continue to assist in    the day-to-day activities of the company and will serve as Chairman    of the Board of Directors.

|                 |   |    |   | **Executive**     |   |               |   |
|----------------------|--------|---------|--------|-------------------|--------|--------------------|--------|
| **Name**             |   | **Age** |   | **Officer Since** |   | **Present Office** |   |
|                      |   |    |        |              |   |                    |   |   |  |   |
| Stephen M. Greenberg |   |    | 60     |              |   | 2000               |   |   | Chief Executive Officer and Vice Chairman of the Board |   |
| Arthur Dubroff       |   |    | 54     |              |   | 2002               |   |   | Chief Financial Officer |   |
| Glenn J. Williams    |   |    | 41     |              |   | 1999               |   |   | Executive Vice President of Business and Legal Affairs, General Counsel and Corporate Secretary |   |
| Jonathan Reich       |   |    | 38     |              |   | 1999               |   |   | Chief Executive Officer, Net2Phone  Global Services |   |
| David Lando          |   |    | 61     |              |   | 2003               |   |   | Chief Operating Officer, Net2Phone Global Services |   |
| Michael Pastor       |   |    | 36     |              |   | 2003               |   |   | President, Net2Phone Cable Telephony |   |

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*Stephen M. Greenberg*has served    as our Chief Executive Officer and Vice Chairman of our Board of Directors    since 2000. Before joining Net2Phone, Mr. Greenberg was a founder of    and senior partner in the New Jersey law firm of Stern & Greenberg. He    served as Executive Assistant to the United States Attorney for the District    of New Jersey from 1969 to 1971. Mr. Greenberg has received many honors    including one for Outstanding Personal Achievement from the New Jersey Bar    Association. He is also a Commissioner of the New Jersey Public Broadcasting    Authority and a member of the New Jersey Israel Commission.

*Arthur Dubroff* has served    as our Chief Financial Officer since November 2002. From February 2002 to    November 2002, Mr. Dubroff was an independent contractor for us, serving    in the capacity of Controller. Prior to February 2002, Mr. Dubroff was    Chief Financial Officer of Virtual Communities, Inc., a provider of ethnic    websites and content management software tools, since July 2000. From 1996    to 2000, he served as Chief Financial Officer of Enhance Financial Services    Group Inc., a financial guaranty reinsurer from 1996 to 2000.

*Glenn J. Williams* has served    as our Executive Vice President of Business and Legal Affairs since 2001    and Corporate Secretary since 1999, and has been General Counsel from October    1999 to February 2001 and since January 2004. Prior to joining us, Mr. Williams    served as Associate General Counsel to IDT Corporation from December 1998    to September 1999. From August 1997 to December 1998, Mr. Williams served    as Associate General Counsel to a privately held company and from 1994 to    1997 worked as an attorney in private practice, including representing the    New Jersey Sports and Exposition Authority.

*Jonathan Reich* has served    as the Chief Executive Officer of Net2Phone Global Services, LLC since August 1,    2003. Mr. Reich was our President, Worldwide Sales and Marketing from    July 2002 to August 2003, and our Executive Vice President—Marketing    and Corporate Development from January 1999 to July 2002. Prior to his employment    with us, Mr. Reich was IDT Corporation’s Senior Vice President    of Advertising, Marketing and Business Development in charge of strategic    relationships for both us and IDT Corporation from June 1997 to December    1998 and IDT Corporation’s Director of Advertising from January 1995    to November 1997.

*David Lando*has served as    the Chief Operating Officer of Net2Phone Global Services, LLC since August 1,    2003. Dr. Lando was our Executive Vice President, Products & Services    from January 2002 to August 2003. Prior to his employment with us, Dr. Lando    was Vice President, Supply Line Engineering, Architecture and Quality for    Lucent Technologies from October 2000 to October 2001, Engineering & Environmental    Technologies Vice President for Bell Labs, a division of Lucent Technologies,    from April 1996 to October 2000, and Vice President Manufacturing for AT&T    Microelectronics and Director, Integrated Circuits Technology for AT&T    Bell Labs from 1986 to 1996.

*Michael Pastor* has served    as the President of Net2Phone Cable Telephony, LLC since August 1, 2003.    Mr. Pastor was Vice President and General Manager of our cable telephony    division from November 2001 to July 2003. Prior to that time, Mr. Pastor    served as our Vice President, Voice Hosting Services from October 1999 to    November 2001. Prior to joining Net2Phone, Mr. Pastor was the Manager,    Business Development for Bloomberg, LP from June 1998 to September 1999.

**Risk Factors**

In addition to other information    in this Annual Report on Form 10-K, the following risk factors should be    carefully considered when evaluating our company and our business. Investing    in our common stock involves a high degree of risk, and you should be able    to bear the complete loss of your investment. Additional risks and uncertainties    not presently known to us or that we currently deem immaterial also may impair    our business operations. If any of the following risk and uncertainties actually    occur, our future operating results and financial condition could be harmed,    and the market price of our common stock could decline, perhaps significantly.

 

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**Risks Related to Our Business**

| **We have reported losses from operations in every fiscal year of our operating history other than 2003.** |
|------------------------------------------------------------------------------------------------------------|

We have never generated income from    operations in any fiscal year, except for fiscal 2003, when we included a    gain from a litigation settlement, which resulted in income from operations.    Our aggregate revenue from inception to July 31, 2004 was approximately    $583.0 million, and our accumulated deficit was $773.7 million    as of that date. We will need to generate significant additional annual revenue    beyond the $82.8 million    of revenue generated in fiscal 2004 to achieve profitability. We may not    be able to do so. Even if we do achieve profitability, we cannot assure you    that we will be able to sustain or increase profitability on a quarterly  or annual basis in the future.

| **We intend to pursue new streams of revenue, including from our cable telephony business, which may not be profitable.** |
|---------------------------------------------------------------------------------------------------------------------------|

In fiscal 2004, we devoted, and we    will continue to devote, significant capital and resources to the development    of our cable telephony business, and we cannot ensure when or if this investment    will be profitable. Our business models for our cable telephony business  are still being defined, and have not been tested on a broad basis.

We have not tested our cable telephony    service on a large scale or with multiple operators in multiple jurisdictions.    We cannot be sure that our service offering will be scalable to the extent    necessary to serve a large customer base or that our services will deliver    sufficient reliability or quality on a large scale basis, or at all. Our    cable telephony business faces other risks, including, but not limited to  the following:

|   | • | end users of cable telephony services may not accept our product as an alternative to their existing telephony services on a wide-scale basis, or at all; |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|

|   |   |                                                                                                                                               |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | cable operators have and may in the future choose to build their own internal cable telephony services, and not outsource to providers such as us; |

|   |   |                                                                                                                   |
|--------|--------|------------------------------------------------------------------------------------------------------------------------|
|   | • | the failure of cable operators to successfully market, and help generate consumer demand for, cable telephony service; |

|   |   |                                                                                                                         |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------|
|   | • | the long period of time required to consummate an agreement with a cable operator, deploy the service and earn revenues; and |

|   |   |                                                                                                                                                                            |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | the legal and regulatory environment related to cable telephony may change in a manner that would preclude us from pursuing this opportunity in a profitable manner, or at all. |

If any of these events occur, we may not be able to recoup our substantial investment in the cable telephony business, and our business, financial condition and results of operations may be materially and adversely affected.

| **We may not be able to obtain sufficient funds to grow our business.** |
|-------------------------------------------------------------------------|

Due to the nature of our industry, our future capital needs are difficult to predict. Therefore, we may require additional capital to fund some or all of the following:

|   | • | deployment of our cable telephony service; |
|--------|--------|--------------------------------------------|

|   |   |                         |
|--------|--------|------------------------------|
|   | • | unanticipated opportunities; |

|   |   |                 |
|--------|--------|----------------------|
|   | • | strategic alliances; |

|   |   |                    |
|--------|--------|-------------------------|
|   | • | potential acquisitions; |

|   |   |                              |
|--------|--------|-----------------------------------|
|   | • | changing business conditions; and |

|   |   |                                 |
|--------|--------|--------------------------------------|
|   | • | unanticipated competitive pressures. |

We believe that, as the expected growth in our Net2Phone Cable Telephony subsidiary accelerates, or if we acquire the business or assets of another company, we may need to raise additional capital from equity or

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debt sources. There can be no assurance    that we will be able to raise such capital on favorable terms or at all.    If we are unable to obtain such additional capital, we may be required to    reduce the scope of our anticipated expansion, which could have a materialadverse effect on our business, financial condition, and results of operations.

| **Pricing pressures and increasing use of VoIP technology may lessen our competitive pricing advantage.** |
|-----------------------------------------------------------------------------------------------------------|

Our success is based partly on our    ability to provide discounted local and long distance telephone services    by taking advantage of cost savings achieved by carrying voice traffic employing    VoIP technology, as compared to carrying calls over traditional networks.    In recent years, the price of telephone service has fallen. The price of    telephone service may continue to fall for various reasons, including the    adoption of VoIP technology by other communications carriers. Many carriers    have adopted pricing plans such that the rates that they charge are not always    substantially higher than the rates that we charge for similar service. In    addition, other providers of long distance services are offering unlimited    or nearly unlimited use of some of their services for an attractive monthly    rate. The overall effect of these developments may be to reduce the price    of local and long distance calls to a point where we no longer have a price    advantage. We would then have to rely on factors other than price to differentiate    our product and service offerings, which we may not be able to do. If we    are not able to do so, our business, financial condition and results of operations  may be materially and adversely affected.

| **We and our cable customers may not be able to compete with providers that can bundle telephony services with other offerings.** |
|-----------------------------------------------------------------------------------------------------------------------------------|

Our competitors as well as the competitors    of our cable operator customers, such as local exchange carriers and satellite    television providers, may bundle services and products that we do not offer    together with long distance or Internet telephony services. These services    could include wireless communications, voice and data services, Internet    access and cable television. This form of bundling would put us at a competitive    disadvantage if these providers can combine a variety of service offerings    at a single attractive price. In addition, some of the telecommunications    and other companies that compete with us and our cable customers may be able    to provide customers with lower communications costs or other incentives    with their services, reducing the overall cost of their communications packages,    and significantly increasing pricing pressures on our services, which could    materially and adversely affect our business, financial condition and results    of operations. While we are entering the cable telephony business, in part,    to take advantage of possible bundled service offerings by our cable operator    customers, we cannot assure you that we will compete successfully in this  business.

Some local exchange carriers, alone    or together with partners such as satellite television providers, are capable    of providing a similar bundled service offering of voice, data and video.    This service offering would directly compete with bundled services offerings    by cable operators that purchase our cable telephony services. If we or our    cable operator customers are unable to successfully compete with these offerings,    our business, financial condition and results of operations may be materially  and adversely affected.

| **Competition could reduce our market share and decrease our revenue.** |
|-------------------------------------------------------------------------|

The market for telecommunications    services is extremely competitive. Many companies offer products and services    like ours, and some of these companies have a superior presence in the markets    we serve. In addition, many of these companies are larger than we are and    have substantially greater financial, distribution and marketing resources    than we do. We may not be able to compete successfully with these companies.    If we do not succeed in competing with these companies, we will lose customers    and our revenue will be substantially reduced, and our business, financial  condition and results of operations may be materially and adversely affected.

Our competitors include the following:

*International Communications Services.*     Competitors include both government-owned phone companies as well as emerging competitive carriers.

 

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*Consumer Division.*     There    are several large and numerous small competitors, and we expect to face continuing    competition based on price and service offerings from existing competitors.    Competitors include AT&T,    MCI, Sprint, IDT and Regional Bell Operating Companies, all of whom offer    their own pre-paid calling cards. Some providers, such as Go2Call and DeltaThree,    Inc., offer similar PC-to-phone services. Other providers, such as Vonage  Holdings Corp., Packet 8, AT&T, Verizon and Primus, compete with our VoiceLine  service offering, and may become competitive with our International Communications  Services service offerings.

*Carrier Services.*     Wholesale    Internet telephony service providers, such as Teleglobe Corp. and iBasis,    Inc. compete with our carrier services, and could become meaningful competitors    to our International Communications Services group. We also compete with    other wholesale communications providers, such as MCI, Global Crossing, IDT,  Qwest Communications and Sprint.

*Cable Telephony.*     Our    ability to sell our cable telephony services may be further limited by the    fact that cable operators have and may in the future elect to develop and    maintain their own cable telephony service instead of buying services from    us. There are several companies who currently market cable telephony services    directly to consumers and cable operators. These companies may be able to    offer services similar to ours, or features that we may be unable to provide,    and they may offer services at prices lower than we intend to charge. Other    companies aggregate a series of elements to deploy cable telephony systems  that could be competitive to us.

We along with cable operators seeking    to provide our telephony services directly to customers, will face competition    for subscribers for telephone service from incumbent local exchange carriers,    such as Verizon, Qwest, SBC and competitive local exchange carriers for subscribers    for telephone services. We expect that competition for telephone services    will be primarily on the basis of price, quality, customer service and the    ability to offer a bundled voice, video and data service offering. Some local    exchange carriers, alone or together with partners such as satellite television    providers, are or may become capable of providing bundled service offerings    of voice, data and video similar to which cable operators who have upgraded    their systems to two-way digital cable can provide. These providers may be    able to provide this bundled service offering at lower prices or with greater    reliability than cable operators, which in turn may adversely affect demand  for our product.

| **Our business may be affected by the proliferation and increased usage of cellular telephones.** |
|---------------------------------------------------------------------------------------------------|

A significant number of our customers    use calling cards while traveling, both domestically and abroad. As more    and more people obtain cellular telephones, and as cellular telephone users    increase their usage, and begin to use their phones in broader geographic    regions,including internationally, the need for these customers to purchase    our calling cards may be reduced. We cannot predict how this development    will impact our business, as our calling card rates and service could be    attractive enough for cellular telephone users to continue to purchase our    cards when traveling. If our calling card rates and service are not attractive    enough to compete with cellular telephone usage, our business, financial  condition and results of operations may be materially and adversely affected.

| **We have and plan to increasingly depend on our international operations, which subject us to unpredictable regulatory, economic and political situations.** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|

Our customers based outside of the    United States generated approximately 55 percent of our revenue during fiscal    2004. A significant component of our strategy is to continue to expand internationally.    We cannot assure you that we will be successful in expanding into additional    international markets. In addition to the uncertainty regarding our ability    to generate revenue from foreign operations and expand our international    presence, there are certain risks inherent in doing business on an international  basis, including:

|   | • | changing regulatory requirements, which vary widely from country to country; |
|--------|--------|------------------------------------------------------------------------------|

|   |   |                                                                                                   |
|--------|--------|--------------------------------------------------------------------------------------------------------|
|   | • | action by foreign governments or foreign telecommunications companies to limit access to our services; |

|   |   |                                       |
|--------|--------|--------------------------------------------|
|   | • | increased bad debt and subscription fraud; |

 

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|   | • | legal uncertainty regarding liability, tariffs and other trade barriers; |
|--------|--------|--------------------------------------------------------------------------|

|   |   |                                    |
|--------|--------|-----------------------------------------|
|   | • | economic and political instability; and |

|   |   |                                  |
|--------|--------|---------------------------------------|
|   | • | potentially adverse tax consequences. |

For example, several of our largest    customers are based in the Middle East, Asia and Latin America and other    areas of the world where there is the potential for significant political    and economic instability. More than 10 percent of our revenue was derived    from customers in the Middle East in fiscal 2004. We have experienced power    supply problems, difficulty maintaining local customer support and difficulties    dealing with local companies and governments in some of these regions. Moreover,    developments in the Middle East, such as the continuation of hostilities    by the United States or others, could result in the disruption of our business    in the regions affected by the hostilities. These events could also reduce    travel to these regions, which could further adversely affect our calling    card business, which relies in large part on the use of calling cards by    travelers. We cannot assure you that these political and economic difficulties    will    not continue or that they will not expand into other geographic areas experiencing    political and economic instability. These difficulties could materially and  adversely affect our business, financial condition and results of operations.

| **If our customers do not perceive our services to be effective or of high quality, our brand and name recognition would suffer.** |
|------------------------------------------------------------------------------------------------------------------------------------|

We believe that establishing and    maintaining brand and name recognition is critical for attracting and expanding    our targeted client base. We also believe that the importance of reputation    and name recognition will increase as competition in our market increases.    Promotion and enhancement of our name will depend on the effectiveness of    our marketing    and advertising efforts and on our success in continuing to    provide high quality and reliable products and services, neither of which    can be assured. Our Net2Phone Global Services business requires us to rely    on third party resellers to promote and market our products and services.    These third parties may not provide the same level of effort as we do to    protect the high quality reputation we believe our services and products    maintain. If they do not, our reputation may be diminished in these markets    which may have a material and adverse effect on our business, results of  operations and financial condition.

Our cable telephony business will    be providing services that have not yet gained widespread customer and market    acceptance. If customers do not perceive cable telephony to be a reliable    and high quality alternative to traditional phone service, our ability to    earn revenues from our cable telephony business and our financial condition  and results of operations may be materially and adversely affected.

| **Any damage to or failure of our systems or operations could result in reductions in, or terminations of, our services.** |
|----------------------------------------------------------------------------------------------------------------------------|

Our success depends on our ability    to provide efficient and uninterrupted, high quality services. Our systems    and operations are vulnerable to damage or interruption from natural disasters,    power loss, telecommunication failures, physical or electronic break-ins,    sabotage,computer viruses, and intentional acts of terrorism or vandalism    and similar events that may be or may not be beyond our control. Our systems    and operations could also be interrupted by Internet service providers or    government owned telecommunications companies that implement network changes    or blocks, which may also be out of our control. The occurrence of any or    all of these events could still hurt our reputation and cause us to lose    customers, which may materially and adversely affect our business, financial  condition and results of operations.

| **Substantially all of the IP telephony calls made by our customers are connected through local telephone companies and, at least in part, through leased facilities that may become unavailable.** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

We are not a local telephone company    or a local exchange carrier. Our network covers only portions of the United    States. Accordingly, we must route parts of some domestic and all international    calls made by our customers over leased transmission facilities. In addition,    because our network does not extend to homes or businesses, we must generally    route calls through a local telephone company to reach our network and, ultimately,  to reach their final destinations.

 

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In many of the foreign jurisdictions    in which we conduct or plan to conduct business, the primary provider of    significant in-country transmission facilities is the national telephone    company, which may be the only provider in that country. Accordingly, we    may have to lease transmission capacity at artificially high rates from such    a monopolistic provider, and consequently, we may not be able to generate    a profit on those calls. In addition, national telephone companies may not    be required by law to lease necessary transmission lines to us or, if applicable    law requires national telephone companies to lease transmission facilities    to us, we may encounter delays in negotiating leases and interconnection    agreements and commencing operations. Additionally, disputes may result with    respect to pricing, billing or other terms of these agreements, and these    disputes could affect our ability to continue to operate in these countries,    which may materially and adversely affect our business, financial condition  and results of operations.

Our ability to implement our cable    telephony services will require us and our underlying providers to negotiate    carrier services and/or interconnection agreements with established telephone    companies and other new market entrants, which can take considerable time,    effort and expense and which may be subject to federal, state and local regulation.    Interconnection agreements are agreements between local telecommunications    services providers that set forth the terms and conditions governing how    these providers will interconnect their networks and/or purchase or lease  network facilities and services.

| **We rely on the Internet and third-party communications infrastructure over which we have little control.** |
|--------------------------------------------------------------------------------------------------------------|

Our service could be disrupted, our    reputation could be harmed and we could lose customers, if the quality and    maintenance of the third-party communications infrastructure on which we    rely suffers. This infrastructure, including the Internet and leased transmission    facilities, is sometimes used to carry our voice traffic between our customers.    We have no control over whether the infrastructure on which we rely will    be adequately maintained by these third parties or whether these third parties    are able to upgrade or improve their equipment and prevent it from becoming    obsolete. If these third parties fail to maintain, upgrade or improve this    equipment, our service quality may be harmed, we may lose customers and our    business, financial condition and results of operations may be materially    and adversely affected. We do not control the security of the Internet and    our business could be materially harmed by unauthorized activity which results  in congestion, failures or deficiencies in the infrastructure.

| **We depend on key vendors            for hardware devices, soft switches and other services.** |
|-------------------------------------------------------------------------------------------------|

We rely on one of our vendors, LG    Electronics, to manufacture approximately fifty percent of the hardware devices    sold by Net2Phone Global Services primarily through its International    Communications Services division. We do not have a contract with LG Electronics, and therefore,    LG Electronics    could    stop    providing us    with these products with little or no prior notice. While we believe our    relationship with LG Electronics is stable, we can provide no assurance that    this relationship will continue to be good, or continue at all. While we    believe we could replace LG Electronics if necessary, this could take a period    of time during which our hardware sales could be materially and adversely    affected, and this could impact our ability to service some of our customers  for this period of time.

We also rely on one of our vendors,    Level3 Communications, Inc., to deliver a suite of local telecommunications    services, including local phone numbers, access to the PSTN, operator assistance,    directory listings and assistance, E911 emergency services and local number    portability. By using Level3, we gain access to its telephone numbering resources,  which expands the availability of our telephony products to cable operators.

| **Our success depends on our ability to handle a large number of simultaneous calls, which our systems may not be able to accommodate.** |
|------------------------------------------------------------------------------------------------------------------------------------------|

We expect the volume of simultaneous    calls to increase significantly as we expand our operations. Our network    hardware and software may not be able to accommodate this additional volume.    If we fail to maintain an appropriate level of operating performance, or    if our service is disrupted, our reputation could be hurt, we could lose    customers and our business, financial condition and results of operations  could be materially and adversely affected.

 

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| **Because we are unable to predict definitely the volume of usage and our capacity needs, we may be forced to enter into disadvantageous contracts that would reduce our operating margins.** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

We may have to enter into additional    long-term agreements for leased communications transmission capacity. To    the extent that we overestimate our call volume, we may be obligated to pay    for more transmission capacity than we actually use, resulting in costs without    corresponding revenue. Conversely, if we underestimate our capacity needs,    we may be required to obtain additional transmission capacity through more    expensive means or such capacity may not be available. As a result, our margins    could be reduced and our business, financial condition and results of operations  could be materially and adversely affected.

| **We may not be able to keep pace with rapid technological changes in the communications industry.** |
|------------------------------------------------------------------------------------------------------|

Our industry is subject to rapid    technological change. We cannot predict the effect of technological changes    on our business. We expect that new services and technologies will emerge    in the market in which we compete. These new services and technologies may    be superior to the services and technologies that we use, or these new services    may render our services and technologies obsolete. To be successful, we must    adapt to our rapidly changing market by continually improving and expanding    the scope of services we offer and by developing new services and technologies    to meet customer needs. Our success will depend, in part, on our ability    to respond to technological advances and emerging industry standards on a    cost effective and timely basis. If we are unable to do so, our business,    financial condition and results of operations may be materially and adversely  affected.

| **Unauthorized use of our intellectual property by third parties may damage our brand.** |
|------------------------------------------------------------------------------------------|

We regard our patents, service marks,    trademarks, trade secrets and other intellectual property as important to    our success. We rely on trademark and copyright law, trade secret protection    and confidentiality agreements with our employees, customers, partners and    others to protect our intellectual property rights. Despite our precautions,    it may be possible for third parties to obtain and use our intellectual property    without authorization. Furthermore, the laws of some foreign countries may    not protect intellectual property rights to the same extent as do the laws    of the United States. It may be difficult for us to enforce certain of our    intellectual property rights against third parties who may have acquired    intellectual property rights by filing unauthorized applications in foreign    countries to register the trademarks that we use because of their familiarity    with our worldwide operations. Since Internet related industries such as    ours are exposed to the intellectual property laws of numerous foreign countries    and trademark rights are territorial, there is uncertainty in the enforceability    and scope of protection of our trademarks. The unauthorized use of our intellectual    property by third parties may damage our brand and may have a material adverse  effect on our business, financial condition and results of operations.

| **Defending against intellectual property infringement claims could be expensive and could disrupt our business.** |
|--------------------------------------------------------------------------------------------------------------------|

We cannot be certain that our products    and services do not or will not infringe upon valid patents, trademarks,    copyrights or other intellectual property rights held or claimed by third    parties. We may be subject to legal proceedings and claims from time to time    relating to the intellectual property of others in the ordinary course of    our business. We may incur substantial expenses in defending against those    third-party infringement claims, regardless of their merit. For example,    in February 2000, Multi-Tech, Inc. filed a lawsuit against us alleging that    we infringe upon its patents. While we have received a successful ruling    in this case, we incurred substantial expenses defending this claim. For  a complete discussion of the Multi-Tech case, please see “Legal Proceedings” below.  Successful infringement claims against us may result in substantial monetary liability or may materially disrupt the conduct of our business.

 

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| **Our risk management practices may not be sufficient to protect us from unauthorized transactions or thefts of services.** |
|-----------------------------------------------------------------------------------------------------------------------------|

As have many others in our industry    whose customers use credit cards to purchase services, we have been the victim    of consumer fraud and theft of service. From time to time, callers have obtained    our services without rendering payment by unlawfully using our access numbers    and personal identification numbers. We attempt to manage these theft and    fraud risks through our internal controls and our monitoring and blocking    systems. If these efforts are not successful, the theft of our services may    cause our revenue to decline significantly and our business, financial condition  and results of operations to be materially and adversely affected.

**Risks Related to Our Relationship with IDT and Liberty Media**

| **We are controlled by IDT and Mr.** **Howard Jonas.** |
|-------------------------------------------------------------|

IDT and Liberty Media own all of    the interests in NTOP Holdings, L.L.C., which, as of October 7, 2004, holds    an aggregate of 37.8 percent of our outstanding capital stock and 54.9 percent    of the aggregate    voting power of our capital stock. IDT controls the right to vote the shares    of Class A Common stock held by the LLC in most matters, and IDT holds additional    common and Class A common stock directly. Our Class A common stock has greater  voting power than our common stock. Mr. Howard Jonas controls IDT because  he beneficially owns a controlling voting interest in the voting securities  of IDT and serves as the chairman of its board of directors. As a result, Mr. Jonas  and IDT have the power to control or influence the selection of our management  and other decisions important to our business. As of December 31,  2004, Liberty Media and IDT each will have the right to dissolve the LLC. If  Liberty Media or IDT elects to do so, IDT will no longer have majority voting  control over Net2Phone, but still will be in a position to influence the management  and operations of Net2Phone through its significant stock ownership, extensive  relationship and interlocking boards of directors. If the LLC is dissolved,  Liberty Media would obtain significant voting power over us and would also  be able to exert significant influence over our management and operations.

| **We may experience conflicts of interest resulting from the LLC’s power to elect the members of our board of directors and the presence of IDT officers and directors on our board.** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

The LLC has the power to nominate    and elect the members of our board of directors when such members become    eligible for re-election, so long as at least five members are not affiliated    with us or IDT, as required by our bylaws. The chairman of our board, Howard  Jonas, is also the chairman of IDT’s board of directors. As we announced  on September 23, 2004, on October 31, 2004, Mr. Jonas  will become vice chairman of our board and Stephen Greenberg, our current chief  executive officer and vice chairman of the board, will become chairman. Mr. Greenberg  has received and may continue to receive compensation from IDT. One of our  other directors, James Courter, serves as a director and the chief executive  officer of IDT. In addition, our new chief executive officer effective October 31,  2004, Liore Alroy, whose appointment was influenced by IDT, will also serve  on our board and is currently a senior vice president of IDT. Although a majority  of our board members are independent directors, our board may still face significant  conflicts of interest with respect to matters involving IDT and other matters  that may arise in the ordinary course of our business or the business of any  of the owners of the LLC.

| **The holdings of the LLC may limit your ability as a stockholder to influence the outcome of matters subject to a stockholder vote.** |
|----------------------------------------------------------------------------------------------------------------------------------------|

The LLC is able to exert considerable    influence over us, including in the election of our directors, the appointment    of management and the approval of any other action requiring the approval    of our stockholders, including any amendments to our certificate of incorporation    and mergers or sales of our company or of all of our assets. In addition,    we could be prevented from entering into certain transactions that could    be beneficial to us and our stockholders, as the LLC can effectively block    these transactions through its voting control of us. Third parties will likely    be discouraged from making a tender offer or bid to acquire us because of  the LLC’s stock ownership and voting control of us.

 

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| **We have contracted with IDT for various services and for the use of its telecommunications network, which contracts we may not be able to renew when they expire.** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|

In May 1999, we entered into agreements    with IDT under which IDT provides administrative and telecommunication services    to us. Since that time we have entered into a variety of other service agreements    with IDT. Some of these agreements are terminable at will. If we or IDT elect    to terminate, we will need to engage other entities to perform these services    or perform these services ourselves. We cannot assure you that IDT will continue    to provide these services. As a result, we may have to purchase these services    from third parties or devote resources to handle these functions internally,  which may cost us more than we paid IDT for the same services.

| **We rely on Liberty Media to introduce us to cable operators.** |
|------------------------------------------------------------------|

Liberty Media has a significant presence    in the cable television marketplace. We view our relationship with Liberty    Media as one of our competitive advantages. Liberty Media has introduced    us to cable operators seeking to deploy cable telephony. If Liberty Media    declines to support our cable telephony efforts, our business, particularly    Net2Phone Cable Telephony, financial condition and results of operations  could be materially and adversely affected.

| **Some of our business relationships with IDT and its affiliates are not covered by written agreements. IDT could stop them at any time.** |
|--------------------------------------------------------------------------------------------------------------------------------------------|

IDT is our largest carrier customer,    representing approximately 33.8 percent of our carrier revenue and, together    with its affiliates, 7.2 percent of our total revenue for fiscal 2004. While    we have understandings in place with IDT relating to the carrier services    we provide to them, only some of them have been reduced to writing, and with    respect to the agreements that are not in writing, they may be terminated    at any time by either party, or the terms could change without notice to    us. Termination of these relationships, or a deterioration of the terms available    to us, could significantly reduce our revenues, which may have a material  adverse effect on our business, financial condition and results of operations.

| **We will depend on IDT to provide various telecommunications services to us. We do not currently have a definitive agreement in place with IDT for these services.** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|

Under Net2Phone Cable Telephony’s    memorandum of understanding with IDT, it is contemplated that IDT and its    affiliates will provide to us telecommunications services that will be important    to our cable telephony business. If we can successfully conclude the negotiation    of definitive agreements with IDT, we expect IDT to provide us with some    or all of the following services: network access, call termination, call    origination, other related services and various primary line services, such    as enhanced 911. We expect to obtain favorable pricing on these services    during the term of our agreement with IDT. We expect to purchase from IDT    a significant    portion of telecommunications services that we require to support our cable  telephony business.

Our agreement with IDT for these    services is currently in the form of a legally binding memorandum of understanding.    The memorandum of understanding requires that we and IDT use good faith efforts    to negotiate, execute and deliver a definitive agreement that comprehensively    sets forth the obligations of IDT to the supply the telecommunications services.    If, for any reason, the parties do not execute a definitive agreement, IDT    may elect not to provide these services to us. If we enter into the definitive    agreement and IDT does not perform its obligations under the agreement, we  will be required to seek alternative supply arrangements.

If we cannot obtain these services    from IDT, one of the sources of supply for these services may be from competitors    to our cable telephony business, including traditional long distance carriers    and incumbent local exchange carriers. We may not be able to obtain these    services from third parties at the prices and on the terms we anticipated    to receive from IDT. If we must seek alternative supply of these services,    we may be delayed in offering our cable telephony services while we negotiate    supply arrangements. As a result, our ability to offer our cable telephony  services may be materially and adversely affected.

 

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| **We are required to issue 6.9** **million shares of Class A common stock to IDT when we enter into definitive telecommunications services and related agreements. Charges relating to the vesting of these shares may materially reduce our earnings.** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

Under the terms of the memorandum of understanding, we have agreed to issue 6.9 million    shares of Class A common stock to IDT at the time we execute definitive agreements    in consideration for IDT providing the telecommunications and other services  to us. The stock will be held in escrow to secure IDT’s performance obligations  and will be released to IDT in equal annual amounts over five years. If third  parties can provide services to us on more favorable terms, we may determine  not to purchase services from IDT. IDT may not be able to provide these services  to us in the quantities we demand. We may determine to purchase similar services  from other suppliers for other reasons as well. Even if we do not purchase  from IDT our anticipated or required volume of services, IDT may still be entitled  to receive all of these shares so long as it is offering the services and otherwise  performing its obligations under the agreement. Assuming these 6.9 million  shares are issued, IDT will control 61.4 percent of our aggregate voting power  based on our outstanding stock on October 7, 2004.

These shares are subject to variable    accounting treatment and therefore must be marked-to-market each quarter,    resulting in a quarterly charge to earnings equal to the aggregate market    value of one-fourth of the shares that will vest on each anniversary of the  agreement. These charges may materially reduce our earnings.

**Risks Related to Our Industry**

| **Federal and state regulations may be passed that could harm our business.** |
|-------------------------------------------------------------------------------|

Our ability to provide VoIP communications    services at attractive rates arises in large part from the fact VoIP services    are not currently subject to the same regulation as traditional telephony.    Because their services are not currently regulated to the same extent as    traditional telephony, VoIP providers can currently avoid paying charges    that traditional telephone companies must pay. Local exchange carriers are    lobbying the Federal Communications Commission (FCC) and the states to regulate    VoIP on the same basis as traditional telephone services. The FCC and several    states are examining this issue. If the FCC or any state determines to regulate    VoIP, they may impose surcharges, taxes or additional regulations upon providers    of Internet telephony. These surcharges could include access charges payable    to local exchange carriers to carry and terminate traffic, contributions    to the Universal Service Fund (USF) or other charges. Regulations requiring    compliance with the Communications Assistance for Law Enforcement Act (CALEA),    or provision of the same type of 911 services as required for traditional    telecommunications providers could also place a significant financial burden    on us depending on the technical changes required to accommodate the requirements.    The imposition of any such additional fees, charges, taxes and regulations    on IP communications services could materially increase our costs and may    limit  or eliminate the competitive pricing advantage we currently enjoy.

We have received directives from    some state regulators that we register as a telecommunications provider in    their states. In response, we are taking the position that VoIP is not, and    should not be, subject to such regulations because VoIP is an information    service, not a telecommunications service. However, these states may reject    our position and may subject us to regulation and require us to pay associated    charges and taxes. As a result, our business, financial condition and results  of operations could be materially and adversely affected.

| **Our ability to offer services outside the U.S. is subject to the local regulatory environment, which may be complicated and often uncertain.** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|

Regulatory treatment of Internet    telephony outside the United States varies from country to country. Net2Phone    Global Services distributes its products and services through resellers that    may be subject to telecommunications regulations in their home countries.    The failure of these resellers to comply with these laws and regulations    could reduce our revenue and profitability. Because of our relationship with    the resellers, some countries may assert that we are required to register    as a telecommunications carrier in that country. In such case, our failure    to do so could subject us to regulatory action such as fines or penalties.    In addition, some countries are considering subjecting VoIP services to the  regulations applied to traditional telephone

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companies. Regulatory developments    such as these could have a material adverse effect on our extensive international    operations, from which we derived approximately 55% of our revenue in fiscal2004.

In many countries in which we operate    or our services are sold, the status of the laws that may relate to our services    is unclear. We cannot be certain that our customers, resellers, or other    affiliates are currently in compliance with regulatory or other legal requirements    in their respective countries, that they or we will be able to comply with    existing or future requirements, and/or that they or we will continue in    compliance with any requirements. Our failure or the failure of those with    whom we transact business to comply with these requirements could materially  adversely affect our business, financial condition and results of operations.

| **New regulations may be adopted affecting our business.** |
|------------------------------------------------------------|

New regulations could increase our    costs of doing business and prevent us from delivering our products and services    over the Internet, which could adversely affect our customer base and our    revenue. The growth of the Internet may also be significantly slowed. This    could delay growth in demand for our products and services and limit the    growth    of our revenue, which may have a material adverse effect on our business,    financial condition and results of operations. In addition to new regulations    being adopted, existing laws may be applied to the Internet. Moreover, as    we begin to offer new products and services, the failure of such products    and services to perform or function properly may also subject us to legal    claims or actions from our customers such as cable operators. For instance,    Net2Phone intends to offer services that enable customers to access emergency    services. While these services may resemble traditional emergency services    such as 911, they are fundamentally different in terms of routing and reliability.    Net2Phone endeavors to disclose any and all limitations of the emergency    services we intend to offer but we cannot guarantee that customers would    use the services    properly or read our disclosures and disclaimers. Accordingly, the offering    of 911-type services may subject us to additional risks and liabilities related    to customer use of these services. New and existing laws may cover issues    that include, but are not limited to:

|   | • | sales and other taxes; |
|--------|--------|------------------------|

|   |   |          |
|--------|--------|---------------|
|   | • | user privacy; |

|   |   |              |
|--------|--------|-------------------|
|   | • | pricing controls; |

|   |   |                                      |
|--------|--------|-------------------------------------------|
|   | • | export and commerce related transactions; |

|   |   |                                                  |
|--------|--------|-------------------------------------------------------|
|   | • | characteristics and quality of products and services; |

|   |   |                 |
|--------|--------|----------------------|
|   | • | consumer protection; |

|   |   |                   |
|--------|--------|------------------------|
|   | • | cross-border commerce; |

|   |   |        |
|--------|--------|-------------|
|   | • | encryption; |

|   |   |                                              |
|--------|--------|---------------------------------------------------|
|   | • | copyright, trademark and patent infringement; and |

|   |   |                                                                |
|--------|--------|---------------------------------------------------------------------|
|   | • | other claims based on the nature and content of Internet materials. |

**Risks Related to Our Capital Structure**

| **The market price of our common stock may be volatile.** |
|-----------------------------------------------------------|

The market price of our common stock    has been and will likely continue to be highly volatile, as is the stock    market in general, and the market for VoIP services and communications related    companies in particular. Some of the factors that may materially affect the    market price of our common stock are beyond our control, such as changes    in financial estimates by securities analysts, conditions or trends in the    VoIP services and other Internet and communications related industries, announcements    made by our competitors or sales of our common stock. These factors may materially    adversely affect the market price of our common stock, regardless of our  performance.

In addition, the public stock markets have experienced extreme price and trading volume volatility. This volatility has significantly affected the market prices of securities of many companies for reasons frequently

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unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of our common stock.

| **Some provisions of our certificate of incorporation, bylaws and Delaware law, as well as the fact that IDT controls us, may deter takeover attempts, which may limit the opportunity of our stockholders to sell their shares at a favorable price.** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

IDT’s control of a majority    of our voting stock enables it to block or deter attempts by third parties    to acquire control of our company. IDT may not approve a takeover bid that    other stockholders believe is in their best interests. In addition, some    of the provisions of our certificate of incorporation and bylaws and in Delaware    law could make it more difficult for a third party to acquire us, even if    doing so might be beneficial to our stockholders by providing them with the    opportunity to sell their shares possibly at a premium over the then market    price. For example, our board of directors is divided into three classes.    At each annual meeting of stockholders, the terms of approximately one-third    of the directors will expire, and new directors will be elected to serve    for three years. It will take at least two annual meetings to effect a change    in control of our board of directors because a majority of the directors    cannot be elected at a single meeting, which may discourage hostile takeover    bids. In addition, our certificate of incorporation authorizes the board    of directors, without further stockholder approval, to issue preferred stock,    which could have the effect of delaying, deferring or preventing a change    in control of us. The issuance of preferred stock could also adversely affect    the voting power of the holders of common stock, including the loss of voting    control to others. Our bylaws and articles of incorporation contain provisions    that    require stockholders to act only at a duly-called meeting in certain circumstances    and make it difficult for any person other than management to introduce business    at a duly-called meeting by requiring such other person to follow certain    notice procedures. Certain provisions of Delaware law could delay or prevent    a change in control of Net2Phone, discourage acquisition proposals or diminish    the opportunities for a stockholder to participate in tender offers,including    tender offers at a price above the then current market value of our common  stock or over a stockholder’s cost basis in our common stock.

| **Additional Information** |
|----------------------------|

The Company’s internet address is www.net2phone.com. We make available, via a link to the Securities and Exchange Commission’s    website, through our investor relations website located at www.net2phone.com,    access to our annual reports on Form 10-K, quarterly reports on Form 10-Q,    current reports on Form 8-K and any amendments to those reports filed or  furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange  Act of 1934 as soon as reasonably practicable after they are electronically  filed with or furnished to the SEC. All such filings on our investor relations  website are available free of charge. A copy of this Annual Report is available  without charge upon written request to: Investor Relations, Net2Phone, Inc.,  520 Broad St., 8th Floor, Newark, NJ 07102.

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| **Item 2.**     ***Properties*** |
|-----------------------------------------------------------|

Our primary facility is our headquarters    and executive offices located on two floors at 520 Broad Street, Newark,    New Jersey. We also locate equipment around the world. Our principal equipment    locations are in Newark and Piscataway, New Jersey, London, England and Hong    Kong, China. Since the equipment is portable, the lease arrangements for    the equipment locations are generally short term or at-will. We believe that    our facilities are suitable and adequate for our business for the foreseeable    future. A summary of the material leased facilities where we conduct business  operations is as follows:

| **Domestic Office Locations(1)** |   | **Total    Sq. Ft.** |   | **Business****Segment****Served** |   | **Description**                   |   | **Lease Expiration Date** |                       |
|----------------------------------|--------|----------------------|--------|-----------------------------------|--------|-----------------------------------|--------|---------------------------|----------------------------|
|                                  |   |                      |        |                              |        |                                   |   |                           |                            |   |  |  |   |
| Newark, New Jersey               |   |                 | 47,401 |                              |   | Net2Phone,          NGS & NCT |   |                      | Headquarters               |   |   | May 31,    2010 |   |
| Brick, New Jersey                |   |                 | 14,663 |                              |   | NCT                               |   |                      | Laboratories               |   |   | March 31,    2006 |   |
| West Long Branch, New Jersey     |   |                 | 31,485 |                              |   | Net2Phone and NGS                 |   |                      | Laboratories               |   |   | September 30,    2007 |   |
| **Foreign Office Locations**     |   |                 |   |                              |   |                              |   |                      |                       |   |   |   |   |
| Jerusalem, Israel                |   |                 | 1,800  |                              |   | NGS                               |   |                      | International Sales Office |   |   | Month-to-month |   |
| Singapore                        |   |                 | 395    |                              |   | NGS                               |   |                      | International Sales Office |   |   | Month-to-month |   |
| Rio De Janeiro, Brazil           |   |                 | 450    |                              |   | NGS                               |   |                      | International Sales Office |   |   | Month-to-month |   |
|                             |   |                 |   |                              |   |                              |   |                      |                       |   |   |   |   |

|  |   |
|--|--------|

| (1) | We lease approximately 22,000 additional square feet of office space in New York, New York, Boston, Massachusetts and Hackensack, New Jersey that is currently vacant, or close to vacant. We have either subleased or are currently attempting to sublease this space. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|                                                             |
|------------------------------------------------------------------|
| **Item 3.**     ***Legal Proceedings*** |

|           |
|----------------|
| **Multi-Tech** |

On February 15, 2000, Multi-Tech Systems, Inc. filed suit against Net2Phone and other companies in the United States Federal District Court in Minneapolis, Minnesota. Multi-Tech alleged “the    defendant companies are infringing because they are providing the end users    with the software necessary to simultaneously transmit voice and data on  their computers in the form of making a phone call over the Internet”. On August 16, 2002, following an initial hearing, the court issued an order construing the claims of all the patents in suit in away that we consider favorable to our non-infringement defenses. On October 31, 2002, the court entered a consent judgment dismissing the patent infringement claims asserted by Multi-Tech Systems, Inc. On November 19,  2002, Multi-Tech filed an appeal with the United States Court of Appeals for  the Federal Circuit. On February 3, 2004, the Court of Appeals for the Federal Circuit affirmed the decision of the District Court in our favor. On February 16,  2004, Multi-Tech filed a Petition for a Rehearing of this decision with the  Court of Appeals, which was denied on March 31, 2004. Subsequently, Multi-Tech filed a Petition for Writ of Certiorari with the United States Supreme Court, which was denied on October 4, 2004. As Multi-Tech has exhausted all avenues of appeal, we consider this matter closed.

| **Class Actions** |
|-------------------|

Four substantially similar class action lawsuits were filed in the United States District Court for the Southern District of New York on behalf of all persons who acquired our stock between July 29, 1999 and December 6,    2000. We, certain of our executive officers and directors and the underwriters    involved in our initial public offering were named as defendants in these    complaints. The complaints allege, in part, that certain underwriters of    our initial public offering violated federal securities laws by failing to    disclose that they had solicited and received undisclosed commissions and    allocated shares in our initial public offering to those investors in exchange    for their agreement to purchase our shares in the after-market at pre-determined    prices. The complaints also allege that, whether or not we and the named  executives were aware of the underwriters’ arrangements, we and the named executives have statutory liability under the federal securities

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laws for issuing a registration statement    in connection with our initial public offering that failed to disclose that    these allegedly undisclosed arrangements existed. The suits against us are    substantially the same as suits asserting the same allegations that have    been filed against hundreds of other companies that closed their initial    public offerings at or about the same time that we did. We have entered into    a settlement agreement along with the majority of the other issuer defendents.The settlement agreement is subject to the court’s approval. Under the termsof the proposed settlement agreement, we are not conceding any liability andwe will not bear any expenses associated with the settlement, other than legalfees we may incur.

We are also subject to litigation and claims in the ordinary course of the operation of our business from time to time. We do not believe that any such litigation and claims, if determined adversely to us, would have a material adverse effect on us.

| **Item 4.**     ***Submission of Matters to a Vote of Security Holders*** |
|----------------------------------------------------------------------------------------------------|

No matters were submitted to our stockholders during the fourth quarter of the fiscal year ended July 31, 2004.

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**PART II**

| **Item 5.**     ***Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities*** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|                   |
|------------------------|
| **Market Information** |

We have two classes of common stock, known as and referred to herein as (1) our common stock and (2) our Class A common stock. Our common stock is quoted on the Nasdaq National Market under the ticker symbol “NTOP.” There    is no public market for our Class A common stock. The following table sets    forth for the periods indicated the high and low sale prices per share for  our common stock as reported on the Nasdaq National Market.

| **Year Ended July** **31, 2004** |   | **High** |     | **Low** |   |
|---------------------------------------|--------|----------|----------|---------|--------|
|                                       |   |          |          |    |        |  |   |
| First Quarter                         |   | $        | 7.79     |    | $      | 4.50 |   |
| Second Quarter                        |   | $        | 8.39     |    | $      | 4.31 |   |
| Third Quarter                         |   | $        | 7.40     |    | $      | 3.49 |   |
| Fourth Quarter                        |   | $        | 4.83     |    | $      | 2.81 |   |
|                                  |   |     |     |    |   |   |   |
| **Year Ended July** **31, 2003** |   |     | **High** |    |   | **Low** |   |
|                                       |   |          |          |    |        |  |   |
| First Quarter                         |   | $        | 4.10     |    | $      | 1.80 |   |
| Second Quarter                        |   | $        | 4.19     |    | $      | 2.65 |   |
| Third Quarter                         |   | $        | 4.39     |    | $      | 2.99 |   |
| Fourth Quarter                        |   | $        | 5.50     |    | $      | 3.77 |   |

On October 7, 2004, the last reported sale price of our common stock on the Nasdaq National Market was $3.43 per share.

| **Holders** |
|-------------|

As of October 7, 2004, there were approximately 412 stockholders of record of our common stock and 7 stockholders of record of our Class A common stock, par value $.01 per share.

| **Dividend Policy** |
|---------------------|

We have not paid any cash dividends in the past and do not intend to pay cash dividends on our capital stock for the foreseeable future. Instead, we intend to retain all earnings, if any, for use in the operation and expansion of our business.

| **Issuer Purchases of Equity Securities** |
|-------------------------------------------|

There have been no purchases of equity securities by the Company required to be disclosed herein.

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| **Item 6.**     ***Selected Financial Data*** |
|------------------------------------------------------------------------|

The following selected financial data should be read in conjunction with our financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included  in Item 7. This financial information is derived from our financial statements.

 

|                                                                                                       |   | **Fiscal Year Ended July** **31,**   |    |
|------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                                                       |   |                                           |    |
| **Statement of Operations Data:**                                                                          |   | **2004**                                  |    | **2003** |   | **2002** |   | **2001** |   | **2000** |   |
|                                                                                                       |   |                                           |         |   |  |  |   |  |  |   |  |  |   |  |  |   |
|                                                                                                       |   | **(in thousands, except per share data)** |    |
| Total revenue                                                                                              |   | $                                         | 82,779  |   | $ | 91,750 |   | $ | 137,855 |   | $ | 150,199 |   | $ | 72,401 |   |
|                                                                                                       |   |                                           |         |   |  |  |   |  |  |   |  |  |   |  |  |   |
| Income (loss) from operations                                                                              |   |                                      | (25,384 | ) |   | 9,532 |   |   | (257,794 | ) |   | (240,210 | ) |   | (128,513) |   |
|                                                                                                       |   |                                           |         |   |  |  |   |  |  |   |  |  |   |  |  |   |
| Net income (loss) available to common stockholders                                                         |   | $                                         | (11,168 | ) | $ | 16,795 |   | $ | (246,061 | ) | $ | (366,508 | ) | $ | (118,334 | ) |
|                                                                                                       |   |                                           |         |   |  |  |   |  |  |   |  |  |   |  |  |   |
| Net income (loss) per common share — basic and diluted                                                |   | $                                         | (0.16   | ) | $ | 0.28 |   | $ | (4.21 | ) | $ | (6.25 | ) | $ | (2.29 | ) |
|                                                                                                       |   |                                           |         |   |  |  |   |  |  |   |  |  |   |  |  |   |
| Weighted average number of common shares used in calculation of basic net income (loss) per common share   |   |                                      | 70,913  |   |   | 59,700 |   |   | 58,442 |   |   | 58,665 |   |   | 51,739 |   |
|                                                                                                       |   |                                           |         |   |  |  |   |  |  |   |  |  |   |  |  |   |
| Weighted average number of common shares used in calculation of diluted net income (loss) per common share |   |                                      | 70,913  |   |   | 60,101 |   |   | 58,442 |   |   | 58,665 |   |   | 51,739 |   |
|                                                                                                       |   |                                           |         |   |  |  |   |  |  |   |  |  |   |  |  |   |
| Cash, cash equivalents, restricted cash and marketable securities                                          |   | $                                         | 132,814 |   | $ | 94,111 |   | $ | 108,691 |   | $ | 253,969 |   | $ | 249,294 |   |
| Total assets                                                                                               |   |                                      | 165,257 |   |   | 144,646 |   |   | 183,405 |   |   | 435,297 |   |   | 411,728 |   |
| Long term obligations and redeemable common stock                                                          |   |                                      | 17,329  |   |   | 16,170 |   |   | 9,753 |   |   | 22,253 |   |   | 25,891 |   |
| Total stockholders’ equity                                                                            |   |                                      | 128,625 |   |   | 76,329 |   |   | 45,913 |   |   | 269,297 |   |   | 331,886 |   |
| Cash dividends declared per common share                                                                   |   |                                      | —  |   |   | — |   |   | — |   |   | — |   |   | — |   |

|                                                                                                   |
|--------------------------------------------------------------------------------------------------------|
| **Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations** |

*You should read the following      discussion together with the more detailed business information and consolidated      financial statements and related notes that appear elsewhere in this report      and in the documents that we incorporate by reference into this report.  This report may contain certain “forward-looking” information within  the meaning of the Private Securities Litigation Reform Act of 1995. This information  involves risks and uncertainties. Our actual results may differ materially  from the results discussed in the forward-looking statements. Factors that  might cause such a difference include, but are not limited to, those discussed  in “Risk factors.”*

| **Overview** |
|--------------|

We are a leading provider of Voice    over Internet Protocol, or VoIP, telephony services. Since we began operations    in 1995, we have evolved from a pioneer in developing PC-to-telephone calling    services over the Internet to a next generation provider of high quality    voice and enhanced communication services throughout the world. Our strategic    investors include IDT Corporation, a global telecommunications, media and    technology company, and Liberty Media Corporation, a global media company.    IDT and Liberty Media together own NTOP Holdings, L.L.C., which, as of October    7, 2004, holds an aggregate of 37.8 percent of our outstanding capital stock    and 54.9 percent of our aggregate voting power. IDT is the controlling member    of NTOP Holdings, through which it effectively controls us. In addition,in    November of 2003, we closed an underwritten common stock offering, which,  in addition to the 11.5 million shares offered to the public and our underwriters, included 1.25 million  shares offered to each of IDT and Liberty Media. Taken together with its control  of NTOP Holdings, the 1.25 million shares IDT purchased in the offering, and an additional 0.3 million shares of our common stock held directly by IDT, IDT controls 56.3 percent of our aggregate voting power.

 

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Our corporate structure is primarily    organized around two wholly owned operating subsidiaries, Net2Phone Global    Services and Net2Phone Cable Telephony. Net2Phone Global Services delivers    VoIP telephony services to businesses and consumers directly and through    its global distribution network of over 500 resellers in over 130 countries    capitalizing on the growth, quality, flexibility and cost advantages of VoIP    technologies. Net2Phone Cable Telephony offers cable and other broadband    operators a complete suite of services, enabling them to deliver residential    phone service to their customers with comparable quality, features and functionality    to that offered by traditional telephone companies. Our segment information  for fiscal 2004 is provided below:

 

|                  |   | **Net2Phone Global Services** |   | **Net2Phone Cable Telephony** |   | **Corporate  &Other** |   | **Total** |    |
|-----------------------|--------|-------------------------------|--------|-------------------------------|--------|---------------------------|--------|-----------|---------|
|                  |   |                               |        |                          |        |                           |   |           |         |   |  |  |   |
|                  |   | **(in thousands)**            |   |
| Revenue               |   | $                             | 81,137 |                          | $      | 1,551                     |   | $         | 91      |   | $ | 82,779 |   |
| Segment income (loss) |   |                          | 5,161  |                          |   | (9,306                    | )      |      | (7,928  | ) |   | (12,073 | ) |
| Capital expenditures  |   |                          | 3,038  |                          |   | 2,481                     |   |      | 20      |   |   | 5,539 |   |
| Total assets          |   |                          | 30,090 |                          |   | 8,607                     |   |      | 126,560 |   |   | 165,257 |   |

Substantially all of our revenue    has been, and is currently, generated by Net2Phone Global Services. We expect    revenue generated by Net2Phone Cable Telephony to represent a growing percentage    of our total revenue over the next few years. In fiscal 2004, international    customers accounted for approximately 55 percent of our revenue. We expect    that international customers will continue to constitute a significant portion    of our revenue for the foreseeable future.

During the past year, Net2Phone Global    Services continued to focus its activities on opportunities in emerging markets    where we believe our services can command higher margins. Specifically, we    have de-emphasized relatively low margin services and during the second quarter    of fiscal 2004 we exited our disposable calling card business. Although these    initiatives have resulted in a decline in our revenue since fiscal 2001,    Net2Phone Global Services has maintained its gross margin percentages and    now generates cash from its operating activities in excess of its capital    expenditures while in the prior year the capital expenditures exceeded cash  generated from its operating activities.

During the past year, our Net2Phone    Cable Telephony business has grown, and we expect it will begin to represent    an increasing proportion of our revenue in future years. Net2Phone Cable    Telephony signed its first contract with Liberty Cablevision of Puerto Rico  on October 22, 2003, and is actively marketing its services to a wide  array of cable and broadband operators in the U.S., Europe and Latin America  whom we believe may prefer to buy our services rather than build their own  cable telephony service. Net2Phone Cable Telephony works with cable and broadband  operators to deploy an integrated, tested and operational telephony service,  including customized operations support systems, network interfaces, carrier  interconnects, telecommunications methods and procedures and real-time service  assurance,including 24 x 7 network operations support.

Net2Phone Cable Telephony offers    cable and broadband operators a range of services, strategic deployment and    economic alternatives. We expect our telephony agreements will reflect multi-year    arrangements, with terms of up to five years. Our primary business model,    what we have previously called our hosted service, has the operator outsourcing    the planning, development and aspects of the ongoing operation of cable telephony    to us. We have seen limited interest in our franchise model, under which    we buy back from the cable operator its cable telephony rights and subscribers    at pre-negotiated periods and valuations. While we offer a variety of deployment    options to our customers, in most cases, the operator will outsource the    planning, development and other aspects of the ongoing operation of cable    telephony to us. In a typical arrangement, the operator will collect revenue    from its    customers and pay us a fee on either a per subscriber basis or on a percentage    of revenue basis for providing our integrated services, as well as ongoing    maintenance and support fees. In addition, the operator will reimburse us    for our telecommunications costs plus a margin. These costs include the set    up and ongoing management of local and long distance interconnection and    termination, the costs of any dedicated circuits and the recurring cost of    maintaining phone numbers and other support services, such as 911 and operator  assisted calling.

 

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Our fees on a particular contract    will depend on a number of variables, including the size of the operator’s    telephony footprint, its ability to sell telephony services to its customers,    the complexity of the deployment and the amount of local versus long distance    calls terminated by those customers. In most cases, the operator will be    responsible for sales and marketing, customer activation, customer support,    billing and collection, plant engineering and service technicians and any    regulatory costs associated with offering telephony. In a typical arrangement,    the operator will also be responsible for the capital expenditures associated    with the cost of new service installation, the cost of equipment deployed  at the subscriber’s premises and the upgrade to its existing cable modem  termination server. We will bear the capital expenditures and operating expenses  for the planning, design, procurement, deployment and operation of the VoIP  telephony infrastructure. Our capital expenditures include the hardware and  software costs of integrating our services and systems with the operator’s  systems.

During fiscal 2004, Net2Phone Cable    Telephony generated $1.6 million    in revenue, primarily related to sales of equipment to one cable telephony    operator. We expect to continue to incur significant costs and capital expenditures    to fund the anticipated growth of Net2Phone Cable Telephony. The revenue    and expenses associated with this business will depend on the number of customers    and contracts we establish and the type of service we provide to our customers.    While we are currently in various stages of negotiations with a number of    potential customers, each customer has different financial, operational and    technical requirements, and, therefore, the time to finalize particular relationships    will vary based upon the individual requirements of the respective customers.    While we believe we have the ability to deliver dial tone within a 90-180    day period with most U.S. cable operators, we expect the implementation period    to vary from customer to customer depending upon their respective requirements,    the time required to negotiate definitive agreements, the time required for    individual customers to implement engineering plans and install hardware    and operating systems. We cannot predict with certainty that we will reach    definitive agreements with any customers we are currently in discussions    with within a particular time period, or at all. While we expect Net2Phone    Cable Telephony will initially adversely affect the profitability of our    company as a whole, we believe the business will contribute to our earnings    in the future as it achieves scale. We cannot predict when this will happen,  or be certain that it will happen at all.

On October 29, 2003, we entered into a binding memorandum of understanding with IDT, which requires us to issue 6.9 million    shares of our Class A common stock to IDT at the time we execute definitive    telecommunications services and related agreements with IDT. Once issued,  the shares will be held in escrow to secure IDT’s performance obligations  under the agreements and will be released to IDT in equal annual installments  over five years. The shares are subject to variable accounting treatment and,  therefore, must be marked-to-market each quarter. Consequently, we recorded  a charge of $3.4 million to non-cash services related to this agreement during fiscal 2004, which represents the market value of the 1.0 million  shares that we may release from escrow to IDT for services and benefits provided  by IDT during fiscal 2004. The 1.0 million shares have been included in the total number of our Class A common stock shares reported as issued and outstanding as of July 31,  2004 in our audited financial statements, although such shares have not yet  been issued to IDT. No definitive agreement has been executed as of October 14, 2004. The parties’ efforts to establish detailed terms and conditions continue. See “Related Party Transactions” below.

| **Critical Accounting Policies** |
|----------------------------------|

Our consolidated financial statements    have been prepared in accordance with U.S. generally accepted accounting    principles. These generally accepted accounting principles require management    to make estimates and assumptions that affect the reported amounts of asset    sand liabilities and disclosure of contingent assets and liabilities at the    date of the financial statements and the reported amounts of revenue and    expenses during the reporting period. We continually evaluate our estimates,    including those related to revenue recognition, bad debts, intangible assets,    income taxes, fixed assets, access line costs, restructuring, contingencies    and litigation. We base our estimates on historical experience and on various    other assumptions that are believed to be reasonable under the facts and    circumstances. Actual results may differ from these estimates under different  assumptions or conditions.

We believe the following critical accounting policies impact our most difficult, subjective and complex judgments used in the preparation of our consolidated financial statements, often as a result of the need to

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make estimates about the effect of    matters that are inherently uncertain. For a further discussion of these    and other accounting policies, please see Note 2 of the Notes to ConsolidatedFinancial Statements included elsewhere in this Annual Report.

*Revenue Recognition.* With    respect to our Net2Phone Global Services business segment, our international    communications service revenue is recognized as service is provided, that    is, as minutes are used. Our retail sales revenue, which consists primarily    of prepaid calling card revenue, is also recognized as service is provided,    that is, as minutes are used, or when service fees are charged. We also recognize    revenue from pre-payments for our services after we conduct evaluations of    outstanding remaining pre-payment balances and determine, based on historical    data, whether such balances are likely to be utilized. The sale of equipment    with software necessary to provide our services is recognized when such products    are delivered, collection of payments is assured and there are no significant  future obligations.

With respect to our Net2Phone Cable    Telephony business segment, to date, we have not recognized significant revenue    from our cable telephony business. However, during fiscal 2004 revenue recorded    by Net2Phone Cable Telephony primarily related to the sale of equipment,    which is recognized when such products are delivered, collection of payments    is assured and there are no significant future obligations. Net2Phone Cable    Telephony also began delivering cable telephony and maintenance services  to customers of Liberty Cablevision of Puerto Rico, Inc. (“LCV”), an affiliate of Liberty Media Corporation under an agreement executed in October 2003. Net2Phone Cable Telephony recognizes such revenue as telecom services are used and when maintenance and support services are provided. In addition,Net2Phone Cable Telephony charges LCV a per subscriber activation fee based on customer contracted commitment levels. These fees are collected and revenue deferred and recognized over the remaining life of the agreement.

*Valuation of Long-Lived and Intangible Assets.* We    assess the recoverability of our long-lived assets and identifiable intangible    assets with finite useful lives whenever events or changes in circumstances    indicate that the carrying value of the asset may not be recoverable. We    evaluate several factors each quarter, which we consider important and which  we believe could trigger an impairment review. These factors include:

|   | • | significant underperformance relative to historical performance or projected future operating results; |
|--------|--------|--------------------------------------------------------------------------------------------------------|

|   |   |                                                                                                     |
|--------|--------|----------------------------------------------------------------------------------------------------------|
|   | • | significant changes in the manner of use of the acquired assets or the strategy of our overall business; |

|   |   |                                                                         |
|--------|--------|------------------------------------------------------------------------------|
|   | • | significant adverse changes in the business climate in which we operate; and |

|   |   |                            |
|--------|--------|---------------------------------|
|   | • | loss of a significant contract. |

If we determined that the carrying    value of certain long-lived assets or identifiable intangible assets may    not be recoverable based upon the existence of one or more of the above indicators    of impairment, we would determine whether an impairment exists based on the    projected undiscounted cash flows expected to be generated by such assets.    If the expected undiscounted future cash flows are less than the carrying  value of the asset, we would record an impairment loss based on such difference.

*Expense Recognition Compared to Capitalized Costs.* Purchases    that exceed $500, provide benefit to future periods and have useful lives    greater than one year are capitalized. All other purchases are expensed in  the period the underlying goods and/or services are received. Specifically:

|   | • | equipment, furniture and fixtures are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets, which range from five to ten years; |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   |   |                                                                                                                                   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------|
|   | • | computer software is amortized using the straight-line method over the shorter of five years or the term of the related agreement; and |

|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | • | software development costs          for the internal development of new software products and substantial          enhancements to existing software products are expensed as incurred          until technological feasibility has been established, at which time          any additional costs would be capitalized. We capitalize certain costs          incurred in connection with developing or obtaining internal use software.          These costs consist of payments made to third parties and the direct          compensation costs of only those employees working on such software          development projects. Capitalized internal use software costs are amortized          using the straight-line method over the shorter of five years or the          useful lives of the internal use software. |

 

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*Restructuring Accruals.* In    fiscal 2004, 2003, and 2002, we recorded charges related to restructuring    within markets, eliminating employee positions and other strategic changes.    The accruals recorded include estimates pertaining to employee termination    costs and remaining lease obligations for closed facilities. Although we    do not anticipate significant changes, the actual costs may differ from these  estimates.

| **Results of Operations** |
|---------------------------|

The following table sets forth certain items in our statement of operations for the periods indicated:

 

|                                                                                                               |   | **Fiscal Year Ended July** **31,** |    |
|--------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|---------|
|                                                                                                               |   |                                         |    |
|                                                                                                               |   | **2004**                                |    | **2003** |   | **2002** |   |
|                                                                                                               |   |                                         |    |  |   |  |   |
|                                                                                                               |   | **(in thousands)**                      |    |
| Total revenue                                                                                                      |   | $                                       | 82,779  |   | $ | 91,750 |   | $ | 137,855 |   |
| Costs and expenses:                                                                                                |   |                                    |    |   |   |   |   |   |   |   |
| Direct cost of revenue (exclusive of items shown below)                                                            |   |                                    | 46,794  |   |   | 52,820 |   |   | 78,502 |   |
| Selling, general and administrative                                                                                |   |                                    | 48,446  |   |   | 53,728 |   |   | 116,570 |   |
| Depreciation and amortization                                                                                      |   |                                    | 10,530  |   |   | 11,037 |   |   | 23,980 |   |
| Non-cash services provided by IDT (attributable to direct cost of revenue and selling, general and administrative) |   |                                    | 3,369   |   |   | — |   |   | — |   |
| Non-cash compensation (attributable to selling, general and administrative)                                        |   |                                    | (3,168  | ) |   | 15,304 |   |   | 19,556 |   |
| Restructuring, severance, impairment and other items                                                               |   |                                    | 2,192   |   |   | 7,363 |   |   | 141,619 |   |
| Settlement of Cisco litigation                                                                                     |   |                                    | —  |   |   | (58,034 | ) |   | 1,572 |   |
| Acquired in-process research and development                                                                       |   |                                    | —  |   |   | — |   |   | 13,850 |   |
|                                                                                                               |   |                                         |         |   |  |  |   |  |  |   |
| Total costs and expenses                                                                                           |   |                                    | 108,163 |   |   | 82,218 |   |   | 395,649 |   |
|                                                                                                               |   |                                         |         |   |  |  |   |  |  |   |
| Income (loss) from operations                                                                                      |   |                                    | (25,384 | ) |   | 9,532 |   |   | (257,794 | ) |
| Interest income, net                                                                                               |   |                                    | 1,981   |   |   | 2,021 |   |   | 4,162 |   |
| Income (loss) on equity investments and other expense, net                                                         |   |                                    | 12,235  |   |   | 696 |   |   | (7,887 | ) |
|                                                                                                               |   |                                         |         |   |  |  |   |  |  |   |
| Income (loss) before minority interests                                                                            |   |                                    | (11,168 | ) |   | 12,249 |   |   | (261,519 | ) |
| Minority interests                                                                                                 |   |                                    | —  |   |   | 4,546 |   |   | 15,591 |   |
|                                                                                                               |   |                                         |         |   |  |  |   |  |  |   |
| Net income (loss)                                                                                                  |   |                                    | (11,168 | ) |   | 16,795 |   |   | (245,928 | ) |
| Redeemable common stock accretion                                                                                  |   |                                    | —  |   |   | — |   |   | (133 | ) |
|                                                                                                               |   |                                         |         |   |  |  |   |  |  |   |
| Net income (loss) available to common stockholders                                                                 |   | $                                       | (11,168 | ) | $ | 16,795 |   | $ | (246,061 | ) |
|                                                                                                               |   |                                         |         |   |  |  |   |  |  |   |

|                                                                 |
|----------------------------------------------------------------------|
| **Comparison of Fiscal Years Ended July** **31, 2004 and 2003** |

*Revenue.*Our revenue is derived from per-minute charges to our customers, primarily on a pre-paid basis, and the sale of VoIP equipment and services to consumers, resellers, IDT, other carriers and cable operators. Revenue decreased 9.8 percent from $91.8 million  in fiscal 2003 to $82.8 million in fiscal 2004. Prior to the current fiscal  year, we significantly reduced our workforce and scaled back certain low-margin  services, including wholesale termination of telecommunications traffic. The  net decrease in revenue was primarily driven by these actions, as well as a  significant reduction in our sales of disposable calling cards, a line of business  we discontinued in the second quarter of fiscal 2004. Disposable calling cards  generated low-margin revenue of $8.9 million during fiscal 2003, compared to $1.1 million  during 2004. We have been focusing our business activities on more strategic,  higher-margin services, such as Enterprise Solutions and Rechargeable Calling  Card and Prefix Dialing services, which we are pursuing through Net2Phone Global  Services, and cable and other broadband telephony services, which we are pursuing  through Net2Phone Cable Telephony.

*Direct cost of revenue.*Our direct cost of revenue consists primarily of network costs associated with carrying our customers’ traffic    on our network and leased networks, and routing their calls through a local    telephone company to reach their final destination. It also includes the    cost of purchasing, storing and shipping VoIP devices. Most of these costs    were incurred within Net2Phone Global Services. However, in fiscal 2004,  Net2Phone Cable Telephony recorded $1.4 million in installation and operating costs relating to

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its deployment to one cable telephony customer. Overall, direct costs of revenue decreased 11.4 percent from $52.8 million in fiscal 2003 to $46.8 million    in fiscal 2004. As a percentage of total revenue, these costs decreased from    57.6 percent in fiscal 2003 to 56.5 percent in fiscal 2004. While the dollar    cost decrease is primarily attributable to lower revenue, we are also realizing    costreductions, despite a $0.6 million inventory obsolescence charge taken duringthe second quarter of fiscal 2004, from a more efficiently structured and utilizednetwork and from more aggressively priced termination contracts, some of whichincluded retroactive credits for a portion of previously terminated traffic.Our decision to discontinue issuing new disposable calling cards during the secondquarter of fiscal 2004 has allowed us to reduce higher direct costs associatedwith this service and to pursue other, more profitable service offerings.

*Selling, general and administrative.* Selling,    general and administrative expense consists of salaries of our employees    and associated benefits, and the cost of insurance, legal, rent, utilities    and other services, expenses associated with acquiring customers, including    commissions paid to our sales force, advertising costs, travel, entertainment,    and referral fees. Selling, general and administrative expense decreased  9.9 percent from $53.7 million in fiscal 2003 to $48.4 million in  fiscal 2004 due to continuing cost management initiatives,and elimination of  expenses directly related to restructured operations. As a percentage of total  revenue, these costs remained flat at 58.5 percent for both fiscal 2004 and  fiscal 2003. We expect to incur significant selling, general and administrative  expense related to the future growth of our Net2Phone Cable Telephony business.

*Depreciation and amortization.*Depreciation and amortization decreased 4.5 percent from $11.0 million in fiscal 2003 to $10.5 million in fiscal 2004, due primarily to $1.2 million    in fiscal 2003 year end depreciation adjustments related to the accelerated    write-off of certain capitalized software during the fourth quarter of fiscal    2003. Excluding this write-off, depreciation during fiscal 2004 would have  increased by $0.7 million or 7.1 percent due to increased depreciation  incurred on certain capitalized software brought into service during fiscal  2004. As a percentage of total revenue, these costs, excluding the aforementioned  adjustments in fiscal 2003, increased from 10.7% in fiscal 2003 to 12.7% in  fiscal 2004. This increase is due primarily to a 9.8% decrease in revenue in  fiscal 2004 as compared with fiscal2003.

*Non-cash services provided by IDT (attributable to direct cost of revenue and selling, general and administrative).* In fiscal 2004, we recorded an expense of $3.4 million    related to the receipt of services from IDT to be paid for through the issuance    of Class A common stock. This expense, which was recorded for the first time  during the fiscal quarter ended January 31, 2004, is based on a binding memorandum of understanding executed on October 29,  2003 with IDT, whereby, in exchange for attractive pricing on local and inter-exchange  network access, termination, origination and other related services, as compared  to third party vendors, access to IDT’s facilities and other benefits, we have agreed to issue 6.9 million  shares of our Class A common stock to IDT at the time we enter into a definitive  agreement. This charge represents the market value of 1.0 million Class A common shares that we may issue and subsequently release from escrow to IDT for services and benefits provided by IDT during the twelve months ended July 31,  2004, as these shares must be marked-to-market each quarter based on their  current market value. It is anticipated that the 6.9 million shares will be issued upon execution of definitive agreements and will be held in escrow to secure IDT’s  performance obligation, and, subsequently, released to IDT in equal annual  installments over five years, with the first release scheduled for October 29, 2004 or the date definitive agreements are signed, whichever is later. See “Related Party Transactions” below.

*Non-cash compensation (attributable to selling, general and administrative).* Non-cash compensation decreased from $15.3 million in fiscal 2003 to a net expense reduction of $3.2 million    for fiscal 2004. There were two primary factors driving this year over year    change; variable accounting for repriced stock options and the fiscal 2003    amortization of the discount of ADIR shares. Based on changes in our stock  price, we recorded a charge of $4.9 million relating to repriced options in fiscal 2003 and a reversal of $5.3 million  of previously recognized non-cash compensation expense relating to stock options  in fiscal 2004. If our stock price increases, we will incur charges over the  vesting period with respect to repriced options, until those options are exercised,  cancelled or expire. The second factor related to the decrease in non-cash  compensation expense is a $6.7 million charge recorded during fiscal 2003 for the amortization of the discount of ADIR shares sold to Net2Phone and ADIR employees in fiscal 2001. The total discount of approximately $17.8 million  was amortized over the vesting period of such shares. The remaining unamortized  discount at

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the close of fiscal 2003 of $3.8 million    was written off as a component of other income, net, during the first quarter    of fiscal 2004, as a result of the termination of all remaining ADIR employees.    For more information regarding ADIR, see Note 6 of the Notes to ConsolidatedFinancial Statements included elsewhere in this Annual Report

*Restructuring, severance, impairment and other items.* Restructuring, severance, impairment and other items decreased from $7.4 million in fiscal 2003 to $2.2 million in fiscal 2004.

The following table summarizes the charges included in restructuring, severance, impairment and other items in the statements of operations:

 

|                                                           |   | **Year ended July** **31,** |    |
|----------------------------------------------------------------|--------|----------------------------------|---------|
|                                                           |   |                                  |    |
|                                                           |   | **2004**                         |    | **2003** |   |
|                                                           |   |                                  |    |  |   |
|                                                           |   | **(in thousands)**               |    |
| Exit and other costs                                           |   |                             | $ 1,293 |   |   | $ 3,970 |   |
| Separation agreements of former CEO,CFO and COO                |   |                             | 1,244   |   |   | 2,877 |   |
| Workforce reductions                                           |   |                             | 163     |   |   | 4,116 |   |
| Impairment charges, including recovery on assets held for sale |   |                             | (89     | ) |   | 1,815 |   |
| Reserve adjustments                                            |   |                             | (419    | ) |   | (5,415 | ) |
|                                                           |   |                                  |         |   |  |  |   |
| Total                                                          |   |                             | $ 2,192 |   |   | $ 7,363 |   |
|                                                           |   |                                  |         |   |  |  |   |

In the first half of fiscal 2002,    both our Chief Executive Officer and Chief Financial Officer resigned as    we began to implement an overall long term restructuring plan, which would    scale down our operations, organize us to compete more efficiently, and allow    us to redirect our focus and resources towards a more profitable business    plan. During the two years since, we have executed our plan and implemented    a series of strategic workforce reductions, sold business units and long-lived    assets, as well as impaired such assets and goodwill.As we continue to execute    our plan, we are realizing lower costs and identifying more attractive revenue    opportunities. While the majority of our restructuring costs were incurred    during fiscal 2001 and 2002, we continued to incur these costs during fiscal    2003 and 2004.Those expenses within these charges that required cash outlays  were funded through current operations.

During fiscal 2004, we incurred a $0.4 million charge to exit our disposable calling card business, recorded various impaired lease and settlement costs totalling $0.9 million, recorded executive separation charges of $1.2 million, employee separation costs of$0.2 million and an asset impairment charge of $0.2 million.    Except for the closing costs associated with the exiting of our disposable    calling card business, all fiscal 2004 restructuring charges relate to pre-fiscal    2004 restructuring initiatives. Partially offsetting these charges were net  reserve reversals of $0.4 million, and a $0.3 million recovery of equipment that was previously written off.

During fiscal 2003, we initiated    several additional restructurings, which resulted in higher charges related    to workforce reductions in fiscal 2003 compared to fiscal 2004. In addition,    the charges related to the separation agreements of the former CEO, CFO and    our Chief Operating Officer, who resigned in July 2003, decreased in fiscal    2004 as compared to fiscal 2003, as components of certain long-term agreements    became fully amortized, and the number of agreements decreased. Exit costs    were higher in fiscal 2003 compared to fiscal 2004primarily due to charges    incurred for exiting various locations and eliminating various equipment    and network build-outs. Additionally, we recorded a net recovery of impaired    assets during fiscal 2004, compared with various asset impairment charges    recorded during fiscal2003. Lastly, in fiscal 2003, we settled various contractual    obligations for amounts less than previously established reserves. This resulted  in $5.4 million of favorable reserve adjustments, as compared with $0.4 million of similar adjustments in fiscal 2004.

*Income (loss) from operations.*We recorded a loss from operations of $25.4 million in fiscal 2004 as compared to income from operations of $9.5 million in fiscal 2003. This change is primarily due to the net gain of $58.0 million    that we realized from the settlement of our Cisco litigation, which we recorded    during the first quarter of fiscal 2003. Excluding this one time gain, we  would have realized a loss from operations,

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in fiscal 2003 totalling $48.5 million, which when compared with our loss from operations in fiscal 2004, reflects a reduction in our overall loss from operations of $23.1 million or 47.6 percent.This decrease is attributable to a $18.5 million decrease in non-cash compensation expense and to a $5.2 million    decrease in restructuring expenses. These reductions were partially offset    by new expenses that were incurred during fiscal 2004, such as non-cash servicesprovided by IDT.

*Interest income, net.*Interest income consists primarily of interest earned on cash equivalents and marketable securities, which is partially offset by interest expense incurred on long-term obligations. Interest income, net remained flat at $2.0 million    in fiscal 2004 as compared with fiscal 2003. This is primarily a result of    higher average cash balances held during fiscal 2004 relative to last year,    which was offset by incremental interest expense incurred through our Deutsche  Bank obligation described below in “Liquidity and Capital Resources” that was executed during the fourth quarter of fiscal 2003.

*Income on equity investments and other expense, net.*Income on equity investments and other expense, net, which includes the losses or gains resulting from non-operating transactions increased from income of $0.7 million recorded in fiscal 2003 to income of$12.2 million recorded in fiscal 2004. This increase is primarily attributable to the non-cash, non-recurring $12.6 million gain realized from the buyout of ADIR’s remaining minority interest holders during the first quarter of fiscal 2004, and to a $0.8 million    gain on the sale of our interest in eXact Advertising LLC, which we recorded    during the fourth quarter of fiscal 2004. Partially offsetting these gains,  is a mark-to-market adjustment of $1.2 million related to Net2Phone shares  held by Deutsche Bank based on a decrease in our stock price at fiscal year  end. These shares may serve to reduce our overall debt obligation to Deutsche  Bank, however the amount of reduction in the debt obligation that these shares  will provide us will vary according to the price of our stock.

| **Comparison of Fiscal Years Ended July** **31, 2003 and 2002** |
|----------------------------------------------------------------------|

*Revenue.*Our revenue is primarily derived from per-minute charges to our customers, primarily on a pre-paid basis, and the sale of VoIP equipment and services to consumers, resellers, IDT and other carriers. Our aggregate revenue decreased 33.4 percent from$137.9 million in fiscal 2002 to $91.8 million in fiscal 2003. The decrease in revenue primarily resulted from the fact that we significantly reduced our sales of disposable calling cards, which generated low-margin sales of $30.7 million in fiscal 2002 compared to$8.9 million in fiscal 2003. We also significantly reduced our workforce in 2003, and scaled back certain low-margin services, including wholesale termination of telecommunications traffic.

*Direct cost of revenue.*Our direct cost of revenue consists primarily of network costs associated with carrying our customers’ traffic    on our network and leased networks and routing those calls through a local    telephone company to reach their final destination. It also includes the    cost of purchasing, storing and shipping VoIP devices. Most of these costs    were incurred within the units that now comprise Net2Phone Global Services.  Direct cost of revenue decreased by 32.7 percent from $78.5 million in fiscal 2002 to $52.8 million  in fiscal2003. As a percentage of total revenue, total direct costs increased  from 56.9 percent in fiscal 2002 to 57.6 percent in fiscal 2003. While the  dollar cost decrease is primarily attributable to lower revenue and one-time  connectivity reserve reversals, which are no longer necessary due to service  disconnections, we are also realizing cost reductions from a more efficiently  structured and utilized network and from more aggressively priced termination  contracts. The slight increase in the percentage of direct costs compared to  revenue is due to the remaining fixed network backbone infrastructure costs  still required to service a significantly reduced revenue base.

*Selling, general and administrative.*Selling,    general and administrative expense consists of the salaries of our employees    and associated benefits and the cost of insurance, legal, rent, utilities    and other services, expenses associated with acquiring customers, including    commissions paid to our sales force, advertising costs, travel, entertainment,    referral fees and amounts paid in connection with revenue-sharing arrangements.  Selling, general and administrative expense decreased 53.9 percent from $116.6 million in fiscal 2002 to$53.7 million  in fiscal 2003 primarily due to the aforementioned restructurings. As a percentage  of total revenue, these costs decreased from 84.6 percent in fiscal 2002 to  58.5 percent in fiscal 2003. The portion of selling, general and administrative  expense driven by payroll costs decreased during fiscal 2003 as the number  of full-time employees on staff dropped from 290 on July 31, 2002 to 241 on July 31, 2003. Selling,

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general and administrative expense related to our Net2Phone Cable Telephony business was $7.0 million    in fiscal 2003. We expect to incur significant selling, general and administrative    expense to continue to fund the growth of our Net2Phone Cable Telephony businessin the future.

*Depreciation and amortization.*Depreciation and amortization decreased 54.2 percent, from $24.0 million in fiscal 2002 to $11.0 million in fiscal 2003, due to an impairment charge for long-lived assets recognized during the quarter ended April 30,    2002 and to the lower demand for capital spending during fiscal 2003, which    came from more efficient utilization of existing assets. As a percentage    of total revenue, depreciation and amortization decreased to 12.0 percent  in fiscal 2003 from 17.4 percent in fiscal 2002.

*Non-cash compensation (attributable to selling, general and administrative).*Non-cash compensation charges from the issuance of stock options decreased 21.9 percent from $19.6 million in fiscal 2002 to $15.3 million    for fiscal 2003. This decrease was primarily caused by lower compensation    expense related to fewer below-market-price options that vested during fiscal    2003 as compared to a larger number of below-market-price options that became    fully vested in fiscal 2002. In addition, due to our various restructurings,    a number of previously granted options have been forfeited, which has served  to further reduce non-cash compensation expense in fiscal 2003. On December 18, 2001, the Board of Directors approved the repricing of options outstanding under Net2Phone’s  1999 Amended and Restated Stock Option and Incentive Plan. The repriced options  are subject to variable accounting treatment and therefore must be marked-to-market  each quarter. During fiscal 2003 and 2002 we recorded charges of $4.9 million and $0.6 million  respectively, related to these repriced options If our stock price increases,  we will continue to incur charges until the options are exercised, canceled  or expired. Lastly, we recorded $6.7 million and $4.5 million during fiscal 2003 and 2002, respectively, for the amortization of the discount of ADIR shares sold toNet2Phone and ADIR employees in fiscal 2001. The total discount of approximately $17.8 million was amortized over the vesting period of such shares. As of July 31, 2003, $15.1 million of this discount has been amortized. The remaining unamortized discount of$3.8 million  was written off against the remaining minority interest balance during fiscal  2004 when we liquidated ADIR. For a further discussion of ADIR, see Note 6  of our Notes to Consolidated Financial Statements included elsewhere in this  Annual Report. As a percentage of total revenue, non-cash compensation costs  increased from 14.2 percent for fiscal 2002 to 16.7 percent for fiscal 2003.  This increase was due primarily to a 33 percent decrease in revenue.

*Restructuring, severance, impairment and other items.*Restructuring, severance, impairment and other items decreased from $141.6 million in fiscal 2002 to $7.4 million in fiscal 2003. The following table summarizes the charges included in restructuring, severance,impairment and other items in the statements of operations:

 

|                                                           |   | **Year ended July** **31,** |   |
|----------------------------------------------------------------|--------|----------------------------------|--------|
|                                                           |   |                                  |   |
|                                                           |   | **2003**                         |   | **2002** |   |
|                                                           |   |                                  |        |   |  |  |   |
|                                                           |   | **(in thousands)**               |   |
| Workforce reductions                                           |   | $                                | 4,116  |   | $ | 13,882 |   |
| Exit and other costs                                           |   |                             | 3,970  |   |   | 15,404 |   |
| Separation agreements of former CEO, CFO and COO               |   |                             | 2,877  |   |   | 12,623 |   |
| Impairment charges, including recovery on assets held for sale |   |                             | 1,815  |   |   | 99,710 |   |
| Reserve adjustments                                            |   |                             | (5,415 | ) |   | — |   |
|                                                           |   |                                  |        |   |  |  |   |
| Total                                                          |   | $                                | 7,363  |   | $ | 141,619 |   |
|                                                           |   |                                  |        |   |  |  |   |

In the first half of fiscal 2002,    both our Chief Executive Officer and Chief Financial Officer resigned. These    events led to the development of an overall long term restructuring plan,    which would scale down our operations, organize us to compete more efficiently,    and allow us to redirect our focus and resources towards a more profitable    business plan. During the two years since, we have executed our plan and    implemented a series of strategic workforce reductions, sold business units    and long-lived assets, as well as impaired such asset sand goodwill. As we    continue to execute our plan we are realizing lower costs and identifying    more reliable revenue opportunities. While the majority of our restructuring    costs were incurred during fiscal 2001 and fiscal 2002, we continued to incur  these costs during fiscal2003. However, we expect that these

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expenditures will decrease prospectively. Those expenses within these charges that required cash outlays were funded through current operations.

In April 2003, Norman Klugman, our former Chief Operating Officer, announced his intention to resign and terminated his employment with us in July 2003. During fiscal 2003, we recorded a $0.8 million  charge related to a severance agreement reached with Mr. Klugman. Mr. Klugman waived all of his rights under his employment agreement.

As a result of our plan to restructure our operations and eliminate various lines of development, an impairment review of our long-lived assets and identifiable intangible assets was conducted as of April 30,    2002, in accordance with SFAS No. 121. As a result of this analysis, we recorded    impairment charges as indicated below. The impairment charges were calculated    as the amount by which the carrying amount of the assets exceeded their fair    values. Fair value was estimated using the present value of expected future  cash flows.

The decrease in restructuring, severance, impairment, and other items in fiscal 2003 compared with fiscal 2002, is due mainly to various impairment charges recorded in fiscal 2002, including an $83.9 million impairment of assets, an $11.6 million  impairment of goodwill and a $4.2 million impairment of intangible assets.

Additionally, we initiated several    restructurings during fiscal 2002, which resulted in higher charges related    to workforce reductions in fiscal 2002 compared to fiscal 2003. Also, the    charges related to the separation agreements of the former CEO and CFO decreased    in fiscal 2003 as compared to fiscal 2002 as components of the agreements    became fully amortized. Also, exit costs were higher in fiscal 2002 compared    to fiscal 2003 primarily due to charges incurred for exiting various locations    and eliminating various equipment and network build-outs. Lastly, reserve    adjustments reduced fiscal 2003 charges due to settlement of various contractual  obligations for amounts less than previously established reserves.

*Settlement of Cisco litigation.*In    August 2002, Net2Phone and its ADIR subsidiary consummated the settlement    of their lawsuit in the United States District Court for the District of    New Jersey against Cisco and a Cisco executive who had been a member of the    Board of Directors of ADIR Technologies, Inc., our majority-owned subsidiary.    The suit arose out of the relationships that had been created in connection  with Cisco’s and Net2Phone’s original investments in ADIR and out of ADIR’s subsequent purchase of NetSpeak, Inc. in August2001. The parties settled the suit and all related claims against Cisco and the Cisco executive in exchange for: (i) the transfer, during the first quarter of fiscal 2003, to Net2Phone of Cisco’s and Softbank Asia Infrastructure Fund’s  respective 11.5 percent and 7.0 percent interests in ADIR, and (ii) the payment  by Cisco, during such quarter, of $19.5 million to Net2Phone and ADIR. As a result of this settlement, we recognized a gain of $58.0 million during fiscal 2003 consisting of a $38.9 million  reduction in minority interests as a result of the transfer of the ADIR shares,  receipt of settlement proceeds of $19.5 million less compensation expense of $0.4 million. No income taxes have been provided for with respect to the gain as we have sufficient net operating loss carry forwards to offset the gain. In fiscal2002, we recorded $1.6 million of legal and other expenses related to this settlement.

*Acquired in-process research and development.*For fiscal 2002, purchased in-process research and development, or IPR&D,    represented the value assigned in a purchase business combination to research    and development projects of the acquired business that had commenced but    had not yet been completed at the date of acquisition and which have no alternative    future use. In accordance with SFAS No. 2, Accounting for Research and Development  Costs, as clarified by FASB Interpretation No. 4, amounts assigned to IPR&D  meeting the above stated criteria must be charged to expense as part of the  allocation of the purchase price of the business combination. Accordingly,  charges totaling $13.9 million were recorded during fiscal 2002 as part  of the allocation of the purchase price related to the acquisition of NetSpeak  by ADIR, our then majority-owned subsidiary.

IPR&D relates primarily to advanced telephony software products for Internet protocol, or IP, networks. The valuation of IPR&D    included both cost and income valuation approaches, and utilized replacement    cost and discounted cash flow methodologies for various aspects of the analysis.    The calculations were based on estimates of operating earnings, capital charges,  and working capital requirements to support the cash flows

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attributed to the technologies. Discount rates reflecting the stage of development, complexity and the risk associated with each technology were used to value IPR&D.Development of the major components of the IPR&D were completed during the second quarter of fiscal 2002. Effective February 14, 2002, further research was suspended while ADIR reevaluated the products’anticipated attractiveness relative to current market conditions. It was ultimately determined that the aspects of the IPR&D necessary to bolster the technological development of Net2PhoneCable Telephony’s product offerings were in place and no further development related to the IPR&D would be initiated.

*Income (loss) from operations.*We recorded a loss from operations of $257.8 million in fiscal 2002 compared to income from operations of $9.5 million    in fiscal 2003. The decrease in loss from operations is primarily due to    operating expenses decreasing at a faster rate than revenue, lower restructuring,  severance, impairment and other related expenses, and a net gain of $58.0 million from the settlement of the Cisco litigation recorded during fiscal 2003.

*Interest income, net.*Interest income consists primarily of interest earned on cash equivalents and marketable securities. Interest income decreased 52.4 percent from $4.2 million in fiscal 2002 to $2.0 million    in fiscal 2003. The reduction primarily resulted from lower cash balances  and interest rate reductions.

*Income (loss) on equity investments and other expense, net.* Income (loss) on equity investments and other expense, net, which includes the losses or gains resulting from non-operating transactions, was a loss of $7.9 million in fiscal 2002 and income of $0.7 million    in fiscal 2003. During the third quarter of fiscal 2002, we recorded a loss    relating to an other-than-temporary decline in value of several of our cost  method investments resulting in a charge of approximately $6.9 million,  as well as a loss relating to the sale of equipment of approximately $1.4 million.  The other income realized in fiscal 2003 is primarily a mark-to-market gain  on shares of our common stock held by a lender, as is more fully described  in Note 7 of the Notes to Consolidated Financial Statements included elsewhere  in this Annual Report.

| **Related Party Transactions** |
|--------------------------------|

Our strategic investors include IDT, a global telecommunications, media and technology company, and Liberty Media Corporation, a global media company. As of October 7,    2004, IDT and Liberty Media together own NTOP Holdings, L.L.C., which holds    an aggregate of 37.8 percent of our outstanding capital stock and 54.9 percent    of our aggregate voting power. IDT is currently the controlling member of    NTOP Holdings, through which it effectively controls us. In November of 2003,    we closed an underwritten common stock offering,through which, in addition  to the 11.5 million shares purchased by the public and our underwriters, 1.25 million shares were purchased by each of IDT and Liberty Media. Including the 1.25 million shares IDT purchased in the offering and an additional 0.3 million  shares of our common stock held directly by IDT, as of October 7, 2004,  IDT controls 56.3 percent of our aggregate voting power. We have also entered  into a Memorandum of Understanding with IDT, described in more detail in Note  14 of our Consolidated Financial Statements included herein, which calls for  us to issue an additional 6.9 million shares of our Class A common stock to IDT upon entering into a definitive telecommunications services agreement with IDT. Assuming these 6.9 million  shares are issued, IDT will control 61.4 percent of our aggregate voting power  based on our outstanding stock on October 7, 2004.

|      ***IDT Corporation*** |
|-----------------------------------------------------|

We maintain significant business relationships with IDT and its affiliates and depend on our relationship with IDT for significant aspects of our business. Our companies’ headquarters are located in the same building in Newark, New Jersey. The chairman of our board,Howard Jonas, is also the chairman of IDT’s board of directors. As we announced on September 23, 2004, on October 31, 2004 Mr. Jonas    will become vice chairman of our board and Stephen Greenberg, our current  chief executive officer and vice chairman, will become chairman. Mr. Greenberg has received and may continue to receive compensation from IDT. In addition, one of our other directors, James Courter, serves as a director and the chief executive officer of IDT. In addition, our new chief executive officer effective October 31,2004, whose appointment was influenced by IDT, will also serve on our board and is currently a senior vice president of IDT.

 

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During the second quarter of fiscal    2004, we executed an agreement with Union Telecard Alliance, LLC (“UTA”),    a subsidiary of IDT, which ended UTA’s distribution of Net2Phone disposable    calling cards effective December 31,    2003, and provided for an orderly wind-down over a two-year period of our  disposable calling card business. This resulted in exit costs of $0.5 million  to compensate UTA for estimated obligations associated with the Net2Phone disposable  calling cards currently in the marketplace. These exit costs were recorded  in our consolidated statement of operations as “Restructuring, severance,  impairment and other items” during the three months ended January 31,  2004. Pursuant to the terms of our agreement with UTA, the parties will settle  the aforementioned obligations over a two-year period ending December 31,  2005, through monthly reconciliations of on-going wind down activities, with  final settlement to be completed by February 15, 2006. Consequently, sales  of prepaid disposable calling cards to IDT affiliates in fiscal 2004 were nominal,compared  with sales of $6.4 million and $17.3 million recorded in fiscal 2003  and fiscal 2002, respectively.

Our corporate headquarters and several other facilities are leased from IDT. During fiscal 2004, fiscal 2003, and fiscal 2002 IDT charged us $1.9 million, $2.1 million and $4.1 million, respectively, in facilities lease fees. IDT’s    treasury function provides investment management services relating to our  portfolio of marketable securities. During fiscal 2004, $38.5 million in securities purchases and sales were settled through IDT, while during fiscal 2003, $10.1 million  in securities sales were settled through IDT. No such investment management  services were provided during fiscal 2002.

On occasion, we have aggregated long distance minutes and other services purchases with IDT.

We outsource some of our administrative    and support functions to IDT. These administrative functions include, but    are not limited to, tax consulting services, payroll services, and internal    audit support services. In most cases, fees for services are negotiated on    a cost recovery basis. In March 2004, we entered into an Intellectual Property    Legal Services Agreement with IDT, pursuant to which we will receive legal    services from IDT related to a wide variety of intellectual property matters,    including, but not limited to, patent and trademark prosecution and technology    protection and development. Based upon this agreement, we will pay IDT a    percentage of licensing fees we may receive related to specific technologies  as a result of IDT’s assistance in these matters, in addition to a $25,000  monthly fee for these services. The agreement has a two-year term, which can  be terminated with 30 days notice upon a material breach, or with 90 days notice  at the discretion of either party. In addition, we have entered into a Tax  Services Agreement pursuant to which we pay IDT $10,000 a month for tax services.

We are currently negotiating other service agreements with IDT. During fiscal 2004 and 2003, we incurred fees totalling $0.5 million and $0.1 million    for all such administrative and support services. No charges were incurred    during fiscal 2002. On occasion, we provide other services to IDT, based    on the need for such services. During fiscal 2004 and 2003 we charged IDT  reimbursement fees for project support services totalling $0.3 million and $0.2 million, respectively, for each fiscal year. No fees were charged during fiscal 2002.

On October 29, 2003, we entered into a binding memorandum of understanding (“MOU”) with IDT, which requires us to issue 6.9 million    shares of our Class A common stock to IDT at the time we execute a definitive    telecommunications services and related agreements with IDT. No definitive  agreement has been executed as of October 14, 2004. The parties’ efforts to establish detailed terms and conditions continue. Once issued, the shares will be held in escrow to secure IDT’s  performance obligations under the agreements and are to be released to IDT  in equal annual installments over five years, with the first release scheduled  for October 29, 2004 or the date we enter into definitive agreements,  whichever is later. During the second quarter of fiscal 2004, IDT started providing  us with services and benefits under the terms of the MOU. The issuance of the  6.9 million shares is subject to variable accounting treatment and, therefore, the shares must be marked-to-market each quarter based on their current market value. Consequently, we recorded charges of $3.4 million  to non-cash services provided by IDT related to this agreement during fiscal  2004, which represents the market value of 1.0 million shares that we  may issue and subsequently release from escrow to IDT for services and benefits  provided by IDT during the aforementioned periods.

We determined that non-cash services provided by IDT are attributable to direct cost of revenue and selling, general and administrative expense. However, given that the services provided by IDT do not

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individually have readily identifiable    market values, and that the variable accounting treatment will result in    different values being ascribed to the same services from period to period,    we believe differentiating between direct cost of revenue and selling, general    and administrative is not practicable. Therefore we have classified the non-cash    services provided by IDT in a separate line in the consolidated statements    of operations. In accordance with EITF Topic D-90, Grantor Balance Sheet    Presentation of Unvested, Forfeitable Equity Instruments Granted to a Nonemployee,the 1.0 million shares we may release from escrow for services receivedfrom IDT have been included in the total number of Class A common stock sharesreported as issued and outstanding as of July 31, 2004, in our consolidatedfinancial statements, although such shares have not yet been issued to IDT.

The MOU memorializes IDT’s agreement    to provide Net2Phone Cable Telephony, directly or through its subsidiaries,    with local and inter-exchange network access, termination, origination and    other related services, including sales and marketing assistance and an agreement    by IDT not to compete in the cable and broadband telephony market. IDT is    a competitive local exchange carrier and an inter-exchange carrier and its    network includes switching facilities in several U.S. cities and additional    points of presence in various countries,allowing us to co-locate our equipment  and interconnect to IDT’s network at those points. On May 12, 2004,  IDT announced its intention to reorganize its Winstar/IDT Solutions affiliate,  and we are  examining the impact of this reorganization as we continue to negotiate definitive  agreements.

|      ***Liberty Media Corporation*** |
|---------------------------------------------------------------|

On October 22, 2003, one of our wholly owned subsidiaries, Net2Phone Cable Telephony, LLC (“NCT”) and Liberty Cablevision of Puerto Rico, Inc. (“LCV”),    an affiliate of Liberty Media Corporation, executed a Cable Telephony Production    Agreement. According to the terms of this agreement, NCT is to provide cable  telephony services to LCV’s customers, and NCT will act as LCV’s  agent in requisitioning, configuring, staging and installing all infrastructure  and technology components that would facilitate these telecommunication services.  We recorded $1.4 million in revenue from LCV during the third quarter of fiscal 2004 of which $1.3 million  reflects infrastructure and related technology components installed during  the quarter that are necessary for LCV to broadly distribute our services.  We widened our service offerings to an increased number of LCV’s customers in the fourth quarter of fiscal 2004.

|      ***Agreements with Officers*** |
|--------------------------------------------------------------|

Pursuant to Stephen M. Greenberg’s, our Chief Executive Officer (“CEO”), employment agreement, dated July 31,    2000, to help defray the tax expense of a grant of 50,000 shares of restricted    stock, we loaned him an amount necessary to pay such taxes. We granted the    CEO a loan for $600,000 in September 2000, with a term of three years and    an interest rate equal to the applicable short-term federal rate. Repayment    would be accelerated if the CEO sold any of his 50,000 shares of restricted    stock or upon the termination of his Employment Agreement. The CEO repaid  this loan in full, plus interest, in the first quarter of fiscal 2004.

In April 2002, we loaned the sum of $3.6 million to our CEO. The loan bears interest at a market rate and principal and interest are due on April 9, 2005 (“Maturity Date”).    The loan is non-recourse to the CEO and is secured by options to purchase    300,000 shares of our common stock granted to the CEO in April 2002. Under    certain circumstances, the Board of Directors may request the CEO to exercise    sufficient options and sell sufficient stock to pay the unpaid balance of    the loan. In addition, the Board may request that the CEO not sell the stock,    which will result in the unpaid loan and interest balance being reduced based    upon a formula set forth in the loan agreement. On the Maturity Date, the    CEO will have to return to us all or a portion of the unexercised options    and/or shares of unsold stock and his unpaid loan and accrued interest balance  will be reduced based upon a formula set forth in the loan agreement.

Due to the uncertainty surrounding    the number of options the CEO will ultimately receive, we are accounting    for the options using a variable accounting model until the options are exercised    or returned to us. Furthermore, due to the non-recourse nature of the loan,    we are recording compensation expense for the $3.6 million principal    amount of the note over its three-year maturity period. However, total compensation

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expense will be calculated at each reporting date as the greater of the compensation expense resulting from (i) variable accounting treatment of the options, or (ii) amortizing the $3.6 millionloan balance over the maturity period of the loan. We recorded compensation expense of $1.2 million in fiscal 2004 and 2003 and $0.3 million in fiscal 2002, relating to this loan.

Pursuant to an employment agreement with our former General Counsel dated January 8, 2001, we guaranteed that the value (as defined in the agreement) of 150,000 options to purchase our common stock held by our then General Counsel would be at least$1.6 million on January 7, 2004. To the extent the value of such options was less than $1.6 million, we would pay our then General Counsel the difference in cash. On January 7, 2004, the value of the 150,000 options was $0.7 million.  As required by the agreement, we paid $0.9 million to our then General Counsel at that time. We had amortized the $1.6 million  guaranteed option value over the three-year term of the agreement, less the  intrinsic value of the stock options as of each fiscal quarter end. Due to  the higher stock price on January 7, 2004 as compared to July 31, 2003, we reversed $0.2 million of previously recorded non-cash compensation expense, as a result of this agreement. During fiscal 2003, we recorded non-cash compensation expense of $0.5 million related to this agreement.

| **Liquidity and Capital Resources** |
|-------------------------------------|

Historically, we have satisfied our    cash requirements through a combination of cash flow from operating activities    and sales of equity securities. Our cash requirements have also been satisfied  through our existing cash, cash equivalents and marketable securities balances.

The following table provides our cash flow data for the twelve months ended July 31, 2004 and 2003.

|                                                 |   | **Twelve Months Ended July** **31,** |    |
|------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                 |   | **2004**                                  |    | **2003** |   |
|                                                 |   |                                           |         |   |  |  |   |
|                                                 |   | **(in thousands)**                        |    |
| Net cash used in operating activities                |   | $                                         | (16,167 | ) | $ | (7,132 | ) |
| Net cash used in investing activities                |   |                                      | (44,713 | ) |   | (22,597 | ) |
| Net cash provided by (used in) financing activities  |   |                                      | 63,938  |   |   | (2,147 | ) |
|                                                 |   |                                           |         |   |  |  |   |
| Net increase (decrease) in cash and cash equivalents |   | $                                         | 3,058   |   | $ | (31,876 | ) |
|                                                 |   |                                           |         |   |  |  |   |

As of July 31, 2004 we reported total cash, cash equivalents, restricted cash, and marketable securities of $132.8 million and working capital of $103.0 million. Of the $132.8 million, $0.2 million in short term restricted cash and $21.0 million    in long term restricted cash, cash equivalents, and marketable securities    were held as collateral for various letter of credit obligations, the majority    of which related to our purchase of Aplio, S.A. from the stockholders of  Aplio. On May 7, 2003, these obligations were assigned to Deutsche Bank AGLondon. Our payment obligations to Deutsche Bank are secured by standby letters of credit from a U.S. commercial bank, which are, in turn, collateralized by $20.6 million in marketable securities held by the bank. The letters of credit expire on August 4,  2006. These restricted marketable securities are included in “restricted cash, cash equivalents and marketable securities-long term” on  our balance sheet. For more information regarding this transaction, please  see Notes 7 and 24 to our Consolidated Financial Statements included elsewhere  in this Annual Report.

Net cash used in operating activities was $16.2 million during fiscal 2004, compared with $7.1 million used during fiscal 2003. The increase in cash flow used in operating activities is primarily due to receipt of $19.5 million,    in the first quarter of fiscal 2003, from the settlement of litigation with  Cisco. Thus, the $16.2 million of cash used in operating activities in fiscal 2004 represents a $10.4 million improvement compared to $26.6 million  used in operating activities in fiscal 2003, excluding the cash received from  the settlement of litigation with Cisco. This improvement was primarily attributable  to favorable changes in working capital as a result of the timing of receipts  and disbursements, as well as reduced operating costs.

Net cash used in investing activities increased from $22.6 million during fiscal 2003 to $44.7 million in fiscal 2004. This increase in cash used in investing activities is primarily due to more cash being available for investment following our issuance of 14 million  shares of common stock as part of a public offering we

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conducted during the second quarter of fiscal 2004 (described below). Our capital expenditures decreased from $7.1 million in fiscal 2003 to $5.5 million    in fiscal 2004. However, we anticipate that capital expenditures will significantly    increase as Net2Phone Cable Telephony acquires fixed assets to build its    infrastructure and deploy equipment related to contract obligations it may    enter into with cable and broadband operators. The net cash proceeds from    the saleof marketable securities increased from $62.4 million in fiscal 2003 to $278.6 millionin fiscal 2004. The net cash used for purchases of marketable securities increasedfrom $78.4 million during fiscal 2003 to $318.2 million during fiscal 2004.

Net cash provided by (used in) financing activities increased from $(2.1) million during fiscal 2003 to $63.9 million in fiscal 2004. This change is due primarily to $58.6 million    in net proceeds from the issuance of shares through an underwritten common  stock offering at $4.50 per share on November 25, 2003. 10.5 million shares were issued to the public, an additional 1.0 million shares were issued as part of an over-allotment option exercised by the underwriters, and an aggregate of 2.5 million  shares were purchased by IDT Corporation and Liberty Media Corporation, our  controlling shareholders. We have used, and intend to use, the net proceeds  from the common share issuance for general corporate purposes, capital expenditures,  and working capital, including funding our Net2Phone CableTelephony business.

We believe that, based upon our present    business plans, our existing cash resources will be sufficient to meet our    currently anticipated working capital and capital expenditure requirements,    and to fund any potential operating cash flow deficits in the foreseeable    future.We believe that as the expected growth in our Net2Phone Cable Telephony    subsidiary accelerates or if we acquire the business or assets of another    company, we may need to raise additional capital from equity or debt sources.    There can be no assurance that we will be able to raise such capital on favorable    terms or at all. If we are unable to obtain such additional capital, we may    be required to reduce the scope of our anticipated expansion, which could    have a material effect on our business, financial condition or results of  operations.

We have no off balance sheet arrangements or transactions with unconsolidated, limited purpose or variable interest entities.

|      *Contractual Obligations* |
|---------------------------------------------------------|

The following table provides a summary of our contractual obligations and commercial commitments. Additional detail regarding these items is included in the Notes to Consolidated Financial Statements included elsewhere in this Annual Report.

|                          |   | **Payments Due by Period** |   |
|-------------------------------|--------|----------------------------|--------|
|                          |   |                            |   |
|                          |   | **Total**                  |   | **Less than 1 year** |   | **1-3 years** |   | **4-5 years** |   | **After 5 years** |   |
|                          |   |                            |   |  |   |  |   |  |   |  |   |
|                          |   | **(in thousands)**         |   |
| Contractual Obligations       |   |                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Capital lease obligations     |   | $                          | 129    |   | $ | 129 |   | $ | — |   | $ | — |   | $ |           — |   |
| Operating leases              |   |                       | 12,942 |   |   | 3,035 |   |   | 7,289 |   |   | 2,618 |   |   | — |   |
| Long term debt                |   |                       | 17,329 |   |   | — |   |   | 17,329 |   |   | — |   |   | — |   |
|                          |   |                            |        |   |  |  |   |  |  |   |  |  |   |  |  |   |
| Total contractual obligations |   | $                          | 30,400 |   | $ | 3,164 |   | $ | 24,618 |   | $ | 2,618 |   | $ | — |   |
|                          |   |                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |

|                                                    |   |                       |   |                 |   |          |   |          |   |              |   |   |   |   |                                                               |   |
|---------------------------------------------------------|--------|----------------------------|--------|----------------------|--------|---------------|--------|---------------|--------|-------------------|--------|--------|--------|--------|--------------------------------------------------------------------|--------|
|                                                    |   | **Payments Due by Period** |   |
|                                                    |   |                            |   |
|                                                    |   | **Total**                  |   | **Less than 1 year** |   | **1-3 years** |   | **4-5 years** |   | **After 5 years** |   |
|                                                    |   |                            |   |                      |   |               |   |               |   |                   |   |
|                                                    |   | **(in thousands)**         |   |
| Other Commercial Commitments                            |   |                       |   |                 |   |          |   |          |   |              |   |   |   |   |                                                               |   |
| Standby          letters of credit and other collateral |   | $                          | 21,742 |                 | $      | 164           |   | $             | 21,416 |              | $      | 162    |   | $      |           — |   |
| Purchase commitments                                    |   |                       | 969    |                 |   | 969           |   |          | — |              |   | — |   |   | —                                                             |   |
|                                                    |   |                            |        |                 |        |               |   |               |        |              |        |        |   |        |                                                                    |   |
| Total other commercial commitments                      |   | $                          | 22,711 |                 | $      | 1,133         |   | $             | 21,416 |              | $      | 162    |   | $      | —                                                             |   |

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Other long term debt represents a $17.3 million    debt obligation to Deutsche Bank which matures in 2006. Market gains on shares    held by Deutsche Bank will serve to reduce our overall obligation if our    stock price increases above a pre-established price. This obligation is secured    by standby letters of credit from a U.S. commercial bank, which are, in turn,  collateralized by $20.6 million of marketable securities held by the bank

| **Effects of Inflation** |
|--------------------------|

Due to relatively low levels of inflation over the last several years, inflation has not had a material effect on our results of operations.

| **Quarterly Results of Operations** |
|-------------------------------------|

The following table sets forth certain quarterly financial data for the eight quarters ended July 31, 2004. This quarterly information is unaudited, has been prepared on the same basis as the annual financial statements, and, in our opinion, reflects all adjustments(consisting only of normal recurring accruals) necessary for a fair presentation of the information for the periods presented.

 

|                                          |   | **Quarter Ended**                         |   |
|-----------------------------------------------|--------|-------------------------------------------|--------|
|                                          |   | **July 31,**                              |   | **April 30,** |   | **Jan. 31,** |   | **Oct. 31,** |   |
|                                          |   | **2004**                                  |   | **2004** |   | **2004** |   | **2003** |   |
|                                          |   |                                           |        |   |  |  |   |  |  |   |  |  |   |
|                                          |   | **(in thousands, except per share data)** |   |
| Total revenue                                 |   | $                                         | 21,111 |   | $ | 21,451 |   | $ | 19,812 |   |   | $ 20,405 |   |
| Direct cost of revenue                        |   |                                      | 11,813 |   |   | 12,790 |   |   | 11,243 |   |   | 10,948 |   |
| Income (loss) from operations                 |   |                                      | (7,214 | ) |   | 392 |   |   | (10,922 | ) |   | (7,640 | ) |
| Net income (loss)                             |   |                                      | (6,282 | ) |   | (462 | ) |   | (9,522 | ) |   | 5,098 |   |
| Net income (loss) per share-basic and diluted |   | $                                         | (0.08  | ) |   | $ (0.01 | ) |   | $ (0.13 | ) |   | $ 0.08 |   |
|                                          |   |                                      |   |   |   |   |   |   |   |   |   |   |   |

|                                          |   | **Quarter Ended**                         |     |
|-----------------------------------------------|--------|-------------------------------------------|----------|
|                                          |   | **July 31,**                              |     | **April 30,** |   | **Jan. 31,** |   | **Oct. 31,** |   |
|                                          |   | **2003**                                  |     | **2003** |   | **2003** |   | **2002** |   |
|                                          |   |                                           |          |   |  |  |   |  |  |   |  |  |   |
|                                          |   | **(in thousands, except per share data)** |     |
| Total revenue                                 |   |                                      | $ 20,963 |   |   | $ 23,788 |   | $ | 23,051 |   | $ | 23,948 |   |
| Direct cost of revenue                        |   |                                      | 12,434   |   |   | 14,158 |   |   | 12,286 |   |   | 13,942 |   |
| Income (loss) from operations                 |   |                                      | (16,140  | ) |   | (9,831 | ) |   | (9,964 | ) |   | 45,467 |   |
| Net income (loss)                             |   |                                      | (10,800  | ) |   | (9,289 | ) |   | (9,241 | ) |   | 46,124 |   |
| Net income (loss) per share-basic and diluted |   |                                      | $ (0.18  | ) |   | $ (0.16 | ) |   | $ (0.15 | ) |   | $ 0.77 |   |

|                                                                      |
|---------------------------------------------------------------------------|
| **Item 7A. *Quantitative and Qualitative Disclosures About Market Risk*** |

The Securities and Exchange Commission’s    rule related to market risk disclosure requires that we describe and quantify    our potential losses from market risk sensitive instruments attributable    to reasonably possible market changes. Market risk sensitive instruments    include all financial or commodity instruments and other financial instruments    (such as investments and debt) that are sensitive to future changes in interest    rates, currency exchange rates, commodity prices or other market factors.    We are not materially exposed to market risks from changes in foreign currency    exchange rates or commodity prices. We do not hold derivative financial instruments    nor do we hold securities for trading or speculative purposes. We are exposed    to changes in interest rates primarily from our investments in cash equivalents.    Under our current policies, we do not use interest rate derivative instruments    to manage our exposure to interest rate changes. Our reported financial results    may vary significantly based upon fluctuations in our stock price. Our long-term    obligation with Deutsche Bank changes based upon our stock price. If our    stock price decreases, this will increase our overall obligation. If our    stock    price increases, this will decrease our overall obligation. In addition,    we have repriced stock options and granted restricted shares that require    variable accounting treatment and, therefore must be marked-to-market each  quarter based on their current fair value.

 

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| **Item 8. *Financial Statements and Supplementary Data*** |
|-----------------------------------------------------------|

The Financial Statements filed as part of this Annual Report are identified in the index to Consolidated Financial Statements on Page F-1 hereto and are set forth on pages F-2 through F-33 hereto.

| **Item 9. *Changes in and Disagreements with Accountants on Accounting and Financial Disclosure*** |
|----------------------------------------------------------------------------------------------------|

None.

| **Item 9A. *Controls and Procedures*** |
|----------------------------------------|

Evaluation of Disclosure Controls    and Procedures. Our Chief Executive Officer and Chief Financial Officer have    evaluated the effectiveness of our disclosure controls and procedures (as    such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities  Exchange Act of 1934, as amended (the “Exchange Act”)) as of the  end of the period covered by this Annual Report. Based on such evaluation,  such officers have concluded that, as of such date, our disclosure controls  and procedures are effective in alerting them on a timely basis to material  information relating to Net2Phone (and its consolidated subsidiaries) required  to be included in our reports filed or submitted under the Exchange Act.

Changes in Internal Control over Financial Reporting. There were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

| **Item 9B. *Other Information*** |
|----------------------------------|

None.

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**PART III**

| **Item 10. *Directors and Executive Officers of the Registrant*** |
|-------------------------------------------------------------------|

Information under the captions “Board of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in    our Proxy Statement for the 2004 Annual Meeting of Stockholders, are incorporated    herein by reference. Certain information concerning our executive officers  is set forth in Part I of this Annual Report under the caption “Executive Officers.”

On April 15, 2003, we adopted    a Code of Conduct applicable to all employees and directors of Net2Phone,    including our principal executive officer, principal financial officer and    principal accounting officer and controller. A copy of the Code of Conduct    is available on our website at www.net2phone.com. We intend to post on our    website any amendments to, or waivers from, our Code of Conduct that apply    to our principal executive officer, principal financial officer and principal  accounting officer and controller.

| **Item 11. *Executive Compensation*** |
|---------------------------------------|

Information set forth under the captions “Executive Compensation” and “Board of Directors” in our Proxy Statement is incorporated herein by reference. The sections captioned “Report of the Compensation Committee on Executive Compensation”, “Report  of the Audit Committee”, and “Stock Price Performance Graph” in our Proxy Statement are not incorporated herein by reference.

| **Item 12. *Security Ownership of Certain Beneficial Owners and Management*** |
|-------------------------------------------------------------------------------|

Information set forth under the caption “Information Regarding Beneficial Ownership of Principal Stockholders, Directors and Management” in our Proxy Statement is incorporated herein by reference.

| **Equity Compensation Plan Information** |
|------------------------------------------|

The following table provides, as of July 31, 2004, information with respect to compensation plans (including individual compensation arrangements) under which our equity securities are authorized for issuance.
|                                                            |   | **(a)**                                                                                         |   | **(b)**                                                                          |   | **(c)**                                                                                                                                                   |
|-----------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
| Plan Category                                                   |   | Number of securities to be      issued upon exercise of outstanding options,warrants and rights |   | Weighted-average exercise      price of outstanding options, warrants and rights |   | Number of          securities remaining available for future issuance under equity compensation      plans (excluding securities reflected in column (a)) |
|                                                            |   |                                                                                            |   |                                                                             |   |                                                                                                                                                      |
| Equity compensation plans approved by security      holders     |   | 9,728,593(1)                                                                                    |   | $4.92                                                                            |   | 1,600,887                                                                                                                                                 |
|                                                            |   |                                                                                                 |   |                                                                                  |   |                                                                                                                                                           |
| Equity compensation plans not approved by      security holders |   | 150,000(2)                                                                                      |   | $4.36                                                                            |   | 0                                                                                                                                                         |
| Total                                                           |   |                                                                                            |   |                                                                             |   |                                                                                                                                                      |
|                                                                 |   |                                                                                            |   |                                                                             |   |                                                                                                                                                      |

|   |   |
|--------|--------|

| (1) | Represents stock options granted pursuant to 1999 Net2Phone Stock Option Plan. |
|-----|--------------------------------------------------------------------------------|

| (2) | On August 6, 2001,          we granted options to purchase 50,000 shares of our common stock to          each of three employees of Aplio, S.A., a subsidiary of Net2Phone.          The exercise price per share of these options was $4.36, subject to          certain adjustments. The options were fully vested upon the execution          of the stock option agreements, and may be exercised through January 3, 2005. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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On October 12, 2004, our Board of    Directors adopted a resolution proposing adding an additional 2,000,000 shares    to the 1999 Net2Phone Stock Option Plan, and we will present this proposal    to our stockholders for approval at the December 16, 2004 annual meeting  of stockholders.

| **Item 13. *Certain Relationships and Related Transactions*** |
|---------------------------------------------------------------|

Information set forth under the caption entitled “Certain Relationships and Related Transactions” in our Proxy Statement is incorporated herein by reference.

| **Item 14. *Principal Accounting Fees and Services*** |
|-------------------------------------------------------|

Information set forth under the caption entitled “Matters Related to our Independent Auditors” in our Proxy Statement is incorporated herein by reference.

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**PART IV**

| **Item 15. *Exhibits, Financial Statement Schedules and Reports on Form 8-K*** |
|--------------------------------------------------------------------------------|

(a) (1) Financial Statements.

The Financial Statements filed as part of this Annual Report are identified in the Index to Consolidated Financial Statements on page F-1 hereto.

(2) Financial Statement Schedules.

The Financial Statement Schedules    filed as part of this Annual Report are identified in the index to Consolidated    Financial Statements on page F-1 hereto. Schedules other than the one identified    on such index have been omitted because the information required to be set    forth therein is not applicable or is shown on the financial statements or  notes thereto.

(3) Exhibits.

The exhibits required by Item 601 of Regulation S-K filed as part of, or incorporated by reference in, this Annual Report are listed below in (b).

(b) Exhibits.

The following exhibits are filed herewith or are incorporated by reference to exhibits previously filed with the Commission.

| **Exhibit**     **No.** |   | **Description**                                                                                                                                                                                                            |   |
|--------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                  |   |                                                                                                                                                                                                                            |   |
|                                             |   |                                                                                                                                                                                                                       |   |
| 3.1                                              |   | Amended and Restated Certificate of Incorporation. (Incorporated by reference from our registration statement on Form S-1 (Registration No.333-78713)).                                                                    |   |
| 3.2                                              |   | Amended and Restated Bylaws. (Incorporated by reference from our Current Report on Form 8-K filed on August 21, 2000).                                                                                                |   |
| 3.3                                              |   | Certificate of Amendment        to the Restated Certificate of Incorporation of the Registrant. (Incorporated        by reference from our registration statement on Form S-1 (Registration    No. 333-78713)).            |   |
| 3.4                                              |   | Certificate of Amendment        to the Restated Certificate of Incorporation of the Registrant. (Incorporated        by reference from our registration statement on Form S-1 (Registration    No. 333-78713)).            |   |
| 3.5                                              |   | Certificate of Amendment to the Amended and Restated Certificate of Incorporation. (Incorporated by reference from our Annual Report on Form10-K for the fiscal year ended July 31, 2000).                            |   |
| 4.1                                              |   | Specimen Common Stock Certificate of the Registrant. (Incorporated by reference from our registration statement on Form S-1. (Registration No.333-78713)).                                                                 |   |
| 10.1                                             |   | Internet/Telecommunications Agreement, dated as of May 7,        1999, by and between IDT and the Registrant. (Incorporated by reference    from our registration statement on Form S-1 (Registration No. 333-78713)) |   |
| 10.2                                             |   | Joint Marketing Agreement, dated as of May 7,        1999, by and between IDT and the Registrant. (Incorporated by reference    from our registration statement on Form S-1 (Registration No. 333-78713))             |   |
| 10.3                                             |   | IDT Services Agreement, dated as of May 7,        1999, by and between IDT and the Registrant. (Incorporated by reference    from our registration statement on Form S-1 (Registration No. 333-78713))                |   |
| 10.4                                             |   | Net2Phone Services Agreement, dated as of May 7,        1999, by and between IDT and the Registrant. (Incorporated by reference    from our registration statement on Form S-1 (Registration No. 333-78713))          |   |
| 10.5                                             |   | Assignment Agreement, dated as of May 7,        1999, by and between IDT and the Registrant. (Incorporated by reference    from our registration statement on Form S-1 (Registration No. 333-78713)).                 |   |

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| **Exhibit**     **No.** |   |   | **Description**                                                                                                                                                                                                                                              |   |
|--------------------------------------------------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                  |   |   |                                                                                                                                                                                                                                                              |   |
|                                             |   |   |                                                                                                                                                                                                                                                         |   |
| 10.6                                             |   |   | Tax Sharing and Indemnification Agreement, dated as of May 7,        1999, by and between IDT and the Registrant. (Incorporated by reference    from our registration statement on Form S-1 (Registration No. 333-78713)).                              |   |
| 10.7                                             |   |   | Separation Agreement, dated as of May 7,        1999, by and between IDT and the Registrant. (Incorporated by reference    from our registration statement on Form S-1. (Registration No. 333-78713)).                                                  |   |
| 10.8                                             |   |   | The Registrant’s Amended        and Restated 1999 Stock Option and Incentive Plan. (Incorporated by reference    from our Proxy Statement dated June 6, 2000).†                                                                               |   |
| 10.9                                             |   |   | Lease for premises located        at 520 Broad Street, Newark, New Jersey. (Incorporated by reference from    our Annual Report on Form 10-K for the fiscal year ended July 31, 2000).                                                                  |   |
| 10.11                                            |   |   | Form of Promissory Note between        Adir Technologies, Inc. and certain executive officers of the Registrant.        (Incorporated by reference from our Annual Report on Form 10-K for the    fiscal year ended July 31, 2000).                     |   |
| 10.12                                            |   |   | Agreement and Plan of Merger, dated as of June 11, 2001, by and among Adir Technologies, Inc., A Tech Merger Sub, Inc. and NetSpeak.(Incorporated by reference from our Current Report on Form 8-K filed on June 21, 2001).                        |   |
| 10.13                                            |   |   | Employment Agreement executed by the Registrant and Bruce Shoulson, dated January 8,        2001. (Incorporated by reference from our Annual Report on Form 10-K    for the fiscal year ended July 31, 2002).†                                |   |
| 10.14                                            |   |   | Memorandum amending Employment Agreement executed by the Registrant and Bruce Shoulson, dated December 10,        2002. (Incorporated by reference from our Quarterly Report on Form 10-Q    for the fiscal quarter ended January 31, 2003).† |   |
| 10.15                                            |   |   | Employment agreement executed by the Registrant and Glenn Williams, dated March 1,        2001. (Incorporated by reference from our Annual Report on Form 10-K    for the fiscal year ended July 31, 2003).†                                  |   |
| 10.16                                            |   |   | Memorandum amending Employment Agreement executed by the Registrant and Glenn Williams, dated December 20,        2002. (Incorporated by reference from our Quarterly Report on Form 10-Q    for the fiscal quarter ended January 31, 2003).† |   |
| 10.17                                            |   |   | Amended and Restated Settlement Agreement, dated May 7,        2003, between Net2Phone, Inc. and Deutsche Bank AG London. (Incorporated    by reference from our Report on Form 8-K dated May 7, 2003).                                            |   |
| 10.18                                            |   |   | Continuing Letter of Credit Agreement, dated May 5,        2003, by Net2Phone, Inc. in favor of Wachovia Bank, N.A. (Incorporated    by reference from our Report on Form 8-K dated May 7, 2003).                                                  |   |
| 10.19                                            |   |   | Security Agreement, dated May 7,        2003, by Net2Phone, Inc. in favor of Wachovia Bank, N.A. (Incorporated    by reference from our Report conform 8-K dated May 7, 2003).                                                                     |   |
| 10.20                                            |   |   | Agreement and Plan of Merger, dated as of June 11, 2001, by and among Adir Technologies, Inc., A Tech Merger Sub, Inc. and NetSpeak.(Incorporated by reference from our Current Report on Form 8-K filed on June 21, 2001).                        |   |
| 10.21                                            |   |   | Employment Agreement by and between the Registrant and Arthur Dubroff, dated as of November 20,        2002. (Incorporated by reference from our Quarterly Report on Form 10-Q    for the fiscal quarter ended October 31, 2002.)                  |   |
| 10.22                                            |   |   | Employment Agreement by and between the Registrant and Norman Klugman, dated January 1,        2003. (Incorporated by reference from our Quarterly Report on Form 10-Q    for the fiscal quarter ended January 31, 2003.)                          |   |
| 10.23                                            |   |   | Employment Agreement, dated August 1,        2003, between Net2Phone, Inc. and Stephen M. Greenberg. (Incorporated        by reference from our Annual Report on Form 10-K for the fiscal year    ended July 31, 2003.)                            |   |
| 10.24                                            |   |   | Employment Agreement, dated as of August 1,        2002, between Net2Phone, Inc. and Jonathan Reich. (Incorporated by reference    from our Annual Report on Form 10-K for the fiscal year ended July 31, 2003.)                                   |   |
| 10.25                                            |   |   | Memorandum of understanding dated October 29, 2003, by and between IDT Corporation, Winstar Communications, LLC and the Registrant.(Incorporated by reference from our Annual Report on Form 10-K for the fiscal year ended July 31, 2003.)        |   |

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| **Exhibit**     **No.** |   |   | **Description**                                                                                                                                                                                                                                           |   |
|--------------------------------------------------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                  |   |   |                                                                                                                                                                                                                                                           |   |
|                                             |   |   |                                                                                                                                                                                                                                                      |   |
| 10.26                                            |   |   | Employment Agreement, dated        November 25, 2003, among Net2Phone Global Services, LLC, Net2Phone, Inc.        and Bryan Wiener. (Incorporated by reference from our Quarterly Report    on Form 10-Q for the fiscal quarter ended October 31, 2003.) |   |
| 10.27                                            |   |   | Memorandum of Understanding Re: Continuing Employment Agreement, effective January 8, 2004, between the Company and Bruce Shoulson.(Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended January 31, 2004)              |   |
| 10.28                                            |   |   | Agreement, dated January        30, 2004, between the Company and Union Telecard Alliance, LLC. (Incorporated        by reference from our Quarterly Report on Form 10-Q for the quarter ended    January 31, 2004)                                       |   |
| 10.29                                            |   |   | Intellectual Property Legal        Services Agreement dated as of January 1, 2004, between the Company and        IDT Corporation. (Incorporated by reference from our Quarterly Report    on Form 10-Q for the quarter ended April 30, 2004)             |   |
| 10.30*                                           |   |   | Memorandum of Understanding, dated July 21, 2004, between the Company and Bryan Wiener.†                                                                                                                                                             |   |
| 10.31*                                           |   |   | Memorandum of Amendment of Employment Agreement, effective November 1, 2004, between Net2Phone, Inc. and Stephen M. Greenberg. †                                                                                                                     |   |
| 14.1                                             |   |   | Net2Phone, Inc. Code of Conduct. (Incorporated by reference from our Annual Report on Form 10-K for the fiscal year ended July 31, 2004.)                                                                                                            |   |
| 21.1*                                            |   |   | Subsidiaries                                                                                                                                                                                                                                              |   |
| 23.1*                                            |   |   | Consent of Ernst & Young LLP.                                                                                                                                                                                                                         |   |
| 24                                               |   |   | Power of Attorney (included in signature page).                                                                                                                                                                                                           |   |
| 31.1*                                            |   |   | Certification of the Chief Executive Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                  |   |
| 31.2*                                            |   |   | Certification of the Chief Financial Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                  |   |
| 32*                                              |   |   | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                              |   |

|  |   |
|--|--------|

| * | Filed herewith |
|---|----------------|

| † | Management contract or compensation plan. |
|--------|-------------------------------------------|

(d) Financial statement schedules required by Regulation S-X (17 CFR 210) which are excluded from the annual report to shareholders by Rule 14a-3(b).

Reference is hereby made to page F-33 for Schedule II — Valuation and Qualifying Accounts.

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**NET2PHONE, INC.****INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE**

| Report of Independent Registered Public Accounting Firm.                                                                  | F-2    |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                                      |   |   |
| Consolidated    Balance Sheets as of July 31, 2004 and 2003.                                                         | F-3    |   |
|                                                                                                                      |   |   |
| Consolidated            Statements of Operations for the years ended July 31, 2004,    2003 and 2002.                | F-4    |   |
|                                                                                                                      |   |   |
| Consolidated            Statements of Stockholders’ Equity for the years ended July 31,    2004, 2003 and 2002. | F-5    |   |
|                                                                                                                      |   |   |
| Consolidated            Statements of Cash Flows for the years ended July 31, 2004,    2003 and 2002.                | F-6    |   |
|                                                                                                                      |   |   |
| Notes to Consolidated Financial Statements.                                                                               | F-7    |   |
|                                                                                                                      |   |   |
| The following consolidated financial statement schedule of Net2Phone, Inc. and Subsidiaries is                            |   |   |
| included in Item 15(a):                                                                                                   |   |   |
|                                                                                                                      |   |   |
| Schedule II-Valuation and Qualifying Accounts                                                                             | F-33   |   |

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

**The Board of Directors and Stockholders**     **Net2Phone, Inc.**

We have audited the accompanying    consolidated balance sheets of Net2Phone, Inc. as of July 31, 2004 and    2003, and the related consolidated statements of operations, stockholders’ equity    and cash flows for each of the three years in the period ended July 31,    2004. Our audits also included the financial statement schedule listed in    the Index at Item 15(a). These financial statements and schedule are the    responsibility of Net2Phone, Inc.’s management. Our responsibility is    to express an opinion on these financial statements and schedule based on    our audits.

We conducted our audits in accordance    with the standards of the Public Company Accounting Oversight Board (United    States). Those standards require that we plan and perform the audit to obtain    reasonable assurance about whether the financial statements are free of material    misstatement. An audit includes examining, on a test basis, evidence supporting    the amounts and disclosures in the financial statements. An audit also includes    assessing the accounting principles used and significant estimates made by    management, as well as evaluating the overall financial statement presentation.    We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements    referred to above present fairly, in all material respects, the consolidated    financial position of Net2Phone, Inc. at July 31, 2004 and 2003 and    the results of their operations and their cash flows for each of the three    years in the period ended July 31, 2004, in conformity with U.S. generally    accepted accounting principles. Also, in our opinion, the related financial    statement schedule, when considered in relation to the basic financial statements    taken as a whole, presents fairly in all material respects the information    set forth therein.

New York, New York,October 8, 2004

/s/ Ernst & Young LLP

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**Net2Phone, Inc.****CONSOLIDATED BALANCE SHEETS**

|                                                                                                            |   | **July 31,** |     |
|-----------------------------------------------------------------------------------------------------------------|--------|--------------|----------|
| **(in thousands, except per share data)**                                                                       |   | **2004**     |     | **2003** |   |
|                                                                                                            |   |              |          |   |  |  |   |
| **Assets:**                                                                                                     |   |         |     |   |   |   |   |
| Current assets:                                                                                                 |   |         |     |   |   |   |   |
| Cash and cash equivalents                                                                                       |   | $            | 12,408   |   | $ | 9,350 |   |
| Restricted cash                                                                                                 |   |         | 246      |   |   | 719 |   |
| Marketable securities                                                                                           |   |         | 99,125   |   |   | 60,554 |   |
| Trade accounts receivable, net of allowance for doubtful accounts of $364                                       |   |         |     |   |   |   |   |
| (2004) and $581 (2003)                                                                                          |   |         | 2,822    |   |   | 2,267 |   |
| Notes receivable from employees                                                                                 |   |         | 925      |   |   | 1,160 |   |
| Prepaid expenses and other current assets                                                                       |   |         | 5,683    |   |   | 9,465 |   |
|                                                                                                            |   |              |          |   |  |  |   |
| Total current assets                                                                                            |   |         | 121,209  |   |   | 83,515 |   |
| Property and equipment, net                                                                                     |   |         | 18,929   |   |   | 24,172 |   |
| Restricted          cash, cash equivalents and marketable securities — long-term                           |   |         | 21,035   |   |   | 23,488 |   |
| Notes receivable from employees — long-term                                                                |   |         | 125      |   |   | 4,990 |   |
| Deferred compensation                                                                                           |   |         | —   |   |   | 3,763 |   |
| Other assets                                                                                                    |   |         | 3,959    |   |   | 4,718 |   |
|                                                                                                            |   |              |          |   |  |  |   |
| Total assets                                                                                                    |   | $            | 165,257  |   | $ | 144,646 |   |
|                                                                                                            |   |              |          |   |  |  |   |
| **Liabilities and Stockholders’ Equity:**                                                                  |   |         |     |   |   |   |   |
| Current liabilities:                                                                                            |   |         |     |   |   |   |   |
| Accounts payable                                                                                                |   | $            | 838      |   | $ | 2,502 |   |
| Accrued expenses                                                                                                |   |         | 9,629    |   |   | 15,438 |   |
| Capital lease obligations                                                                                       |   |         | 127      |   |   | 3,079 |   |
| Due to IDT                                                                                                      |   |         | 971      |   |   | 1,057 |   |
| Deferred revenue                                                                                                |   |         | 6,166    |   |   | 7,090 |   |
| Current portion of long-term obligations                                                                        |   |         | 463      |   |   | 437 |   |
|                                                                                                            |   |              |          |   |  |  |   |
| Total current liabilities                                                                                       |   |         | 18,194   |   |   | 29,603 |   |
| Other liabilities                                                                                               |   |         | 1,109    |   |   | 1,825 |   |
| Capital lease obligations-long-term                                                                             |   |         | —   |   |   | 708 |   |
| Long-term obligations                                                                                           |   |         | 17,329   |   |   | 16,170 |   |
|                                                                                                            |   |              |          |   |  |  |   |
| Total liabilities                                                                                               |   |         | 36,632   |   |   | 48,306 |   |
| Minority interests                                                                                              |   |         | —   |   |   | 20,011 |   |
| Stockholders’ equity:                                                                                      |   |         |     |   |   |   |   |
| Common stock, $.01 par value; 200,000 shares authorized; 50,083 and 34,632 shares issued and outstanding        |   |         | 501      |   |   | 346 |   |
| Class A common stock, $.01 par value, 37,924 shares authorized; 29,958 and 28,921 shares issued and outstanding |   |         | 299      |   |   | 289 |   |
| Additional paid-in capital                                                                                      |   |         | 938,361  |   |   | 874,077 |   |
| Accumulated deficit                                                                                             |   |         | (773,699 | ) |   | (760,486 | ) |
| Accumulated other comprehensive income (loss)                                                                   |   |         | (962     | ) |   | 226 |   |
| Deferred compensation                                                                                           |   |         | (1,159   | ) |   | (456) |   |
| Loans to stockholders                                                                                           |   |         | (1,171   | ) |   | (1,394 | ) |
| Treasury stock, at cost; 3,326 and 3,476 shares                                                                 |   |         | (33,545  | ) |   | (36,273 | ) |
|                                                                                                            |   |              |          |   |  |  |   |
| Total stockholders’ equity                                                                                 |   |         | 128,625  |   |   | 76,329 |   |
|                                                                                                            |   |              |          |   |  |  |   |
| Total liabilities and stockholders’ equity                                                                 |   | $            | 165,257  |   | $ | 144,646 |   |
|                                                                                                            |   |              |          |   |  |  |   |

See accompanying notes.

 

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**Net2Phone, Inc.****CONSOLIDATED STATEMENTS OF OPERATIONS**

|                                                                                                                |   | **Year ended July 31,** |    |
|---------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|
| **(in thousands, except per share data)**                                                                           |   | **2004**                |    | **2003** |   | **2002** |   |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Revenue                                                                                                             |   | $                       | 82,779  |   | $ | 91,750 |   | $ | 137,855 |   |
| Costs and expenses:                                                                                                 |   |                    |    |   |   |   |   |   |   |   |
| Direct cost of revenue (exclusive of items shown below)                                                             |   |                    | 46,794  |   |   | 52,820 |   |   | 78,502 |   |
| Selling, general and administrative                                                                                 |   |                    | 48,446  |   |   | 53,728 |   |   | 116,570 |   |
| Depreciation and amortization                                                                                       |   |                    | 10,530  |   |   | 11,037 |   |   | 23,980 |   |
| Non-cash services provided by IDT (attributable to direct cost of revenue and selling, general and administrative)  |   |                    | 3,369   |   |   | — |   |   | — |   |
| Non-cash compensation (attributable to selling, general and                                                         |   |                    |    |   |   |   |   |   |   |   |
| administrative)                                                                                                     |   |                    | (3,168) |   |   | 15,304 |   |   | 19,556 |   |
| Restructuring, severance, impairment and other items                                                                |   |                    | 2,192   |   |   | 7,363 |   |   | 141,619 |   |
| Settlement of Cisco litigation                                                                                      |   |                    | —  |   |   | (58,034 | ) |   | 1,572 |   |
| Acquired in-process research and development                                                                        |   |                    | —  |   |   | — |   |   | 13,850 |   |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Total costs and expenses                                                                                            |   |                    | 108,163 |   |   | 82,218 |   |   | 395,649 |   |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Income (loss) from operations                                                                                       |   |                    | (25,384 | ) |   | 9,532 |   |   | (257,794 | ) |
| Interest income, net                                                                                                |   |                    | 1,981   |   |   | 2,021 |   |   | 4,162 |   |
| Income (loss) on equity investments and other expense, net                                                          |   |                    | 12,235  |   |   | 696 |   |   | (7,887 | ) |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Income (loss) before minority interests                                                                             |   |                    | (11,168 | ) |   | 12,249 |   |   | (261,519 | ) |
| Minority interests                                                                                                  |   |                    | —  |   |   | 4,546 |   |   | 15,591 |   |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Net income (loss)                                                                                                   |   |                    | (11,168 | ) |   | 16,795 |   |   | (245,928 | ) |
| Redeemable common stock accretion                                                                                   |   |                    | —  |   |   | — |   |   | (133 | ) |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Net income (loss) available to common stockholders                                                                  |   | $                       | (11,168 | ) | $ | 16,795 |   | $ | (246,061 | ) |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Net income (loss) per common share — basic and diluted                                                         |   | $                       | (0.16   | ) | $ | 0.28 |   | $ | (4.21 | ) |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Weighted average number of common shares used in the calculation of net income (loss) per common share—basic   |   |                    | 70,913  |   |   | 59,700 |   |   | 58,442 |   |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |
| Weighted average number of common shares used in the calculation of net income (loss) per common share—diluted |   |                    | 70,913  |   |   | 60,101 |   |   | 58,442 |   |
|                                                                                                                |   |                         |         |   |  |  |   |  |  |   |

See accompanying notes.

 

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**Net2Phone, Inc.****Consolidated Statements of Stockholders’ Equity****Years ended July 31, 2002, 2003, 2004**

|                                                                | **Common Stock** |   | **Class A Stock** |   | **Additional****Paid-in** |   | **Accumulated** |   | **Accumulated****Other****Comprehensive** |   | **Deferred**         |    | **Loans to**      |   | **Treasury Stock** |   | **Total****Stockholders’ Equity****** |
|---------------------------------------------------------------------|------------------|--------|-------------------|--------|---------------------------|--------|-----------------|--------|-------------------------------------------|--------|----------------------|---------|-------------------|--------|--------------------|--------|--------------------------------------------|
|  **(in            thousands)**                                 | **Shares**       |   | **Amount**        |   | **Shares**                |   | **Amount**      |   | **Capital**                               |   | **(Deficit)/Profit** |    | **Income (Loss)** |   | **Compensation**   |   | **Stockholders**                           |   | **Shares** |   | **Amount** |   |
|                                                                |                  |   |                   |        |                      |        |            |        |                                           |   |                      |         |              |        |                    |   |                                            |  |   |  |  |   |  |  |   |  |   |  |  |   |  |  |   |
| Balance at July 31, 2001                                            | 29,146           |   | $                 | 292    |                      | 32,316 |            | $      | 323                                       |   | $                    | 857,956 |              | $      | (514,765           | )      | $                                          | 149 |   | $ | (14,232 | ) | $ | (3,513 | ) | 4,362 |   | $ | (56,913 | ) | $ | 269,297 |  |
| Net loss for the year ended July 31, 2002                           | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | (245,928           | )      |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | (245,928 | ) |
| Unrealized gain on marketable securities, net                       | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | 360 |   |   | — |   |   | — |   | — |   |   | — |   |   | 360 |  |
| Foreign currency translation                                        | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | (269 | ) |   | — |   |   | — |   | — |   |   | — |   |   | (269 | ) |
|                                                                |             |   |              |   |                      |   |            |   |                                      |   |                 |    |              |   |               |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |  |  |
| Comprehensive loss                                                  | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | (245,837 | ) |
| Repurchase of common stock                                          | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | 120 |   |   | (510 | ) |   | (510 | ) |
| Treasury share donation for charitable contribution                 | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | (8,718             | )      |                                       | — |   |   | — |   |   | — |   | (600 | ) |   | 11,670 |   |   | 2,952 |  |
| Issuance of shares to IDT from treasury shares                      | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | (3,599             | )      |                                       | — |   |   | — |   |   | — |   | (274 | ) |   | 5,022 |   |   | 1,423 |  |
| Conversion    of Class A common stock to common stock               | 3,321            |   |              | 33     |                      | (3,321 | )               |   | (33                                       | )      |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | — |  |
| Exercise of stock options                                           | 1,404            |   |              | 14     |                      | — |            |   | —                                    |   |                 | 560     |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | 574 |  |
| Variable    accounting adjustment to repriced stock options         | —           |   |              | — |                      | — |            |   | —                                    |   |                 | 4,300   |              |   | —             |   |                                       | — |   |   | 869 |   |   | — |   | — |   |   | — |   |   | 5,169 |  |
| Recission of exercised stock options                                | —           |   |              | — |                      | — |            |   | —                                    |   |                 | 217     |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | 143 |   |   | (476 | ) |   | (259 | ) |
| Accretion of redeemable common stock                                | —           |   |              | — |                      | — |            |   | —                                    |   |                 | (266    | )                 |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | (266 | ) |
| Amortization of deferred compensation                               | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | 11,897 |   |   | — |   | — |   |   | — |   |   | 11,897 |  |
| Loan forgiveness                                                    | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | 1,473 |   | — |   |   | — |   |   | 1,473 |  |
| Other                                                               | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | (256               | )      |                                       | — |   |   | 256 |   |   | — |   | — |   |   | — |   |   | — |  |
|                                                                |                  |   |                   |        |                      |        |            |        |                                           |   |                      |         |              |        |                    |   |                                            |  |   |  |  |   |  |  |   |  |   |  |  |   |  |  |  |
| Balance at July 31, 2002                                            | 33,871           |   | $                 | 339    |                      | 28,995 |            | $      | 290                                       |   | $                    | 862,767 |              | $      | (773,266           | )      | $                                          | 240 |   | $ | (1,210 | ) | $ | (2,040 | ) | 3,751 |   | $ | (41,207 | ) | $ | 45,913 |  |
| Net income for the year ended July 31, 2003                         | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | 16,795             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | 16,795 |  |
| Foreign currency translation                                        | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | (59 | ) |   | — |   |   | — |   | — |   |   | — |   |   | (59 | ) |
| Unrealized gain on marketable securities, net                       | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | 45 |   |   | — |   |   | — |   | — |   |   | — |   |   | 45 |  |
|                                                                |             |   |              |   |                      |   |            |   |                                      |   |                 |    |              |   |               |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |  |  |
| Comprehensive income                                                | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | 16,781 |  |
| Treasury share funding of 401K Plan                                 | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | (4,015             | )      |                                       | — |   |   | — |   |   | — |   | (275 | ) |   | 4,934 |   |   | 919 |  |
| Conversion of Class A common stock tocommon stock                   | 74               |   |              | 1      |                      | (74    | )               |   | (1                                        | )      |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | — |  |
| Conversion of redeemable common to common stock                     | 294              |   |              | 3      |                      | — |            |   | —                                    |   |                 | (3      | )                 |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | — |  |
| Transfer    of IDT minority interest in ADIR to Net2Phone           | —           |   |              | — |                      | — |            |   | —                                    |   |                 | 5,068   |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | 5,068 |  |
| Exercise of stock options                                           | 393              |   |              | 3      |                      | — |            |   | —                                    |   |                 | 985     |              |   | —             |   |                                       | — |   |   | — |   |   | (63 | ) | — |   |   | — |   |   | 925 |  |
| Issuance of restricted share grant to executive                     | —           |   |              | — |                      | — |            |   | —                                    |   |                 | 394     |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | 394 |  |
| Repayment of loans to stockholders                                  | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | 98 |   | — |   |   | — |   |   | 98 |  |
| Loan forgiveness                                                    |             |   |              |   |                      |   |            |   |                                      |   |                 |    |              |   |               |   |                                       |   |   |   |   |   |   | 611 |   |   |   |   |   |   |   | 611 |  |
| Forfeiture of stock options                                         | —           |   |              | — |                      | — |            |   | —                                    |   |                 | (104    | )                 |   | —             |   |                                       | — |   |   | 104 |   |   | — |   | — |   |   | — |   |   | — |  |
| Variable    accounting adjustment to repriced stock options         | —           |   |              | — |                      | — |            |   | —                                    |   |                 | 4,970   |              |   | —             |   |                                       | — |   |   | (4,970 | ) |   | — |   | — |   |   | — |   |   | — |  |
| Amortization of deferred compensation                               | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | 5,620 |   |   | — |   | — |   |   | — |   |   | 5,620 |  |
|                                                                |                  |   |                   |        |                      |        |            |        |                                           |   |                      |         |              |        |                    |   |                                            |  |   |  |  |   |  |  |   |  |   |  |  |   |  |  |  |
| Balance at July 31, 2003                                            | 34,632           |   | $                 | 346    |                      | 28,921 |            | $      | 289                                       |   | $                    | 874,077 |              | $      | (760,486           | )      | $                                          | 226 |   | $ | (456 | ) | $ | (1,394 | ) | 3,476 |   | $ | (36,273 | ) | $ | 76,329 |  |
| Net income for the year ended July 31, 2004                         | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | (11,168            | )      |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | (11,168 | ) |
| Foreign currency translation                                        | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | (50 | ) |   | — |   |   | — |   | — |   |   | — |   |   | (50 | ) |
| Unrealized loss on marketable securities, net                       | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | (1,138 | ) |   | — |   |   | — |   | — |   |   | — |   |   | (1,138 | ) |
|                                                                |             |   |              |   |                      |   |            |   |                                      |   |                 |    |              |   |               |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |  |  |
| Comprehensive (loss)                                                | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | (12,356 | ) |
| Issuance of common stock in follow-onpublic offering                | 14,000           |   |              | 140    |                      | — |            |   | —                                    |   |                 | 58,504  |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | 58,644 |  |
| Treasury share funding of 401K Plan                                 | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | (2,045             | )      |                                       | — |   |   | — |   |   | — |   | (150 | ) |   | 2,728 |   |   | 683 |  |
| Conversion    of Class A common stock to common stock               | 9                |   |              | 1      |                      | (9     | )               |   | (1                                        | )      |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | — |  |
| Exercise of stock options                                           | 1,270            |   |              | 12     |                      | — |            |   | —                                    |   |                 | 5,424   |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | 5,436 |  |
| Issuance of stock bonuses to employees & officers               | 172              |   |              | 2      |                      | — |            |   | —                                    |   |                 | 2,551   |              |   | —             |   |                                       | — |   |   | (1,449 | ) |   | — |   | — |   |   | — |   |   | 1,104 |  |
| Shares which may be released to IDT per memorandum of understanding | —           |   |              | — |                      | 1,046  |            |   | 11                                        |   |                 | 3,358   |              |   | —             |   |                                       | — |   |   | — |   |   | — |   | — |   |   | — |   |   | 3,369 |  |
| Repayment of loan by stockholder                                    | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | 64 |   | — |   |   | — |   |   | 64 |  |
| Variable    accounting adjustment to repriced stock options         | —           |   |              | — |                      | — |            |   | —                                    |   |                 | (5,553  | )                 |   | —             |   |                                       | — |   |   | 5,553 |   |   | — |   | — |   |   | — |   |   | — |  |
| Forgiveness of loan to stockholder                                  | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | — |   |   | 159 |   | — |   |   | — |   |   | 159 |  |
| Amortization of deferred compensation                               | —           |   |              | — |                      | — |            |   | —                                    |   |                 | —  |              |   | —             |   |                                       | — |   |   | (4,807 | ) |   | — |   | — |   |   | — |   |   | (4,807 | ) |
|                                                                |                  |   |                   |        |                      |        |            |        |                                           |   |                      |         |              |        |                    |   |                                            |  |   |  |  |   |  |  |   |  |   |  |  |   |  |  |   |
| Balance at July 31, 2004                                            | 50,083           |   | $                 | 501    |                      | 29,958 |            | $      | 299                                       |   | $                    | 938,361 |              | $      | (773,699           | )      | $                                          | (962 | ) | $ | (1,159 | ) | $ | (1,171 | ) | 3,326 |   | $ | (33,545 | ) | $ | 128,625 |   |
|                                                                |                  |   |                   |        |                      |        |            |        |                                           |   |                      |         |              |        |                    |   |                                            |  |   |  |  |   |  |  |   |  |   |  |  |   |  |  |   |

See accompanying notes.

F-5

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**Net2Phone, Inc.****CONSOLIDATED STATEMENTS OF CASH FLOWS**

|                                                                                 |   | **Year ended July 31,** |     |
|--------------------------------------------------------------------------------------|--------|-------------------------|----------|
|                                                                                 |   |                         |     |
|                                                                                 |   | **2004**                |     | **2003** |   | **2002** |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
|                                                                                 |   | **(in thousands)**      |     |
| **Operating activities:**                                                            |   |                    |     |   |   |   |   |   |   |   |
| Net income (loss)                                                                    |   | $                       | (11,168  | ) | $ | 16,795 |   | $ | (245,928 | ) |
| Adjustments to reconcile net income (loss) to net cash used in operating activities: |   |                    |     |   |   |   |   |   |   |   |
| Depreciation and amortization                                                        |   |                    | 10,530   |   |   | 11,037 |   |   | 23,980 |   |
| Non-cash compensation expense                                                        |   |                    | (3,168   | ) |   | 15,304 |   |   | 19,556 |   |
| Non-cash services                                                                    |   |                    | 3,369    |   |   | — |   |   | — |   |
| Gain on buyout of minority interests                                                 |   |                    | (12,182  | ) |   | — |   |   | — |   |
| Loss on sale of assets                                                               |   |                    | —   |   |   | 348 |   |   | 1,921 |   |
| Write-down of investments                                                            |   |                    | —   |   |   | — |   |   | 7,251 |   |
| Write-off of acquired in-process research and development                            |   |                    | —   |   |   | — |   |   | 13,850 |   |
| Restructuring, severance, impairment and other non-cash items                        |   |                    | 4,387    |   |   | 7,703 |   |   | 144,178 |   |
| Loss on sale of business                                                             |   |                    | —   |   |   | — |   |   | 1,786 |   |
| Non-cash litigation settlement                                                       |   |                    | —   |   |   | (38,929 | ) |   | — |   |
| Issuance of common stock to charitable foundation                                    |   |                    | —   |   |   | — |   |   | 2,952 |   |
| Minority interests                                                                   |   |                    | —   |   |   | (4,546 | ) |   | (15,591) |   |
| Changes in assets and liabilities:                                                   |   |                    |     |   |   |   |   |   |   |   |
| Accounts receivable                                                                  |   |                    | (871     | ) |   | (188) |   |   | 4,252 |   |
| Other assets                                                                         |   |                    | 2,578    |   |   | 1,358 |   |   | (2,880) |   |
| Accounts payable and accrued expenses                                                |   |                    | (8,156   | ) |   | (16,587 | ) |   | (30,226) |   |
| Deferred revenue                                                                     |   |                    | (270     | ) |   | (1,022 | ) |   | (177) |   |
| Net advances from (repayments to) IDT Corporation                                    |   |                    | 178      |   |   | 1,595 |   |   | (15,559) |   |
| Other                                                                                |   |                    | (1,394   | ) |   | — |   |   | — |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
| Net cash used in operating activities                                                |   |                    | (16,167  | ) |   | (7,132 | ) |   | (90,635) |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
|                                                                                 |   |                    |     |   |   |   |   |   |   |   |
| **Investing activities:**                                                            |   |                    |     |   |   |   |   |   |   |   |
| Purchases of property and equipment                                                  |   |                    | (5,539   | ) |   | (7,068 | ) |   | (17,852) |   |
| Purchases of marketable securities                                                   |   |                    | (318,195 | ) |   | (78,388 | ) |   | (74,965) |   |
| Payments of acquisition related obligations                                          |   |                    | —   |   |   | — |   |   | (13,889) |   |
| Proceeds from the sale of marketable securities                                      |   |                    | 278,624  |   |   | 62,358 |   |   | 89,421 |   |
| Acquisitions, net of cash acquired                                                   |   |                    | —   |   |   | — |   |   | (27,764) |   |
| Issuance of notes receivable                                                         |   |                    | —   |   |   | — |   |   | (3,912) |   |
| Other                                                                                |   |                    | 397      |   |   | 501 |   |   | (146) |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
| Net cash used in investing activities                                                |   |                    | (44,713  | ) |   | (22,597 | ) |   | (49,107) |   |
|                                                                                 |   |                    |     |   |   |   |   |   |   |   |
| **Financing activities:**                                                            |   |                    |     |   |   |   |   |   |   |   |
| Proceeds from the sale of common stock                                               |   |                    | 58,644   |   |   | — |   |   | — |   |
| Proceeds from the issuance of subsidiary preferred stock                             |   |                    | —   |   |   | — |   |   | 13,999 |   |
| Payments of capital lease obligations                                                |   |                    | (4,417   | ) |   | (1,759) |   |   | (1,938) |   |
| Proceeds from exercise of stock options                                              |   |                    | 5,436    |   |   | 1,055 |   |   | 572 |   |
| Proceeds from repayment of employee loans                                            |   |                    | 670      |   |   | 115 |   |   | — |   |
| Purchases of redeemable common stock                                                 |   |                    | —   |   |   | — |   |   | (3,306 | ) |
| Repurchase of common stock                                                           |   |                    | —   |   |   | — |   |   | (510) |   |
| Net change in restricted stock                                                       |   |                    | 2,785    |   |   | (1,217 | ) |   | (821) |   |
| Other                                                                                |   |                    | 820      |   |   | (341 | ) |   | — |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
| Net cash provided by (used in) provided by financing activities                      |   |                    | 63,938   |   |   | (2,147) |   |   | 7,996 |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
| Net increase (decrease) in cash and cash equivalents                                 |   |                    | 3,058    |   |   | (31,876 | ) |   | (131,746) |   |
| Cash and cash equivalents at beginning of period                                     |   |                    | 9,350    |   |   | 41,226 |   |   | 172,972 |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
| Cash and cash equivalents at end of period                                           |   |                    | $12,408  |   | $ | 9,350 |   | $ | 41,226 |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
| **Supplemental disclosure of cash flow information:**                                |   |                    |     |   |   |   |   |   |   |   |
| Cash payments for interest                                                           |   | $                       | 789      |   | $ | 170 |   | $ | 450 |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |
| Liabilities incurred to acquired fixed assets                                        |   | $                       | —   |   | $ | — |   | $ | 6,969 |   |
|                                                                                 |   |                         |          |   |  |  |   |  |  |   |

See accompanying notes.

 

F-6

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS****July 31, 2004**

 

 

| **1. Description of Business and Basis of Presentation** |
|----------------------------------------------------------|

The accompanying consolidated financial    statements reflect the historical financial information of Net2Phone, Inc.    and its subsidiaries. Our company was incorporated in October 1997, to operate    and develop our Internet telephony business. Prior to such time, our business    was conducted as a division of IDT Corporation (“IDT”).

We are a leading provider of Voice    over Internet Protocol, or VoIP, communications services. Since we began    operations in 1995, we have evolved from a pioneer in developing PC-to-telephone    calling services over the Internet to a next generation provider of high    quality voice and enhanced communication services throughout the world. Our    strategic investors include IDT Corporation, a global telecommunications,    media and technology company, and Liberty Media Corporation, a global media    company. IDT and Liberty Media together own NTOP Holdings, L.L.C., which    as of October 7, 2004, currently holds an aggregate of 37.8 percent of our    outstanding    capital stock and 54.9 percent of our aggregate voting power. IDT is the    controlling member of NTOP Holdings, through which it effectively controls    us.

| **2. Summary of Significant Accounting Policies** |
|---------------------------------------------------|

     ***Principles of Consolidation***

The consolidated financial statements    include our accounts and the accounts of all companies in which we have a    controlling voting interest (“subsidiaries”), as if we, and our    subsidiaries were a single company. Significant intercompany accounts and    transactions between consolidated subsidiaries have been eliminated in consolidation.

The effect of any changes in our ownership interests resulting from the issuance of equity capital by consolidated subsidiaries or equity investments to unaffiliated parties are included in our results of operations.

     ***Use of Estimates***

The preparation of financial statements    in conformity with U.S. generally accepted accounting principles requires    management to make estimates and assumptions that affect the amounts reported    in the financial statements and accompanying notes. Actual results may differ    from those estimates.

     ***Reclassifications***

Certain prior year amounts have been reclassified to conform to the current year presentation.

     ***Earnings (Loss) Per Share***

Basic earnings (loss) per share is    computed by dividing the net income (loss) available to common stockholders    by the weighted average of common shares outstanding during the period. Diluted    earnings (loss) per share adjusts basic earnings (loss) per share for the    effect of stock options and warrants and other contingently issuable shares,    only in the periods in which such effect is dilutive.

Stock options of 9.7 million,    9.9 million, and 10.6 million shares for the years ended July 31,    2004, 2003, and 2002, respectively, were not included in the computation    of diluted earnings per share, as their inclusion would have been anti-dilutive.    Additionally, restricted shares of 0.3 million, for the twelve months    ended July 31, 2004, were not included in the computation of diluted    earnings per share as their inclusion would be anti-dilutive. The weighted    average number of common shares outstanding for computing diluted earnings    per share for the twelve months ended July 31, 2003, includes 0.4 million    shares for the assumed conversion of dilutive stock options. Lastly, 5.9 million    shares of the 6.9 million shares of our Class A common stock to be issued    in connection with definitive agreements reached pursuant to the memorandum    of understanding with IDT (see note 14) have been excluded from the calculation    of earnings per share for the twelve months ended July 31, 2004.

F-7

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

     ***Cash and Cash Equivalents***

We consider all highly liquid investments    with a maturity of three months or less when purchased to be cash equivalents.    Cash and cash equivalents are carried at cost, which approximates market    value. A portion of our cash is restricted, as these balances are required    to collateralize our outstanding letters of credit.

     ***Inventory***

Inventories are stated at the lower    of cost or market. Cost is computed on a specific identification basis. For    fiscal years 2004, 2003, and 2002, direct cost of revenue includes inventory    write-downs of $0.6 million, $0.1 million, and $2.8 million,    respectively, that relate to inventory identified as obsolete or slow moving.    This inventory has been written down to its net realizable value.

     ***Property and Equipment***

Equipment and furniture and fixtures are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets, which range from five to ten years.

Computer software is amortized using the straight-line method over the shorter of five years or the term of the related agreement.

     ***Software Development Costs***

Costs for the internal development    of new software products and substantial enhancements to existing software    products are expensed as incurred until technological feasibility has been    established, at which time any additional costs would be capitalized. Software    development costs are our only research and development expenditures. For    the years ended July 31, 2004, 2003, and 2002, included in selling,    general administrative costs are research and development costs totaling    approximately $8.2 million, $5.4 million, and $11.2 million,    respectively.

     ***Capitalized Internal Use Software Costs***

We capitalize certain costs incurred    in connection with developing, once technological feasibility has been established,    or obtaining internal use software. These costs consist of payments made    to third parties and the compensation costs, including fringe benefits, of    employees working on such software development. Capitalized internal use    software costs are amortized using the straight-line method over the shorter    of five years or the useful lives of the internal use software. For the years    ended July 31, 2004, 2003, and 2002, we have capitalized approximately    $4.4 million, $4.5 million, and $7.3 million, respectively,    of internal use software costs as computer software.

     ***Long-Lived Assets, including amortizable intangible assets***

We review long-lived assets and certain    identifiable intangibles for impairment on a quarterly basis by determining    whether events or changes in circumstances indicate that the carrying amount    of an asset may not be recoverable. The analysis of the recoverability utilizes    undiscounted cash flows. The measurement of the loss, if any, will be calculated    as the amount by which the carrying amount of the asset exceeds the fair    value of the asset.

     ***Goodwill***

Goodwill has been tested for impairment    in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. The    goodwill impairment test under SFAS No. 142 requires a two-step approach,    which is performed at the reporting unit level, as defined in SFAS No.142.    Step one identifies potential impairments by comparing the fair value of    the reporting unit to its carrying amount. Step two, which is only performed    if there is a potential impairment, compares the carrying amount of the reporting    unit’s goodwill to its implied value, as defined in SFAS No. 142. If    the carrying amount of the reporting unit’s goodwill exceeds the implied    fair value of that goodwill, an impairment loss is recognized for an amount    equal to that excess.

F-8

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

     ***Revenue Recognition***

Internet telephony service revenue, including pre-paid calling card revenue, is recognized as service is provided, that is, as minutes are used and service charges are levied.

Pre-payments for communications services    are deferred and recognized as revenue as the communications services are    provided. We also recognize revenue from pre-payments for services after    we conduct evaluations of outstanding, remaining pre-payment balances and    determine, based on historical data, that such balances are not likely to    be utilized.

The sale of equipment with software necessary to provide our services is recognized when such products are delivered, collection of payments are assured and there are no significant future obligations.

Per subscriber activation fees which are invoiced based on contracted service commitment levels, are collected when invoiced and revenue is deferred and recognized over the remaining life of the service agreement.

     ***Direct Cost of Revenue***

Direct cost of revenue consists primarily of telecommunication costs, connectivity costs, and the cost of equipment sold to customers. Direct cost of revenue excludes depreciation and amortization and non-cash services provided by IDT.

     ***Advertising Costs***

We expense the costs of advertising as incurred. For fiscal 2004, 2003, and 2002, advertising expense amounted to $1.8 million, $1.8 million and $3.7 million, respectively.

     ***Income Taxes***

We account for income taxes using    the liability method. Under this method, deferred tax assets and liabilities    are determined based on differences between the financial reporting and tax    bases of assets and liabilities. Due to our accumulated losses, we fully    offset net deferred tax assets against a valuation allowance due to the uncertainty    of the realization of the assets.

At July 31, 2004, we had net    operating loss carry-forwards for federal income tax purposes of approximately    $515.9 million expiring in years through 2024. These net operating loss    carry-forwards may be limited by both the future taxable earnings of our    company and limitations imposed by Internal Revenue Code Section 382.

     ***Stock Based Compensation Expense***

We account for our stock-based employee    compensation plan under the intrinsic value method in accordance with Accounting    Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*,    (APB 25) and related Interpretations. Compensation expense for stock options    issued to employees is measured as the excess of the quoted market price    of our stock at the date of grant over the amount an employee must pay to    acquire the stock. APB 25 requires that stock options that have been modified    to reduce the exercise price be accounted for as variable until the options    are exercised, forfeited or expire unexercised. Charges that result from    the variable accounting treatment of repriced options are recorded as non-cash    compensation.

The company has adopted the disclosure-only    provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation* (SFAS    No. 123), as amended by FASB Statement No. 148, *Accounting for Stock-Based    Compensation—Transition and Disclosure* (SFAS No. 148). Pro forma    information regarding net income (loss) per share has been determined as    if we had accounted for employee stock options under the fair value method    proscribed by SFAS No. 123. The weighted average fair value of options granted    was $5.73, $3.30, and $4.20 per share for the years ended July 31, 2004,    2003, and 2002, respectively. The fair value of

F-9

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

the stock options was estimated at the date of grant using the Black-Scholes option pricing model with the following assumptions for vested and non-vested options:

| **Assumptions**                                                    |   | **July** **31, 2004** |    | **July** **31, 2003** |   | **July** **31, 2002** |   |
|--------------------------------------------------------------------|--------|----------------------------|---------|----------------------------|--------|----------------------------|--------|
|                                                                    |   |                            |         |                       |        |                            |   |  |  |   |
| Average risk-free interest rate                                    |   |                       | 3.35%   |                       |   | 2.88%                      |   |   | 4.29% |   |
| Dividend yield                                                     |   |                       | —  |                       |   | —                     |   |   | — |   |
| Volatility factor of the expected market price of our common stock |   |                       | 88%     |                       |   | 110%                       |   |   | 108% |   |
| Average life                                                       |   |                       | 5 years |                       |   | 5 years                    |   |   | 5 years |   |

The Black-Scholes option valuation    model was developed for use in estimating the fair value of traded options    which have no vesting restrictions and are fully transferable. In addition,    option valuation models require the input of highly subjective assumptions    including the expected stock price volatility. Because our employee stock    options have characteristics that are significantly different from those    of traded options, and because changes in the subjective input assumptions  can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period.

The following table illustrates the effect on net income (loss) and earnings (loss) per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

 

|                                                                                                                     |   | **Year ended July** **31,**          |    |
|--------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                                                                     |   |                                           |    |
|                                                                                                                     |   | **2004**                                  |    | **2003** |   | **2002** |   |
|                                                                                                                     |   |                                           |         |   |  |  |   |  |  |   |
|                                                                                                                     |   | **(in thousands, except per share data)** |    |
| Net income (loss), as reported                                                                                           |   | $                                         | (11,168 | ) | $ | 16,795 |   | $ | (246,061) |   |
| Add: Stock option-related employee compensation expense included in reported net income (loss)                           |   |                                      | (5,096  | ) |   | 6,255 |   |   | 13,698 |   |
| Deduct: Total stock option-related employee compensation expense determined under fair value based method for all awards |   |                                      | (5,081  | ) |   | (16,949) |   |   | (65,157) |   |
|                                                                                                                     |   |                                           |         |   |  |  |   |  |  |   |
| Pro forma net income (loss)                                                                                              |   | $                                         | (21,345 | ) | $ | 6,101 |   | $ | (297,520) |   |
|                                                                                                                     |   |                                           |         |   |  |  |   |  |  |   |
| Basic and diluted income (loss) per share, as reported                                                                   |   | $                                         | (0.16   | ) | $ | 0.28 |   | $ | (4.21) |   |
|                                                                                                                     |   |                                           |         |   |  |  |   |  |  |   |
| Basic and diluted income (loss) per share, Pro forma                                                                     |   | $                                         | (0.30   | ) | $ | 0.10 |   | $ | (5.09) |   |
|                                                                                                                     |   |                                           |         |   |  |  |   |  |  |   |

Non-cash compensation expense for    other stock-based compensation included in net income, as reported for the    years ended July 31, 2004, 2003 and 2002 was $1.9 million, $9.0 million,    and $5.9 million, respectively. These expenses primarily relate to restricted    stock, bonuses paid in stock, stock funding of the Company’s 401(k)    plan (see Note 19), and the discount on the ADIR shares (see Note 6).

     ***Current Vulnerability Due to Certain Concentrations***

Financial instruments that potentially    subject us to concentrations of credit risk consist principally of cash,    cash equivalents, marketable securities and trade receivables. Management    regularly monitors the creditworthiness of its domestic and international    customers and believes that it has adequately provided for any exposure to  potential credit losses.

F-10

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

| **3. Common Stock Offering** |
|------------------------------|

On November 25, 2003, we issued additional shares through an underwritten common stock offering. The transaction, which was completed at $4.50 per share, included 10.5 million shares issued to the public, an additional 1.0 million    shares purchased as part of an over allotment option exercised by the underwriters,  and an aggregate of 2.5 million shares purchased by IDT Corporation and Liberty Media Corporation, our controlling shareholders. We received net proceeds of $58.6 million  as a result of the offering. We have used, and intend to use, the net proceeds  for general corporate purposes, capital expenditures, and working capital,  including funding our cable telephony business.

| **4. Settlement of Cisco Litigation** |
|---------------------------------------|

In August 2002, Net2Phone and ADIR    Technologies, Inc., our majority-owned subsidiary, consummated the settlement    of their lawsuit in the United States District Court for the District of    New Jersey against Cisco Systems and a Cisco executive who had been a member    of the board of directors of ADIR. The suit arose out of the relationships  that had been created in connection with Cisco’s and Net2Phone’s original investments in ADIR and out of ADIR’s  subsequent purchase of NetSpeak, Inc. in August 2001. The parties settled the  suit and all related claims against Cisco and the Cisco executive in exchange  for: (i) the transfer, during the first quarter of fiscal 2003, to Net2Phone  of Cisco’s and Softbank Asia Infrastructure Fund’s respective 11.5  percent and 7.0 percent interests in ADIR, and (ii) the payment by Cisco, during  such quarter, of $19.5 million to Net2Phone and ADIR. As a result of this settlement, we recognized a gain of $58.0 million during fiscal 2003 consisting of a $38.9 million  reduction in minority interests as a result of the transfer of the ADIR shares,  receipt of settlement proceeds of $19.5 million less compensation expense of $0.4 million. No income taxes have been provided for with respect to the gain as we have sufficient net operating loss carry-forwards to offset the gain. In fiscal 2002, we recorded $1.6 million of legal and other expenses related to this settlement.

| **5. Restructuring, Severance, Impairment and Other Items** |
|-------------------------------------------------------------|

The following table summarizes the charges included in Restructuring, severance, impairment and other items in the statements of operations:

|                                                           |   | **Year ended July** **31,** |   |
|----------------------------------------------------------------|--------|----------------------------------|--------|
|                                                           |   |                                  |   |
|                                                           |   | **2004**                         |   | **2003** |   | **2002** |   |
|                                                           |   |                                  |        |   |  |  |   |  |  |   |
|                                                           |   | **(in thousands)**               |   |
| Exit and other costs                                           |   | $                                | 1,293  |   | $ | 3,970 |   | $ | 15,404 |   |
| Separation agreements of former CEO, CFO & COO             |   |                             | 1,244  |   |   | 2,877 |   |   | 12,623 |   |
| Workforce reductions                                           |   |                             | 163    |   |   | 4,116 |   |   | 13,882 |   |
| Impairment charges, including recovery on assets held for sale |   |                             | (89)   |   |   | 1,815 |   |   | 99,710 |   |
| Reserve adjustments                                            |   |                             | (419   | ) |   | (5,415 | ) |   | — |   |
|                                                           |   |                                  |        |   |  |  |   |  |  |   |
| Total                                                          |   | $                                | 2,192  |   | $ | 7,363 |   | $ | 141,619 |   |
|                                                           |   |                                  |        |   |  |  |   |  |  |   |

|                     |
|--------------------------|
| **Exit and Other Costs** |

During fiscal 2004, we incurred exit and other costs of $1.3 million, which included $0.4 million in costs to exit our disposable calling card business, $0.7 million in costs primarily related to losses on existing office leases, and $0.2 million    in various contract dispute settlement costs and costs to close two overseas  businesses.

F-11

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

During fiscal 2003, we incurred exit and other costs of approximately $4.0 million. These included $1.9 million for the write off of fixed assets that we were unable to deploy in our network; $1.6 million  relating to lease termination costs on various leases, including ADIR’s Boca Raton lease, which was ultimately terminated on May 8, 2003; and $0.5 million relating to the sale of our web-based banner advertising business in fiscal 2002.

As a result of the fiscal 2002 restructurings,    we eliminated various equipment and network build-outs, and incurred costs    to exit connectivity agreements. These exit activities resulted in total    costs of approximately $7.9 million.    The restructurings also led to the reduction of operations at various Net2Phone    and ADIR locations. As a result, we and ADIR incurred lease related exit  costs, which totaled approximately $6.3 million. Also in fiscal 2002,  we exited our web-based banner advertising business by selling its assets and  the assets of Mail.com to the management group of this division. As a result  of the transaction, we incurred a $1.8 million loss and we retained a  10 percent equity interest in the entity formed to acquire the business. Partially  offsetting these fiscal 2002 exit costs was a favorable mark-to-market adjustment  of $0.6 million relating to the Aplio settlement obligations (see Note  6).

| **Separation Agreements of Former CEO, CFO & COO** |
|--------------------------------------------------------|

In October 2001, Howard Balter resigned    as our Chief Executive Officer. Pursuant to an agreement between Mr. Balter    and us, Mr. Balter    waived various rights under his employment agreement, entered into a 30-month    restrictive non-compete covenant and agreed to provide consulting services    for a 15 month period, all in exchange for settlement of various loans from    us and the guarantee of continued benefits for a similar period. In addition,  Mr. Balter’s options were repriced at the conclusion of the first  three months of the consultancy period. Mr. Balter waived all rights to  assert any claims against Net2Phone and ADIR relating to his employment agreement  with Net2Phone. The aggregate principal amount of Mr. Balter’s borrowings  from Net2Phone and ADIR was $4.4 million. In addition, Net2Phonehad guaranteed  the repayment of a bank loan to Mr. Balter in the principal sum of $5.0 million.  Net2Phone repaid the bank loan and forgave $2.0 million  of the other indebtedness after the completion of the first three months of  his consulting period and agreed to forgive the balance after the completion  of the entire consulting period. As a result of this agreement, there were  charges of $9.5 million in fiscal 2002. The charge primarily consists  of $3.9 million for the repricing of options, $5.4 million of loan  forgiveness, and approximately $0.2 million of amortization of the non-compete  covenant which was valued at $0.8 million. During fiscal 2004 and 2003,  an additional $0.2 million and 1.9 million charge, respectively,  was recorded relating to Mr. Balter’s separation agreement. In January  2002, Ilan Slasky tendered his resignation as our Chief Financial Officer.  Mr. Slasky’s resignation became effective upon his successor’s  assumption of the responsibility in March 2002. Pursuant to an agreement between  Mr. Slasky and us, Mr. Slasky waived all of his rights under his  employment agreement, entered into a 2 year restrictive non-compete covenant  and agreed  to provide consulting services for a 4 year period, all in exchange for settlement  of various loans with us and the guarantee of continued benefits for a similar  period. In addition, Mr. Slasky’s options were repriced on January 31,  2002. Of the 300,000 options repriced at this time, 232,000 were exercised  immediately. The remaining 68,000 options were exercised during the second  quarter of fiscal 2003. The aggregate principal sum of Mr. Slasky’s  borrowings from us was $1.5 million. We agreed to forgive these borrowings  in four equal installments upon the completion of each of the four years of  his consulting  arrangement. We recorded charges of $2.7 million for fiscal 2002, $0.6 million  in fiscal 2003 and $0.5 million in fiscal 2004 related to Mr. Slasky’s  separation agreement. In connection with the termination of his employment,  Mr. Slasky sold 500 shares of ADIR stock to IDT Corporation. IDT then  transferred the ADIR shares to us in exchange for 273,798 shares of our common  stock valued at $1.4 million or $5.20 per share, the closing price of  the stock on the date of transfer. Under certain circumstances, we are required  to guarantee to IDT that those shares still owned by IDT on January 31,  2007 will have a market value of at least $5.20 per share on that date. During  fiscal 2002, we recorded a charge of $0.4 million

F-12

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

relating to this guarantee based on the decrease in value of our common stock. The $0.4 million charge was reversed during fiscal 2003, based on an increase in our stock price above the $5.20 per share guaranteed value. During fiscal 2004 we once again recorded a charge of $0.5 million relating to this guarantee based on the decrease in value of our common stock.

In April 2003, Norman Klugman, our    Chief Operating Officer, announced his intention to resign and terminated    his employment with us in July 2003. During fiscal 2003, we recorded a $0.8 million    charge related to a severance agreement reached with Mr. Klugman. Mr. Klugman    waived all of his rights under his employment agreement.

| **Workforce Reductions** |
|--------------------------|

During fiscal 2004, we incurred workforce reduction costs totalling $0.2 million relating to severance expense for six employees whose jobs were either consolidated or eliminated.

On October 24, 2002, we announced    that we were reducing our staff by approximately 20 percent, or 55 employees.    This staff reduction was primarily focused on consolidating our development    and support organizations and scaling back development activities that were    not critical to revenue generating business lines. We had an additional workforce  reduction of 8 employees in the fourth quarter of fiscal 2003. Of the $4.1 million of severance related charges incurred in fiscal 2003, approximately $4.0 million  was the result of these two staff reduction initiatives.

During fiscal 2002, we executed three    significant company-wide workforce reductions programs in our core business    and two in our ADIR subsidiary. In November 2001, we announced plans to restructure    our operations, which included the elimination of various lines of development    business related to voice hosting products and specific enterprise products,    relocation of certain facilities, and an immediate reduction in workforce    of approximately 270 employees. As a result of this restructuring, we recorded  a charge of $6.2 million relating to this workforce reduction. In February  2002, we announced plans to reduce our workforce by approximately 85 employees  or 28 percent. We underwent a significant restructuring process, identifying  business lines that required lower capital expenditures and provided a greater  return on investment with higher margins. As such, we significantly reduced  our workforce and scaled back certain unprofitable businesses, including our  disposable calling card business and wholesale termination business. We recorded  a severance charge of approximately $3.5 million relating to this workforce  reduction initiative. In April 2002, we further reduced our workforce by 20  employees through a scale back of our technical development team, which had  been working on projects related to the restructured businesses. We recorded  severance of approximately $0.9 million in fiscal 2002 related to this  workforce reduction initiative.

Two additional workforce reductions programs were also executed during fiscal 2002 in our ADIR subsidiary, after we reached and impasse with Cisco refusing to honor commitments provided to us during ADIR’s formation. Since much of ADIR’s    business plans and activities focused on developing software for Cisco, a  decision was reached first in February 2002 to reduce ADIR’s workforce by 60 employees, which resulted a charge of approximately $1.3 million  related to these terminated employees. A second ADIR workforce reduction was  executed in May 2002, as a result of unresolved negotiations with Cisco, and  resulted in the termination of an additional 30 employees and a severance charge  of $2.0 million.

| **Impairment Charges and Changes in Assets Held for Sale** |
|------------------------------------------------------------|

During fiscal 2004, we recorded a net recovery of $0.1 million for equipment that had been previously written off. In addition, we transferred $0.2 million of these assets to service in our network based on our operational needs. At the close of fiscal 2004 we had $0.2 million in Assets Held for Sale. We are in the process of identifying buyers for this equipment, and expect to sell these assets in fiscal 2005.

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

During fiscal year 2003, we recognized $0.9 million of net impairment charges related to the elimination of various equipment and network build-outs, $0.4 million    of impairment charges to capitalized software related to the de-emphasis  of our carrier services business and $0.2 million of charges relating  to the write-off of acquired software and equipment due to vendor bankruptcies.  In addition, we recorded a write-down to net realizable value of $0.3 million  on equipment that we had determined would not be deployed in our network and  that we would sell in the secondary equipment market.

During fiscal 2002, a comprehensive    review of our assets was conducted. As a result, several impairment charges    were determined to be required. First, an impairment charge of $83.9 million    was recognized during the third quarter of fiscal 2002 when it was determined    that the future undiscounted cash flows of our long-lived assets were estimated    to be insufficient to recover their related carrying values. As such, the    carrying values of these assets were written down to their estimated fair    value. Secondly, during the third quarter of fiscal 2002, as a result of  the significant reduction in ADIR’s workforce, the goodwill for ADIR’s  software sales reporting unit was tested for impairment and, as a result, a  goodwill impairment loss of $11.6 million was recognized. Finally, as  a result of our plan to restructure our operations and eliminate various lines  of development, an impairment review of our long-lived assets and identifiable  intangible assets was conducted as of April 30, 2002, in accordance with  SFAS No. 121. As a result of this analysis, we recorded impairment charges  of approximately $2.0 million related to customer lists, $0.5 million  related to technology and $1.7 million related to developed product technology  assets. The impairment charge was calculated as the amount by which the carrying  amount of the assets exceeded their estimated fair values. The estimate of  fair value for each of the fiscal 2002 impairments were determined using the  present  value of expected future cash flows.

| **Reserve Adjustments** |
|-------------------------|

During fiscal 2004, $0.4 million    in net reserves were reversed primarily due to the execution of sub lease    agreements at more favorable terms than originally estimated and to adjustments    of employee termination agreements based on subsequent decisions to retain  certain employees.

During fiscal 2003, we recorded reserve adjustments of $(5.4) million. During the first quarter of fiscal 2003, we reversed $2.1 million    of previously recognized charges as a result of a preliminary settlement    agreement with vendors regarding cancellation charges. In the first and second  quarter of fiscal 2003, we reversed a total of $0.5 million of previously  recognized severance expense as a result of the subsequent retention of several  individuals whose employment had been terminated. During the fourth quarter  of fiscal 2003, we reversed $1.9 million in reserves based on final contract settlement with one of our media partners. Additionally, we reversed $0.9 million in reserves related the termination of ADIR’s  Boca Raton office lease based upon executing a termination agreement relating  to the lease on more favorable terms than previously anticipated.

F-14

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

The following table summarizes the remaining reserve balances related to restructuring, severance, and exit costs:

|                                                            |   | **Balance @ July** **31, 2003** |   | **Charged to Expense** |   | **Payments** |   | **Non-Cash Charges** |   | **Reserve Adjustments** |    | **Balance @ July** **31, 2004** |   |
|-----------------------------------------------------------------|--------|--------------------------------------|--------|------------------------|--------|--------------|--------|----------------------|--------|-------------------------|---------|--------------------------------------|--------|
|                                                            |   |                                      |        |                   |        |              |   |                      |        |                    |         |                                      |   |  |  |   |  |  |   |
|                                                            |   | **(in thousands)**                   |   |
| **Workforce Reductions**                                        |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| Net2Phone Global Services                                       |   | $                                    | 288    |                   | $      | 137          |   | $                    | (417   | )                       | $       | 95                                   |   | $ | (103 | ) | $ | — |   |
| Corporate and Other                                             |   |                                 | 360    |                   |   | 26           |   |                 | (359   | )                       |    | 39                                   |   |   | (66 | ) |   | — |   |
|                                                            |   |                                      |        |                   |        |              |   |                      |        |                    |         |                                      |   |  |  |   |  |  |   |
| Total                                                           |   |                                 | 648    |                   |   | 163          |   |                 | (776   | )                       |    | 134                                  |   |   | (169) |   |   | — |   |
|                                                            |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| **Exit and Other Costs**                                        |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| Net2Phone Global Services                                       |   |                                 | 3,192  |                   |   | 1,168        |   |                 | (2,360 | )                       |    | (318                                 | )      |   | (258 | ) |   | 1,424 |   |
| Corporate and Other                                             |   |                                 | 152    |                   |   | 125          |   |                 | 23     |                    |    | (181                                 | )      |   | 8 |   |   | 127 |   |
|                                                            |   |                                      |        |                   |        |              |   |                      |        |                    |         |                                      |   |  |  |   |  |  |   |
| Total                                                           |   |                                 | 3,344  |                   |   | 1,293        |   |                 | (2,337 | )                       |    | (499                                 | )      |   | (250 | ) |   | 1,551 |   |
|                                                            |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| **Separation Agreements of Former CEO, CFO & COO**          |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| Net2Phone Global Services                                       |   |                                 | — |                   |   | —       |   |                 | — |                    |    | —                               |   |   | — |   |   | — |   |
| Corporate and Other                                             |   |                                 | 792    |                   |   | 1,244        |   |                 | (855   | )                       |    | (618                                 | )      |   | — |   |   | 563 |   |
|                                                            |   |                                      |        |                   |        |              |   |                      |        |                    |         |                                      |   |  |  |   |  |  |   |
| Total                                                           |   |                                 | 792    |                   |   | 1,244        |   |                 | (855   | )                       |    | (618                                 | )      |   | — |   |   | 563 |   |
|                                                            |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| **Impairment Charges and changes in Assets Held for Sale**      |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| Net2Phone Global Services                                       |   |                                 | — |                   |   | (89          | )      |                 | — |                    |    | 89                                   |   |   | — |   |   | — |   |
| Corporate and Other                                             |   |                                 | — |                   |   | —       |   |                 | — |                    |    | —                               |   |   | — |   |   | — |   |
|                                                            |   |                                      |        |                   |        |              |   |                      |        |                    |         |                                      |   |  |  |   |  |  |   |
| Total                                                           |   |                                 | — |                   |   | (89          | )      |                 | — |                    |    | (89                                  | )      |   | — |   |   | — |   |
|                                                            |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| **Total Restructuring, Severance, Impairment, and Other Items** |   |                                 |   |                   |   |         |   |                 |   |                    |    |                                 |   |   |   |   |   |   |   |
| Net2Phone Global Services                                       |   |                                 | 3,480  |                   |   | 1,216        |   |                 | (2,777 | )                       |    | (134                                 | )      |   | (361 | ) |   | 1,424 |   |
| Corporate and Other                                             |   |                                 | 1,304  |                   |   | 1,395        |   |                 | (1,191 | )                       |    | (760                                 | )      |   | (58 | ) |   | 690 |   |
|                                                            |   |                                      |        |                   |        |              |   |                      |        |                    |         |                                      |   |  |  |   |  |  |   |
| Total                                                           |   | $                                    | 4,784  |                   | $      | 2,611        |   | $                    | (3,968 | )                       |  $ | (894                                 | )      |  $ | (419 | ) | $ | 2,114 |   |
|                                                            |   |                                      |        |                   |        |              |   |                      |        |                    |         |                                      |   |  |  |   |  |  |   |

|                           |
|--------------------------------|
| **6. ADIR Technologies, Inc.** |

In the first quarter of fiscal 2001,    ADIR Technologies, Inc., our majority-owned subsidiary, issued 74,250 shares    of its Series A Preferred Stock to us in exchange for rights to certain software    and sold 13,277 of such shares to Cisco Systems, Softbank and IDT in a private    placement transaction for aggregate gross proceeds of approximately $23.2 million.    In addition, ADIR sold 18,525 shares of its common stock in fiscal 2001 to    employees of Net2Phone and ADIR in exchange for promissory notes of approximately    $3.2 million, which was below the $21.0 million aggregate value    of such shares. Accordingly, the discount of approximately $17.8 million    was amortized over the vesting period of such shares. We recorded compensation    expense of $6.7 million and $4.5 million in fiscal 2003 and fiscal    2002, respectively, as the amortization of this discount. The expense was    recorded as non-cash compensation expense in the accompanying statements    of operations.

In the fourth quarter of fiscal 2001, ADIR raised an additional $25.0 million in exchange for 9,905 shares of its Series B preferred stock from its previous investors, Cisco and Softbank, and, in the first quarter of fiscal 2002, ADIR raised an additional $21.0 million  from the sale of 8,319 shares of its Series B preferred

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

stock to Cisco, Softbank and us. With the exception of 1,750 shares of Series A preferred stock, all of the preferred shares held by Cisco and Softbank were transferred to us as part of the settlement of litigation in the first quarter of fiscal 2003.

On August 14, 2001, ADIR acquired all of the issued and outstanding capital stock of NetSpeak Corporation, or NetSpeak. Results of operations for NetSpeak have been included in the accompanying financial statements since August 14,    2001. The primary reason for the acquisition of NetSpeak was the belief that    its route server and associated software would allow ADIR to offer a broader  product base to its customers.

NetSpeak was a strategic partner    of Cisco Systems and Cisco was an important investor in and a strategic partner    of ADIR. ADIR bid against at least one other party for NetSpeak and the final    purchase price agreed upon was determined based upon the assets being received  and future revenue projections.

The total aggregate consideration paid for the acquisition was $48.1 million. The purchase price allocation was as follows:

| **(in thousands)**                  |   |   |    |   |
|-------------------------------------|--------|--------|---------|--------|
| Current assets                      |   | $      | 23,375  |   |
| Current liabilities                 |   |   | (3,567) |   |
| Property, plant and equipment       |   |   | 2,295   |   |
| Other assets                        |   |   | 802     |   |
| Development product technology      |   |   | 2,140   |   |
| In-process research and development |   |   | 13,850  |   |
| Goodwill                            |   |   | 9,189   |   |
|                                |   |        |         |   |
|                                |   | $      | 48,084  |   |
|                                |   |        |         |   |

See Note 4 for additional information regarding litigation with Cisco relating to ADIR and its impact on goodwill and intangible assets recorded in connection with the NetSpeak acquisition.

Purchased in-process research and development, or IPR&D,    represents the value assigned in a purchase business combination to research    and development projects of the acquired business that had commenced but    had not yet been completed at the date of acquisition and which have no alternative  future use. In accordance with SFAS No. 2, “Accounting for Research and Development Costs,” as clarified by FASB Interpretation No. 4, amounts assigned to IPR&D  meeting the above stated criteria must be charged to expense as part of the  allocation of the purchase price of the business combination. Accordingly,  charges totaling $13.9 million were recorded during fiscal 2002 as part of the allocation of the purchase price related to the acquisition of NetSpeak.

IPR&D relates primarily to advanced telephony software products for Internet protocol, or IP, networks. The valuation of the IPR&D    included both cost and income valuation approaches, and utilized replacement    cost and discounted cash flow methodologies for various aspects of the analysis.    The calculations were based on estimates of operating earnings, capital charges,    and working capital requirements to support the cash flows attributed to    the technologies. Discount rates reflecting the stage of development, complexity  and the risk associated with each technology were used to value IPR&D. Development of the major components of the IPR&D were completed during the second quarter of fiscal 2002. Effective February 14,  2002, further research and development was suspended while ADIR reevaluated  the product’s anticipated attractiveness relative to current market conditions. It was ultimately determined that the aspects of the IPR&D necessary to bolster the technological development of Net2Phone Cable Telephony’s  product offerings were in place and no further development related to the IPR&D would be initiated.

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

On July 31, 2003, we acquired    4,000 shares of ADIR’s Series A-1 preferred stock from IDT. As consideration    for the shares, we assigned to IDT our rights to a $1.0 million    note receivable from a third party. We had previously written off such note    receivable, but during recovery negotiations in the fourth quarter of fiscal  2003, we estimated a $0.1 million value to our claim. As a result of this  transaction, we recorded a capital contribution from IDT of approximately $4.5 million,  which equaled the excess of the recorded value of IDT’s minority interest  in ADIR over the $0.1 million value of the note receivable. Also, during  the fourth quarter of fiscal 2003, we transferred to ADIR $14.5 million  of the cash we received in the first quarter of fiscal 2003 from the settlement  of the Cisco litigation (see Note 4). This transfer was recorded as a capital  contribution from us to ADIR since we did not receive any additional shares  in ADIR. In addition, we recorded $2.4 million of minority interest expense,  which represents the portion of the $14.5 million capital contribution  that was allocated to the ADIR minority shareholders.

Also, in the fourth quarter of fiscal 2003, we recorded a decrease to minority interest expense of $7.0 million,    principally to reallocate prior year operating losses of ADIR between Net2Phone    and the ADIR minority shareholders. This decrease in minority interest expense    was partially offset by an adjustment to ADIR related deferred compensation  expense of $3.6 million.

In September 2003, we paid $0.5 million to acquire 1,750 shares of ADIR’s    Series A-1 preferred stock that was held by a group of investment funds.    The recorded value of the minority interest related to these 1,750 shares  on the date of this transaction was approximately $3.4 million. As a result, we recorded other income of approximately $2.9 million in the first quarter of fiscal 2004 representing the excess of the minority interest balance over the $0.5 million paid. With the acquisition of these preferred shares, Net2Phone owns all of the outstanding preferred stock of ADIR.

Also in September 2003, in consideration    for general releases from certain current and former employees of Net2Phone,    and the surrender by them of their shares of ADIR common stock, ADIR canceled    the promissory notes originally delivered by such employees. The principal    amount of the notes and all accrued interest equaled the book value of the    surrendered shares. Therefore, the notes and accrued interest receivable  of $3.5 million were written off against minority interest in the first  quarter of fiscal 2004. In addition, since all outstanding employee shares  were redeemed and all remaining options were forfeited, we wrote-off $3.8 million  in unamortized deferred compensation against minority interest in the first  quarter of fiscal 2004. Following this transaction, we became the sole shareholder  of ADIR. As a result, in addition to the aforementioned $2.9 million approximate gain from the acquisition of the remaining preferred shares during the first quarter of fiscal 2004, we recorded additional other income of approximately $9.3 million in the first quarter of fiscal2004, representing the remaining minority interest balance after all minority shareholder interests have been satisfied.

Pursuant to approvals of their respective boards of directors, both ADIR and NetSpeak have been liquidated; ADIR on June 30, 2004 and NetSpeak on July 31,    2004. As part of the liquidation of both companies, we, as the sole shareholder,    entered into an agreement with the Chief Executive Officer of ADIR and NetSpeak    pursuant to which he released all of his rights under his existing employment    agreement, agreed to a two year covenant against competition with us and    further agreed to provide consulting services to us with respect to the businesses    formerly conducted by ADIR and NetSpeak for a period of two years. In exchange,    we agreed that we would forgive outstanding loans from ADIR to the Chief  Executive Officer totaling $0.6 million over the period of his restrictive  covenant and consultation agreement. We did not record any charges during the  fourth quarter of fiscal 2004 related to this agreement, as the agreement was  executed at fiscal year end July 31, 2004. Charges associated with this  agreement will be recorded over the period of his restricted covenant and consultancy  period, beginning in the first fiscal quarter of 2005.

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

| **7. Aplio Acquisition** |
|--------------------------|

On July 7, 2000, we acquired    all of the outstanding capital stock of Aplio, S.A. (“Aplio”) a    company located in France with technology that enabled VoIP hardware devices    to provide our services. Consideration consisted of $2.9 million in    cash at closing and 582,749 shares of our redeemable common stock which were    valued at $35.50 per share and were redeemable at $36.947 per share, promissory    notes aggregating $6.5 million, $1.4 million in acquisition related    costs and $4.8 million    in cash to be paid within eighteen months of the closing of the transaction.  In addition, we were required to pay two contingent cash payments of $2.8 million  each on July 7, 2001 and July 7, 2002 and a third payment of $2.5 million  on July 7,  2003. As collateral for the first two contingent payments, the company placed  150,329 shares of its common stock in escrow. Certain of the selling shareholders  also were given the right to require us to repurchase their shares on various  dates prior to January 31, 2002.

The aggregate purchase price of $36.2 million plus the fair value of net liabilities assumed of $2.7 million totaled approximately $38.9 million which was allocated as follows: approximately $17.7 million to goodwill, $13.9 million to technology, $2.3 million  to trademarks, $4.5 million to patents and $0.5 million to workforce.

This acquisition was accounted for as a purchase, and accordingly, the net assets and results of operations of the acquired business have been included in the consolidated financial statements from July 7, 2000, the date of acquisition.

In the third quarter of fiscal 2001, we discontinued Aplio’s operations.

As of June 7, 2001, we entered    into a Settlement Agreement with certain former Aplio shareholders pursuant    to which we redeemed 116,549 shares for a total of $4.3 million, of    which $1.0 million was paid before July 31, 2001, and the balance    was paid in August 2001. On April 30, 2003, we had the option of redeeming    the remaining 294,046 shares of the Company’s stock owned by these same    shareholders for $10.9 million    or simply paying the excess, if any, of $36.947 per share over the market    value of the shares at that time. In exchange, these shareholders waived  their rights to receive $2.0 million held back by us at the closing to  secure certain indemnification obligations. As a result, we recorded $9.8 million  of redeemable stock as of July 31,  2002 based on the excess of $36.947 over the value of 294,046 shares of our  common stock on such date.

As of July 31, 2001, we entered    into Settlement Agreements with three other former shareholders of Aplio    pursuant to which we agreed to pay to such shareholders the aggregate sum    of $6.6 million in two installments on August 31, 2001 and January 8,  2002. In addition, we agreed to pay such shareholders on April 30, 2003  the aggregate sum of $8.3 million,  reduced by the market value at that time of the 291,279 shares (including the  150,329 shares released to such shareholders from escrow) of our stock owned  by such shareholders. In exchange, these shareholders waived their rights to  receive $1.0 million held back by the Company at the closing to secure  certain indemnification obligations. As a result, we had recorded a liability  of $7.6 million as of July 31, 2002 based on the excess of $8.3 million  over the value of 291,279 shares of the Company’s common stock on such  date.

Pursuant to these agreements, we were required to pay the shareholders $19.2 million, less the then current value of the 585,325 shares, on April 30, 2003. On May 7,    2003, as the result of several simultaneous transactions, our payment obligations  with respect to the shares were extended to May 1, 2006. The former Aplio shareholders transferred their 585,325 Company shares and assigned their rights under the 2001 settlement agreements to Deutsche Bank AG London in exchange for a payment of $19.2 million.  Simultaneously, we and Deutsche Bank amended and restated the settlement agreements  to provide for the extension of the payment obligation to May 1, 2006 and payment by us of annual interest of 3.5 percent on the unpaid balance during the period.

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

Under the amended and restated settlement agreements, on May 1, 2006, we are required to purchase from Deutsche Bank the 585,325 shares for a total price of $19.2 million. However, we also have, at our sole and exclusive option, the right to cause Deutsche Bank,on or before December 31, 2005, to commence selling the shares in regular market transactions during the period between January 2, 2006 and April 25, 2006. In the event we exercise this right, we will pay Deutsche Bank on May 1, 2006, only the excess of $19.2 million  over the amount, net of commissions, received by Deutsche Bank from the sales of the shares during this period. As a result, we recorded a long- term obligation of $19.2 million less the value of the 585,325 shares of Net2Phone common stock on May 7,  2003. As of July 31, 2004, the obligation was $17.3 million. We will continue to mark-to-market this obligation at each reporting period based on the value of Net2Phone’s common stock. This mark-to-market is included in income (loss) on equity investments and other expense.

Our payment obligations are secured by standby letters of credit from a U.S. commercial bank, which are, in turn, collateralized by $20.6 million of restricted marketable securities held by the bank. The letters of credit expire on August 4,    2006. Interest cost incurred and charged to expense related to this agreement  was approximately $0.7 million and $0.2 million for fiscal years 2004 and 2003, respectively.

| **8. Marketable Securities** |
|------------------------------|

Marketable securities consist of    U.S. Government Agency Obligations and commercial paper. We utilize a specific    identification process to determine the cost basis of securities sold and    amounts to be reclassified out of accumulated other comprehensive income  and into earnings.

The following is a summary of the marketable securities at July 31, 2004:

 

| **(in thousands)**                 |   | **Carrying Amount** |    | **Gross Unrealized Gains** |   | **Gross Unrealized Losses** |   | **Fair Value** |   |
|------------------------------------|--------|---------------------|---------|----------------------------|--------|-----------------------------|--------|----------------|--------|
|                                    |   |                     |         |                       |        |                             |   |                |        |   |  |  |   |
| U.S. Government Agency Obligations |   | $                   | 98,662  |                       | $      | 32                          |   | $              | (1,112 | ) | $ | 97,582 |   |
| Commercial paper                   |   |                | 1,556   |                       |   | 4                           |   |           | (17    | ) |   | 1,543 |   |
|                               |   |                     |         |                       |        |                             |   |                |        |   |  |  |   |
| Total                              |   | $                   | 100,218 |                       | $      | 36                          |   | $              | (1,129 | ) | $ | 99,125 |   |
|                               |   |                     |         |                       |        |                             |   |                |        |   |  |  |   |

The following is a summary of the marketable securities at July 31, 2003:

 

| **(in thousands)**                 |   | **Carrying Amount** |   | **Gross Unrealized Gains** |   | **Gross Unrealized Losses** |   | **Fair Value** |   |
|------------------------------------|--------|---------------------|--------|----------------------------|--------|-----------------------------|--------|----------------|--------|
|                                    |   |                     |        |                       |        |                             |   |                |        |   |  |  |   |
| U.S. Government Agency Obligations |   | $                   | 60,145 |                       | $      | 382                         |   | $              | (337   | ) | $ | 60,190 |   |
| Commercial paper                   |   |                | 364    |                       |   | —                      |   |           | — |   |   | 364 |   |
|                               |   |                     |        |                       |        |                             |   |                |        |   |  |  |   |
| Total                              |   | $                   | 60,509 |                       | $      | 382                         |   | $              | (337   | ) | $ | 60,554 |   |
|                               |   |                     |        |                       |        |                             |   |                |        |   |  |  |   |

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

| **9. Property and Equipment** |
|-------------------------------|

Property and equipment consists of the following:

 

|                                 |   | **July** **31,** |
|--------------------------------------|--------|-----------------------|
|                                 |   |                       |
| **(in            thousands)**        |   | **2004**              |   | **2003** |
|                                      |   |                       |  |   |  |  |   |
| Equipment                            |   | $                     | 20,122 |   | $ | 20,354 |   |
| Computer          software           |   |                  | 18,985 |   |   | 14,398 |   |
| Furniture and fixtures               |   |                  | 1,720 |   |   | 1,785 |   |
|                                 |   |                       |  |   |  |  |   |
|                                 |   |                  | 40,827 |   |   | 36,537 |   |
| Accumulated depreciation             |   |                  | (21,898 | ) |  | (12,365 | ) |
|                                 |   |                       |  |   |  |  |   |
| Property          and equipment, net |   | $                     | 18,929 |   | $ | 24,172 |   |
|                                 |   |                       |  |   |  |  |   |

Fixed assets under capital leases    aggregated $0.7 million and $1.9 million, respectively, at July 31,    2004 and at July 31, 2003. The accumulated amortization related to these    assets under capital leases was $0.7 million and $0.6 million at    July 31, 2004 and 2003, respectively. Amortization of assets recorded    under capital leases is included in depreciation and amortization expense    in the accompanying consolidated statements of operations.

Depreciation and amortization of fixed assets for the years ended July 31, 2004, 2003, and 2002 was approximately $10.2, $10.6 million, and $22.5 million respectively.

| **10. Investments** |
|---------------------|

During the fourth quarter of fiscal 2004 we sold our minority interest in eXact Advertising resulting in a gain of $0.8 million,    which is reflected in Income (loss) on equity investments and other expense,    net. The core assets that formed eXact Advertising were previously part of    our web-based, banner advertising business, a majority stake of which we  sold to former employees in fiscal 2002.

As a result of restructuring our    operations and eliminating various lines of development announced in the    third quarter of fiscal 2002, we wrote-off the value of several of our cost    method investments which were no longer deemed to be strategic to our business.    In addition, an other-than-temporary impairment charge was recorded with    respect to one of our cost method investments that we continue to reflect    on our Balance Sheet. The charge was recorded to reduce the carrying value    of the investment to fair value determined based on a recent third-party  financing completed by the investee. These charges totaled $6.9 million and are reflected in Income (loss) on equity investments and other expense, net in the statements of operations.

We have invested in minority holdings of several other technology companies. Such investments are recorded at cost and amounted to $1.4 and $1.5 million, respectively, at July 31, 2004 and at July 31, 2003.

| **11. Goodwill and Other Intangible Assets** |
|----------------------------------------------|

There were no changes in the carrying amount of goodwill of $1.7 million, which is attributable to our Net2Phone Global Services segment, net of accumulated amortization for the years ended July 31, 2004 and 2003.

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

The major components and average useful lives of our other acquired intangible assets follows:

|                  |   |                           |   | **July** **31, 2004** |   | **July** **31, 2003**   |   |
|-----------------------|--------|--------------------------------|--------|----------------------------|--------|------------------------------|--------|
|                  |   |                           |   |                            |   |                              |   |
| **($ in thousands)**  |   | **Amortization Period (mos.)** |   | **Gross Carrying Amount**  |   | **Accumulated Amortization** |   | **Net Carrying Amount** |   | **Gross Carrying Amount** |   | **Accumulated Amortization** |   | **Net Carrying Amount** |   |
|                       |   |                                |        |                       |        |                              |   |  |  |   |  |  |   |  |  |   |  |  |   |  |  |   |
| Technology            |   |                           | 35     |                       | $      | 160                          |   | $ | (123 | ) | $ | 37 |   |  $ | 160 |   | $ | (69 | ) | $ | 91 |   |
| Trademarks            |   |                           | 36     |                       |   | 1,387                        |   |   | (800 | ) |   | 587 |   |   | 1,380 |   |   | (523 | ) |   | 857 |   |
| Non-compete covenants |   |                           | 24-30  |                       |   | 800                          |   |   | (800 | ) |   | — |   |   | 800 |   |   | (588 | ) |   | 212 |   |
|                  |   |                                |        |                       |        |                              |   |  |  |   |  |  |   |  |  |   |  |  |   |  |  |   |
|                  |   |                           |   |                       | $      | 2,347                        |   | $ | (1,723 | ) | $ | 624 |   | $ | 2,340 |   | $ | (1,180 | ) | $ | 1,160 |   |
|                  |   |                           |   |                       |        |                         |        |   |  |   |  |   |  |   |  |   |

Intangible assets (other than goodwill and intangible assets with indefinite lives)are amortized on a straight-line basis. Intangible assets amortization expense for the years ended July 31, 2004, 2003, and2002 was $0.3 million $0.7 million, and $1.5 million,respectively. Intangible assets amortization expense isestimated to be $0.3 million in fiscal 2005, $0.3 million in fiscal 2006, $0.1 million in fiscal 2007. After fiscal2007, all intangible assets will be fully amortized.

| **12. Financial Instruments** |
|-------------------------------|

The carrying value of our financial    instruments, which include our investments (see Note 10), marketable securities    (see Note 8), and long-term obligations (see Note 7), approximates fair value.    It was not practicable to estimate the fair value of certain of our equity    investments because of the lack of quoted market prices and the inability    to estimate fair value without incurring excessive costs. The balance of  these investments at July 31, 2004 was $1.4 million and at July 31, 2003 was $1.5 million.  The fair value of financial instruments is generally determined by reference  to market values resulting from trading on a national securities exchange or  in an over-the-counter market. In cases where quoted market prices are not  available, fair value is based on estimates using present value or other valuation  techniques.

| **13. Leasing Arrangements** |
|------------------------------|

We lease certain facilities and equipment for use in our operations under both capital and operating leases.

The aggregate minimum rental commitments under non-cancelable leases for the periods shown at July 31, 2004, are as follows:

 

| **Fiscal Years Ending July** **31,**          |   | **Capital Leases** |   | **Operating Leases** |   |
|----------------------------------------------------|--------|--------------------|--------|----------------------|--------|
|                                                    |   |                    |        |                 |        |  |   |
|                                               |   | **(in thousands)** |   |
| 2005                                               |   | $                  | 129    |                 | $      | 3,035 |   |
| 2006                                               |   |               | — |                 |   | 2,673 |   |
| 2007                                               |   |               | — |                 |   | 2,488 |   |
| 2008                                               |   |               | — |                 |   | 2,128 |   |
| 2009                                               |   |               | — |                 |   | 1,544 |   |
| Thereafter                                         |   |               | — |                 |   | 1,074 |   |
|                                               |   |                    |        |                 |        |  |   |
| Total minimum rental commitments                   |   | $                  | 129    |                 | $      | 12,942 |   |
|                                               |   |               |   |                 |        |   |
| Less amounts due for interest                      |   |               | 2      |                 |   |   |   |
| Less current portion                               |   |               | 127    |                 |   |   |   |
|                                               |   |                    |   |                 |   |   |
| Capital lease obligations — long-term portion |   | $                  | — |                 |   |   |   |
|                                               |   |                    |   |                 |   |   |

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

Rent expense for the years ended July 31, 2004, 2003 and 2002 was $2.8 million, $3.4 million, and $8.2 million, respectively.

As of July 31, 2004, the aggregate minimum sublease rentals to be received in the future for operating subleases is $0.5 million.

| **14. Related Party Transactions** |
|------------------------------------|

Our strategic investors include IDT, a global telecommunications, media and technology company, and Liberty Media Corporation, a global media company. As of October 7,    2004, IDT and Liberty Media together own NTOP Holdings, L.L.C., which holds    an aggregate of 37.8 percent of our outstanding capital stock and 54.9 percent    of our aggregate voting power. IDT is currently the controlling member of    NTOP Holdings, through which it effectively controls us. In November of 2003,    we closed an underwritten common stock offering,through which, in addition  to the 11.5 million shares purchased by the public and our underwriters, 1.25 million shares were purchased by each of IDT and Liberty Media. Including the 1.25 million shares IDT purchased in the offering and an additional 0.3 million  shares of our common stock held directly by IDT, as of October 7, 2004, IDT controls 56.3 percent of our aggregate voting power. We have also entered into a Memorandum of Understanding with IDT which calls for us to issue an additional 6.9 million  shares of Class A common stock to IDT upon entering into a definitive telecommunications  services agreement with IDT. Assuming these 6.9 million shares are issued, IDT will control 61.4 percent of our aggregate voting power based on our outstanding stock on October 7, 2004.

     ***IDT Corporation***

We maintain significant business    relationships with IDT and its affiliates, and IDT maintains a controlling    ownership interest in us. Consequently, we interact with IDT and its affiliates    in several different areas and on several different levels. The following  summarizes our interactions with IDT and its affiliates:

 

|                                                                              |   | **Years ended July** **31,** |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                              |   |                                   |   |
| **(in thousands)**                                                                |   | **2004**                          |   | **2003** |   | **2002** |   |
|                                                                                   |   |                                   |        |   |  |  |   |  |  |   |
| Opening Balance                                                                   |   | $                                 | 1,057  |   | $ | (682 | ) | $ | 14,401 |   |
| Charges to IDT affiliate for purchases of disposable calling cards from Net2Phone |   |                              | (188   | ) |   | (6,399 | ) |   | (17,313 | ) |
| Charges to IDT for services provided by Net2Phone                                 |   |                              | (4,821 | ) |   | (7,871 | ) |   | (12,463 | ) |
| Charges to Net2Phone for services provided by IDT                                 |   |                              | 6,171  |   |   | 11,124 |   |   | 28,542 |   |
| Expenses paid by IDT on behalf of Net2Phone requiring Net2Phone remittance        |   |                              | 1,192  |   |   | 2,862 |   |   | 2,146 |   |
| Expenses paid by Net2Phone on behalf of IDT requiring IDT reimbursement           |   |                              | (698   | ) |   | (884 | ) |   | (3,661 | ) |
| Payments received from IDT                                                        |   |                              | 544    |   |   | 9,948 |   |   | 21,366 |   |
| Payments remitted to IDT                                                          |   |                              | (2,286 | ) |   | (7,041 | ) |   | (33,700 | ) |
|                                                                              |   |                                   |        |   |  |  |   |  |  |   |
| Ending Balance                                                                    |   | $                                 | 971    |   | $ | 1,057 |   | $ | (682 | ) |
|                                                                              |   |                                   |        |   |  |  |   |  |  |   |
| Average Balance Owed to IDT:                                                      |   | $                                 | 854    |   | $ | 1,112 |   | $ | 1,282 |   |
| Securities Purchases/Sales Settled through IDT:                                   |   | $                                 | 38,491 |   | $ | 10,124 |   | $ | — |   |

In fiscal 2004, fiscal 2003 and fiscal 2002 we provided carrier services to IDT of $4.9 million, $7.9 million and $12.5 million, respectively, and purchased wholesale carrier services from IDT of $4.5 million, $9.2 million and $24.5 million, respectively.

During the second quarter of fiscal 2004, we executed an agreement with Union Telecard Alliance, LLC (“UTA”), a subsidiary of IDT, which ended UTA’s distribution of Net2Phone disposable calling cards

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

effective December 31, 2003, and provided for an orderly wind-down over a two-year period of our disposable calling card business. This resulted in exit costs of $0.5 million    to compensate UTA for estimated obligations associated with the Net2Phone    disposable calling cards currently in the marketplace. These exit costs wererecorded in our consolidated statement of operations as “Restructuring, severance, impairment and other items” during the three months ended January 31,2004. Pursuant to the terms of our agreement with UTA, the parties will settlethe aforementioned obligations over a two-year period ending December 31, 2005, through monthly reconciliations of on-going wind down activities, with final settlement to be completed by February 15,2006. Consequently, sales of prepaid disposable calling cards to IDT affiliatesin fiscal 2004 were nominal, compared with sales of $6.4 million and $17.3 million recorded in fiscal 2003 and fiscal 2002, respectively.

Our corporate headquarters and several other facilities are leased from IDT. During fiscal 2004, fiscal 2003, and fiscal 2002 IDT charged us $1.9 million, $2.1 million and $4.1 million, respectively, in facilities lease fees. IDT’s    treasury function provides investment management services relating to our  portfolio of marketable securities. During fiscal 2004, $38.5 million in securities purchases and sales were settled through IDT, while during fiscal 2003, $10.1 million  in securities sales were settled through IDT. No such investment management  services were provided during fiscal 2002.

On occasion, we have aggregated long distance minutes and other services purchases with IDT.

We outsource some of our administrative    and support functions to IDT. These administrative functions include, but    are not limited to, tax consulting services, payroll services, and internal    audit support services. In most cases, fees for services are negotiated on    a cost recovery basis. In March 2004, we entered into an Intellectual Property    Legal Services Agreement with IDT, pursuant to which we will receive legal    services from IDT related to a wide variety of intellectual property matters,    including, but not limited to, patent and trademark prosecution and technology    protection and development. Based upon this agreement, we will pay IDT a    percentage of licensing fees we may receive related to specific technologies  as a result of IDT’s assistance in these matters, in addition to a $25,000  monthly fee for these services. The agreement has a two-year term, which can  be terminated with 30 days notice upon a material breach, or with 90 days notice  at the discretion of either party. In addition, we have entered into a Tax  Services Agreement pursuant to which we pay IDT $10,000 a month for tax services.  We are currently negotiating other service agreements with IDT. During fiscal  2004 and 2003 we incurred fees totalling $0.5 million and $0.1million  for all such services. No charges were incurred during fiscal 2002.

On occasion, we provide other services to IDT, based on the need for such administrative and support services. During fiscal 2004 and 2003, we charged IDT reimbursement fees for project support services totalling $0.3 million and $0.2 million,  respectively, for each fiscal year. No fees were charged during fiscal 2002.

On October 29, 2003, we entered into a binding memorandum of understanding (“MOU”) with IDT, which requires us to issue 6.9 million    shares of Class A common stock to IDT at the time we execute definitive telecommunications    services and related agreements with IDT. No definitive agreement has been  executed as of October 14, 2004. The parties’ efforts to establish detailed terms and conditions continue. Once issued, the shares will be held in escrow to secure IDT’s  performance obligations under the agreements and are to be released to IDT  in equal annual installments over five years, with the first release scheduled  for October 29, 2004 or the date definitive agreements are signed, whichever  is later. During the second quarter of fiscal 2004, IDT started providing us  with services and benefits under the terms of the MOU. The issuance of the  6.9 million shares is subject to variable accounting treatment and, therefore, the shares must be marked-to-market each quarter based on their current market value. Consequently, we recorded charges of $3.4 million  to non-cash services provided by IDT related to this agreement during fiscal  2004, which

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

represents the market value of 1.0 million shares that we may issue and subsequently release from escrow to IDT for services and benefits provided by IDT during the aforementioned periods.

We determined that non-cash services    provided by IDT are attributable to direct cost of revenue and selling, general    and administrative expense. However, given that the services provided by    IDT do not individually have readily identifiable market values, and that    the variable accounting treatment will result in different values being ascribed    to the same services from period to period, we believe differentiating between    direct cost of revenue and selling, general and administrative is not practicable.    Therefore we have classified the non-cash services provided by IDT in a separate    line in the consolidated statements of operations. In accordance with EITF  Topic D-90, *Grantor Balance Sheet Presentation of Unvested, Forfeitable  Equity Instruments Granted to a Non employee*, the 1.0 million shares  we may release from escrow for services received from IDT have been included  in the total number of Class A common stock shares reported as issued and outstanding  as of July 31, 2004, in our consolidated financial statements, although such shares have not yet been issued to IDT.

The MOU memorializes IDT’s agreement    to provide Net2Phone Cable Telephony, directly or through its subsidiaries,    with local and inter-exchange network access, termination, origination and    other related services, including sales and marketing assistance and an agreement    by IDT not to compete in the cable and broadband telephony market. IDT is    a competitive local exchange carrier and an inter-exchange carrier and its    network includes switching facilities in several U.S. cities and additional    points of presence in various countries,allowing us to co-locate our equipment  and interconnect to IDT’s network at those points. On May 12, 2004,  IDT announced its intention to reorganize its Winstar/IDT Solutions affiliate,  and we are  examining the impact of this reorganization as we continue to negotiate definitive  agreements.

|      ***Liberty Media Corporation*** |
|---------------------------------------------------------------|

On October 22, 2003, one of our wholly owned subsidiaries, Net2Phone Cable Telephony, LLC (“NCT”) and Liberty Cablevision of Puerto Rico, Inc. (“LCV”),    an affiliate of Liberty Media Corporation, executed a Cable Telephony Production    Agreement. According to the terms of this agreement, NCT is to provide cable  telephony services to LCV’s customers, and NCT will act as LCV’s  agent in requisitioning, configuring, staging and installing all infrastructure  and technology components that would facilitate these telecommunication services.  We recorded $1.4 million in revenue from LCV during the third quarter of fiscal 2004 of which $1.3 million reflects infrastructure and related technology components installed during the quarter that are necessary for LCV to broadly distribute our services.

|      ***Agreements with Officers*** |
|--------------------------------------------------------------|

Pursuant to Stephen M. Greenberg’s, our Chief Executive Officer (“CEO”) employment agreement, dated July 31,    2000, to help defray the tax expense of a grant of 50,000 shares of restricted    stock, we loaned him an amount necessary to pay such taxes. We granted the    CEO a loan for $600,000 in September 2000, with a term of three years and    an interest rate equal to the applicable short-term federal rate. Repayment    would be accelerated if the CEO sold any of his 50,000 shares of restricted    stock or upon the termination of his Employment Agreement. The CEO repaid  this loan in full, plus interest, in the first quarter of fiscal 2004.

In April 2002, we loaned the sum of $3.6 million to our CEO. The loan bears interest at a market rate and principal and interest are due on April 9, 2005 (“Maturity Date”).    The loan is non-recourse to the CEO and is secured by options to purchase    300,000 shares of our common stock granted to the CEO in April 2002. Under    certain circumstances, the Board of Directors may request the CEO to exercise    sufficient options and sell sufficient stock to pay the unpaid balance of  the loan. In addition, the Board may request that the CEO

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

not sell the stock, which will result    in the unpaid loan and interest balance being reduced based upon a formula    set forth in the loan agreement. On the Maturity Date, the CEO will have    to return to us all or a portion of the unexercised options and/or shares    of unsold stock and his unpaid loan and accrued interest balance will bereduced based upon a formula set forth in the loan agreement.

Due to the uncertainty surrounding    the number of options the CEO will ultimately receive, we are accounting    for the options using a variable accounting model until the options are exercised    or returned to us. Furthermore, due to the non-recourse nature of the loan,  we are recording compensation expense for the $3.6 million principal amount  of the note over its three-year maturity period. However, total compensation  expense will be calculated at each reporting date as the greater of the compensation  expense resulting from (i) variable accounting treatment of the options, or  (ii) amortizing the $3.6 million loan balance over the maturity period of the loan.

We recorded compensation expense of $1.2 million in fiscal 2004 and 2003 and $0.3 million in fiscal 2002, relating to this loan.

Pursuant to an employment agreement    with our former General Counsel dated January 8, 2001, we guaranteed    that the value (as defined in the agreement) of 150,000 options to purchase    our common stock held by our then General Counsel would be at least $1.6 million    on January 7, 2004. To the extent the value of such options was less    than $1.6 million, we would pay our then General Counsel the difference    in cash. On January 7, 2004, the value of the 150,000 options was $0.7 million.  As required by the agreement, we paid $0.9 million to our then General  Counsel at that time. We had amortized the $1.6 million  guaranteed option value over the three-year term of the agreement, less the  intrinsic value of the stock options as of each fiscal quarter end. Due to  the higher stock price on January 7, 2004 as compared to July 31,  2003, we reversed $0.2 million of previously recorded non-cash compensation  expense as a result of this agreement. During fiscal 2003, we recorded non-cash  compensation expense of $0.5 million related to this agreement.

| **15. Stock Compensation** |
|----------------------------|

     ***Options***

In April 1999, we adopted a stock option and incentive plan, as amended (the “Plan”).    Pursuant to the Plan, our officers, employees and non-employee directors,    as well as those of IDT, are eligible to receive awards of incentives and    non-qualified stock options, stock appreciation rights, limited stock appreciation    rights and restricted stock. There are currently 18,940,000 shares of common    stock authorized for issuance under the plan. The compensation committee    of our board of directors is responsible for determining the type of award,when    and to whom awards are granted, the number of shares and terms of the awards    and the exercise price. The options are exercisable for a period not to exceed    ten years from the date of the grant, unless otherwise approved by the committee.  Vesting periods range from immediate to four years.

In the fourth quarter of fiscal 1999,    we granted options to purchase 8,821,500 shares of common stock at exercise    prices ranging from $3.33 to $15.00 per share to our employees and employees    of IDT. The options generally vest over periods up to four years and expire    ten years from the date of grant. In connection with the exercise of such  options, we extended $3.1 million of recourse loans to employees. In order to obtain the loans, optionees agreed to the cancellation of 23,382 outstanding options.

For the years ended 2003 and 2002, we recorded non-cash compensation expense of $6.3 million and $13.7 million, respectively, from the issuance of stock options. In 2004, we reversed $5.1 million    of previously recorded non-cash compensation expense. All our non-cash compensation  is attributable to general and administrative expense.

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

Based on our stock price at July 31, 2004, there was no deferred compensation relating to the issuance of stock options.

A summary of stock option activity under our stock option plan is as follows:

 

|                              |   | **Shares** |               | **Weighted Average Exercise Price** |   |
|-----------------------------------|--------|------------|--------------------|-------------------------------------|--------|
|                              |   |            |                    |                                |        |  |   |
|                              |   |       | **(in thousands)** |                                |   |   |   |
| Outstanding at July 31, 2001 |   |       | 12,133             |                                |   |   |   |
| Granted                           |   |       | 9,297              |                                |   | $ 4.20 |   |
| Exercised                         |   |       | (1,113             | )                                   |   | 0.51 |   |
| Cancelled                         |   |       | (4,546             | )                                   |   | 17.78 |   |
| Forfeited                         |   |       | (5,452             | )                                   |   | 19.99 |   |
|                              |   |            |               |                                |   |   |
| Outstanding at July 31, 2002 |   |       | 10,319             |                                |   |   |   |
| Granted                           |   |       | 1,055              |                                |   | 3.30 |   |
| Exercised                         |   |       | (393)              |                                |   | 2.85 |   |
| Cancelled                         |   |       | (181)              |                                |   | 6.47 |   |
| Forfeited                         |   |       | (447)              |                                |   | 12.58 |   |
|                              |   |            |               |                                |   |   |
| Outstanding at July 31, 2003 |   |       | 10,353             |                                |   |   |   |
| Granted                           |   |       | 974                |                                |   | 5.73 |   |
| Exercised                         |   |       | (1,270             | )                                   |   | 4.18 |   |
| Cancelled                         |   |       | (66                | )                                   |   | 5.56 |   |
| Forfeited                         |   |       | (262               | )                                   |   | 10.58 |   |
|                              |   |            |               |                                |   |   |
| Outstanding at July 31, 2004 |   |       | 9,729              |                                |   |   |   |
|                              |   |            |               |                                |   |   |

The following table summarizes the status of the stock options outstanding and exercisable at July 31, 2004:

 

|                         |   | **Stock Options Outstanding** |   | **Stock Options Exercisable**           |   |
|------------------------------|--------|-------------------------------|--------|-----------------------------------------|--------|
|                         |   |                               |   |                                         |   |
| **Range of Exercise Prices** |   | **Number of Options**         |   | **Weighted Remaining Contractual Life** |   | **Weighted Average Exercise Price** |   | **Number of Options** |   | **Weighted Average Exercise Price** |   |
|                         |   |                               |        |                                    |        |  |   |  |  |   |  |  |   |  |  |   |
|                         |   | **(in thousands)**            |   | **(in years)**                          |   |   |   | **(in thousands)** |   |   |   |   |
| $2.25 — 3.33            |   |                          | 1,379  |                                    |   | 5.3 |   | $ | 3.22 |   |   | 1,245 |   | $ | 3.28 |   |
| $3.43 — 5.08            |   |                          | 5,966  |                                    |   | 6.2 |   |   | 4.12 |   |   | 5,428 |   |   | 4.13 |   |
| $5.25 — 7.37            |   |                          | 2,184  |                                    |   | 7.1 |   |   | 6.39 |   |   | 1,343 |   |   | 6.80 |   |
| $10.69 — 15.00          |   |                          | 114    |                                    |   | 5.1 |   |   | 14.62 |   |   | 114 |   |   | 14.62 |   |
| $16.75 — 25.00          |   |                          | 18     |                                    |   | 6.2 |   |   | 16.99 |   |   | 17 |   |   | 16.99 |   |
| $35.00 — 48.50          |   |                          | 68     |                                    |   | 5.5 |   |   | 42.82 |   |   | 68 |   |   | 42.82 |   |
|                         |   |                               |   |                                    |   |   |   |   |   |  |   |   |   |   |
|                         |   |                          | 9,729  |                                    |   |   |   |   |   |   |   | 8,215 |   |   |   |   |
|                         |   |                               |   |                                    |   |   |   |   |   |  |   |   |   |   |

     ***Option Repricing***

On December 18, 2001, the Board of Directors approved the repricing of options to purchase 6,373,863 shares of our common stock granted on or before December 18,    2001. The exercise price per share of the repriced options ranged from $3.50    per share to $7.00 per share. The repriced options are subject to variable    accounting treatment and, therefore, the repriced options, which are vested    and unexercised, must be marked-to-market each quarter. Based on our stock  price at July 31, 2004, we reversed $5.3 million of

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

previously recognized non-cash compensation expense related to these repriced options for the twelve months ended July 31, 2004. For the twelve months ended July 31, 2003 we recorded $4.9 million,    of non-cash compensation expense relating repriced options. As our share    price changes from period to period, we will record market adjustments related    to these price variations over the vesting period, until these options areexercised.

     ***Incentive Stock Compensation***

On September 20, 2004, the compensation committee of our board of directors approved a compensation program for fiscal 2004, that includes granting $1.25 million of Net2Phone’s    common stock to employees as a component of the fiscal 2004 bonus programs.  On October 9, 2003, the compensation committee of our board of directors approved a compensation program that included granting approximately $1.0 million of Net2Phone’s  common stock to employees as a component of the fiscal 2003 bonus program.  Fiscal 2003 bonus shares were issued on January 2, 2004 and were reflected in non-cash compensation expense for fiscal 2003. We expect to issue fiscal 2004 bonus shares in October 2004. The corresponding cost of these shares, have been recorded in non-cash compensation expense for fiscal 2004.

     ***Restricted Stock Grants***

During fiscal 2004 we granted 279,881    restricted shares of Net2Phone common stock to officers, directors, employees    and a consultant under our Plan. In general, the restricted shares vest equally    over the four years following the date of grant. Total non-cash compensation  relating to restricted shares granted was $0.4 million for fiscal 2004. No similar compensation expense had been incurred prior to fiscal 2004. Deferred compensation related to these restricted stock grants totaled $1.2 million as of July 31,2004.  Of the total restricted shares granted during fiscal 2004, 28,908 shares have  been issued and are outstanding as of July 31, 2004. The weighted average price of grants issued during fiscal 2004 is $5.56.

| **17. Charitable Contributions** |
|----------------------------------|

On December 31, 2001, Net2Phone    transferred 600,000 shares of its common stock to the Net2Phone Charitable    Foundation Philanthropic Fund established under the auspices of the Jewish    Community Foundation of MetroWest. The fair value of the shares contributed  was approximately $3.0 million and is reflected as a general and administrative expense for the year ended July 31, 2002. The shares were transferred to the Net2Phone Charitable Foundation, Inc., a New Jersey not-for-profit corporation that, on February 13,  2002, was determined by the Internal Revenue Service to be a 501(c)(3) organization.  The shares were used as collateral to support non-interest bearing loans of  $0.4 million from Net2Phone and $1.0 million from IDT Corporation.  The proceeds of the loans were used to provide liquidity to the Foundation  for purposes of matching charitable gifts contributed by employees of Net2Phone  in accordance with a matching charitable gift program approved by the Board  of Directors of Net2Phone in March 2001. Certain executives of Net2Phone are  also trustees and officers of the Foundation. In the third quarter of fiscal  2004, the Foundation sold the 600,000 shares of Net2Phone common stock for  net proceeds of $3.9 million. The Foundation used these proceeds to repay  its loan obligations to Net2Phone and IDT, and will use the remaining proceeds  to continue to match charitable gifts in accordance with the Net2Phone matching  charitable gift program.

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

| **18. Other Comprehensive Income** |
|------------------------------------|

The accumulated balances for each classification of other comprehensive income (loss) consists of the following:

|                          |   | **Unrealized gain (loss) on available for sale securities** |   | **Foreign Currency Translation** |   | **Accumulated other comprehensive income (loss)** |   |
|-------------------------------|--------|-------------------------------------------------------------|--------|----------------------------------|--------|---------------------------------------------------|--------|
|                          |   |                                                             |        |                             |        |                                                   |   |  |  |   |
|                          |   | **(in thousands)**                                          |   |
| Balance at July 31, 2002 |   | $                                                           | — |                             | $      | 240                                               |   | $ | 240 |   |
| Change during period          |   |                                                        | 45     |                             |   | (59                                               | )      |   | (14) |   |
|                          |   |                                                             |        |                             |        |                                                   |   |  |  |   |
| Balance at July 31, 2003 |   | $                                                           | 45     |                             | $      | 181                                               |   | $ | 226 |   |
| Change during period          |   |                                                        | (1,138 | )                                |   | (50                                               | )      |   | (1,188) |   |
|                          |   |                                                             |        |                             |        |                                                   |   |  |  |   |
| Balance at July 31, 2004 |   | $                                                           | (1,093 | )                                | $      | 131                                               |   | $ | (962) |   |
|                          |   |                                                             |        |                             |        |                                                   |   |  |  |   |

|                |
|---------------------|
| **19. 401(k) Plan** |

In October 1999, we established a    401(k) Plan which permits employees to make contributions to the plan on    a pre-tax salary reduction basis in accordance with the Internal Revenue    Code. All full-time employees 21 years old or over are eligible to participate    in the plan after completing three months of service. Eligible employees    may contribute up to 15% of their annual compensation, subject to IRS limitations.  Prior to January 2002, we matched a discretionary amount of the employees’ contributions  in cash. Beginning January 1,2002, we match a discretionary amount of  the employees’ contributions in our common shares. As of July 31,  2004, we have contributed 150,186 shares of common stock to the matching plan.  We provided no cash contributions for the years ended July 31, 2004 and  2003, and approximately $0.8 million for the year ended July 31,  2002, and bore the administrative cost of the Plan. During fiscal 2004 and  2003 we recorded $0.5 million and $0.8 million,  respectively, in non-cash compensation expense related to matching contributions  in our common shares.

| **20. Income Taxes** |
|----------------------|

Significant components of our deferred tax assets and liabilities consists of the following:

 

|                                               |   | **July** **31,** |     |
|----------------------------------------------------|--------|-----------------------|----------|
|                                               |   |                       |     |
|                                               |   | **2004**              |     | **2003** |   |
|                                               |   |                       |          |   |  |  |   |
|                                               |   | **(in thousands)**    |     |
| Deferred tax assets:                               |   |                  |     |   |   |   |   |
| Net operating loss carry-forward                   |   | $                     | 211,506  |   | $ | 196,995 |   |
| Compensation charge from issuance of stock options |   |                  | 10,485   |   |   | 14,033 |   |
| Restructuring costs                                |   |                  | 15,831   |   |   | 39,018 |   |
| Contribution carryover                             |   |                  | 1,345    |   |   | 1,336 |   |
| Deferred tax liabilities:                          |   |                  |     |   |   |   |   |
| Depreciation                                       |   |                  | (15,418  | ) |   | (14,524 | ) |
| Other                                              |   |                  | (304     | ) |   | (92 | ) |
| Unrealized gain on investments                     |   |                  | —   |   |   | (17,334 | ) |
|                                               |   |                       |          |   |  |  |   |
| Net deferred tax asset                             |   | $                     | 223,445  |   | $ | 219,432 |   |
| Valuation allowance                                |   |                  | (223,445 | ) |   | (219,432 | ) |
|                                               |   |                       |          |   |  |  |   |
| Total deferred tax assets                          |   | $                     | —   |   | $ | — |   |
|                                               |   |                       |          |   |  |  |   |

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

The net deferred tax assets have been fully offset by a valuation allowance due to the uncertainty of the realization of the assets.

At July 31, 2004, we had net operating loss carry-forwards for federal income tax purposes of approximately $515.9 million    expiring in years through 2024. These net operating loss carry-forwards may    be limited by both the future taxable earnings of our company and limitations  imposed by Internal Revenue Code Section 382.

 

|                                    |   | **Year ended July** **31,** |   |
|-----------------------------------------|--------|----------------------------------|--------|
|                                    |   |                                  |   |
| **(in thousands)**                      |   | **2004**                         |   | **2003** |   | **2002** |   |
|                                         |   |                                  |        |   |  |  |   |  |  |   |
| Tax at effective rate                   |   | $                                | (3,909 | ) | $ | 5,878 |   | $ | (86,712) |   |
| Non-deductible expenses                 |   |                             | 25     |   |   | 5 |   |   | 21,916 |   |
| Losses for which no benefit is provided |   |                             | 3,884  |   |   | (5,883 | ) |   | 64,796 |   |
|                                    |   |                                  |        |   |  |  |   |  |  |   |
| Tax Provision                           |   | $                                | — |   | $ | — |   | $ | — |   |
|                                    |   |                                  |        |   |  |  |   |  |  |   |

|                                 |
|--------------------------------------|
| **21. Business Segment Information** |

In June 2003, we implemented a change    in our corporate structure. We created two wholly-owned operating subsidiaries.    We began presenting segment reporting of the results of these subsidiaries    in fiscal 2003, as their structures were completed in the fourth quarter  of fiscal 2002.

Operating results presented for our business segments are as follows:

| **(in thousands)**            |   | **NGS**            |    | **NCT** |   | **Corporate & Other** |   | **Total** |    |
|-------------------------------|--------|--------------------|---------|---------|--------|---------------------------|--------|-----------|---------|
|                               |   |                    |         |    |        |                           |   |           |         |   |  |  |   |
|                          |   | **(in thousands)** |    |
| **2004**                      |   |               |    |    |   |                      |   |      |    |   |   |   |   |
| Revenue total                 |   | $                  | 81,137  |    | $      | 1,551                     |   | $         | 91      |   | $ | 82,779 |   |
|                          |   |                    |         |    |        |                           |   |           |         |   |  |  |   |
| US based                      |   |               | 35,689  |    |   | 1,551                     |   |      | 91      |   |   | 37,331 |   |
| Foreign based                 |   |               | 45,448  |    |   | —                    |   |      | —  |   |   | 45,448 |   |
|                          |   |               |    |    |   |                      |   |      |    |   |   |   |   |
| Segment income (loss)         |   |               | 5,161   |    |   | (9,306                    | )      |      | (7,928  | ) |   | (12,073) |   |
| Depreciation and amortization |   |               | 7,747   |    |   | 1,126                     |   |      | 1,657   |   |   | 10,530 |   |
| Capital expenditures          |   |               | 3,038   |    |   | 2,481                     |   |      | 20      |   |   | 5,539 |   |
| Total assets                  |   |               | 30,090  |    |   | 8,607                     |   |      | 126,560 |   |   | 165,257 |   |
|                          |   |               |    |    |   |                      |   |      |    |   |   |   |   |
| **2003**                      |   |               |    |    |   |                      |   |      |    |   |   |   |   |
| Revenue total                 |   | $                  | 91,131  |    | $      | 33                        |   | $         | 586     |   | $ | 91,750 |   |
|                          |   |                    |         |    |        |                           |   |           |         |   |  |  |   |
| US based                      |   |               | 45,473  |    |   | 33                        |   |      | 586     |   |   | 46,092 |   |
| Foreign based                 |   |               | 45,658  |    |   | —                    |   |      | —  |   |   | 45,658 |   |
|                          |   |               |    |    |   |                      |   |      |    |   |   |   |   |
| Segment income (loss)         |   |               | 1,833   |    |   | (7,202                    | )      |      | (7,700  | ) |   | (13,069) |   |
| Depreciation and amortization |   |               | 9,051   |    |   | 335                       |   |      | 1,651   |   |   | 11,037 |   |
| Capital expenditures          |   |               | 4,044   |    |   | 2,345                     |   |      | 679     |   |   | 7,068 |   |
| Total assets                  |   |               | 38,995  |    |   | 13,445                    |   |      | 92,206  |   |   | 144,646 |   |
|                          |   |               |    |    |   |                      |   |      |    |   |   |   |   |
| **2002**                      |   |               |    |    |   |                      |   |      |    |   |   |   |   |
| Revenue total                 |   | $                  | 133,016 |    | $      | 35                        |   | $         | 4,834   |   | $ | 137,885 |   |
|                          |   |                    |         |    |        |                           |   |           |         |   |  |  |   |
| US based                      |   |               | 71,719  |    |   | 35                        |   |      | 4,083   |   |   | 75,837 |   |
| Foreign based                 |   |               | 61,297  |    |   | —                    |   |      | 751     |   |   | 62,048 |   |
|                          |   |               |    |    |   |                      |   |      |    |   |   |   |   |
| Segment loss                  |   |               | (20,604 | )       |   | (5,950                    | )      |      | (24,890 | ) |   | (51,444) |   |
| Depreciation and amortization |   |               | 17,752  |    |   | 111                       |   |      | 6,117   |   |   | 23,980 |   |
| Capital expenditures          |   |               | 14,418  |    |   | 601                       |   |      | 2,833   |   |   | 17,852 |   |
| Total assets                  |   |               | 49,644  |    |   | 15,089                    |   |      | 118,672 |   |   | 183,405 |   |

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

One of our operating subsidiaries,    Net2Phone Global Services (NGS), includes our International Channel Sales    and U.S. Consumer Division, formerly our Domestic Retail Services unit, and    also our carrier services group. No single customer contributed 10 percent    or more to NGS revenue during fiscal 2004. During fiscal 2003 and fiscal    2002, IDT and its affiliates accounted for 18.3 percent and 31.3 percent  of total revenue, respectively.

Our second subsidiary, Net2Phone    Cable Telephony (NCT), includes all employees dedicated to providing cable    and broadband telephony solutions to cable services and broadband operators.    Almost all of NCT’s revenue during fiscal 2004 was generated by Liberty    Cablevision of Puerto Rico, Inc., an affiliate of Liberty Media Corporation.

Our Corporate and Other subsidiary    includes all of our administrative departments, such as our executive, legal,    finance, human resources and facilities departments, as well as the results    of our ADIR Technologies, Inc. subsidiary. None of our subsidiaries maintain    significant assets in foreign countries. The operating results of our business    segments are distinguishable and are regularly reviewed by senior executive    management. We evaluate the performance of our business segments based primarily    on segment income (loss) and capital expenditures. Segment income (loss)    excludes from net income (loss), depreciation and amortization, minority    interests,    other income, interest income, non-cash compensation, non-cash services provided  by IDT, gain from litigation, acquired in-process R&D, redeembable common  stock accretion, inventory obsolescence expense, restructuring, severance,  impairment and other items, and non-recurring selling, general and administrative  expenses. Management, in allocating resources and making other daily operating  decisions, excludes these items in evaluating segment performance. Portions  of corporate expenses are allocated to the business segments based on relative  headcount and attributed value-added.

     ***Reconciliation to Consolidated Financial Information***

A reconciliation of segment loss to consolidated net income (loss) as reported is as follows:

 

|                                       |   | **Years ended July** **31,** |    |
|--------------------------------------------|--------|-----------------------------------|---------|
|                                       |   |                                   |    |
|                                       |   | **2004**                          |    | **2003** |   | **2002** |   |
|                                       |   |                                   |         |   |  |  |   |  |  |   |
|                                       |   | **(in thousands)**                |    |
| Segment loss, reportable segments          |   | $                                 | (12,073 | ) | $ | (13,069 | ) | $ | (51,444 | ) |
| Add/(Deduct):                              |   |                              |    |   |   |   |   |   |   |   |
| Depreciation and amortization              |   |                              | (10,530 | ) |   | (11,037 | ) |   | (23,980 | ) |
| Inventory obsolescence expense             |   |                              | (556    | ) |   | — |   |   | (2,772 | ) |
| Charitable contribution                    |   |                              | —  |   |   | — |   |   | (3,001 | ) |
| Other SG&A expense                     |   |                              | 168     |   |   | (481 | ) |   | — |   |
| Forgiveness of former executive loan       |   |                              | —  |   |   | (1,248 | ) |   | — |   |
| Gain on settlement of Cisco litigation     |   |                              | —  |   |   | 58,034 |   |   | (1,572 | ) |
| Restructuring and other charges            |   |                              | (2,192  | ) |   | (7,363 | ) |   | (141,619 | ) |
| Acquired in-process R&D                |   |                              | —  |   |   | — |   |   | (13,850 | ) |
| Non-cash compensation expense              |   |                              | 3,168   |   |   | (15,304 | ) |   | (19,556 | ) |
| Non-cash services                          |   |                              | (3,369  | ) |   | — |   |   | — |   |
| Interest income, net                       |   |                              | 1,981   |   |   | 2,021 |   |   | 4,162 |   |
| Other income/(loss), net                   |   |                              | 12,235  |   |   | 696 |   |   | (7,887 | ) |
| Minority interest                          |   |                              | —  |   |   | 4,546 |   |   | 15,591 |   |
| Redeemable common stock accretion          |   |                              | —  |   |   | — |   |   | (133 | ) |
|                                       |   |                                   |         |   |  |  |   |  |  |   |
| Consolidated net income (loss) as reported |   | $                                 | (11,168 | ) | $ | 16,795 |   | $ | (246,061 | ) |
|                                       |   |                                   |         |   |  |  |   |  |  |   |

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

| **22. Customer and Geographical Area** |
|----------------------------------------|

Revenue from customers outside the United States represented approximately 55 percent, 50 percent, and 45 percent of total revenue during the years ended July 31,    2004, 2003, and 2002, respectively. More than 10 percent of total revenue    was derived from customers in the Middle East during fiscal 2004 and fiscal    2003. No single geographic area outside of the United States accounted for  more than 10 percent of total revenue during fiscal 2002.

| **23. Legal Proceedings** |
|---------------------------|

     ***Multi-Tech***

On February 15, 2000, Multi-Tech Systems, Inc. filed suit against Net2Phone and other companies in the United States Federal District Court in Minneapolis, Minnesota. Multi-Tech alleged “the    defendant companies are infringing because they are providing the end users    with the software necessary to simultaneously transmit voice and data on  their computers in the form of making a phone call over the Internet”. On August 16,  2002, following an initial hearing, the Court issued an order construing the  claims of all the patents in suit in a way that we consider favorable to our  non-infringement defenses. On October 31, 2002, the Court entered a consent judgment dismissing the patent infringement claims asserted by Multi-Tech Systems, Inc. On November 19,  2002, Multi-Tech filed an appeal with the United States Court of Appeals for  the Federal Circuit. On February 3, 2004, the Court of Appeals for the Federal Circuit affirmed the decision of the District Court in our favor. On February 16,  2004, Multi-Tech filed a Petition for a Rehearing of this decision with the  Court of Appeals, which was denied on March 31, 2004. Subsequently, Multi-Tech filed a Petition for Writ of Certiorari with the United States Supreme Court, which was denied on October 4,  2004. As Multi-Tech has exhausted all avenues of appeal, we consider this matter  closed.

     ***Class-Actions***

Four substantially similar class-action lawsuits were filed in the United States District Court for the Southern District of New York on behalf of all persons who acquired our stock between July 29, 1999 and December 6,    2000. Net2Phone, certain of our executive officers, directors and underwriters    involved in our initial public offering were named as defendants in these    complaints. The complaints allege, in part, that certain underwriters of    our initial public offering violated federal securities laws by failing to    disclose that they had solicited and received undisclosed commissions and    allocated shares in our initial public offering to those investors in exchange    for their agreement to purchase our shares in the after-market at pre-determined    prices. The complaints also allege that, whether or not Net2Phoneand the  named executives were aware of the underwriters’ arrangements, Net2Phone  and the named executives have statutory liability under the federal securities  laws for issuing a registration statement in connection with our initial public  offering that failed to disclose that these allegedly undisclosed arrangements  existed. The suits against us are substantially the same as suits asserting  the same allegations that have been filed against several hundred other companies  that closed their initial public offerings at or about the same time that we  did.We have been able to secure the voluntary dismissal of the claims against  those executive officers and directors named in the lawsuits. In addition,  we have entered into a settlement agreement along with the majority of the  other issuer defendants. The settlement agreement is subject to the court’s approval. Under the terms of the proposed settlement agreement, we are not conceding any liability and we will not bear any expenses associated with the settlement, other than legal fees we may incur.

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**Net2Phone, Inc.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)****July 31, 2004**

 

| **24. Commitments and Contingencies** |
|---------------------------------------|

     ***Letters of Credit***

As of July 31, 2004, we had letters of credit outstanding totaling $21.2 million, of which $0.2 million    expires during fiscal 2005 and the remainder will expire in 2006 through    2010. The letters of credit primarily relate to payments we are required  to make as a result of the Deutsche Bank agreement (See Note 7).

     ***Purchase Commitments***

We have entered into purchase commitments of approximately $1.0 million as of July 31, 2004, primarily related to our product sales. The term of commitment is less than one year for all purchase commitments.

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**Net2Phone, Inc.****SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS****For the Years Ended July 31, 2004, 2003 and 2002**

|                                            |   | **Balance at****Beginning****of Period** |   | **Charged to****Expenses** |   | **Deductions****(Note (a))** |   | **Balance at****End of Period** |   |
|-------------------------------------------------|--------|------------------------------------------|--------|----------------------------|--------|------------------------------|--------|---------------------------------|--------|
|                                            |   |                                          |   |                            |   |                              |   |                                 |   |
|                                            |   | **(in thousands)**                       |   |
| Allowance For UncollectibleAccounts Receivable: |   |                                     |   |                       |   |                         |   |                            |   |   |   |   |   |
|                                            |   |                                     |   |                       |   |                         |   |                            |   |   |   |   |   |
| Fiscal 2004                                     |   | $                                        | 581    |                       | $      | 28                           |   | $                               | (245   | ) | $ | 364 |   |
| Fiscal 2003                                     |   |                                     | 507    |                       |   | 272                          |   |                            | (198   | ) |   | 581 |   |
| Fiscal 2002                                     |   |                                     | 1,900  |                       |   | 2,260                        |   |                            | (3,653 | ) |   | 507 |   |
|                                            |   |                                     |   |                       |   |                         |   |                            |   |   |   |   |   |

|  |   |
|--|--------|

| (a) Amounts written off as uncollectible. |
|-------------------------------------------|

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

|   | Net2Phone, Inc. |
|--------|-----------------|
|   |            |   |
|   | By:        | /s/     STEPHEN M.    GREENBERG  |
|   |            |  |
|   |            | Stephen M. Greenberg |
|   |            | *Chief Executive Officer* |
|   |            |   |

**Power of Attorney**

Each person whose signature appears    below hereby constitutes and appoints each of Glenn J. Williams and Arthur    Dubroff the true and lawful attorneys-in-fact and agents of the undersigned,    with full power of substitution, for and in the name, place and stead of    the undersigned, in any and all capacities, to sign any and all amendments    to this report, and to file the same, with all exhibits thereto, and other    documents in connection therewith, with the Securities and Exchange Commission,    and hereby grants to such attorneys-in-fact and  agents full power and authority    to do and perform each and every act and thing requisite and necessary to    be done, as fully to all intents and purposes as the undersigned might or    could do in person, hereby ratifying and confirming all that said attorneys-in-fact    and agents, or their substitute or substitutes, may lawfully do or cause    tobe done by virtue hereof.

Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on this 14th day of October, 2004.

|                                                                                            |   |                                 |   |                         |   |
|-------------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|------------------------------|--------|
| /s/     HOWARD S. JONAS                                                |   | Chairman of the Board                |   | Dated: October 14, 2004 |   |
|                                                                                                 |   |                                 |   |                         |   |
|             Howard S. Jonas         |   |                                 |   |                         |   |
|                                                                                            |   |                                 |   |                         |   |
| /s/     STEPHEN M.    GREENBERG                                   |   | Chief Executive Officer and Director |   | Dated: October 14, 2004 |   |
|                                                                                                 |   | (Principal Executive Officer)        |   |                         |   |
|             Stephen M. Greenberg    |   |                                 |   |                         |   |
|                                                                                            |   |                                 |   |                         |   |
| /s/     ARTHUR DUBROFF                                            |   | Chief Financial Officer              |   | Dated: October 14, 2004 |   |
|                                                                                                 |   | (Chief Accounting Officer)           |   |                         |   |
|             Arthur Dubroff          |   |                                 |   |                         |   |
|                                                                                            |   |                                 |   |                         |   |
| /s/     JAMES R. MELLOR                                                |   | Director                             |   | Dated: October 14, 2004 |   |
|                                                                                                 |   |                                 |   |                         |   |
|             James R. Mellor         |   |                                 |   |                         |   |
|                                                                                            |   |                                 |   |                         |   |
| /s/     JAMES A.    COURTER                                            |   | Director                             |   | Dated: October 14, 2004 |   |
|                                                                                                 |   |                                 |   |                         |   |
|             James    A. Courter     |   |                                 |   |                         |   |
|                                                                                            |   |                                 |   |                         |   |
| /s/     STEPHEN GOLDSMITH                                         |   | Director                             |   | Dated: October 14, 2004 |   |
|                                                                                                 |   |                                 |   |                         |   |
|             Stephen Goldsmith       |   |                                 |   |                         |   |
|                                                                                            |   |                                 |   |                         |   |
|                                                                                            |   | Director                             |   | Dated: October 14, 2004 |   |
|                                                                                                 |   |                                 |   |                         |   |
|             Anthony G. Werner       |   |                                 |   |                         |   |
|                                                                                            |   |                                 |   |                         |   |
| /s/     HARRY C.    MCPHERSON, JR.                                |   | Director                             |   | Dated: October 14, 2004 |   |
|                                                                                                 |   |                                 |   |                         |   |
|             Harry C. McPherson, Jr. |   |                                 |   |                         |   |

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|                                                                                           |   |     |   |                        |   |
|------------------------------------------------------------------------------------------------|--------|----------|--------|-----------------------------|--------|
| /s/     JOYCE J. MASON                                                |   | Director |   | Dated:October 14, 2004 |   |
|                                                                                                |   |     |   |                        |   |
|             Joyce    Mason         |   |     |   |                        |   |
|                                                                                           |   |     |   |                        |   |
| /s/     STEPHEN R.    BROWN                                      |   | Director |   | Dated:October 14, 2004 |   |
|                                                                                                |   |     |   |                        |   |
|             Stephen    R. Brown    |   |     |   |                        |   |
|                                                                                           |   |     |   |                        |   |
| /s/     JESSE P.    KING                                         |   | Director |   | Dated:October 14, 2004 |   |
|                                                                                                |   |     |   |                        |   |
|             Jesse    P. King       |   |     |   |                        |   |
|                                                                                           |   |     |   |                        |   |
| /s/     MICHAEL WEISS                                                 |   | Director |   | Dated:October 14, 2004 |   |
|                                                                                                |   |     |   |                        |   |
|             Michael    Weiss       |   |     |   |                        |   |
|                                                                                                |   |     |   |                        |   |
| /s/     MARC J.    OPPENHEIMER                                   |   | Director |   | Dated:October 14, 2004 |   |
|                                                                                                |   |     |   |                        |   |
|             Marc    J. Oppenheimer |   |     |   |                        |   |
|                                                                                                |   |     |   |                        |   |

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