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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

                               ----------------

                                   FORM 10-K

                           ANNUAL REPORT PURSUANT TO
               SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934


                     For the Year Ended December 31, 2000
                       Commission File Number 000-26441

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                              CLARENT CORPORATION
            (Exact name of registrant as specified in its charter)

                               ----------------


<TABLE>
<S>                                            <C>
                  Delaware                                       77-0433687
       (State or other jurisdiction of                        (I.R.S. Employer
       incorporation or organization)                       Identification No.)
</TABLE>

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                             700 Chesapeake Drive
                        Redwood City, California 94063
                                (650) 306-7511
  (Address, including zip code, and telephone number, including area code, of
                   registrant's principal executive offices)

                               ----------------

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

          Securities registered pursuant to Section 12(g) of the Act:
                         Common stock, $.001 par value

  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 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 [X] 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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference to Part III of this Form 10-K or any
amendment to this form 10-K. [_]

  39,645,000 shares of the registrant's common stock, $.001 par value, were
outstanding at February 28, 2001.

  The aggregate market value of voting stock held by non-affiliates of the
registrant was approximately $278 million as of February 28, 2001, based upon
the closing price on the Nasdaq National Market reported for such date. This
calculation does not reflect a determination that certain persons are
affiliates of the registrant for any other purpose and excludes approximately
13,180,000 of the registrant's outstanding common stock held by directors,
officers and stockholders whose ownership exceeds 5% of the common stock
outstanding as of February 28, 2001. Exclusion of shares held by any person
should not be construed to indicate that such person possesses the power,
direct or indirect, to direct or cause the direction of the management or
policies of the registrant, or that such person is controlled by or under
common control with the registrant.

                      DOCUMENTS INCORPORATED BY REFERENCE

  PART III--Portions of the registrant's definitive proxy statement to be
issued in connection with the registrant's annual meeting of stockholders to
be held on June 7, 2001, are incorporated by reference to Part III of this
report.

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                              CLARENT CORPORATION

                                   FORM 10-K

                          YEAR ENDED DECEMBER 31, 2000

                               TABLE OF CONTENTS

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 <C>      <S>                                                               <C>
                                     PART I
 Item 1.  Business.......................................................     1

 Item 2.  Properties.....................................................    18

 Item 3.  Legal Proceedings..............................................    18

 Item 4.  Submission of Matters to a Vote of Security Holders............    18

                                    PART II
          Market For Registrant's Common Equity and Related Stockholder
 Item 5.   Matters.......................................................    19

 Item 6.  Selected Financial Data........................................    20

          Management's Discussion and Analysis of Financial Condition and
 Item 7.   Results of Operations.........................................    21

 Item 7A. Quantitative and Qualitative Disclosures About Market Risk.....    38

 Item 8.  Financial Statements and Supplementary Data....................    39

          Changes in and Disagreements With Accountants on Accounting and
 Item 9.   Financial Disclosures.........................................    67

                                    PART III
 Item 10. Directors and Executive Officers of the Registrant.............    67

 Item 11. Executive Compensation.........................................    67

 Item 12. Security Ownership of Certain Beneficial Owners and Management.    67

 Item 13. Certain Relationships and Related Transactions.................    67

                                    PART IV
          Exhibits, Financial Statement Schedules and Reports on Form 8-
 Item 14.  K.............................................................    68
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                                    PART I

  You should be aware that the following discussion contains both historical
information and forward-looking statements. Forward-looking statements are
statements made about future events and include projections and other
statements about what may or could happen in the future based on our current
expectations about our business and industry. In some cases, these statements
may be identified by terminology such as "may," "will," "should," "expect,"
"plan," "anticipate," "believe," "estimate," "predict," "potential," and
"continue," or the negatives of such terms, and other comparable terminology.
You should be aware that forward-looking statements involve known and unknown
risks and uncertainties. Our actual results could differ significantly from
those you might expect based on our forward-looking statements. Factors that
may cause or contribute to such differences include, among others, those
discussed under the captions "Business" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations." You should also
consider the additional risks described in the section entitled "Risk Factors
That May Impact Future Operating Results."

ITEM 1. BUSINESS

                                   OVERVIEW

  Clarent Corporation is a leading provider of software-based communications
solutions that are designed to take advantage of the flexibility and universal
reach of Internet Protocol (IP) communications networks, the most prominent of
which is the public network known as the Internet. Our software-based
solutions, in conjunction with our hardware or equipment provided by others,
are designed to enable service providers to deliver simultaneous transmission
of voice, fax and data over IP networks.

  Our customers include service providers, system integrators, resellers and
enterprises. Service provider customers include traditional local,
international and wholesale long distance telecommunication companies, as well
as "next generation" service providers, including Internet Service Providers
(ISPs), Application Service Providers (ASPs), web-to-phone providers and
others employing Internet-based business models. Traditional telecommunication
service providers--companies that have previously served as the monopoly or
incumbent provider in their region--and "next generation" service providers
are addressing business challenges and service demands that result from a
worldwide movement towards deregulation of telecommunications markets, a trend
that has been reinforced by a mandate from the World Trade Organization (WTO).

  Clarent's solutions provide seamless bridges between the traditional
circuit-switched telephone system and Internet Protocol networks, allowing the
use of IP telephony to be transparent to end user customers using their
existing wire line or wireless telephones. Our solutions deliver a level of
voice quality that can be indistinguishable from the voice quality of the
traditional telephone system.

  Using our technology to simultaneously transmit voice, fax and data, our
customers are able to more efficiently and cost effectively use the available
capacity of their networks. Clarent's clearinghouse solutions also enable
interconnection among communication service providers' networks for resource
sharing, minutes exchange and other applications.

  Clarent's software platform offers service providers an opportunity to
generate new revenue and enhance their competitive position by offering their
customers personalized, enhanced services and features. Clarent's solutions
feature a modular architecture that permits our customers to add new product
and service features without extensive product cost or development time.

  The end-users that utilize our systems are increasingly served both by
service providers and a community of partners such as systems integrators and
resellers. Our products have been and are increasingly being deployed to
provide additional service options, flexibility, and cost-savings to small,
medium and large enterprises and to consumers. We believe that in the future,
end-user customers will use communications services in both new and
traditional ways that leverage the ubiquity of the Internet and related
networks and the real-time response that has become the hallmark of the
worldwide web.

                                       1
<PAGE>

  We began commercial shipment of Clarent's long distance products in the
first quarter of 1997, introduced our clearinghouse solutions in 1999 and
introduced our local access solution in the fourth quarter of 2000. In August
2000, the acquisition of ACT Networks, Inc. solidified our commitment to
becoming a leader in the IP communications industry by fortifying key areas of
our organization and expanding our product portfolio. As of December 31, 2000,
we had shipped to more than 300 telecommunications service providers around
the globe. Clarent's IP communications solutions are now installed in networks
of some of the world's leading telecommunications carriers, including those of
AT&T Corporation, British Telecom, China Telecom, China Mobile, KPN and NTT.

                              INDUSTRY BACKGROUND

               THE TECHNOLOGY--CIRCUIT-SWITCHED VS. IP TELEPHONY

  Traditional, or circuit-switched, telephone systems are built around
architecture that requires a dedicated connection, or physical circuit, in
order for a call to be completed. This technology requires the circuit to
remain dedicated between calling parties for the entire duration of the call.

  Most data today is transmitted over Internet Protocol (IP) based networks.
These networks are more efficient for voice transmission than circuit-switched
networks because they do not require a dedicated circuit for the entire path
of the call and because voice and data can travel at the same time on the same
network. In a network using Internet Protocol, the voice, fax or data
communication is divided into packets that are sent over multiple routes to
the final destination where they are reassembled back to their original form.
The differences between a circuit-switched call and an IP telephony call
(sometimes called "packet telephony" or "voice over IP" (VOIP)) are
illustrated in the diagram below.

               [CIRCUIT-SWITCHED VS. IP TELEPHONY CALL DIAGRAM]

                                       2
<PAGE>

               MARKET FORCES DRIVING GROWTH OF IP COMMUNICATIONS

Growth of the Internet

  The Internet is a very large global data network that has experienced most
of its growth within the last five years. The Internet is largely a separate
network from the circuit-switched voice network.

  The volume of data traffic now exceeds the volume of voice calls, and is
growing at a faster pace. The physical infrastructure of the Internet backbone
has expanded dramatically to accommodate rapid growth in data traffic over the
Internet around the world. The build out of the Internet infrastructure--from
the core "backbone" transport network to the broadband access network to the
premises at the "edge" of the Internet--continues to aggressively meet
exploding demand for data and voice transportation.

Deregulation

  Deregulation of communications markets around the globe has been a driving
force in the adoption of IP telephony. Regulatory barriers that restricted
service providers to a particular geography and regulated rates and service
offerings are disappearing. New competitive service providers are entering the
market, challenging incumbent monopolies and offering voice services where
none existed before. The flexibility and cost-effectiveness of IP telephony
networks, compared to circuit switched technology, are particularly important
in an increasingly deregulated and competitive market environment. Once
competitors enter new markets and deploy IP telephony-based networks, the
incumbent service providers frequently upgrade their network to include IP
telephony technology so that they can compete with the new entrants.

Technological and quality improvements in IP telephony

  Developments in IP telephony technology have significantly bridged the voice
quality gap between the circuit-switched system and IP telephony systems.
Today a voice call placed over an IP telephony network can sound virtually
indistinguishable from the same call made over the traditional telephone
system.

Cost savings opportunities

  Voice over IP offers service providers cost savings and operational
efficiencies relative to circuit switched networks:

  Efficiencies of a shared network. The Internet was initially developed as a
  data network that is separate from and parallel to the circuit-switched
  voice network. Each network--the Internet and the circuit-switched
  network--has its own dedicated equipment. Each network has operational
  support systems built around it (provisioning, installation, etc.) and
  personnel that manage and maintain those systems.

  The unification, or "convergence," of these two networks by moving voice
  traffic from the circuit-switched network onto this Internet data network
  will enable service providers to share traffic, equipment and operational
  support systems rather than maintaining completely separate networks
  dedicated to their own applications of voice or data.

  Efficiency of IP transport. When calls are routed over the Internet, the
  calls are "compressed." Advanced speech compression technology can compress
  a call to consume as little as 10% of the network capacity that an
  uncompressed circuit-switched call would take up. Because the call takes up
  less space, it allows for more efficient use of the bandwidth in the data
  network.

  Savings on international settlement charges. When phone calls travel
  between countries over the circuit-switched network, there is usually a
  per-minute "settlement charge" placed on each call. The originating phone
  company pays the terminating phone company this settlement charge, which
  can be in excess of $.20 per minute, depending on the countries exchanging
  traffic. In most places, Internet traffic is generally

                                       3
<PAGE>

  excluded from these per minute settlement charges. When phone calls are
  sent over the Internet, they become Internet data like any other Internet
  traffic and are, therefore, not subject to these settlement charges. This
  reduces the cost of transporting a phone call over the Internet and
  provides a financial incentive for international telecommunications service
  providers to route their phone traffic over the Internet. The circuit-
  switched settlement charges are dropping internationally and are expected
  to decline over time.

Market outlook--size and growth

  Telecommunication industry analysts predict strong industry growth for the
IP telephony market. According to Probe Research (1), "growth has been
strong . . . we estimate packet telephony traffic so far represents less than
one-half of one percent of overall public telephony minutes of use--clearly,
there is a mountain of opportunity for participants yet to climb." Probe
continues by saying "the local access gateway market, although a small segment
still in 2000, will be the largest product segment by 2005." According to
International Data Corporation (2), the [IP telephony] gateway market "will
continue to experience steady and reasonably robust growth." And according to
the Yankee Group (3), "The Yankee Group believes that 2001 will open up
tremendous opportunities for the vendors of softswitch products
internationally."

  Probe has provided growth estimates for the market, predicting that voice
over packet traffic, as measured in minutes, will grow from 2.5 billion
minutes in 1999 to 611 billion minutes in 2005. Probe also predicts that
revenues to voice over packet technology suppliers, for gateways, signaling
servers, and softswitch/call control/call agents will grow from $1.2 billion
in 2000 to $24.7 billion in 2005(1).

  (1) "Voice over Packet Networks: Year-End Wrap-Up: Annual Outlook and
      Review," by Hilary Mine and John Marcus, Probe Research, Year End 2000.

  (2) "Standalone VOIP Gateways: Market Analysis," by Thomas Valovic,
      International Data Corporation, August 2000.

  (3) "Going Global: A Quick Look at Softswitching Internationally," by
      Christin Flynn, The Yankee Group, December 2000.

      DEVELOPMENT OF THE MARKET FOR CLARENT'S IP COMMUNICATIONS SOLUTIONS

  Clarent's business has been historically driven by the opportunities for
service providers to achieve significant cost savings on international calls
by transporting those calls over IP networks based on: 1) realizing the
efficiencies of sharing voice and data traffic on a single network; and 2)
realizing the savings of not being subject to international settlement
charges.

  In 2000, Clarent saw significant growth in the demand for our solutions for
domestic long-distance services, including major domestic deployments by China
Telecom and China Mobile. We anticipate continued growth in the deployment of
Clarent products for domestic long distance phone networks in a number of
locations around the world.

  Clarent believes that the next major growth segment in this market will be
the deployment of IP telephony-based "local access" solutions and the
development of new enhanced communication features for end users.

  Local access solutions allow IP communications to be delivered over the
"last mile," or "local loop", to the customer's premises. Clarent's local
access solution, scheduled to be formally launched in the spring of 2001,
includes small gateways, called "customer premises gateways" or "local access
devices," installed on the customer premises to packetize voice calls from
traditional phones, and transmit those calls over any local access broadband
medium, including wireless, cable, fiber or DSL.

  We believe the flexibility of software-based IP communications platforms,
extended to end-user premises through our local access solutions, will allow
service providers to offer new revenue-generating features and

                                       4
<PAGE>

enhanced services to consumers and business customers. Examples of these
services include universal messaging, intelligent call forwarding and call
blocking, and mobile e-commerce. Furthermore, Clarent's technology is designed
to enable service providers to give users the ability to add, change and
delete features and services using an Internet web browser.

  IP telephony global clearinghouses play an important role in accelerating
the development of the market for IP telephony traffic traveling through
Clarent's products. These clearinghouses are designed to enable service
providers to exchange calls between multiple destinations worldwide without
having to enter into individual agreements with other service providers in
each geographic region. The clearinghouses serve as brokers, or single points
of contact, for regionally based telecommunication service providers,
introducing them to other regionally-based providers around the world for
exchange of IP telephony based phone calling traffic and the associated
accounting and settlement services. These clearinghouses are accelerating
market development by providing a much larger global phone-calling footprint
to these regional service providers.

                  BENEFITS OF CLARENT'S IP TELEPHONY SOLUTION

Total solution

  Clarent offers a suite of IP telephony software and hardware products that
allow service providers to offer services to consumers and to small, medium
and large business customers. These products are supported by a flexible
software architecture and a unified, consistent back-end management system
(the Clarent Command Center), providing centralized provisioning, billing,
call routing, network management, and a variety of other operational support
systems, including network diagnostics and maintenance. Clarent's platform can
support small or large networks; local or long distance networks; and limited
or extensive feature sets. Clarent provides a consistent and flexible set of
solutions to enable the processing of calls and centralized network management
functions. Because Clarent's products support both the call processing and
operational support functions in a network, system-wide enhancements and new
features can be implemented on a flexible and efficient basis.

New revenue streams for service providers

  Our flexible, customized client-server software architecture allows our
customers to quickly design and deliver new features and services to their
customers. In a deregulated telecommunications marketplace these services can
provide sources of revenue to sustain the business models of the "next
generation" communications service providers, establishing a new leadership
hierarchy in the communications industry and can allow the traditional,
monopoly-bred carriers to have a leaner, more marketing oriented and customer-
driven organization.

Rapid, low-cost deployment and maintenance

  The Clarent system provides a comprehensive solution that can be rapidly put
into use by service providers with a modest initial capital investment. By
centralizing management and distributing functionality, the Clarent system
allows service providers to perform network administration in an economical
manner. In addition, the operation of a single network for voice, fax and data
communications allows service providers to operate more efficiently, sharing
traffic, equipment and operational support systems rather than keeping
completely separate networks dedicated to separate applications of voice or
data.

Speed and low cost of implementing new features

  Implementing changes to the traditional telephone system can be costly and
difficult. For example, based on estimates from the International Engineering
Consortium, we believe the recent integration of such basic services as Caller
I.D. and call return services into the traditional telephone system took more
than a decade to accomplish and hundreds of millions of dollars to implement
in the United States alone. In contrast, Clarent's software-based IP telephony
solutions are designed to enable service providers to quickly add and use
additional features and services without the need for costly network upgrades.

                                       5
<PAGE>

Distributed architecture

  The Clarent system is comprised of distinct units that can be spread across
a network. Compared to a circuit-switched network, a network using a Clarent
system may be modified quickly to accommodate new features, support new
protocols or handle new end-user devices, such as cable modems and IP
telephones, as they become widely-used or available. Clarent's distributed
architecture also enhances adaptability to ever changing standards and
technologies.

Personalized services and control for end-users

  In this new world, where there is a wider variety of communications service
offerings, end-users may expect a different level of responsiveness and
flexibility from their communications service providers. The worldwide web has
made real-time, round-the-clock delivery of services a new standard. In the
world of voice, fax and data communications, we believe end-users will expect
the same level of service. Clarent's technology enables service providers to
give users the ability to subscribe to voice service and to add, change and
delete phone features (such as call waiting or caller I.D.) themselves, using
an Internet Web browser.

Network interconnection

  The Clarent system is designed to support the seamless interconnection
between networks that use Clarent's products and the traditional telephone
system. This includes bridging an enterprise's private IP telephony network
with a telecommunications service provider-based IP telephony network and IP
telephony global clearinghouses so that the enterprise could take advantage of
IP telephony for calls made both within and outside of its business. The
Clarent system also provides interconnection to the traditional
telecommunications service providers' networks, known as the SS7 or C7
network. These interconnections provide a level of security that enables
service providers to exchange large volumes of calls and billing data with
each other and with their business customers.

Voice quality

  Calls over a Clarent network generally have sound quality that is
indistinguishable from the sound quality of calls over the traditional
network. In addition, the Clarent system enables the simultaneous transmission
of voice, fax and data traffic. These features are enabled by using standard
compression and echo cancellation technologies and our proprietary packet
technologies.

                                   STRATEGY

  Our objective is to be the leading provider of comprehensive IP
communications solutions to service providers and enterprises worldwide. Key
elements of our strategy include the following:

Leverage the intelligence of our software solutions

  We believe that significant value is derived from the architectural design
and feature set provided by intelligent software elements in the platform of
Clarent's IP telephony solutions. This includes our flagship software product:
the Clarent Command Center; our "softswitch" product: the Clarent Call
Manager; our network interconnection, billing and settlement product: Clarent
Connect; and our interoperability software product: the Clarent Gatekeeper.
Because Clarent's software platform supports multiple communications
protocols, our software can be used to manage networks containing Clarent
Gateways, gateway equipment provided by other companies, such as Cisco, or a
combination of Clarent and third-party equipment.

  We believe that our software architecture and products provide us with a
marketplace competitive advantage. Our software-based products have been
deployed and are actively used in the IP communications

                                       6
<PAGE>

networks of over 300 telecommunications service providers around the globe,
making Clarent the provider of one of the most widely-deployed softswitch
architectures in the industry.

  Our objective is to continue to develop the power and functionality of our
software and to increase market penetration by implementing our software to
control networks of additional service providers. The proportion of Clarent's
revenues attributable to software sales increased to 34% in 2000 as compared
to 21% in 1999 and 10% in 1998.

Market our software solutions to manage interoperable networks composed of
Clarent and other suppliers' IP communications hardware

  Today, many of Clarent's customers prefer to purchase complete IP
communications solutions from Clarent, including both hardware and software
elements. As standards for interoperability in the industry mature, we believe
that more customers will elect to include hardware from multiple vendors in
their networks.

  As the market demand for interoperable products increases and as new
suppliers for these products emerge, Clarent's objective is to provide the
software platform used by service providers to manage these devices in their
networks, as well as to continue to provide a diversified set of hardware
delivery vehicles.

Expand our family of hardware solutions as the delivery vehicles for our
intelligent software

  To deliver our intelligent software solutions, Clarent has released and
continues to develop, a suite of robust hardware products. During 2001,
Clarent plans to introduce a number of new hardware products, including
gateways that are larger and have greater density for deployment by service
providers in the core of their networks, as well as smaller gateways for
deployment in residential or small business locations.

  We chose to develop and market certain hardware products, such as the
customer premises gateway for Clarent's local access solution, primarily
because no similar products are currently available on the market. We expect
that other suppliers will offer customer premises devices in the future.

Target key geographic growth markets worldwide

  As the market for IP communications solutions develops, we continue to find
that some parts of the world are ready to adopt IP telephony before others.
Factors influencing demand for Clarent solutions include 1) the existence and
extent of legacy investment in existing communications infrastructure, 2) the
build-out of the Internet backbone and broadband access networks, and 3)
telecommunications deregulation and existence of an increasingly competitive
environment for service providers. We believe that certain international
markets represent particularly attractive opportunities for our products. We
plan to continue to add sales, marketing, and customer service and support
resources in key growth regions in order to be able to respond to
opportunities in those markets as they emerge.

Target emerging growth markets for new VoIP applications

  Our growth during the last several years has been largely driven by the
demand for IP communications solutions for international long distance
deployments. In 2000, our solutions were deployed for domestic (intra-country)
long distance applications in several geographic regions, including domestic
backbone deployments by China Telecom and China Mobile. With these long
distance IP communications networks maturing, we anticipate the next growth
phases to occur in the deployment of IP telephony solutions for local access
and the development of new enhanced communications features for end users.

  Local access solutions allow for the delivery of IP communications over the
"last mile", or "local loop", to the end user customer's premises. Clarent's
local access solutions, formally launched in the spring of 2001, include small
gateways (called "customer premises gateways" or "local access devices")
installed on the

                                       7
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customer premises to packetize voice calls made using the customers'
traditional phones and transmit those calls over any local access medium,
including wireless, cable, fiber, or DSL. At the end of 2000, Clarent's local
access solutions were being tested in both lab and commercial deployments by a
number of broadband service providers around the world, and we expect sales of
our local access solutions to represent an increasing proportion of our
revenues in 2001 and beyond.

Grow our base of software applications and development partners

  The flexibility of software-based IP communications platforms allow service
providers to offer new, revenue-generating features and enhanced services to
end-users, both consumers and business customers. Examples of these services
include universal messaging, intelligent call forwarding and call blocking,
and mobile e-commerce.

  Clarent plans to develop some of these features ourselves and market them to
our service provider customer base. We also plan, through our STAR Partner
program, to foster development of these features by third-party software
application developers who build the applications to work with Clarent's
products. During 2001 we plan to release Application Programming Interfaces
(APIs) designed to facilitate the development of applications to work with our
products by third-party software developers.

Promote strategic relationships between our customers

  We will continue to promote the formation of bilateral minutes exchange
partnerships and clearinghouse arrangements between our customers. Concert,
NTT, Telia, ITXC and a number of other communications service providers have
used Clarent's Connect software products to establish international IP
telephony partnerships and clearinghouses. We believe the existence of these
Clarent-based clearinghouses will, by enabling service providers to terminate
calls for their customers virtually anywhere in the world, lead to increased
installations of our products in both existing and new customers' networks. We
expect other service providers in different geographic regions to continue to
establish bilateral relationships with other Clarent customers or join
additional clearinghouses.

                  CLARENT'S SOLUTIONS: TECHNOLOGY & PRODUCTS

  The Clarent system incorporates both internally developed and third party
technologies. Clarent's architecture is comprised of three separate elements:

  .  Intelligent Management: the Clarent Command Center software is designed
     to enable a service provider to manage its physical network, provision
     service, intelligently route calls, track its subscriber/customer base
     and their service elections, and bill customers. The Command Center also
     has the capability to link to enhanced service applications built by
     Clarent or by outside application developers.

  .  Call Control/Softswitch: software that is designed to enable the set up
     and teardown of calls and associated call management functions.
     Clarent's call control software is embedded in some models of Clarent's
     gateway (hardware) products and is provided separately, through
     Clarent's Call Manager softswitches, for other gateway models.

  .  Transport (hardware): Clarent's gateway products convert voice to
     packets and to language that the Internet understands and then re-
     assemble the packets back to language understood by the traditional
     phone network.

  This architecture integrates all functions performed by the Clarent system
in a modular, flexible manner that enables the easy addition or alteration of
system components and features.

                                       8
<PAGE>

  In order to implement the Clarent solution in a long distance network, as
shown below, a service provider must acquire a connection to a local central
office switch owned by a local telephone company and acquire access to the
Internet or an Internet Protocol network. This graphic shows that a service
provider connects the IP telephony gateway to a central office switch and the
Internet, or other IP network, to allow the Clarent solution to work. The
implementation for an enterprise is similar, except an enterprise usually
connects the gateway to a private branch exchange, commonly known as PBX,
instead of a central office switch.

             [CLARENT'S LONG DISTANCE SOLUTION LOGO APPEARS HERE]

                                       9
<PAGE>

  Clarent's local access solution, as shown below, involves a small device
located on an end-user's premises that connects on one side to an end-user's
telephone and on the other side to a broadband modem, such as a DSL or cable
modem, or directly to the Internet through an Ethernet connection.

                 [DIAGRAM OF CLARENT'S LOCAL ACCESS SOLUTION]

Clarent Command Center

  The core of the Clarent solution is the Clarent Command Center, a
centralized client/server software package that processes network management
and back-office functions, including the routing and pricing of calls,
subscriber management, gateway monitoring and billing. In conjunction with
third-party relational databases, the Clarent Command Center provides unified,
intelligent back-end management functions for service providers, including
user administration, billing, dynamic call routing, call detail records and
class of service. A single Clarent Command Center can support and control
multiple Clarent gateways. The Clarent Command Center communicates with
Clarent gateways over the Internet or an Internet Protocol network, and does
not require a dedicated connection to each Clarent gateway. The Clarent
Command Center supports multi-vendor interoperability and can control third-
party gateways from vendors such as Cisco.

  By centralizing all network management and back-office functions, networks
using the Clarent system can be configured and modified quickly and easily.
Furthermore, the Clarent Command Center is designed to be fully redundant
through the use of multiple Clarent Command Centers to enhance network
efficiency and reliability.

                                      10
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  Examples of network management and back-office functions performed by the
Clarent Command Center include:

  Subscription management: Subscriber data is stored in the database in an
  easily accessible format. This allows telecommunications service providers
  to frequently access information about their subscribers; determine who can
  use the system and what to charge them; and easily modify the information
  about their subscribers.

  End-user feature control: With the Clarent software architecture, the
  system can be set up to allow the end-user to add or remove
  telecommunications features, such as call waiting, additional phone lines,
  and Caller I.D., through a Web browser.

  The Clarent Command Center requires the installation of a third-party
relational database that stores operational support system data for a network
of Clarent gateways. The data stored in the database is used by the Clarent
Command Center to provide comprehensive back-office functionality. Customers
using the Clarent system can develop their own customized Web interfaces,
billing systems and advanced management tools. The Clarent system is currently
compatible with several third-party databases, including current releases from
Oracle Corporation and Microsoft Corporation.

  Examples of the data stored in the relational database include:

  Subscriber data: Information about authorized users or subscribers is
  stored in the database. This allows for the system to decide who to allow
  access to the system and how to bill them. It also allows for customized
  feature sets for end-users. Service providers can easily extract subscriber
  data from the database so they can understand detailed information about
  the subscriber's use of the system.

  Billing information: Billing data is collected and stored in the relational
  database and includes extensive detail on all calls made through the
  network. Invoice generation and reporting programs can be developed using
  standard database reporting tools.

  Domain management: Service provider and enterprise customers want to
  determine what calls can be completed within their networks. The Clarent
  system provides these customers with the capability to segment a network
  into domains, or "subnetworks" within a larger network. This means that
  enterprises can manage part of the IP telephony network themselves, with
  the service provider offering overall management capability.

Clarent Gateways

  Clarent's gateways are hardware or integrated hardware and software products
that convert voice, fax or data communications into packets and transmit the
packets over IP networks. At the destination, another Clarent gateway converts
these packets back into circuit-switched voice, fax or data. The Clarent
gateway is a bridge between the traditional telephone network or a PBX on one
side and the IP network on the other side. Typically, a service provider or
enterprise will deploy more than the number of gateways sufficient to handle
the projected call volume to provide gateways for system redundancy.

  Our family of gateways includes Clarent's Gateway 400 and Gateway 1200,
which are integrated hardware and software products designed for deployment by
service providers. These gateways have the capacity to handle up to 360
simultaneous voice calls, fax, and data transmissions. Clarent's call control
software, or softswitch, is embedded in these gateway products. Clarent's
gateway line also includes the ACT Networks' SX-10 (renamed the Clarent
Gateway 400LE) and NetPerformer products. We plan to launch the new versions
of these products in 2001 on platforms that link these enterprise gateways to
Clarent's existing softswitch architecture. In 2001, we also plan to introduce
a new, higher density gateway, the Clarent Backbone High-density Gateway (BHG)
that is designed to handle up to 1,920 simultaneous voice, fax, or data
transmissions.

  In the spring of 2001, we formally launched a new line of low-density
customer premises gateways (CPGs) for Clarent's local access solution. These
gateways, which have the capacity to handle 2 to 8 simultaneous phone,

                                      11
<PAGE>

fax, or data transmissions, are designed to reside on the end-user's premises.
The CPGs will be controlled by Clarent's Local Access Call Manager software.

  Clarent gateways provide the following functionality:

  Standard telephony interfaces. Clarent gateways support many standard
  telephony interfaces and signaling protocols. Available telephony
  interfaces include both analog and digital. Supported signaling protocols
  include MFCR1, MFCR2, PRI-ISDN, and SS7/C7, among others.

  Caller interface. Clarent's programmable interactive voice response
  software provides a voice interface for prepaid calling card applications,
  captures account codes for specific calls and routes users to specific
  features or options. This software also processes different call types
  based on the number dialed (such as toll-free 800 numbers), the automatic
  number identification of the calling party or characteristics stored as
  part of a user's record.

  Integrated voice, fax and data. Clarent gateways simultaneously handle
  voice, fax and data transmissions through universal ports, eliminating the
  need to dedicate ports to specific types of transmissions.

  Compliance with major telecommunication standards. Clarent gateways
  incorporate relevant International Telecommunications Union standards,
  including the H.323, G.723.1, G.729a and G.711 codecs, as well as the
  proprietary AudioCodes, Ltd. NetCoder codecs, among others. We also utilize
  Q.931 signaling for call setup and control between the gateways, as
  specified in H.323. Clarent has also developed products to work with the
  MGCP (Media Gateway Control Protocol) standard and is developing products
  to work with Session Initiation Protocol (SIP), a newer industry standard.

  Low call latency. Clarent gateways have a measured latency, the lag between
  transmission and reception of a voice message, of approximately 100
  milliseconds, or ms. Even with the addition of a typical 100 ms to 150 ms
  of network-induced latency, the total system latency typically experienced
  with Clarent gateways is only between 200 ms to 250 ms.

  Echo cancellation. Clarent gateways employ the G.165 standard to provide
  clear, virtually echo-less voice transmission.


Clarent Call Manager

  The Clarent Call Manager is an open, standards-based softswitch product that
works in conjunction with the Clarent Command Center as primary software
elements in the Clarent architecture. Clarent's call control software, sold as
an integrated element of Clarent's Gateway 400 and 1200 products, manages all
aspects of a single call, or session, including call set up, call tear down,
and other call control functions.

  In late 2000, we introduced (in limited release) Clarent's Local Access Call
Manager as a stand-alone softswitch solution. The Clarent Local Access Call
Manager is designed to perform call control for Clarent's local access
customer premises gateways. This new product works within Clarent's existing
architecture, allowing a local access carrier to interconnect with other
service providers using Clarent-based networks worldwide as well as with
traditional circuit-switched networks. We recognized our first revenues for
sales of our Local Access Call Manager product in the fourth quarter of 2000,
and we formally launched the Local Access Call Manager in the spring of 2001.

  During 2001, we plan to introduce Clarent's Backbone High Density Call
Manager (BHCM), which will provide call control functionally for the Backbone
High-density Gateway that we also plan to introduce in 2001.

                                      12
<PAGE>

Other Clarent Products and Services

  The following table provides a summary of additional Clarent products and
services:

<TABLE>
<CAPTION>
  Product or Service          Features

  <S>                         <C>
  Clarent clearinghouse       Provide network interconnection; real-time
   products including         account settlement; least-cost routing of calls;
   Clarent Connect            balancing of calls between partners; and
                              connection of service providers and private
                              networks of companies. Also provides harvesting,
                              sorting, grouping and archiving of billing data
                              from individual gateways and networks of
                              gateways.
------------------------------------------------------------------------------
  Clarent SS7/C7 Signaling    Provides seamless connection between a service
   Server                     provider's network and a Clarent gateway.
------------------------------------------------------------------------------
  Clarent Gatekeeper          Allows Clarent gateways to interoperate with
                              other vendors' gateways using industry standard
                              (H.323) protocols.
------------------------------------------------------------------------------
  Clarent Application Server  A centralized system that stores additional
                              applications and allows them to work with
                              Clarent products in a Clarent-based network.
------------------------------------------------------------------------------
  DynaStar                    A protocol mediation platform that allows
                              service providers to consolidate, into a central
                              network management system, management
                              information from diverse equipment and tools
                              (acquired with ACT Networks).
------------------------------------------------------------------------------
  SkyPerformer                Provides interconnection for remote branch
                              offices for small to medium size networks in
                              markets where geography, or the lack of wire
                              line infrastructure, necessitate the use of
                              space-based communications facilities (acquired
                              with ACT Networks).
------------------------------------------------------------------------------
  Clarent Care                Provides software upgrades and worldwide
                              technical support to customers seven days a
                              week, 24 hours a day.
------------------------------------------------------------------------------
  Clarent Education           Provides basic and advanced training courses to
                              users of Clarent products.
------------------------------------------------------------------------------
</TABLE>

Products Under Development

  We are currently developing and testing a number of products and expect
these products to be released during 2001.

  Clarent Backbone High Density Gateway (BHG): This Clarent gateway is being
  designed to perform the same functions as the current Clarent gateways, but
  is expected to allow up to 1,920 simultaneous calls with the capability to
  bring in phone traffic over a larger pipe (a "T-3"). Clarent's BHG is
  planned for release in mid-2001.

  Clarent Backbone High-density Call Manager (BHCM): This is being designed
  to provide softswitching functionality for Clarent's high-density gateways
  (BHG) and is planned for release in mid-2001.

  Clarent NetPerformer: A new version of the NetPerformer (acquired with ACT
  Networks) is being designed to interoperate with Clarent's softswitch
  architecture and incorporate standard signaling session initiation protocol
  (SIP) and media (RTP) protocols. This is currently planned for release in
  the third quarter of 2001.

                                      13
<PAGE>

  Clarent Gatekeeper 2.0: This upgrade to the Clarent Gatekeeper is being
  designed to allow devices using the SIP communications protocol to
  communicate with Clarent-based networks and is planned for release in mid-
  2001.

  Clarent Gateway 400LE (CG400LE): This upgrade to the SX-10 product
  (acquired with ACT Networks) is being designed to enable the gateway to
  interoperate with Clarent's softswitch architecture and to support DTMF
  over IP and fax. The CG400LE is planned for release mid-2001. An additional
  enhancement to the CG400LE is planned to be available by the end of 2001,
  which will incorporate standard signaling SIP communication protocols.

                                   CUSTOMERS

  We began commercial shipments of our products in March 1997 and, as of
December 31, 2000, had shipped Clarent solutions to over 300
telecommunications service providers in more than 70 countries. We sell our
products directly and through distributors to service providers.

  The following list includes the top 10 revenue customers for 2000 (in
alphabetical order):

  .  Bright Oceans Corporation (HK) Limited (distributor to China Mobile and
     other China-based telecom service providers)

  .  D-Link, Ltd. (distributor to a variety of Asia Pacific telecom service
     providers)

  .  Great Mincom Corp. (distributor to China Telecom and other Asia Pacific
     telecom service providers)

  .  Impsat S.A. (Latin American telecom service provider)

  .  ITXC (international wholesale IP telephony telecom service provider)

  .  Lucent Technologies, Inc. (distributor for Clarent's ACT Networks
     products)

  .  New C&C Co. Ltd. (distributor to SKTelink and other Korean telecom
     service providers)

  .  Triumph Technology, Inc. (distributor to ChungHwa and other Taiwanese
     telecom service providers)

  .  Vic Telehome, S.L. (new generation telecom service provider
     headquartered in Spain)

  .  Vitcom Corporation (international long distance wholesale telecom
     service provider)

  In 2000, sales to these customers represented approximately 48% of net
revenue as compared to 1999 when sales to Clarent's top 10 revenue customers
represented approximately 61% of net revenue. One customer, Triumph
Technology, Inc. accounted for 10% of net revenue in 2000. In 1999, entities
affiliated with AT&T corporation accounted for 15% of net revenue and Technet
International accounted for 10% of net revenue.

                                     SALES

  We currently have a global sales organization with sales and support
personnel based in Argentina, Australia, Belgium, Brazil, Canada, Colombia,
France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Mexico, New
Zealand, the People's Republic of China, Peru, Poland, Russia, Singapore,
South Korea, Spain, Sweden, Taiwan, the United Kingdom and the United States.
Our sales force sells our products to service providers and enterprises both
directly and through third-party distributors. Direct sales accounted for 54%
of net revenue in 2000 and 84% in 1999. We have approximately 30 third-party
distributors in 20 countries. Our arrangements with these distributors include
provisions for certain discount levels and may also provide entitlement to
geographical sales regions.

  Revenue from U.S. customers represented 27% of Clarent's total revenues
during 2000, 46% during 1999, and 52% during 1998. During 2000, sales to
Taiwanese customers, including several large distributors serving China
Mobile, China Telecom, and other service providers in Asia, represented 24% of
Clarent's total revenue.

                                      14
<PAGE>

                                   MARKETING

  Our marketing organization develops strategies and implements programs to
support the sale of our products. Our current marketing efforts include a
number of programs designed to increase industry visibility, including
press/analyst tours, advertising, seminars, trade shows and events, speaking
engagements and ongoing interaction with analysts and the media as well as
targeted direct marketing programs. We have established the STAR Partner
marketing program to enhance members' ability to develop applications and
complementary technology to work with our products. Additional programs
include our annual customer summit, which provides the opportunity for our
customers to meet each other and learn more about Clarent solutions. We also
undertake co-operative marketing programs with our clearinghouse customers to
help them build their customer base.

                         CUSTOMER SERVICE AND SUPPORT

  We believe that customer service and support are critical to maintaining
existing customer relationships and developing relationships with new
customers.

  Our professional services group performs the following functions:

  .  pre-sales support;

  .  technical support and consulting services;

  .  customer training;

  .  product maintenance.

  In addition to our sales and support offices in The Americas, Australia,
Asia and Europe, we have established a support center in the United States
that provides support seven days a week, 24 hours a day. We also currently
partner with Equant Integration Services, Inc., a supplier of international
network support services, to provide global call center and technical support
to our customers.

                                  COMPETITION

  Our market is new, rapidly evolving, highly competitive and fragmented, and
we expect competition to intensify in the future. We believe that the main
competitive factors in our market are product quality, features, cost and
customer relationships. We believe a critical component to success in this
market is the ability to establish and maintain strong customer relationships
with a wide variety of service providers around the globe and to facilitate
relationships between those service providers increasing the geographic
coverage of their services.

  Our current principal competitors include large networking equipment
manufacturers, such as Cisco Systems, Inc., large telecommunications equipment
manufacturers, such as Lucent Inc. and Nortel Networks Corporation, and IP
telephony technology companies, such as Sonus Networks and VocalTec
Communications, Ltd. We also expect new competitors to emerge. Many of our
competitors are substantially larger than we are and have significantly
greater financial, sales and marketing, technical, manufacturing and other
resources, and more established distribution channels and stronger
relationships with service providers. These competitors may be able to respond
more rapidly to new or emerging technologies and changes in customer
requirements or devote greater resources to the development, promotion and
sale of their products than we can. In addition, they may be able to compete
more effectively because they will be able to add IP telephony features to
their existing equipment or bundle these features as part of a broader
solution. Furthermore, we believe some of our competitors may offer aggressive
sales terms, including financing alternatives, which we might not be able to
match. These competitors may enter our existing or future markets with
solutions that may be less expensive, provide higher performance or additional
features or be introduced earlier than our solutions. Given the market

                                      15
<PAGE>

opportunity, we also expect that other companies may enter our market with
better products and technologies. If any technology that is competing with
ours is more reliable or faster or less expensive or has other advantages over
our technology, then the demand for our products and services could decrease.

  We expect our competitors to continue to improve the performance of their
current products and introduce new products or new technologies. Successful
new product introductions or enhancements by our competitors could reduce the
sales or market acceptance of our products and services, perpetuate intense
price competition or make our products obsolete. To be competitive, we must
continue to invest significant resources in research and development, sales
and marketing and customer support. We cannot be sure that we will have
sufficient resources to make these investments or that we will be able to make
the technological advances necessary to be competitive.

  Increased competition is likely to result in price reductions, reduced gross
margins and loss of market share. Our failure to compete successfully against
current or future competitors could seriously harm our business, financial
condition and results of operations.

                           RESEARCH AND DEVELOPMENT

  To maintain our technology leadership position, we continue to focus our
research and development efforts on improving the functionality and
performance of our existing products and developing new products. We obtain
extensive product development input from our customers and monitor our
customers' needs and changes in the marketplace. We are currently working on
key areas, such as ways to improve the transmission of packets as well as the
interoperability of our products with those of other vendors. In addition we
are developing improvements to network management and enhanced end-user
features.

  We believe our success will depend, in part, on our ability to develop and
introduce new products and enhancements to our existing products. In the past
we have made, and intend to continue to make, significant investments in
research and development. Our research and development expenditures totaled
approximately $29.9 million in 2000, $9.2 million in 1999 and $3.4 million in
1998.

  We perform much of our research and product development activities at our
principal offices in Redwood City, California. In addition, through our
acquisitions of Peak Software Solutions and ACT Networks in 2000, we have
acquired research and development teams based in Calabasas, California;
Littleton, Colorado; Montreal, Canada; and Manassas, Virginia.

  If we are unable to develop new products or enhancements to existing
products on a timely basis, or if the new products or enhancements fail to
achieve market acceptance, our business, financial condition and results of
operations could be seriously harmed.

                          MANUFACTURING AND ASSEMBLY

  Our manufacturing operations consist of materials planning and procurement,
basic assembly, final assembly, product assurance testing, quality control and
packaging and shipping. Our manufacturing facilities are ISO 9002 certified.
We assemble and test most of our service provider gateways in Redwood City and
rely on some local outsourcing of our basic assembly and test procedures.
NetPerformer, SX-10 and DynaStar products are final assembled and tested at
our facilities in Calabasas, California, with some reliance on outsourcing of
procurement, basic assembly and functional testing both in Washington and
Virginia. Our local access devices, or CPGs, are assembled and tested by a
contract manufacturer in Taiwan. Based on volume, geographic or customer
requirements, we intend to outsource additional assembly and test functions.

  We have developed an assembly process that enables us to configure our
products to be adapted to different customer specifications at the final
assembly stage. This flexibility is designed to reduce both our assembly cycle

                                      16
<PAGE>

time and our need to maintain a large inventory of finished goods. We believe
that the efficiency of our assembly process to date is largely due to our
product architecture and our commitment to assembly process design. However,
this assembly process involves some risks, including the potential absence of
adequate capacity and reduced control over delivery schedules, manufacturing
yields, quality and costs.

  We test our products during and after the assembly process using both
industry standard and internally developed product assurance-testing
procedures. Generally we use standard components for our products and try to
maintain alternative sources of supply. Some key components are purchased from
sole or single source suppliers for which alternative sources are not
currently available. We may experience supply problems in the future from any
of our suppliers, which could delay our ability to assemble and ship our
products and seriously harm our business, financial condition and results of
operations.

                       PATENTS AND INTELLECTUAL PROPERTY

  We rely on a combination of copyright, trademark and trade secret laws and
restrictions on disclosure to protect our intellectual property rights. We
currently have one United States patent issued for our dynamic forward error
correction technology and multiple pending applications in the United States,
Germany, and Japan.

  We also enter into confidentiality and proprietary information and
inventions agreements with our employees and consultants, and control access
to and distribution of our software, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use our
products or technology. Monitoring unauthorized use of our products is
difficult, and we cannot be certain that the steps we have taken will prevent
misappropriation of our technology. The laws of some foreign countries do not
protect our proprietary rights to as great an extent as the laws of the United
States, and many United States companies have encountered substantial
infringement problems in these countries, some of which are countries in which
we have sold and continue to sell products. There is a risk that our means of
protecting our proprietary rights may be inadequate. For example, our
competitors may independently develop similar technology, duplicate our
products or design around our patents, when or if issued, or our other
intellectual property rights. If we fail to adequately protect our
intellectual property, it would be easier for our competitors to sell
competing products.

  From time to time, third parties may assert exclusive patent, copyright,
trademark and other intellectual property rights to technologies that are
important to us. In addition, third parties may assert claims or initiate
litigation against us or our manufacturers, suppliers or customers with
respect to existing or future products, trademarks or other proprietary
rights. We have not conducted an exhaustive search of patents issued to other
companies or organizations. Because of the number of patents issued and patent
applications filed relating to the transmission of voice over packet-switched
networks, we believe there is a risk that current and potential customers and
other third parties have filed, or in the future will file applications for,
or have received or in the future will receive, patents or obtain additional
intellectual property rights relating to materials or processes that we use or
propose to use. If these third-party patents or other proprietary rights have
been or are issued, or are otherwise asserted by third parties, the holders of
these patents or other proprietary rights may bring infringement claims
against us. Furthermore, former employers of our current and future employees
may assert that our employees have improperly disclosed confidential or
proprietary information to us. We may in the future initiate claims or
litigation against third parties for infringement of our proprietary rights or
to determine the scope and validity of our proprietary rights and the rights
of competitors. Any of these claims, with or without merit, may be time-
consuming, result in costly litigation and diversion of technical and
management personnel or require us to develop non-infringing technology.
Alternatively, others may claim that we infringe their intellectual property
rights, and we may be required to obtain a license or royalty agreement under
the intellectual property rights of those parties claiming the infringement.
In addition, an adverse ruling could result in a negative impact on our
operations, including treble damages or the issuance of an injunction against
us requiring that we cease development and withdraw some products from the
marketplace.

                                      17
<PAGE>

                                   EMPLOYEES

  As of December 31, 2000, we had a total of approximately 850 employees, of
which approximately 255 were in research and development, 400 were in sales,
marketing and customer support and 195 were in finance, administration and
operations. Our future performance depends, in significant part, upon our
ability to attract new personnel and retain existing personnel in key areas
including engineering, technical support and sales. Competition for these
personnel is intense, especially in the San Francisco Bay Area where we are
headquartered, and we cannot be sure that we will be successful in attracting
or retaining the personnel in the future. None of our employees is subject to
a collective bargaining agreement. We consider our relationship with our
employees to be satisfactory.

ITEM 2. PROPERTIES

  Our principal offices are located in Redwood City, California. We occupy
approximately 186,100 square feet in Redwood City, California and
approximately 59,000 square feet in Calabasas, California. The Calabasas lease
expires mid 2006. The leases for the Redwood City facilities for 45,700,
47,100 42,300 and 51,000 square feet expire in 2003, 2004, 2007 and 2011,
respectively. In addition to our California based research and development and
manufacturing facilities, we also lease 45,000 square feet in Littleton,
Colorado, 15,000 square feet in Montreal, Canada and 14,000 square feet in
Manassas, Virginia. Clarent leases sales and support offices both domestically
in New Jersey and Illinois and internationally in Argentina, Australia,
Belgium, Brazil, Canada, France, Germany, Greece, Hong Kong, Ireland, Italy,
Japan, Singapore, South Korea, Spain, Sweden, Taiwan and the United Kingdom.
We also have three sales and support offices in the People's Republic of China
located in Beijing, Shanghai and Guangzhou. If we require additional space, we
believe that we will be able to secure such space on commercially reasonable
terms without undue operational disruption.

ITEM 3. LEGAL PROCEEDINGS

  We are not currently a party to any material legal proceedings.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

  There were no matters submitted to a vote of security holders during the
fourth quarter of 2000.

                                      18
<PAGE>

                                    PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
     MATTERS

                            MARKET FOR COMMON STOCK

  Our common stock is traded on the Nasdaq National Market under the symbol
"CLRN." Public trading of our common stock commenced on July 1, 1999. Prior to
that date there was no public market for our common stock. The following table
lists the high and low sale prices of our common stock for each quarter, as
reported by the Nasdaq National Market.

<TABLE>
<CAPTION>
Quarter Ended                                                     High    Low
-------------                                                    ------- ------
<S>                                                              <C>     <C>
2001
March 31 (through March 27, 2001)............................... $ 18.81 $ 6.75

2000
December 31..................................................... $ 41.00 $10.00
September 30.................................................... $ 97.63 $30.00
June 30......................................................... $ 98.94 $29.50
March 31........................................................ $178.75 $67.00

1999
December 31..................................................... $110.25 $49.50
September 30.................................................... $ 54.00 $19.88
</TABLE>

  On March 27, 2001, the last reported sale price of the common stock on the
Nasdaq National Market was $11.92 per share. As of February 28, 2001, there
were approximately 290 stockholders of record of Clarent's common stock.

                                   DIVIDENDS

  We have never declared or paid any cash dividends on our common stock. We
intend to retain any future earnings to fund the development and growth of our
business and do not anticipate paying any cash dividends in the foreseeable
future.

                                      19
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

  The following selected consolidated financial data should be read in
conjunction with the consolidated financial statements and notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" appearing elsewhere in this Annual Report on Form 10-K.

<TABLE>
<CAPTION>
                                                                    Period from
                                                                    July 2, 1996
                                                                    (inception)
                                                                         to
                                   Year ended December 31,          December 31,
                              ------------------------------------  ------------
                                2000      1999     1998     1997        1996
                              --------  --------  -------  -------  ------------
                                 (in thousands, except per share amounts)
<S>                           <C>       <C>       <C>      <C>      <C>
Statement of operations
 data:
Net revenue.................  $151,581  $ 47,823  $14,647  $ 3,359     $ --
Cost of revenue.............    59,847    20,305    6,653    1,189       --
                              --------  --------  -------  -------     -----
Gross profit................    91,734    27,518    7,994    2,170       --
Operating expenses:
  Research and development..    29,894     9,172    3,356    1,044       136
  Sales and marketing.......    59,301    25,111    7,099    2,046       --
  General and
   administrative...........    18,076     6,877    2,484      639       140
  Amortization of
   compensation.............     6,201    19,371      879      --        --
  Amortization of goodwill
   and other intangibles....    15,654       150      --       --        --
  In-process research and
   development..............    32,882       --       --       --        --
  Settlement expense........       --        --       --       570       --
                              --------  --------  -------  -------     -----
    Total operating
     expenses...............   162,008    60,681   13,818    4,299       276
                              --------  --------  -------  -------     -----
Loss from operations........   (70,274)  (33,163)  (5,824)  (2,129)     (276)
Other income, net...........    17,097     2,512       32       70       --
                              --------  --------  -------  -------     -----
Loss before income taxes....   (53,177)  (30,651)  (5,792)  (2,059)     (276)
Provision for income taxes..      (924)     (132)     (40)     --        --
                              --------  --------  -------  -------     -----
Net loss....................  $(54,101) $(30,783) $(5,832) $(2,059)    $(276)
                              ========  ========  =======  =======     =====
Basic and diluted net loss
 per share..................  $  (1.54) $  (1.87) $ (1.65) $ (2.14)      N/A
                              ========  ========  =======  =======     =====
Shares used to compute basic
 and diluted net loss per
 share......................    35,063    16,457    3,544      962       --
                              ========  ========  =======  =======     =====

<CAPTION>
                                               December 31,
                              --------------------------------------------------
                                2000      1999     1998     1997        1996
                              --------  --------  -------  -------  ------------
                                              (in thousands)
<S>                           <C>       <C>       <C>      <C>      <C>
Balance Sheet Data:
Cash, cash equivalents and
 short-term investments.....  $260,614  $281,305  $11,903  $   474     $ 147
Working capital.............   293,383   290,227   11,531      781       146
Total assets................   554,368   335,368   25,177    2,818       244
Total stockholders' equity..   482,164   308,842   13,764    1,334       242
</TABLE>

                                      20
<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

  You should read the following discussion in conjunction with Clarent
Corporation's Consolidated Financial Statements and related Notes. Certain
statements contained in this Annual Report, including, without limitation,
statements containing the words "believes", "anticipates", "estimates",
"expects", and words of similar import, constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. You should not place undue reliance on these forward-looking
statements. Our actual results could differ materially from those anticipated
in these forward-looking statements for many reasons, including the risks
faced by us described below and elsewhere in this Annual Report, and in other
documents we file with the SEC.

Overview

  Clarent Corporation is a leading provider of software-based communications
solutions that are designed to take advantage of the flexibility and universal
reach of Internet Protocol (IP) communications networks, the most prominent of
which is the public network known as the Internet. Our software-based
solutions, in conjunction with our hardware, or equipment provided by others,
are designed to enable service providers to deliver simultaneous transmission
of voice, fax and data over IP networks.

  Our customers include service providers, system integrators, resellers and
enterprises. Service provider customers include traditional local,
international and wholesale long distance telecommunication companies, as well
as "next generation" service providers, including Internet Service Providers
(ISPs), Application Service Providers (ASPs), web-to-phone providers and
others employing Internet-based business models.

  Our focus is on expanding our research and development, sales and marketing
and customer support activities, thereby reinforcing our strong worldwide
position in providing the technology and intelligent product foundation for
IP-based communication networks. These activities include developing new
products and technologies and enhancing existing products, hiring research and
development engineers, hiring sales and marketing personnel, expanding our
customer base, developing customer relationships, marketing the Clarent IP
telephony solution, expanding our domestic and international distribution
channels and hiring customer support personnel.

  We sell our products through both distributors and our direct sales force.
We have customer support and or sales personnel based in Argentina, Australia,
Belgium, Brazil, Canada, Colombia, France, Germany, Greece, Hong Kong,
Ireland, Italy, Japan, Mexico, New Zealand, the People's Republic of China,
Peru, Poland, Russia, Singapore, South Korea, Spain, Sweden, Taiwan, the
United Kingdom and in many locations throughout the United States.

  Net revenue from international sales totaled $110.2 million or approximately
73% of net revenue in 2000, $25.7 million or approximately 54% of net revenue
in 1999 and $7.1 million or approximately 48% of net revenue in 1998. We
expect that we will continue to derive a majority of our revenue from
customers outside of the United States, subjecting our revenue stream to risks
from economic uncertainties, currency fluctuations, political instability and
uncertain regulatory environments.

  Although our revenue has grown each quarter, we cannot be certain that our
revenue will continue to grow or that we will achieve or maintain
profitability in the future. We expect to continue to experience growth in
absolute dollar expenditures on research and development, sales and marketing
and general and administrative expenses as we attempt to expand our business
and maintain or improve our market position. We cannot accurately predict the
future growth rate, if any, or the ultimate size of our market. In addition,
our ability to increase revenue and achieve or maintain profitability depends
on a number of factors outside our control, including the extent to which:

  .  our products are able to gain market acceptance;

  .  our customers are able to secure the financial resources necessary to
     build their infrastructures;

                                      21
<PAGE>

  .  our competitors develop competing products; and

  .  our distributors and other marketing partners dedicate resources to
     selling our products.

  Furthermore, we have experienced significant erosion of average selling
prices of our products due to a number of factors, including competitive
pricing pressures, rapid technological change and increases in sales discounts.
We anticipate that the average selling prices of our products will decrease in
the future in response to the same factors. Therefore, to maintain or increase
our gross margin, we must develop and introduce new products and product
enhancements on a timely basis and continually reduce our product costs. Our
failure to do so will cause our revenue to grow more slowly and our gross
margin to decline, which will seriously harm our business, financial condition
and results of operations.

  Because of continuing capital expenditures and increasing research and
development, sales and marketing and general and administrative expenses, we
will need to generate significant revenue growth to achieve profitability and
positive operating cash flows. Even if we do achieve profitability and positive
cash flows, we may not be able to sustain or increase profitability or positive
operating cash flows on a quarterly or annual basis.

Results of Operations

  The following table presents certain consolidated statement of operations
data for the periods indicated as a percentage of total net revenue:

<TABLE>
<CAPTION>
                                                            Year ended
                                                           December 31,
                                                         ---------------------
                                                         2000    1999    1998
                                                         -----   -----   -----
<S>                                                      <C>     <C>     <C>
Net revenue:
  Product and software..................................  90.4 %  92.4 %  94.3 %
  Service revenue.......................................   9.6     7.6     5.7
                                                         -----   -----   -----
    Total net revenue................................... 100.0   100.0   100.0
Cost of revenue:
  Product and software..................................  34.0    35.0    40.3
  Service...............................................   5.5     7.5     5.1
                                                         -----   -----   -----
    Total cost of revenue...............................  39.5    42.5    45.4
                                                         -----   -----   -----
Gross margin............................................  60.5    57.5    54.6
Operating expenses:
  Research and development..............................  19.7    19.2    22.9
  Sales and marketing...................................  39.1    52.5    48.4
  General and administrative............................  11.9    14.4    17.0
  Amortization of compensation..........................   4.1    40.5     6.0
  Amortization of goodwill and intangible assets........  10.3     0.2     --
  Purchased in-process research and development.........  21.7     --      --
                                                         -----   -----   -----
    Total operating expenses............................ 106.8   126.8    94.3
                                                         -----   -----   -----
Loss from operations.................................... (46.3)  (69.3)  (39.7)
Other income, net.......................................  11.2     5.3     0.2
                                                         -----   -----   -----
Loss before income taxes................................ (35.1)  (64.0)  (39.5)
Provision for income taxes..............................  (0.6)   (0.3)   (0.3)
                                                         -----   -----   -----
    Net loss............................................ (35.7)% (64.3)% (39.8)%
                                                         =====   =====   =====
</TABLE>

                                       22
<PAGE>

Comparison of Years Ended December 31, 2000, 1999 and 1998

 Net Revenue

   Net revenue increased 217% to $151.6 million in 2000 from $47.8 million in
1999 following an increase of 227% from $14.6 million in 1998. The increase in
net revenue for 2000 was primarily attributable to an increase in product and
software sales of 210% to $137.0 million from $44.2 million in 1999 primarily
driven by increased volume in unit sales of Clarent Gateways, Clarent Command
Centers and new products acquired during the year including the NetPerformer
and DynaStar products. The increase in demand for Clarent's IP based
communication solution was from both existing and new customers on a worldwide
basis. Service revenue from maintenance and support increased by 301% to $14.6
million in 2000 from $3.6 million in 1999. The increase in maintenance and
support revenue primarily resulted from the increase in product sales as well
as follow-on contracts with our existing customer base. The increase in 1999
net revenue was largely due to the increase of product and software sales by
220% to $44.2 million in 1999 from $13.8 million in 1998. The increased sales
volume was partially offset by the decrease in the average selling prices of
our products. One customer, Triumph Technology, Inc. accounted for 10% of net
revenue in 2000. In 1999, entities affiliated with AT&T Corporation accounted
for 15% of net revenue and entities affiliated with Ji Tong Communications
accounted for 10% of net revenue. Entities affiliated with AT&T Corporation
accounted for 36% of net revenue, and Technet International accounted for 12%
of net revenue in 1998.

 Cost of Revenue

  Cost of revenue increased 195% to $59.8 million in 2000 from $20.3 million
in 1999 following an increase of 203% from $6.7 million in 1998. These
increases were primarily attributable to increases in product and software
costs of 201% to $51.5 million in 2000 from $16.7 million in 1999 and of 184%
from $5.9 million in 1998. Gross margin increased to 61% in 2000 from 58% in
1999 and 55% in 1998. The increase in margin was predominantly attributable to
a change in sales mix to include approximately 34% of software sales in 2000
as compared to approximately 21% in 1999 and 10% in 1998.

  The mix of products we sell significantly impacts our gross margin. The
sequential increase in sales of our software products both in absolute dollars
and as a percentage of revenue has positively impacted our gross margin, but
the acquisition of ACT Networks during the third quarter of 2000 and the
addition of their hardware revenue to the sales mix, partially offset the
effect of increasing software sales. We expect a negative impact on our gross
margin from the introduction of new integrated hardware and software products
and new versions of existing integrated hardware and software products. Our
gross margins also have been affected by significant erosion in the average
selling prices of our products due to a number of factors, including
competitive pricing pressures, rapid technological change and sales discounts
and we expect this to continue. We expect gross margin to be adversely
affected by increases in material or labor costs, costs related to maintaining
higher inventory balances, changes in the geographical mix of customers and
changes in the channels of distribution. We expect to continue to increase the
percentage of sales to distributors, which generally results in a lower gross
margin.

 Research and Development Expenses

  Research and development expenses increased 226% to $29.9 million in 2000
from $9.2 million in 1999 following an increase of 173% from $3.4 million in
1998. As a percentage of revenue, research and development expenses increased
to 20% in 2000 from 19% in 1999 and decreased as a percentage of net revenue
to 19% in 1999 from 23% in 1998. The increases in research and development
expenses were primarily attributable to increases in the number of research
and development personnel to 253 at the end of 2000 from 63 at the end of 1999
and from 21 at December 31, 1998. The decrease in research and development
expenses as a percentage of net revenue in 1999 was a result of the
significant increase in revenue. Management expects research and development
expenses to continue to increase in absolute dollars and to remain relatively
the same as a percentage of revenue based upon increases in the number of
research and development personnel from acquisitions during the third quarter
of 2000 as well as continued hiring in 2001.

                                      23
<PAGE>

 Sales and Marketing Expenses

  Sales and marketing expenses increased 136% to $59.3 million in 2000 from
$25.1 million in 1999 following an increase of 254% from $7.1 million in 1998.
The absolute dollar increase in sales and marketing expenses for 2000 as
compared to 1999 and for 1999 as compared to 1998 were primarily attributable
to increases in personnel and related expenses required to implement our sales
and marketing strategy, and to a lesser extent, increased public relations and
other promotional expenses. Sales and marketing expenses, as a percentage of
revenue, decreased to 39% for 2000 from 53% in 1999 following an increase from
48% in 1998. The decrease as a percentage of revenue in 2000 is attributable to
the significant increase in revenue. The increase as a percentage of revenue in
1999 resulted because the growth rate of sales and marketing expenses in 1999
exceeded the growth rate of net revenue for the period because we were adding
sales and marketing personnel and spending on promotional activities in
anticipation of increased future sales. We currently expect that sales and
marketing expenses will continue to increase in absolute dollars.

 General and Administrative Expenses

  General and administrative expenses increased 163% to $18.1 million in 2000
from $6.9 million in 1999 following an increase of 176% from $2.5 million in
1998. The absolute dollar increases in general and administrative expenses were
primarily attributable to increased personnel and related expenses required to
build the infrastructure to support a large public company. General and
administrative personnel increased to 125 at the end of 2000 as compared to 41
and 22 at the end of 1999 and 1998. General and administrative expenses
decreased as a percentage of net revenue to 12% in 2000 from 14% in 1999 and
from 17% in 1998 as a result of the significant increase in revenue. We expect
general and administrative expenses to decrease as a percentage of net revenue
but to continue to grow in absolute dollars.

 Amortization of Compensation

  Amortization of compensation expense for 2000 was $6.2 million as compared to
$19.4 million in 1999 and $879,000 for 1998. Amortization of compensation
resulted from the granting of stock options and warrants to purchase common
stock as well as the assumption of stock options through acquisition at prices
below the deemed fair value of our common stock. We expect to amortize deferred
compensation using the graded method through 2004, the vesting period of the
stock options. Compensation charges related to a warrant provided for
consulting services of $12.3 million and $357,000 were recognized in 1999 and
1998, respectively. There was no compensation expense related to warrants in
2000.

  On February 14, 2001, the Company cancelled approximately 2.89 million
outstanding options under a cancellation and re-grant program for employees
holding common stock options with an exercise price per share in excess of the
fair market price of the Company's common stock. Replacement options to
purchase common stock of approximately 635,000 shares were granted to employees
on February 15, 2001 at the fair market value of $13.625 per share. These
shares will vest in full on August 15, 2001 and will expire if unexercised on
November 15, 2001. The options granted on February 15 will be subject to
variable accounting in accordance with the requirements of FIN 44 (Note 1)
until they are exercised or they expire. These options could result in
significant future charges to the Company.

 Amortization of Goodwill and Purchased Intangible Assets

  Amortization of goodwill and purchased intangible assets for 2000 was $15.7
million as compared to $150,000 in 1999. The goodwill and purchased intangible
assets were the result of three purchase business combinations. One was
completed in the fourth quarter of 1999 and two in the third quarter of 2000.
The value of the purchased intangible assets was determined using independent
valuations for both the PEAK Software Solutions and ACT Networks acquisitions
in 2000. We expect to amortize goodwill and intangible assets using the
straight-line method over periods ranging from three to five years from the
dates of acquisition (See Note 2 to the Consolidated Financial Statements).

                                       24
<PAGE>

 Merger Related Costs

  The merger related costs of $1.4 million in 2000 resulted from our
acquisition of ACT Networks. The merger related costs are primarily accruals
for the disposal of redundant inventory components replaced by an ACT product
and other costs incurred with the integration of the Clarent and ACT
information systems.

 Purchased In-Process Research and Development (IPRD)

  The purchased in-process research and development costs, were $31.5 million
in 2000 as compared to $0 in 1999 and 1998. These resulted from our acquisition
of ACT Networks in the third quarter of 2000.

  The cost of IPRD is based on a fair value allocation of the purchase price we
paid to acquire ACT Networks. The fair value allocation to in-process research
and development was determined by identifying projects underway at the time of
the ACT merger that required additional efforts to establish technological
feasibility after consummation of the ACT Networks merger. These projects have
identifiable technological risk factors, which indicate that even though
successful completion is expected, it is not assured. If an identified project
is not successfully completed, there is no alternative future use for the
project and the expected future income will not be realized.

                      Approach used for valuation of IPRD

  In valuing IPRD, we considered, among other factors, the stage of completion
of the development efforts and the estimated net present value of cash flows
expected to result from the successful deployment of the new products. The
stage of completion was determined by estimating the costs and time incurred to
date, relative to the costs and time to be incurred to develop the in-process
technology into commercially viable products. The estimated net present value
of cash flows was based on incremental future cash flows from revenues expected
to be generated by the products being developed, taking into account the
characteristics and applications of the technology, the size and growth rate of
existing and future markets and an evaluation of past and anticipated product
life cycles. Estimated future cash flows were discounted to arrive at a net
present value and were allocated to IPRD based on the percentage of completion
at the date of acquisition. The after-tax risk adjusted discount rate used as
an assumption in the valuation of IPRD was 25% and the percentage of completion
at the date of acquisition was estimated as 67%.

          Overview of IPRD purchased from ACT Networks in August 2000

  NetPerformer: A new version of the NetPerformer is being designed to
interoperate with softswitch architecture and incorporate standard signaling
session initiation protocol (SIP) and media (RTP) protocols.

  SX-10: The upgrade to the SX-10 product (Clarent 400LE Gateway) is being
designed to enable the gateway to interoperate with Clarent's softswitch
architecture and to support DTMF over IP and fax. The CG400LE is planned for
release mid-2001. An additional enhancement to the CG400LE is planned to be
available by the end of 2001, which will incorporate standard signaling SIP
communication protocols.

  DynaStar: New versions of DynaStar, which has traditionally been sold in the
North American market, are being designed to enable the product to be available
for sale in the global marketplace. Development efforts are also focusing on
specific industry interfaces, such as those required by the power industry, for
example.

               Status of R&D projects acquired from ACT Networks

  We believe that the projections used in performing valuations with respect to
the research and development projects acquired from ACT Networks are still
materially valid, however, there can be no assurance that the projected results
will be achieved. We expect to continue the development of each project not yet
completed and believe that there is a reasonable chance of successful
completion. However, if we do not successfully deploy

                                       25
<PAGE>

commercially accepted technology or products based on the IPRD, our operating
results could be adversely affected in future periods. Additionally, the value
of other intangible assets could become impaired. The following list provides
the information regarding the status of research and development projects at
the date of acquisition (in millions):

<TABLE>
<CAPTION>
                                           Estimated costs
                                             to complete    Expected   Expected
                                             at time of     Costs at   Date of
                                             acquisition   Completion Completion
                                           --------------- ---------- ----------
   <S>                                     <C>             <C>        <C>
   NetPerformer...........................      $3.9          $3.9     Q3 2001
   SX-10..................................      $0.8          $0.8     Q4 2001
   DynaStar...............................      $0.8          $0.8     Q2 2001
</TABLE>

 Other Income

  Other income, net was $17.1 million in 2000 as compared to $2.5 million in
1999 and $32,000 in 1998. The other income was attributable to interest income
earned on our cash, cash equivalents and investments primarily as a result of
the funds raised in our initial and secondary public offerings during 1999 plus
cash of companies acquired in 2000. Interest income in 1998 was related to cash
received from bridge financing obtained during that year. A charge for
estimated impairment of equity investments in private companies of $1 million
was recognized in the fourth quarter of 2000 as an offset to other income.

 Income Taxes

  The provision for income taxes of approximately $924,000 for 2000, $132,000
for 1999 and $40,000 for 1998 consists of current foreign income taxes provided
on the profits attributable to certain foreign operations and US alternative
minimum taxes. As of December 31, 2000, we had approximately $115 million of
federal and $16 million of state net operating loss carryforwards to offset
future taxable income. We also had federal and state research and development
tax credit carryforwards of approximately $1.1 million and $1 million,
respectively, at December 31, 2000. The difference between available net
operating losses and our accumulated deficit as reported for financial
statement purposes is principally the result of differences in the tax
treatment of deferred compensation, accounts receivable reserves, other non-
deductible accruals and reserves and deferred revenue.

  We cannot assure you that we will realize the benefit of the net operating
loss carryforwards and have therefore set up a valuation allowance against a
portion of these deferred tax assets. The federal and state net operating loss
carryforwards will expire at various dates beginning in fiscal year 2004
through 2020, if we do not use them. Due to the "change of ownership"
provisions of the Internal Revenue Code, the availability of a portion of our
net operating loss and tax credit carryforwards are subject to an annual
limitation against taxable income in future periods.

Liquidity and Capital Resources

  From inception through June 1999, we financed our operations primarily
through private sales of convertible preferred stock, which totaled $18.9
million in aggregate net proceeds. In July 1999 we completed an initial public
offering of our common stock, and in November 1999 we completed a secondary
public offering, which together, resulted in aggregate net proceeds of
approximately $303 million.

  Net cash used in operating activities was $22.8 million in 2000, $15.9
million in 1999, and $5.8 million in 1998. The net cash used in operating
activities in 2000 was principally the result of the net loss of $54.1 million,
the increase in trade accounts receivable of $31 million, an increase in
prepaid and other assets of $11.2 million and an increase in inventories of
$4.6 million partially offset by adjustments for depreciation and amortization
of $32.7 million, tax benefit from employee stock options of $2.0 million, a
charge for purchased in-process research and development of $31.5 million,
increases in accounts payable and accrued liabilities of $9 million and in
deferred revenue of $3.4 million. Amortization expense has increased
significantly as a result of the

                                       26
<PAGE>

deferred compensation, goodwill and intangibles related to two acquisitions
completed during the third quarter of 2000. The increase in accounts receivable
is the result of increased sales both through growth and acquisition and the
result of the timing of sales in the quarter. During the year ended December
31, 2000, we increased our allowance for doubtful accounts by $5.3 million to
address potential exposures related to the slowdown in the market. We have also
decreased dependency on key customers with only one customer individually
contributing 10% of net revenue in 2000. The increase in deferred revenue for
2000 is a result of increased service revenue deferred for support and
maintenance contracts as a result of the overall increase in sales.

  Net cash used in operating activities for 1999 was attributable primarily to
a net loss of $30.8 million and increases in trade accounts receivable of $15.9
million, inventory of $4.8 million and prepaid and other assets of $2.7 million
partially offset by depreciation and amortization of $22.3 million, increases
in accounts payable and accrued liabilities of $10.2 million and increases in
deferred revenue of $5.7 million. The increase in inventory for 1999 was
primarily in anticipation of expected growth in product revenue as well as a
greater need for evaluation units. The increase in accounts receivable for 1999
is primarily the result of a significant portion of our increased sales
occurring during the last quarter of the year. Deferred revenue increased due
to sales that had contingencies, which were not satisfied at December 31, 1999
as well as increased sales of maintenance and support contracts.

  For 1998, cash used in operating activities was attributable primarily to a
net loss of approximately $5.8 million, and increases in trade accounts
receivable of $6.2 million and inventory of $2.7 million offset in part by
depreciation of approximately $516,000, amortization of compensation of
$879,000 and increases in accounts payable and accrued liabilities of
approximately $3.4 million and an increase in deferred revenue of approximately
$4.3 million. The increase in accounts receivable was primarily the result of
higher sales levels during the fourth quarter. During the year ended December
31, 1998, we increased our allowance for doubtful accounts by $769,000 to
address potential exposures related to an increase in international sales and
changes in the composition of our customer base to include more international
and new entrant customers. Revenue was recognized on sales to these customers,
as collectibility was probable. The increase in deferred revenue as a result of
not meeting the fixed and determinable criteria was $1.4 million in 1998.

  Net cash used in investing activities was $38.2 million in 2000, $58.5
million in 1999 and $2.2 million in 1998. For 2000, a net $27.3 million of cash
used in investing activities was for the purchase of investment securities net
of sales and maturities. Included in the net cash used in investing activities
during 2000 was a net $14 million invested in long term investments represented
by interests in various privately held companies and a venture capital
management fund. For 1999, $45.6 million of cash used in investing activities
was for the purchase of investment securities net of sales and maturities. We
acquired net cash of $33.3 million from business combinations in 2000 and
$325,000 in 1999. The remaining cash used in investing activities for each year
was for purchases of property and equipment totaling $30.2 million in 2000,
$13.2 million in 1999 and $2.2 million in 1998.

  Net cash provided by financing activities was $8.1 million in 2000, $301.2
million in 1999 and $19.5 million in 1998. During 2000, cash provided by
financing activities was primarily from the issuance of common stock upon the
exercise of employee stock options and purchases under the employee stock
purchase plan. For the year ended December 31, 1999, cash provided by financing
activities was attributable primarily to net proceeds from the issuance of
common stock principally through our initial and secondary public offerings. In
1998 cash provided by financing activities was attributable to $14.8 million in
proceeds from the issuance of preferred stock, $2.5 million of short-term
borrowings and $2.6 million of funds received from the issuance of bridge notes
convertible into Series C preferred stock offset by $550,000 in repayment of
those bridge notes.

  As of December 31, 2000, our principal commitments consisted of obligations
outstanding under operating leases. Although we have no material commitments
for capital expenditures, we anticipate an increase in capital expenditures and
lease commitments consistent with our anticipated growth in operations,
infrastructure and personnel. We also may establish additional operations as we
continue to expand globally.

  We believe that our current cash, cash equivalents and short-term investments
balance of $260.6 million will be sufficient to meet our anticipated cash needs
for working capital and capital expenditures for at least the

                                       27
<PAGE>

next 12 months. If our current cash, cash equivalents and short-term
investments balances are insufficient to satisfy our liquidity requirements,
we may seek to sell additional equity or debt securities or obtain borrowings
through a line of credit. If additional funds are raised through the issuance
of debt securities, these securities could have rights, preferences and
privileges senior to holders of common stock, and the terms of this debt could
impose restrictions on our operations. The sale of additional equity or
convertible debt securities could result in additional dilution to our
stockholders, and we cannot be certain that additional financing will be
available in amounts or on terms acceptable to us, if at all. If we are unable
to obtain this additional financing, we may be required to reduce the scope of
our planned product development and marketing efforts, which could harm our
business, financial condition and operating results.

Recent Accounting Pronouncements

  In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Financial
Instruments and for Hedging Activities" ("FAS 133") which provides a
comprehensive and consistent standard for the recognition and measurement of
derivatives and hedging activities. FAS 133 is effective for fiscal years
beginning after June 15, 2000 and did not have an impact on our results of
operations or financial condition when adopted as we hold no derivative
financial instruments and do not currently engage in hedging activities. In
June 2000, the FASB issued Statement No. 138, "Accounting for Certain
Derivative Instruments and Certain Hedging Activities" ("FAS 138"). FAS 138
addresses certain issues related to the implementation of FAS 133 but does not
change the basic model of FAS 133 or further delay the implementation of FAS
133.

  In December 1998, the AICPA issued Statement of Position 98-9, "Modification
of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions" ("SOP 98-9"). SOP 98-9 requires use of the "residual method" for
recognition of revenue when vendor-specific objective evidence exists for
undelivered elements but does not exist for delivered elements of a software
arrangement. We adopted the provisions of SOP 98-9 for applicable transactions
entered into beginning January 1, 2000. The adoption of SOP 98-9 did not have
a material impact on our consolidated financial statements.

  In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements"("SAB 101"). SAB 101 provides guidance on the recognition,
presentation, and disclosure of revenue in financial statements. In October
2000, the SEC issued additional written guidance to further supplement SAB
101. We adopted SAB 101 in the fourth quarter of 2000. SAB 101 did not have a
material impact on our consolidated financial statements.

  In March 2000, the Financial Accounting Standards Board issued
Interpretation NO. 44, "Accounting for Certain Transactions Involving Stock
Compensation--an Interpretation of APB 25" ("FIN 44"). FIN 44 clarifies (a)
the definition of "employee" for purposes of applying Opinion 25, (b) the
criteria for determining whether a plan qualifies as a non compensatory plan,
(c) the accounting consequence of various modifications to the terms of a
previously fixed stock option or award, and (d) the accounting for an exchange
of stock compensation awards in a business combination. FIN 44 became
effective July 1, 2000, but certain conclusions cover specific events that
occur after either December 15, 1998, or January 12, 2000. To the extent that
this Interpretation covers events occurring during the period after December
15, 1998, or January 12, 2000 but before the effective date of July 1, 2000.
The effects of applying FIN 44 are recognized on a prospective basis from July
1, 2000. The adoption of FIN 44 had no impact on our consolidated financial
statements.

                                      28
<PAGE>

             RISK FACTORS THAT MAY IMPACT FUTURE OPERATING RESULTS

  Factors that have affected our results of operations in the past and are
likely to affect our results of operations in the future, include the
following:

We have a limited operating history, which makes it difficult to evaluate our
prospects.

  We are an early-stage company in the emerging IP telephony market. Because
of our limited operating history, we have limited insight into trends that may
emerge in our market and affect our business. The revenue and income potential
of the IP telephony market, and our business in particular, are unproven. As a
result of our limited operating history, we have limited financial data that
you can use to evaluate our business. You must consider our prospects in light
of the risks, expenses and challenges we might encounter because we are at an
early stage of development in a new and rapidly evolving market. Unless we
generate significant revenue growth, our increasing expenses will
significantly harm our financial position.

  As of December 31, 2000, we had an accumulated deficit of $93.1 million. We
expect to incur operating losses for the foreseeable future, and these losses
may be substantial. Further, we expect to incur negative operating cash flow
in the future. We expect to continue to increase capital expenditures and our
research and development, sales and marketing and general and administrative
expenses. We will need to generate significant revenue growth to achieve
profitability and positive operating cash flows. Even if we do achieve
profitability and positive operating cash flows, we may not be able to sustain
or increase profitability or positive operating cash flows on a quarterly or
annual basis.

  We have experienced operating losses in each year since inception. The
following table shows our operating losses for the periods indicated:

<TABLE>
<CAPTION>
     Year ended December 31,                                     Operating Loss
     -----------------------                                     --------------
                                                                 (in thousands)
     <S>                                                         <C>
     2000.......................................................    $(70,274)
     1999.......................................................     (33,163)
     1998.......................................................      (5,824)
     1997.......................................................      (2,129)
</TABLE>

Our operating results are volatile, and an unanticipated decline in revenue
may disproportionately affect our net income or loss in a quarter.

  Our quarterly and annual operating results have varied significantly in the
past and will likely vary significantly in the future. As a result, our future
operating results are difficult to predict. Further, we incur expenses in
significant part on our expectations of our future revenue. As a result of
this and as a result of integration of acquired operations, we expect our
expense levels to increase in the short term. Therefore, an unanticipated
decline in revenue for a particular quarter may disproportionately affect our
net income or loss in that quarter.

  Any of the above factors could harm our business, financial condition and
results of operations. We believe that period-to-period comparisons of our
results of operations are not meaningful, and you should not rely upon them as
indicators of our future performance.

If we do not reduce costs, introduce new products or increase sales volume,
our gross margin may decline.

  We have experienced significant erosion in the average selling prices of our
products due to a number of factors, including competitive pricing pressures,
rapid technological change and sales discounts. We anticipate that the average
selling prices of our products will decrease and fluctuate in the future in
response to the same factors. Therefore, to maintain or increase our gross
margin, we must develop and introduce new products and product enhancements on
a timely basis. We must also continually reduce our costs of production. As
our

                                      29
<PAGE>

average selling prices decline, we must increase our unit sales volume to
maintain or increase our revenue. To date, the erosion in the average selling
prices has not had a material effect on our business. However, we cannot be
certain that the erosion in the average selling prices will not affect our
business in the future. If our average selling prices decline more rapidly
than our costs of production, our gross margin will decline, which could
seriously harm our business, financial condition and results of operations.

Our markets are highly competitive, and we cannot assure you that we will be
able to compete effectively.

  We compete in a new, rapidly evolving and highly competitive and fragmented
market. We expect competition to intensify in the future. We cannot assure you
that we will be able to compete effectively. We believe that the main
competitive factors in our market are product quality, features, cost and
customer relationships. Our current principal competitors include Cisco
Systems, Inc., Lucent Technologies Inc., Nortel Networks Corporation, Sonus
Networks and VocalTec Communications Ltd. Many of our large competitors have
significantly larger market shares (as measured by ports shipped) and stronger
relationships with service providers than we do. In addition, they may be able
to compete more effectively because they will be able to add IP telephony
features to their existing equipment or bundle these features as part of a
broader solution. We also expect that other companies may enter our market
with better products and technologies.

  We expect our competitors to continue to improve the performance of their
current products and introduce new products or new technologies. To be
competitive, we must continue to invest significant resources in research and
development, sales, marketing and customer support. We cannot be sure that we
will have sufficient resources to make these investments or that we will be
able to make the technological advances necessary to be competitive. Increased
competition is likely to result in price reductions, reduced gross margin and
loss of market share. Our failure to compete successfully against current or
future competitors could seriously harm our business, financial condition and
results of operations.

Our future ability to generate sales depends on the interoperability of our
products with those of other vendors.

  While our products currently connect to the traditional system using
standard interfaces, an increasing number of our customers have requested that
our products interoperate with competing IP telephony products from other
vendors. The interoperability standards for IP telephony equipment are
evolving. We have developed only initial interoperable solutions, but if we
are unable to provide or maintain our customers' interoperable solutions with
other vendors' products, they may seek vendors who provide greater product
interoperability. This could seriously harm our business, financial condition
and results of operations.

If we lose key personnel, we may not be able to operate our business
successfully.

  Our future success depends, in large part, on our ability to attract and
retain highly skilled personnel. The loss of the services of any of our key
personnel, the inability to attract or retain qualified personnel in the
future or delays in hiring required personnel, particularly engineers, sales
personnel and marketing personnel, may seriously harm our business, financial
condition and results of operations. We will need to expand our sales
operations and marketing operations in order to increase market awareness of
our products and generate increased revenue. New sales personnel and marketing
personnel will require training and take time to achieve full productivity. In
addition, the design and installation of IP telephony solutions can be
complex. Accordingly, we need highly trained professional services and
customer support personnel. We will need to continue to increase the number of
service and support staff to support new customers and the expanding needs of
existing customers. Competition for personnel is intense, especially in the
San Francisco Bay Area where we maintain our headquarters. We cannot be
certain that we will successfully attract and retain additional qualified
personnel. In addition, our key person life insurance policy, covering some of
our key employees, may be insufficient to cover the costs associated with the
loss of one of these employees.

                                      30
<PAGE>

Our failure to integrate successfully our acquired companies could prevent us
from operating efficiently.

  We have been involved in, and may in the future be involved in, a number of
acquisition transactions. These transactions have been motivated by many
factors, including our desire to acquire skilled personnel, our desire to
obtain new technologies and our desire to expand and enhance our product and
services lines. Growth through acquisition has several identifiable risks,
including difficulties associated with successfully integrating the previously
distinct businesses into a single unit, the substantial management time
devoted to integrating the companies, the possibility that we might not be
successful in retaining the employees of the acquired companies, undisclosed
liabilities, the failure to realize anticipated benefits (such as cost savings
and synergies) and issues related to product transition (such as distribution,
engineering and customer support). Realization of any of these risks in
connection with our acquisitions could have a material adverse effect on our
business, operating results, and financial condition.

Our failure to manage our rapid growth effectively could negatively affect our
results of operations.

  Since we began commercial shipment of our products in March 1997, we have
experienced a period of rapid growth and expansion that is significantly
straining all of our resources. From December 31, 1999 to December 31, 2000,
the total number of our employees increased from approximately 285 to 850, in
part, as the result of acquisitions. We expect our anticipated growth and
expansion to continue to place strain on our management and operational and
financial resources. We may not be able to install adequate control systems in
an efficient and timely manner, and our current or planned operational
systems, procedures and controls may not be adequate to support our future
operations. Delays in the implementation of new systems or operational
disruptions when we transition to new systems would impair our ability to
accurately forecast sales demand, manage our product inventory and record and
report financial and management information on a timely and accurate basis.
Our inability to manage growth effectively could seriously harm our business,
financial condition and results of operations.

The IP telephony alternative may not achieve widespread acceptance, which
could cause our business to fail.

  The IP telephony market is relatively new and evolving rapidly. Less than 1%
of all voice calls worldwide are currently transmitted over IP-based data
networks. Our ability to increase revenue in the future depends on some of
both existing and future circuit-switched telephone network calls moving to
IP-based data networks. The use of IP telephony for voice calls might be
hindered by the:

  .  reluctance of service providers that have invested substantial resources
     in the existing telephone network infrastructure to replace or expand
     their current networks with this new technology; and

  .  lack of partnerships between service providers, keeping them from having
     global IP telephony network coverage.

  Accordingly, in order to achieve commercial acceptance, we will have to
educate prospective customers, including large, established telecommunications
companies, about the benefits and uses of IP telephony solutions in general,
our products in particular, and the need to partner with other IP telephony
service providers to extend the coverage of their networks. If these efforts
fail or if IP telephony does not achieve commercial acceptance, our business,
financial condition and results of operations could be seriously harmed.

Our inability to introduce new products and product enhancements could prevent
us from increasing revenue.

  We expect that the IP telephony market will be characterized by rapid
technological change. We also expect that the increased use of IP telephony
will require us to rapidly evolve and adapt our products to remain
competitive. The successful operation of our business depends on our ability
to develop and introduce new products and product enhancements that respond to
technological changes or evolving industry standards on a timely and cost-
effective basis. We cannot be certain that we will successfully develop and
market these types of

                                      31
<PAGE>

products and product enhancements. Our failure to produce technologically
competitive products in a cost-effective manner and on a timely basis will
seriously harm our business, financial condition and results of operations.

Future regulation or legislation could restrict our business or increase our
cost of doing business.

  At present there are few laws or regulations that specifically address
access to or commerce on the Internet, including IP telephony. We are unable
to predict the impact, if any, that future legislation, legal decisions or
regulations concerning the Internet may have on our business, financial
condition and results of operations. Regulation may be targeted towards, among
other things, assessing access or settlement charges, imposing tariffs or
imposing regulations based on encryption concerns or the characteristics and
quality of products and services, which could restrict our business or
increase our cost of doing business. The increasing growth of the IP telephony
market and popularity of IP telephony products and services heighten the risk
that governments will seek to regulate IP telephony and the Internet. In
addition, large, established telecommunications companies may devote
substantial lobbying efforts to influence the regulation of the IP telephony
market, which may be contrary to our interests.

We depend on new entrants in the service provider market to generate a portion
of our revenue and our operating results may be harmed if these new entrants
are not commercially viable.

  We expect to generate a portion of our revenue from new entrants in the
telecommunications service provider market. Failure to generate revenue from
these new entrants could have a negative impact on our business. Examples of
these service providers include traditional, local, international and
wholesale long distance companies, competitive local exchange carriers and
Internet telephony service providers. Many of these new entrants are still
building their infrastructures and rolling out their services. We cannot be
sure that any of these companies will achieve commercial viability. Given that
these new entrants may be start-up operations with uncertain financial
resources, we cannot be sure that these new entrants will be able to pay their
obligations to us for purchase of our products on a timely basis, or at all.
Some of our new entrant customers have been late in making payments to us. To
date, late payments from our customers have not significantly impacted our
operations. However, we cannot be certain that late payments from our
customers will not impact our operations in the future. The failure of these
companies to achieve commercial viability or pay their obligations to us
would, in turn, seriously harm our business, financial condition and results
of operations.

A loss of one or more of our key customers could cause a significant decrease
in our net revenue.

  We have historically derived the majority of our revenue from a small number
of customers. In 2000, Triumph Technologies was the only customer that
accounted for 10% or more of our net revenues. In 1999, entities affiliated
with AT&T Corporation accounted for 15% of net revenue and entities affiliated
with Ji Tong Communications accounted for 10% of net revenue. Entities
affiliated with AT&T Corporation accounted for 36% of net revenue, and Technet
International accounted for 12% of net revenue in 1998. None of our customers
is obligated to purchase additional products or services. Accordingly, we
cannot be certain that present or future customers will not terminate their
purchasing arrangements with us or significantly reduce or delay their orders.
Any termination, change, reduction or delay in orders could seriously harm our
business, financial condition and results of operations.

We may not be able to expand our direct sales and distribution channels, which
would harm our ability to generate revenue.

  We believe that our future success is dependent upon our ability to expand
our direct sales force and establish and manage successful relationships with
a variety of international distribution partners. To date, we have entered
into agreements with more than 30 distribution partners that accounted for
approximately 46% of revenue in 2000 and 16% of revenue in 1999. These
distribution agreements typically may be terminated without cause upon 90 days
notice. We cannot be certain that we will be able to reach agreement with
additional

                                      32
<PAGE>

distribution partners on a timely basis or at all, or that these distribution
partners will devote adequate resources to marketing, selling and supporting
our products. To generate greater revenue from distributors, we must
successfully manage our distributor relationships, which we cannot guarantee
that we will be able to do in the future. Our inability to generate revenue
from distribution partners may harm our business, financial condition and
results of operations.

Sales to customers based outside the United States have historically accounted
for a significant portion of our revenue, which exposes us to risks inherent
in international operations.

  International sales represented approximately 73% of total revenue in 2000
and 54% of total revenue in 1999. Our international operations are subject to
a variety of risks associated with conducting business internationally any of
which could seriously harm our business, financial condition and results of
operations.

  These risks include:

  .  greater difficulty in accounts receivable collections;

  .  import or export licensing and product certification requirements;

  .  tariffs, duties, price controls or other restrictions on foreign
     currencies or trade barriers imposed by foreign countries;

  .  potential adverse tax consequences, including restrictions on
     repatriation of earnings;

  .  fluctuations in currency exchange rates;

  .  seasonal reductions in business activity in some parts of the world;

  .  unexpected changes in regulatory requirements;

  .  burdens of complying with a wide variety of foreign laws, particularly
     with respect to intellectual property and license requirements;

  .  difficulties and costs of staffing and managing foreign operations;

  .  political instability;

  .  the impact of recessions in economies outside of the United States; and

  .  limited ability to enforce agreements, intellectual property and other
     rights in some foreign countries.

We may not be able to expand our international operations, which would reduce
our ability to increase revenue.

  We currently have employees based in Argentina, Australia, Belgium, Brazil,
Canada, Colombia, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan,
Mexico, New Zealand, Peru, the People's Republic of China, Poland, Russia,
Singapore, South Korea, Spain, Sweden, Taiwan, the United Kingdom and the
United States. We intend to expand the scope of our international operations,
which will require us to enhance our communications infrastructure and may
include the establishment of overseas assembly operations. If we are unable to
expand our international operations effectively and quickly, we may be unable
to successfully market, sell, deliver and support our products
internationally.

Our sales cycle is typically long and unpredictable, causing us to incur
expenditures prior to the receipt of orders.

  We incur research and development, and sales and marketing, including
customer support, expenditures prior to receiving orders for our products from
any given customer. The length of the sales cycle with a particular customer
is influenced by a number of factors, including:

  .  a customer's experience with sophisticated telecommunications equipment,
     such as our product;

                                      33
<PAGE>

  .  the particular telecommunications market that the customer serves; and

  .  the cost of purchasing our product, including the cost of converting
     from installed equipment, which may be significant.

Before we receive orders, our customers typically test and evaluate our
products for a period of many months.

  We cannot be certain that the sales cycle for our products will not lengthen
in the future. In addition, the emerging and evolving nature of the IP
telephony market may cause prospective customers to delay purchase decisions
as they evaluate new technologies and develop and implement new systems. As
the average order size for our products grows, the process for approving
purchases is likely to become more complex, leading to potential delays in
receipt of these orders. As a result, our long and unpredictable sales cycle
contributes to the uncertainty of our future operating results.

Delays in customer orders could have a negative impact on our results of
operations for any given quarter.

  We have historically received a significant portion of our product orders
near the end of a quarter. Accordingly, a delay in an anticipated receipt or
delivery of a given order past the end of a particular quarter may negatively
impact our results of operations for that quarter. These delays may become
more likely given that we expect that the average size of our customer orders
may increase. As a result, a delay in the recognition of revenue, even from
just one customer, may have a significant negative impact on our results of
operations for a given period. Additionally, the volatility in capital markets
and in the U.S. economy may cause some customers to postpone or terminate
significant capital expenditures, such as expenditures on our products. Any
delay in sales of our products could result in a significant decrease in cash
flow, which, in turn, could severely affect our ability to make payments as
they come due and could cause our operating results to vary significantly from
quarter to quarter.

Our dependence on independent manufacturers may result in product delivery
delays.

  We license technology that is incorporated into our products from
independent manufacturers, including AudioCodes, Ltd. and Natural
Microsystems. If these vendors fail to supply us with their components on a
timely basis, we could experience significant delays in shipping our products.
Although we believe there are other sources for this licensed technology, any
significant interruption in the supply or support of any licensed technology
could seriously harm our sales, unless and until we can replace the
functionality provided by this licensed technology. Also, because our products
incorporate software developed and maintained by third parties, we depend on
these third parties to deliver reliable products, support these products,
enhance their current products, develop new products on a timely and cost-
effective basis, and respond to emerging industry standards and other
technological changes. The failure of these third parties to meet these
criteria could seriously harm our business, financial condition and results of
operations.

Our business could be harmed if we are unable to forecast our inventory needs
accurately.

  Lead times for materials and components used in the assembly of our products
vary significantly. If orders do not match forecasts, we may have excess or
inadequate inventory of some materials and components.

Our strategy to outsource assembly and test functions in the future could
delay our ability to deliver our products on a timely basis.

  We assemble and test our products at our facilities in Redwood City and
Calabasas, California and in Manassas, Virginia. Based on volume or customer
requirements, we may begin outsourcing some of our assembly and test
functions. This outsourcing strategy involves risks, including the potential
absence of adequate capacity and reduced control over delivery schedules,
manufacturing yields, quality and costs. In the event that any significant
subcontractor was unable or unwilling to continue to manufacture and/or test
our products in the

                                      34
<PAGE>

required volumes, we would have to identify and qualify acceptable
replacements. This process could be lengthy, and we cannot be sure that
additional sources would be available to us on a timely basis. Any delay or
increase in costs in the assembly and testing of products by third-party
subcontractors could seriously harm our business, financial condition and
results of operations.

Our facilities are vulnerable to damage from earthquakes and other natural
disasters.

  Some of our assembly facilities are located on or near known earthquake
fault zones and all are vulnerable to damage from fire, floods, earthquakes,
power loss, telecommunications failures and similar events. If such a disaster
occurs while we still assemble our products in-house, our ability to assemble,
test and ship our products would be seriously, if not completely, impaired,
which would seriously harm our business, financial condition and results of
operations. We cannot be sure that the insurance we maintain against fires,
floods, earthquakes and general business interruptions will be adequate to
cover our losses in any particular case.

Our operations may be adversely affected by the California energy crisis

  We have various facilities located in California, including our principal
facilities in Redwood City. Some of our suppliers are also located in
California. The energy crisis that has resulted in disruptions in power supply
and increases in utility costs could disrupt the operations of Clarent and its
suppliers. We, or our suppliers, may experience additional power disruptions,
power rationing and significantly higher costs of energy in California and be
unable to continue operations. Any such interruption in operations could harm
our ability to service and retain existing customers and may inhibit our
ability to obtain new customers, and could result in lost revenue, any of
which could adversely affect our financial condition.

Fluctuations in the values of foreign currencies could have a negative impact
on our profitability.

  Due to our international operations, we incur expenses in a number of
currencies. We do not currently engage in currency hedging activities to limit
the risks of exchange rate fluctuations. Therefore, fluctuations in the value
of foreign currencies could have a negative impact on the profitability of our
global operations, which would seriously harm our business, financial
condition and results of operations. All of our sales, including international
sales are currently denominated in U.S. dollars. However, we do not expect
that future international sales will continue to be denominated in U.S.
dollars. Fluctuations in the value of the U.S. dollar and foreign currencies
may make our products more expensive than local product offerings.

Defects in our products may seriously harm our credibility and harm our
business.

  We have detected and may continue to detect errors and product defects in
connection with new product releases and product upgrades. These problems may
affect network uptime and cause us to incur significant warranty and repair
costs and cause significant customer relations problems. Service providers
require a strict level of quality and reliability from telecommunications
equipment suppliers. Traditional telecommunications equipment is expected to
provide a 99.999% level of reliability. IP telephony products are inherently
complex and frequently contain undetected software or hardware errors when
first introduced or as new versions are released. In addition, the detection
of errors in software products requires an unknown level of effort to correct
and may delay the release of new products or upgrades or revisions to existing
products, which could materially affect the market acceptance and sales of our
products. If we deliver products or upgrades with undetected material software
errors or product defects, our credibility and market acceptance and sales of
our products may be harmed. In some of our contracts, we have agreed to
indemnify our customers against certain liabilities arising from defects in
our products. While we carry insurance policies covering this type of
liability, these policies may not provide sufficient protection should a claim
be asserted. To date, product defects have not had a material negative effect
on our results of operations. However, we cannot be certain that product
defects will not have a material negative effect on our results of operations
in the future. A material product liability claim may have significant
consequences on our ability to compete effectively and generate positive cash
flow and may seriously harm our business, financial condition and results of
operations.

                                      35
<PAGE>

We may have difficulty identifying the source of the problem when there is a
problem in a network.

  Our products must successfully integrate with products from other vendors,
such as traditional telephone systems. As a result, when problems occur in a
network, it may be difficult to identify the source of the problem. The
occurrence of hardware and software errors, whether caused by our products or
another vendor's products, may result in the delay or loss of market
acceptance of our products and any necessary revisions may force us to incur
significant expenses. The occurrence of some of these types of problems may
seriously harm our business, financial condition and results of operations.

We may not have adequate protection for our intellectual property, which may
make it easier for others to sell competing products.

  We rely on a combination of copyright, trademark and trade secret laws and
restrictions on disclosure to protect our intellectual property rights.
Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy or otherwise obtain and use our products or technology.
Monitoring unauthorized use of our products is difficult, and we cannot be
certain that the steps we have taken will prevent misappropriation of our
technology. The laws of some foreign countries do not protect our proprietary
rights to as great an extent as the laws of the United States, and many United
States companies have encountered substantial infringement problems in these
countries, some of which are countries in which we have sold and continue to
sell products. If we fail to protect our intellectual property rights
adequately, it would be easier for our competitors to sell competing products.

Our products may infringe on the intellectual property rights of third
parties, which may result in lawsuits and prohibit us from selling our
products.

  We believe there is a risk that third parties have filed, or will file
applications for, or have received or will receive, patents or obtain
additional intellectual property rights relating to materials or processes
that we use or propose to use. As a result, from time to time, third parties
may assert exclusive patent, copyright, trademark and other intellectual
property rights to technologies that are important to us. In addition, third
parties may assert claims or initiate litigation against us or our
manufacturers, suppliers or customers with respect to existing or future
products, trademarks or other proprietary rights. Any claims against us or
customers that we indemnify against intellectual property claims, with or
without merit, may be time-consuming, result in costly litigation and
diversion of technical and management personnel or require us to develop non-
infringing technology. If a claim is successful, we may be required to obtain
a license or royalty agreement under the intellectual property rights of those
parties claiming the infringement. If we are unable to obtain the license, we
may be unable to market our products. Limitations on our ability to market our
products and delays and costs associated with monetary damages and redesigns
in compliance with an adverse judgment or settlement could harm our business,
financial condition and results of operations.

We may not be able to raise capital as needed to maintain our operations.

  We may need to raise additional funds and additional financing may not be
available on favorable terms, if at all. We may also require additional
capital to acquire or invest in complementary businesses or products or obtain
the right to use complementary technologies. If we cannot raise needed funds
on acceptable terms, we may not be able to develop or enhance our products,
take advantage of future opportunities or respond to competitive pressures or
unanticipated requirements, which could seriously harm our business, financial
condition and results of operations. If we issue additional equity securities
to raise funds, the ownership percentage of our existing stockholders would be
reduced. New investors may demand rights, preferences or privileges senior to
those of existing holders of our common stock.

Our stock price is highly volatile.

  The trading price of our common stock has fluctuated significantly since our
initial public offering in July 1999. In addition, the trading price of our
common stock could be subject to wide fluctuations in response to

                                      36
<PAGE>

quarterly variations in operating results, announcements of technological
innovations or new products by us or our competitors, developments with
respect to patents or proprietary rights, announcements of strategic
partnerships or new customers by us or our competitors, changes in financial
estimates by securities analysts and other events or factors. Also, the stock
market has experienced volatility that has particularly affected the market
prices of equity securities of many high technology companies and that often
has been unrelated or disproportionate to the operating performance of these
companies. These broad market fluctuations may adversely affect the market
price of our common stock, as evidenced by a fluctuation in our per share
price on the Nasdaq National Market from a low of $10.00 to a high of $178.75
during the year ended December 31, 2000.

We may in the future be the target of securities class action or other
litigation, which could be costly and time consuming to defend.

  In the past, securities class action litigation has often been brought
against a company following periods of volatility in the market price of its
securities. We may in the future be the target of similar litigation. Our
acquisition activity may involve us in disputes from time to time. Litigation
that may arise from these disputes may lead to volatility in our stock price
and/or may result in our being the target of securities class action
litigation. Securities litigation may result in substantial costs and divert
management's attention and resources, which may seriously harm our business,
financial condition and results of operations.

Our certificate of incorporation and bylaws and Delaware law contain
provisions that could delay or prevent a change of control of Clarent.

  Certain provisions of our certificate of incorporation and bylaws and
Delaware law may discourage, delay or prevent a merger or acquisition that a
stockholder may consider favorable. These provisions include:

  .  authorizing the board of directors to issue preferred stock;

  .  prohibiting cumulative voting in the election of directors;

  .  limiting the persons who may call special meetings of stockholders;

  .  prohibiting stockholder action by written consent; and

  .  establishing advance notice requirements for nominations for election of
     the board of directors or for proposing matters that can be acted on by
     stockholders at stockholder meetings.

  In addition, in February 2001, we adopted a shareholder rights plan which
may also discourage, delay or prevent a merger that a stockholder may consider
favorable. We are also subject to certain provisions of Delaware law that
could delay, deter or prevent us from entering into an acquisition, including
Section 203 of the Delaware General Corporation Law, which prohibits a
Delaware corporation from engaging in a business combination with an
interested stockholder unless specific conditions are met.

Substantial future sales of our shares in the public market may cause our
stock price to fall.

  If our stockholders sell substantial amounts of our common stock, including
shares issued upon exercise of outstanding options and warrants, in the public
market during a short period of time, our stock price may decline
significantly. These sales also might make it more difficult for us to sell
equity or equity related securities in the future at a time and price that we
deem appropriate.

We do not intend to pay dividends.

  We have never declared or paid any cash dividends on our capital stock. We
currently intend to retain any future earnings for funding growth. Therefore,
we do not expect to pay any dividends in the foreseeable future.

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<PAGE>

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Financial Market Risk

  Our financial market risk includes risks associated with international
operations and related foreign currencies. We anticipate that international
sales will continue to account for a significant portion of our consolidated
revenue. Our international sales are largely denominated in U.S. dollars and
therefore are not subject to material foreign currency exchange risk. Expenses
of our international operations are denominated in each country's local
currency and therefore are subject to foreign currency exchange risk; however,
through December 31, 2000 we have not experienced any significant negative
impact on our operations as a result of fluctuations in foreign currency
exchange rates. We do not currently engage in any hedging activities or use
derivative financial instruments.

  We have an investment portfolio of fixed income securities, including those
classified as cash equivalents, of $ 222.5 million at December 31, 2000. These
securities are subject to interest rate fluctuations and will decrease in
market value if interest rates increase.

  The primary objective of our investment activities is to preserve principal
while at the same time maximizing yields without significantly increasing
risk. We invest primarily in high-quality, short-term debt instruments such as
U.S. government securities and instruments issued by high quality financial
institutions and companies including money market instruments and debt issued
by corporations. A hypothetical 100 basis point increase in interest rates
would result in less than a $0.2 million decrease (less than 0.2%) in the fair
market value of our available-for-sale securities.

  We have investments in equity securities of privately held companies for the
promotion of business and strategic objectives of $14.5 million, net at
December 31, 2000. These investments are generally in companies in the
telecommunications industry. We also have invested in a venture capital
management fund. These investments are included in long-term investments and
are accounted for using the cost method. For investments in which no public
market exists, our policy is to regularly review the operating performance,
recent financing transactions and cash flow forecasts for such companies in
assessing the net realizable values of the securities of these companies.
Impairment losses on equity investments are recorded when events and
circumstances indicate that such assets are impaired and the decline in value
is other than temporary. We recorded $1 million in impairment losses during
2000.


                                      38
<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                              CLARENT CORPORATION

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<S>                                                                           <C>
Consolidated Financial Statements:

Report of Ernst & Young LLP, Independent Auditors............................  40

Consolidated Balance Sheets..................................................  41

Consolidated Statements of Operations........................................  42

Consolidated Statements of Stockholders' Equity..............................  43

Consolidated Statements of Cash Flows........................................  47

Notes to Consolidated Financial Statements...................................  49

Financial Statement Schedule:

For the three years ended December 31, 2000

  Schedule II--Valuation and Qualifying Accounts.............................  68
</TABLE>

                                       39
<PAGE>

               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Clarent Corporation

  We have audited the accompanying consolidated balance sheets of Clarent
Corporation as of December 31, 2000 and 1999, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the
three years in the period ended December 31, 2000. Our audits also included
the financial statement schedule listed in the Index at Item 14(a). These
financial statements and schedule are the responsibility of the Company'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 auditing standards generally
accepted in the 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 Clarent
Corporation at December 31, 2000 and 1999, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2000, in conformity with accounting principles generally accepted
in the United States. 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.

                                          /s/ Ernst & Young LLP

San Jose, California
January 18, 2001,
except as to Note 15, as to which the date is February 15, 2001.

                                      40
<PAGE>

                              CLARENT CORPORATION

                          CONSOLIDATED BALANCE SHEETS
                       (in thousands, except par values)

<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              2000      1999
                                                            --------  --------
ASSETS
<S>                                                         <C>       <C>
Current assets:
  Cash and cash equivalents................................ $185,627  $238,724
  Short-term investments...................................   74,987    42,581
  Accounts receivable, net of allowance for doubtful
   accounts of $7,645 at 2000 and $2,314 at 1999...........   61,610    24,218
  Inventories..............................................   17,487     8,404
  Prepaid expenses and other current assets................   11,342     2,826
                                                            --------  --------
    Total current assets...................................  351,053   316,753
Investments................................................   14,479     2,988
Property and equipment, net................................   36,630    12,696
Goodwill, net..............................................   93,644     2,558
Purchased intangible assets, net...........................   38,057       --
Deferred tax assets........................................   15,988       --
Other assets...............................................    4,517       373
                                                            --------  --------
                                                            $554,368  $335,368
                                                            ========  ========
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
<S>                                                         <C>       <C>
Current liabilities:
  Accounts payable......................................... $ 14,337  $  8,552
  Compensation related accruals............................    7,948     2,991
  Deferred revenue.........................................   13,947    10,117
  Merger related restructuring accrual.....................    8,656       --
  Other accrued liabilities................................   12,782     4,866
                                                            --------  --------
    Total current liabilities..............................   57,670    26,526
Commitments and contingencies
Deferred tax liabilities...................................   14,534       --
Stockholders' equity:
  Preferred Stock, $0.001 par value: 5,000 shares
   authorized; none issued and outstanding.................      --        --
  Common stock, $0.001 par value: 200,000 and 50,000 shares
   authorized; 39,350 and 30,986 issued and outstanding at
   2000 and 1999, respectively.............................  585,281   353,894
  Deferred compensation....................................   (9,740)   (5,990)
  Accumulated other comprehensive loss.....................     (326)     (112)
  Accumulated deficit......................................  (93,051)  (38,950)
                                                            --------  --------
    Total stockholders' equity.............................  482,164   308,842
                                                            --------  --------
                                                            $554,368  $335,368
                                                            ========  ========
</TABLE>

                            See accompanying notes.

                                       41
<PAGE>

                              CLARENT CORPORATION

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                    Year ended December 31,
                                                   ---------------------------
                                                     2000      1999     1998
                                                   --------  --------  -------
<S>                                                <C>       <C>       <C>
Net revenue:
  Product and software............................ $136,987  $ 44,182  $13,810
  Service.........................................   14,594     3,641      837
                                                   --------  --------  -------
    Total net revenue.............................  151,581    47,823   14,647
Cost of revenue:
  Product and software............................   51,480    16,746    5,902
  Service.........................................    8,367     3,559      751
                                                   --------  --------  -------
    Total cost of revenue.........................   59,847    20,305    6,653
                                                   --------  --------  -------
  Gross profit....................................   91,734    27,518    7,994
Operating expenses:
  Research and development........................   29,894     9,172    3,356
  Sales and marketing.............................   59,301    25,111    7,099
  General and administrative......................   18,076     6,877    2,484
  Amortization of compensation....................    6,201    19,371      879
  Amortization of goodwill and purchased
   intangible assets..............................   15,654       150      --
  Merger Related Costs............................    1,386       --       --
  Purchased in-process research and development...   31,496       --       --
                                                   --------  --------  -------
    Total operating expenses......................  162,008    60,681   13,818
                                                   --------  --------  -------
Loss from operations..............................  (70,274)  (33,163)  (5,824)
Other income:
  Interest and other income.......................   17,103     2,812      204
  Interest expense................................      (6)      (300)    (172)
                                                   --------  --------  -------
    Total other income............................   17,097     2,512       32
                                                   --------  --------  -------
Loss before income taxes..........................  (53,177)  (30,651)  (5,792)
Provision for income taxes........................     (924)     (132)     (40)
                                                   --------  --------  -------
Net loss.......................................... $(54,101) $(30,783) $(5,832)
                                                   ========  ========  =======
Basic and diluted net loss per share.............. $  (1.54) $  (1.87) $ (1.65)
                                                   ========  ========  =======
Shares used to compute basic and diluted net loss
 per share........................................   35,063    16,457    3,544
                                                   ========  ========  =======
</TABLE>


                            See accompanying notes.

                                       42
<PAGE>

                              CLARENT CORPORATION

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                (in thousands)

<TABLE>
<CAPTION>
                   Convertible
                    Preferred                                    Notes                    Accumulated
                      Stock      Common Stock                  Receivable                    Other                    Total
                  -------------- --------------    Deferred       from     Comprehensive Comprehensive Accumulated Stockholders
                  Shares Amount  Shares  Amount  Compensation Stockholders     Loss          Loss        Deficit      Equity
                  ------ ------- ------  ------  ------------ ------------ ------------- ------------- ----------- ------------
<S>               <C>    <C>     <C>     <C>     <C>          <C>          <C>           <C>           <C>         <C>
Balances as of
 December 31,
 1997...........  4,220  $ 3,685 5,401   $  27      $  --         $(9)         $--           $(34)       $(2,335)    $ 1,334
Issuance of
 Series C
 Convertible
 preferred
 stock, net of
 issuance costs
 of $159........  2,279   14,834   --      --          --          --           --             --            --       14,834
Issuance of
 Series C
 preferred stock
 for settlement
 expense........     45      300   --      --          --          --           --             --            --          300
Conversion of
 Series C Bridge
 notes and
 related accrued
 interest of $56
 to Series C
 preferred
 stock, net of
 issuance costs
 of $129........    320    1,977   --      --          --          --           --             --            --        1,977
Issuance of
 warrants in
 conjunction
 with Series C
 bridge
 financing......    --       228   --      --          --          --           --             --            --          228
Exercise of
 common stock
 options........    --       --  1,065      36         --          --           --             --            --           36
Exercise of
 common stock
 warrants.......    --       --    768      38         --          --           --             --            --           38
Repurchase of
 common stock...    --       --   (105)     (5)        --          --           --             --            --           (5)
Forgiveness of
 stockholder
 notes
 receivable.....    --       --    --      --          --           9           --             --            --            9
Deferred
 compensation
 related to
 grant of stock
 options........    --       --    --    2,293      (2,293)        --           --             --            --          --
</TABLE>

                            See accompanying notes.

                                       43
<PAGE>

                              CLARENT CORPORATION

                CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY
                                (in thousands)

<TABLE>
<CAPTION>
                    Convertible                                     Notes                    Accumulated
                  Preferred Stock     Common Stock                Receivable                    Other                    Total
                  -----------------  --------------   Deferred       from     Comprehensive Comprehensive Accumulated Stockholders
                  Shares    Amount   Shares Amount  Compensation Stockholders     Loss          Loss        Deficit      Equity
                  -------  --------  ------ ------- ------------ ------------ ------------- ------------- ----------- ------------
<S>               <C>      <C>       <C>    <C>     <C>          <C>          <C>           <C>           <C>         <C>
Compensation
 related to
 issuance of
 warrants for
 services.......      --   $    --      --  $   357   $    --        $ --        $   --         $ --        $   --      $   357
Amortization of
 deferred
 compensation...      --        --      --      --         522         --            --           --            --          522
Comprehensive
 loss:
Net loss........      --        --      --      --         --          --         (5,832)         --         (5,832)     (5,832)
Foreign currency
 translation
 adjustment.....      --        --      --      --         --          --            (34)        (34)           --          (34)
                                                                                 -------
Comprehensive
 loss...........      --        --      --      --         --          --         (5,866)         --            --          --
                  -------  --------  ------ -------   --------       ----        =======        ----        -------     -------
Balances as of
 December 31,
 1998...........    6,864    21,024   7,129   2,746     (1,771)        --                        (68)        (8,167)     13,764
Compensation
 related to
 issuance of
 warrants for
 services.......      --        --      --   12,272        --          --            --           --            --       12,272
Exercise of
 common stock
 warrants.......      --        --      992      50        --          --            --           --            --           50
Exercise of
 Series C
 preferred stock
 warrants.......       59       332     --      --         --          --            --           --            --          332
Conversion of
 preferred stock
 into common
 stock..........   (6,923)  (21,356) 13,847  21,356        --          --            --           --            --          --
Deferred
 compensation
 related to
 grant of stock
 options........      --        --      --   11,318    (11,318)        --            --           --            --          --
</TABLE>

                            See accompanying notes.

                                       44
<PAGE>

                              CLARENT CORPORATION

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                (in thousands)

<TABLE>
<CAPTION>
                     Convertible
                      Preferred                                   Notes                    Accumulated
                        Stock      Common Stock                 Receivable                    Other                    Total
                    ------------- ---------------   Deferred       from     Comprehensive Comprehensive Accumulated Stockholders
                    Shares Amount Shares  Amount  Compensation Stockholders     Loss          Loss        Deficit      Equity
                    ------ ------ ------ -------- ------------ ------------ ------------- ------------- ----------- ------------
<S>                 <C>    <C>    <C>    <C>      <C>          <C>          <C>           <C>           <C>         <C>
Issuance of common
 stock in initial
 and secondary
 public offerings,
 net of issuance
 costs of $18,515.    --   $ --    7,566 $302,563   $   --         $--        $    --         $--        $    --      $302,563
Issuance of common
 stock for
 exercise of
 options and
 employee stock
 purchase plan....    --     --    1,409      789       --                         --          --             --           789
Common stock
 issued in
 connection with
 acquisition......    --     --       43    2,800       --          --             --          --             --         2,800
Amortization of
 Deferred
 compensation.....    --     --      --       --      7,099         --             --          --             --         7,099
Comprehensive
 loss:
  Net loss........    --     --      --       --        --          --         (30,783)        --         (30,783)     (30,783)
  Foreign currency
   Translation
   adjustment.....    --     --      --       --        --          --             (29)        (29)           --           (29)
Unrealized loss on
 securities.......    --     --      --       --        --          --             (15)        (15)           --           (15)
                                                                              --------
Comprehensive
 loss.............    --     --      --       --        --          --        $(30,827)        --             --           --
                     ----  -----  ------ --------   -------        ---        ========        ----       --------     --------
Balances as of
 December 31,
 1999.............    --     --   30,986  353,894    (5,990)        --                        (112)       (38,950)     308,842
Common stock for
 options and
 employee stock
 purchase plan....    --     --    3,388    8,113       --          --             --          --             --         8,113
Common stock for
 acquisitions.....    --     --    4,974  221,321       --          --             --          --             --       221,321
</TABLE>

                            See accompanying notes.

                                       45
<PAGE>

                              CLARENT CORPORATION

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                (in thousands)

<TABLE>
<CAPTION>
                   Convertible
                    Preferred                                   Notes                    Accumulated
                      Stock      Common Stock                 Receivable                    Other                    Total
                  ------------- ---------------   Deferred       from     Comprehensive Comprehensive Accumulated Stockholders
                  Shares Amount Shares  Amount  Compensation Stockholders     Loss          Loss        Deficit      Equity
                  ------ ------ ------ -------- ------------ ------------ ------------- ------------- ----------- ------------
<S>               <C>    <C>    <C>    <C>      <C>          <C>          <C>           <C>           <C>         <C>
Deferred
 compensation
 for grant of
 stock options
 in acquisition.    --    $ --     --  $    --    $(9,952)        $--       $    --         $ --       $    --      $ (9,952)
Exercise of
 common stock
 warrants.......    --      --       2      --        --           --            --           --            --           --
Amortization of
 deferred
 compensation...    --      --     --       --      6,202          --            --           --            --         6,202
Tax benefit from
 employee stock
 options and
 other..........    --      --     --     1,953       --           --            --           --            --         1,953
Comprehensive
 income:
Net loss........    --      --     --       --        --           --        (54,101)         --        (54,101)     (54,101)
Foreign currency
 translation
 adjustment.....    --      --     --       --        --           --           (260)        (260)          --          (260)
Unrealized gain
 on securities..    --      --     --       --        --           --             46           46           --            46
                                                                            --------
Comprehensive
 loss...........    --      --     --       --        --           --       $(54,315)         --            --           --
                   ---    ----  ------ --------   -------        ----       ========        -----      --------     --------
Balances as of
 December 31,
 2000...........    --    $ --  39,350 $585,281   $(9,740)       $ --                       $(326)     $(93,051)    $482,164
                   ===    ====  ====== ========   =======        ====                       =====      ========     ========
</TABLE>

                            See accompanying notes.

                                       46
<PAGE>

                              CLARENT CORPORATION

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)
<TABLE>
<CAPTION>
                                                   Year ended December 31,
                                                  ----------------------------
                                                    2000       1999     1998
                                                  ---------  --------  -------
<S>                                               <C>        <C>       <C>
Cash flows from operating activities:
  Net loss....................................... $ (54,101) $(30,783) $(5,832)
  Adjustments to reconcile net loss to net cash
   used in operating activities:
    Depreciation and amortization................    32,725    22,330    1,395
    Deferred income taxes........................    (1,454)      --       --
    In-process research and development..........    31,496       --       --
    Tax benefits from employee stock options
     plans.......................................     1,953       --       --
    Impairment of investments....................     1,000       --       --
    Interest expense from warrant issued in
     conjunction with Series C bridge notes......       --        --        99
    Preferred stock issued for interest payable..       --        --        56
    Forgiveness of stockholder notes receivable..       --        --         9
    Changes in operating assets and liabilities,
     net of effect of acquired businesses:
      Accounts receivable........................   (31,024)  (15,860)  (6,166)
      Inventories................................    (4,588)   (4,759)  (2,731)
      Prepaid expenses and other current assets..    (7,326)   (2,348)    (353)
      Other assets...............................    (3,892)     (361)      10
      Accounts payable and accrued liabilities...     8,981    10,154    3,440
      Deferred revenue...........................     3,424     5,703    4,259
                                                  ---------  --------  -------
      Net cash used in operating activities......   (22,806)  (15,924)  (5,814)
                                                  ---------  --------  -------
Cash flows from investing activities:
  Purchases of short-term investments...........   (221,919)  (45,759)     --
  Purchases of long-term investments.............   (16,719)   (3,000)     --
  Sale and maturity of short-term investments....   191,601     3,175      --
  Sale and maturity of long-term investments.....     5,728       --       --
  Purchases of property and equipment............   (30,158)  (13,228)  (2,207)
  Acquisition of businesses, net of cash
   acquired......................................    33,316       325      --
                                                  ---------  --------  -------
      Net cash used in investing activities......   (38,151)  (58,487)  (2,207)
                                                  ---------  --------  -------
Cash flows from financing activities:
  Proceeds from (payment of) line of credit......       --     (2,500)   2,500
  Proceeds from Series C bridge notes............       --        --     2,600
  Principal payment on Series C bridge notes.....       --        --      (550)
  Net proceeds from issuance of common stock.....     8,113   303,402       69
  Net proceeds from issuance of preferred stock..       --        332   14,834
                                                  ---------  --------  -------
      Net cash provided by financing activities..     8,113   301,234   19,453
                                                  ---------  --------  -------
Effect of exchange rate changes on cash and cash
 equivalents.....................................      (253)       (2)      (3)
                                                  ---------  --------  -------
Net increase (decrease) in cash and cash
 equivalents.....................................   (53,097)  226,821   11,429
Cash and cash equivalents, beginning of year.....   238,724    11,903      474
                                                  ---------  --------  -------
Cash and cash equivalents, end of year........... $ 185,627  $238,724  $11,903
                                                  =========  ========  =======
</TABLE>

                            See accompanying notes.

                                       47
<PAGE>

                              CLARENT CORPORATION

               CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
                                 (in thousands)

<TABLE>
<CAPTION>
                                                         Year ended December 31,
                                                         -----------------------
                                                           2000    1999    1998
                                                         -------- ------- ------
<S>                                                      <C>      <C>     <C>
Supplemental disclosure of cash flow information:
Cash paid for interest.................................  $      6 $   300 $   28
                                                         ======== ======= ======
Supplemental disclosure of non-cash financing
 activities:
Common stock received in exchange for settlement of
 accounts receivable...................................  $  1,500 $   --  $  --
                                                         ======== ======= ======
Conversion of bridge notes to Series C preferred stock,
 less unamortized cost of related preferred stock
 warrant...............................................  $    --  $   --  $1,921
                                                         ======== ======= ======
Issuance of preferred stock for settlement expense.....  $    --  $   --  $  300
                                                         ======== ======= ======
Conversion of preferred stock to common stock..........  $    --  $21,356 $  --
                                                         ======== ======= ======
Issuance of common stock in connection with
 acquisitions..........................................  $221,321 $ 2,800 $  --
                                                         ======== ======= ======
</TABLE>

                            See accompanying notes.

                                       48
<PAGE>

                              CLARENT CORPORATION

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. The Company and Summary of Significant Accounting Policies

 Description of Business

  Clarent Corporation (Clarent or the Company) is a leading provider of
software-based communications solutions that are designed to take advantage of
the flexibility and universal reach of Internet Protocol (IP) communications
networks, the most prominent of which is the public network known as the
Internet. Clarent customers include telecommunications service providers and
enterprises in over 70 countries throughout the globe.

 Basis of Consolidation

  The consolidated financial statements include the accounts of Clarent and
its subsidiaries. All significant inter-company accounts and transactions have
been eliminated.

 Use of Estimates

  The preparation of financial statements in conformity with 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 could differ from those estimates.

 Revenue Recognition

  Revenue is recognized at the time of shipment of the products when
persuasive evidence of an arrangement exists, the fee is fixed and
determinable, when no significant contractual obligations or acceptance terms,
if any, remain outstanding and collection of the resulting receivable is
deemed probable. Revenue from services is recognized when the services are
performed. Amounts billed or received in advance of satisfying revenue
recognition criteria are classified as deferred revenue in the accompanying
balance sheets. The Company accrues for warranty costs based upon its
experience.

 Concentrations of Credit Risk and Credit Evaluations

  Financial instruments, which subject the Company to concentrations of credit
risk, primarily consist of cash, short and long term investments and trade
accounts receivable. The Company maintains its cash and cash equivalents
principally in domestic financial institutions of high-credit standing. The
Company's receivables are derived primarily from sales of software and
hardware products and services to companies primarily in the domestic and
international telecommunications arena. Approximately 46% of the trade
accounts receivable at December 31, 2000 were from the Asia Pacific region,
21% from Europe, Middle East and Africa and 33% from the Americas. The Company
performs ongoing credit evaluations of its customers and generally does not
require collateral. Reserves are maintained for potential credit losses.

  A limited number of customers have historically accounted for a substantial
portion of the Company's revenue. One customer, Triumph Technology, Inc.,
accounted for 10% of net revenue for the year ended December 31, 2000 and one
customer, D-Link Corporation, was 20% of accounts receivable at December 31,
2000. Two customers, AT&T Corporation and Ji Tong Communications Co. Ltd.,
accounted for 15% and 10%, respectively, of net revenue for the year ended
December 31, 1999 and two customers, AT&T Corporation and Technet, were 10%
and 12%, respectively, of the accounts receivable balance at December 31,
1999. Two customers, AT&T Corporation and Technet International, accounted for
36% and 12%, respectively, of net revenue for the year ended December 31,
1998.

                                      49
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Cash Equivalents and Short-Term Investments

  The Company considers all highly liquid investment securities with maturity
from date of purchase of three months or less to be cash equivalents and
investment securities with maturity from date of purchase of more than three
months but less than one year to be short-term investments.

  Management determines the appropriate classification of debt and equity
securities at the time of purchase and reevaluates such designation as of each
balance sheet date. To date, all investments have been classified as
available-for-sale and are carried at fair value with unrealized gains and
losses reported net-of-tax as a separate component of comprehensive income.
Realized gains and losses on available-for-sale securities are included in
interest income. The cost of securities sold is based on specific
identification. Premiums and discounts are amortized over the period from
acquisition to maturity and are included in investment income along with
interest and dividends.

 Other Investments

  Other investments primarily consist of strategic investments of less than
20% equity interest in certain companies. Clarent does not have the ability to
exercise significant influence over any of these companies therefore they are
recorded at cost and are accounted for under the cost method of accounting.
Realized gains and losses are recorded in interest and other income when the
related investments are sold. Clarent's investments in privately held
companies are regularly assessed for impairment through review of operations
and indications of continued viability. Reviews of operations to assess
carrying values include evaluation of operating performance, financing status,
liquidity prospects and cash flow forecasts. Impairment losses are recorded
when events and circumstances indicate that such assets might be impaired and
the decline in value is other than temporary.

 Inventories

  Inventories are stated at the lower of cost or market on a first-in, first-
out basis.

 Property and Equipment

  Property and equipment are stated at cost. Depreciation and amortization is
computed using the straight-line method over the estimated useful lives of the
assets. Estimated useful lives ranging from one to three years are used for
computer equipment, purchased software, production and engineering equipment
and five years for office equipment, furniture and fixtures. Leasehold
improvements are depreciated over the shorter of five years or the remaining
term of the applicable lease.

 Intangible Assets

  Intangible assets consist of assembled workforce, customer base, purchased
technology and goodwill related to the acquisitions of ACT Networks, Inc.,
PEAK Software Inc. and Global Media Concepts, a Belgium corporation. These
acquisitions were accounted for as purchases and are further described in Note
2. Goodwill and other intangible assets are amortized, on a straight-line
basis, over the estimated useful lives of the assets, which generally range
from three to five years. Purchased in-process research and development
without alternative future use is charged to operations at the date of
acquisition.

  We record impairment losses on intangible assets when events and
circumstances indicate that such assets might be impaired and the estimated
fair value of the asset is less than its recorded amount. Conditions that
would trigger an impairment assessment include material adverse changes in
operations or our decision to

                                      50
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

abandon acquired products, services or technologies. Measurement of fair value
would be based on discounted cash flows at our incremental borrowing rate and
would include a factor for the probability that the impaired product, service
or technology would be successful. To date, no such impairment has occurred.

  Software Development Costs Statement of Financial Accounting Standards No.
86, "Accounting for the Costs of Computer Software to Be Sold, Leased or
Otherwise Marketed," requires capitalization of certain software development
costs subsequent to the establishment of technological feasibility. These
costs have not been significant to date.

 Stock-Based Compensation

  The Company accounts for stock-based awards to employees under the intrinsic
value method in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB 25), and has adopted the
disclosure-only alternative of Statement of Financial Accounting Standards No.
123, "Accounting for Stock-Based Compensation" (FAS 123).

 Advertising Expenses

  The Company expenses advertising costs in the period in which they are
incurred. Advertising expenses for 2000, 1999 and 1998 were $6.5 million, $2.6
million and $706,000, respectively.

 Income Taxes

  Income tax expense is based on reported earnings before income taxes.
Deferred tax assets and liabilities are recognized for the expected tax
consequences of temporary differences between the carrying amounts of assets
and liabilities for financial reporting purposes and the amounts used for
income tax purposes.

 Foreign Currency Translation

  Assets and liabilities of the Company's wholly owned foreign subsidiaries
are translated from their respective functional currencies at exchange rates
in effect at the balance sheet date, and revenues and expenses are translated
at average exchange rates prevailing during the year. Resulting translation
adjustments are reflected as a separate component of stockholders' equity.
Foreign currency transaction gains and losses, which have been immaterial, are
included in results of operations.

 Comprehensive Loss

  The Company reports comprehensive income or loss in accordance with
Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive
Income" ("FAS 130"). FAS 130 establishes standards for reporting comprehensive
income and its components in financial statements. At December 31, 2000 and
1999, comprehensive loss included foreign currency cumulative translation
adjustments and unrealized gains and losses on available for sale investments.
At December 31, 1998, the Company's comprehensive loss consisted entirely of
foreign currency cumulative translation adjustments. Comprehensive loss is
reflected in the consolidated statements of stockholders' equity, net of
related income tax effects.

 Development Costs

  Since January 1, 1999, the Company has accounted for internal use software
costs, including website development costs, in accordance with Statement of
Position 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use" ("SOP 98-1"). In accordance with SOP 98-1, the
Company

                                      51
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

capitalizes its costs to develop software for its website and other internal
uses when preliminary development efforts are successfully completed,
management has authorized and committed project funding and it is probable
that the project will be completed and the software will be used as intended.
Costs incurred prior to meeting these criteria, together with costs incurred
for training and maintenance, are expensed. Costs incurred for upgrades and
enhancements that are probable to result in additional functionality are
capitalized. All capitalized costs are amortized to expense over their
expected useful lives. Costs required to be capitalized under SOP 98-1 have
been insignificant to date. Prior to the adoption of SOP 98-1, costs incurred
by the Company to develop, enhance, manage, monitor, and operate its website
were expensed as incurred.

 Recent Accounting Pronouncements

  In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Financial
Instruments and for Hedging Activities", ("FAS 133") which provides a
comprehensive and consistent standard for the recognition and measurement of
derivatives and hedging activities. FAS 133 is effective for fiscal years
beginning after June 15, 2000 and did not anticipate to have an impact on the
Company's results of operations or financial condition when adopted, as the
Company holds no derivative financial instruments and does not currently
engage in hedging activities. In June 2000, the FASB issued Statement No. 138,
"Accounting for Certain Derivative Instruments and Certain Hedging Activities"
"(FAS 138)". FAS 138 addresses certain issues related to the implementation of
FAS 133 but does not change the basic model of FAS 133 or further delay the
implementation of FAS 133.

  In December 1998, the AICPA issued Statement of Position 98-9, "Modification
of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions" ("SOP 98-9"). SOP 98-9 requires use of the "residual method" for
recognition of revenue when vendor-specific objective evidence exists for
undelivered elements but does not exist for delivered elements of a software
arrangement. The Company adopted the provisions of SOP 98-9 for applicable
transactions entered into beginning January 1, 2000. The adoption of SOP 98-9
did not have a material impact on the Company's consolidated financial
statements.

  In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements"
("SAB 101"). SAB 101 provides guidance on the recognition, presentation, and
disclosure of revenue in financial statements. In October 2000, the SEC issued
additional written guidance to further supplement SAB 101. The Company adopted
SAB 101 in the fourth quarter of 2000. SAB 101 did not have a material impact
on the Company's consolidated financial statements.

  In March 2000, the Financial Accounting Standards Board issued
Interpretation NO. 44, "Accounting for Certain Transactions Involving Stock
Compensation--an Interpretation of APB 25" ("FIN 44"). FIN 44 clarifies (a)
the definition of "employee" for purposes of applying Opinion 25, (b) the
criteria for determining whether a plan qualifies as a non compensatory plan,
(c) the accounting consequence of various modifications to the terms of a
previously fixed stock option or award, and (d) the accounting for an exchange
of stock compensation awards in a business combination. FIN 44 became
effective July 1, 2000, but certain conclusions in FIN 44 cover specific
events that occur after either December 15, 1998, or January 12, 2000. To the
extent that FIN 44 covers events occurring during the period after December
15, 1998, or January 12, 2000 but before the effective date of July 1, 2000.
The effects of applying FIN 44 are recognized on a prospective basis from July
1, 2000. There was no material effect resulting from the adoption of FIN 44.

Note 2. Acquisitions

  On August 10, 2000 the Company acquired ACT Networks, Inc., a leading
provider of multi-service access and voice/data integration products that
enable the convergence of voice, video and data onto one managed network.
Under the terms of the acquisition agreement, each outstanding share of ACT
Networks common stock

                                      52
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

was exchanged for 0.4198 of a share of Clarent common stock. The exchange
ratio was based upon an ACT Networks stock value of $14 per share divided by
Clarent's five trading day average closing price ending on and including
August 9, 2000 of $33.35 per share. The Company issued approximately $150
million of stock for the outstanding shares of ACT Networks and assumed stock
options to purchase approximately 1.1 million shares of Clarent's common stock
with an aggregate fair value of $27 million. The ACT Networks acquisition has
been accounted for as a purchase and accordingly, results of operations and
the estimated fair value of the assets acquired and liabilities assumed are
included in Clarent's financial statements from the date of acquisition.

  The ACT Networks acquisition cost, allocation of excess purchased cost over
the fair value of net assets acquired and the related life of the intangible
assets are as follows (in thousands, except for asset life):

<TABLE>
<CAPTION>
                                                         Acquisition
                                                            Cost     Asset Life
                                                         ----------- ----------
                                                                     (in years)
   <S>                                                   <C>         <C>
   Value of common stock and stock options issued.......  $176,789
   Transaction costs....................................     7,008
   Merger related restructuring costs...................     8,885
                                                          --------
                                                           192,682
   Less fair value of net tangible assets acquired......    68,950
                                                          --------
   Excess purchase cost over the fair value of net
    tangible assets acquired............................  $123,732
                                                          ========
   Excess purchase cost was allocated to the following:
     Assembled workforce................................    $6,642        3
     Customer base......................................    19,276        5
     Developed technology...............................    13,860        5
     In-process research and development................    31,496
     Goodwill...........................................    42,506        5
     Deferred compensation..............................     9,952        4
                                                          --------      ---
                                                          $123,732
                                                          ========
</TABLE>

  The fair value assigned to the purchased in-process research and development
in the allocation of purchase cost included research and development projects
for which technological feasibility had not been achieved and no future
alternative uses had been established. The Company computed its valuations of
in-process research and development using a discounted cash flow analysis on
the anticipated income stream to be generated by the purchased technology.
This allocation of fair value was charged to operations at the date of
acquisition in the third quarter of 2000 and totaled $31.5 million.

  In valuing in-process research and development, the Company considered,
among other factors, the stage of completion of the development efforts and
the estimated net present value of the cash flows expected to result from the
successful deployment of the new products. The stage of completion was
determined by estimating the costs and time incurred to date relative to the
costs and time to be incurred to develop the in-process technology into
commercially viable products. The estimated net present value of cash flows
was based on incremental future cash flows from revenues expected to be
generated by the products being developed, taking into account the
characteristics and applications of the technology, the size and growth rate
of existing and future markets and an evaluation of past and anticipated
product life cycles. Estimated future cash flows were discounted to arrive at
a net present value and were allocated to in-process research and development
based upon the percentage of completion at the date of acquisition.

  In valuing the developed technology of $13.9 million the expected future
cash flows from the existing developed technologies were discounted taking
into account the characteristics and applications of the products,

                                      53
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

the size of existing markets, growth rates of existing and future markets, as
well as an evaluation of past and anticipated product-life cycles.

  To determine the value of the assembled work force of $6.6 million the
Company evaluated the work force in place at the acquisition date and utilized
the cost approach to estimate the value of replacing the work force. Costs
considered in replacing the work force included costs of identifying,
recruiting and interviewing candidates, as well as the cost of training new
employees. These costs were then summed up and tax-affected to estimate the
value of the assembled workforce.

  To determine the value of the customer base of $19.3 million the Company
utilized the avoided cost approach. Under this approach, the fair value of the
acquired customer relationships is equal to the costs which the acquirer will
avoid spending in recreating similar functional customer relationships. Costs
considered in recreating the customer base included the amount of costs and
time that sales, marketing, development and corporate personnel would have to
spend in order to acquire the customer base.

  Current accruals for merger related restructuring costs relating to the ACT
Networks acquisition of $8.7 million remained outstanding at December 31,
2000. These accruals are to provide $4.0 million for the costs of exiting non-
cancelable operating leases for the Calabasas manufacturing facility, $2.6
million for potential excess inventory to be scrapped upon discontinuation of
certain product lines, $1.2 million for involuntary employee termination costs
related to approximately twenty-five duplicative management personnel and
manufacturing employees in the ACT organization and $0.9 million in fixed
asset disposition costs for disposal of manufacturing equipment and leasehold
improvements in the Calabasas facility. These costs are related to a plan that
existed at the time of the acquisition to exit the manufacturing activities
currently performed at the Calabasas facility through discontinuation of
certain product lines and outsourcing the manufacturing of the remaining
products. The Company has identified a contract manufacturer and expects to be
ceasing production at the Calabasas facility by June 30, 2001.

  The following summary prepared on an unaudited pro forma basis reflects the
condensed consolidated results of operations of the Company, excluding the
charge for purchased in-process research and development, as if the
acquisition of ACT Networks had occurred at the beginning of 1999 and does not
purport to be indicative of what would have occurred had the acquisition been
made as of the beginning of 1999 or of results which may occur in the future.
Amortization of goodwill, purchased intangible assets and deferred
compensation are included for both years.

  The pro forma results of operations combine the consolidated results of
operations of the Company (excluding the charge for purchased in-process
research and development) and the historical results for ACT Networks for the
years ended December 31, 2000 and 1999 (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                                Year Ended
                                                               December 31,
                                                             ------------------
                                                               2000      1999
                                                             --------  --------
   <S>                                                       <C>       <C>
   Net revenue.............................................. $206,862  $ 98,300
                                                             ========  ========
   Net loss................................................. $(41,171) $(63,207)
                                                             ========  ========
   Net loss per share--basic and diluted.................... $  (1.04) $  (3.05)
                                                             ========  ========
   Denominator for basic and diluted net loss per share.....   39,462    20,690
</TABLE>

  On July 24, 2000 the Company completed the acquisition of PEAK Software
Solutions, Inc., a software development firm specializing in building IP-
based, carrier class data and telecommunications infrastructure software. The
acquisition added approximately 56 software engineers to Clarent's research
and development

                                      54
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

headcount. Under the terms of the agreement, each outstanding share of PEAK
stock was exchanged for 0.8636 of a share of Clarent common stock and cash of
approximately $25 per share, and the Company paid PEAK approximately $1.6
million to retire certain PEAK obligations. The Company issued approximately
$44.5 million in stock and paid $16.7 million in cash. The operating results
of PEAK have been included in the statements of operations from the date of
acquisition. This acquisition was accounted for using the purchase method and
was not included in the calculation of pro forma results as it is was not
classified as a significant acquisition.

  On October 25, 1999, the Company acquired all the outstanding stock of
Global Media Concept N.V., a Belgium based distributor of the Company's
products. The purchase consideration totaled $2.8 million and consisted of
43,487 shares of the Company's common stock with a fair value of $64.39 per
share and acquisition costs of approximately $140,000. A total of 17,394
shares of the Company's common stock are held in escrow until April 2001. The
purchase consideration allocated to the fair value of the assets acquired and
goodwill of $2.7 million is being amortized over its estimated useful life of
three years. The operating results of Global Media Concept are included in the
consolidated financial statements from the acquisition date. This acquisition
was accounted for using the purchase method and was not included in the
calculation of pro forma results as it is not considered to be material to the
operating results of the Company.

Note 3. Balance Sheet Details

  Inventories are comprised of the following at December 31, (in thousands):

<TABLE>
<CAPTION>
                                                                2000     1999
                                                              --------  -------
   <S>                                                        <C>       <C>
   Raw materials.............................................  $10,901   $7,347
   Work in process...........................................       83      --
   Finished goods............................................    6,503    1,057
                                                              --------  -------
                                                               $17,487   $8,404
                                                              ========  =======
</TABLE>
  Property and equipment is comprised of the following at December 31, (in
thousands):

<TABLE>
<CAPTION>
                                                                2000     1999
                                                              --------  -------
   <S>                                                        <C>       <C>
   Production and engineering equipment...................... $ 19,734  $ 5,255
   Computer equipment and purchased software.................   17,082    5,086
   Leasehold improvements....................................    8,248    4,131
   Office equipment, furniture and fixtures..................    4,536    1,551
                                                              --------  -------
                                                                49,600   16,023
   Less accumulated depreciation and amortization............  (12,970)  (3,327)
                                                              --------  -------
                                                              $ 36,630  $12,696
                                                              ========  =======
</TABLE>

  Goodwill and purchased intangible assets are comprised of the following at
December 31, (in thousands):

<TABLE>
<CAPTION>
                                                                 2000     1999
                                                               --------  ------
   <S>                                                         <C>       <C>
   Goodwill................................................... $106,728  $2,708
   Purchased intangible assets................................   41,856     --
                                                               --------  ------
                                                                148,584   2,708
   Less accumulated amortization..............................  (16,883)   (150)
                                                               --------  ------
                                                               $131,701  $2,558
                                                               ========  ======
</TABLE>

                                      55
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The following table details the classification of amortization of goodwill
and purchased intangible assets as reported in the Consolidated Statements of
Operations (in thousands):

<TABLE>
<CAPTION>
                                                                  Year ended
                                                                 December 31,
                                                              ------------------
                                                               2000   1999  1998
                                                              ------- ----- ----
   <S>                                                        <C>     <C>   <C>
   Cost of revenue........................................... $ 1,079 $ --  $
   Operating expenses........................................  15,654   150   --
                                                              ------- ----- ----
                                                              $16,733 $ 150 $ --
                                                              ======= ===== ====
</TABLE>

  Accumulated other comprehensive loss, net of related taxes, are comprised of
the following at December 31, (in thousands):

<TABLE>
<CAPTION>
                                                                   2000   1999
                                                                   -----  -----
   <S>                                                             <C>    <C>
   Unrealized gain (loss) on securities, net...................... $  31  $ (15)
   Foreign currency translation adjustment........................  (357)   (97)
                                                                   -----  -----
                                                                   $(326) $(112)
                                                                   =====  =====
</TABLE>
Note 4. Financial Instruments

  Estimated fair values of financial instruments are based on quoted market
prices. The following is a summary of available-for-sale securities at
December 31, (in thousands):

<TABLE>
<CAPTION>
                                                          2000
                                        ----------------------------------------
                                                    Gross      Gross
                                        Amortized Unrealized Unrealized   Fair
                                          Cost      Gains      Losses    Value
                                        --------- ---------- ---------- --------
<S>                                     <C>       <C>        <C>        <C>
Commercial paper....................... $126,142     $ 36       $ (9)   $126,169
Government securities..................   62,833        6         (2)     62,837
Market auction preferred...............   33,529       --         --      33,529
                                        --------     ----       ----    --------
                                        $222,504       42       $(11)   $222,535
                                        ========     ====       ====    ========
Classified as:
  Cash equivalents..................... $147,559     $ --       $(11)   $147,548
  Short-term investments...............   74,945       42         --      74,987
                                        --------     ----       ----    --------
                                        $222,504     $ 42       $(11)   $222,535
                                        ========     ====       ====    ========
</TABLE>

<TABLE>
<CAPTION>
                                                          1999
                                        ----------------------------------------
                                                    Gross      Gross
                                        Amortized Unrealized Unrealized   Fair
                                          Cost      Gains      Losses    Value
                                        --------- ---------- ---------- --------
<S>                                     <C>       <C>        <C>        <C>
Money market fund...................... $    477     $ --       $ (3)   $    474
Commercial paper.......................  206,188       52        (40)    206,200
Government securities..................   44,189        4        (28)     44,165
Market auction preferred...............   22,255       --         --      22,255
                                        --------     ----       ----    --------
                                        $273,109     $ 56       $(71)   $273,094
                                        ========     ====       ====    ========
Classified as:
  Cash equivalents..................... $227,496     $ 56       $(27)   $227,525
  Short-term investments...............   42,613       --        (32)     42,581
  Investments..........................    3,000       --        (12)      2,988
                                        --------     ----       ----    --------
                                        $273,109     $ 56       $(71)   $273,094
                                        ========     ====       ====    ========
</TABLE>


                                      56
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

  The contractual maturities of Clarent's long-term investments at December
31, 1999 were between one and two years. Expected maturities may differ from
contractual maturities because the issuers of the securities may have the
right to prepay or call obligations without prepayment penalties. Realized
gains and losses on sales of available-for-sale securities were immaterial for
the years ended December 31, 2000, 1999 and 1998.

Note 5. Investments

  The Company invests in equity instruments of privately held companies for
the promotion of business and strategic objectives. The Company has also
invested in a venture capital management fund. Except for the $1.5 million
investment noted below, all of the Company's investments are valued at the
cash paid for the equity received. These investments are included as long-term
investments in the balance sheet and are accounted for under the cost method
when ownership is less than 20% and there are no indicators of control. For
these non-quoted investments, the Company regularly reviews operating
performance, financing status, liquidity prospects and cash flow forecasts in
assessing carrying values. Impairment losses are recorded when events and
circumstances indicate that such assets might be impaired and the decline in
value is other than temporary. During 2000, the company provided $1 million
for estimated impairment losses on investments.

  During 2000, the Company has invested $8.7 million in various privately held
companies and $6.75 million in a venture capital management fund. The Company
is committed to invest an additional $8.25 million in the venture capital
management fund during 2001.

  During 2000, the Company reduced its accounts receivable by accepting common
stock with a value of $1.5 million in one of its privately held customers as
an alternative to cash payment.

  During 2000, the Company recorded revenues from certain customers in which
the Company had an investment. This revenue is not material as a proportion of
net revenue and was mostly recorded prior to Clarent obtaining an equity
interest in those companies. Revenues from these customers have been recorded
at the value of the products and services sold.

Note 6. Short-Term Borrowings

  In February 1998, the Company obtained $2.6 million in bridge financing from
certain investors and other parties. The financing was obtained via promissory
notes convertible into shares of the Company's Series C preferred stock issued
by the Company at a conversion price of $6.58 per share, at the option of the
note holders. In conjunction with this bridge financing, the Company issued to
the bridge financing investors warrants to purchase 59,266 shares of the
Company's Series C preferred stock at an exercise price of $5.593 per share
(including a discount of 15%). The warrants had a contractual life of 10
years. At the date of grant, the value ascribed to the warrants (using the
Black-Scholes valuation method with the following assumptions; expected life
of 10 years, exercise price of $5.593, stock price on date of grant of $6.58,
expected dividend yield of 0%, risk-free interest rate of 6%, and expected
volatility of .3) was approximately $228,000, of which approximately $99,000
was recorded by the Company as additional interest expense over the period the
debt was outstanding. The remaining $129,000 was recorded as issuance costs
upon the conversion to Series C preferred stock. The effective interest rate
of the bridge promissory notes, as adjusted for the ascribed value of the
bridge financing warrants, was approximately 24.3%. In June 1998, $2,050,000
of the bridge financing and approximately $56,000 of related accrued interest
was converted into 319,999 shares of the Company's Series C preferred stock.
The Company repaid the remaining $550,000 of the bridge financing and all
related accrued interest in June 1998. In May and June 1999, investors
purchased 59,266 shares of Series C preferred stock under these warrants.

  At December 31, 1999, the Company had a $7 million line of credit with a
financial institution of which no amount was outstanding. The line of credit
expired on February 16, 2000. In June 1999, in connection with this

                                      57
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

line of credit, the financial institution received a fully vested warrant for
3,000 shares of common stock at an exercise price equal to the fair value
price of $15.00 per share. This warrant was net exercised in June, 2000 for
2,213 shares of common stock.

Note 7. Related Party Transactions

  In June 1997, the Company entered into an agreement for advisory services
with WK Technology Fund, a Taiwanese corporation, one of whose principals is a
member of the Company's board of directors. The advisory services primarily
related to business strategy for the Company and were to be performed over a
four-year term. As consideration for the advisory services, the Company
granted to WK Technology Fund a warrant to purchase up to 1,400,000 shares of
the Company's common stock at an exercise price of $0.05 per share. On the 6-
month anniversary of the warrant effective date, 175,000 of the warrants
vested with the remaining warrants scheduled to vest ratably over the
subsequent 42 months or immediately 30 days prior to the closing of the
Company's public offering. The warrant had a life of five years. The Company
valued the warrant using the guidance in the Financial Accounting Standards
Board's Emerging Issues Task Force Issue 96-18. The value of the warrant was
determined using the Black-Scholes valuation method. The inputs used included
the exercise price of the warrant of $0.05, the value of the Company's common
stock at each vesting date, expected dividend yield of 0%, risk free interest
rate of 6.0%, expected volatility of 0.3 and the contractual life of the
warrant of five years. The Company has recorded compensation charges totaling
$12,272,000 and $357,000 for the years ended December 31, 1999 and 1998,
respectively. These amounts are included in amortization of compensation in
the consolidated statement of operations. The Board of Directors terminated
the advisory services arrangement in June 1999 and elected to have the
unvested portion of the warrants become fully vested. WK Technology Fund
purchased 408,328 shares of the Company's common stock under this warrant in
August 1998 and the remaining 991,672 shares in July 1999.

  Also in June 1997, the Company entered into another agreement for certain
services with WK Technology Fund. These services were to assist the Company in
identifying, evaluating, and recommending an outside director for the Company.
Under the terms of this agreement, the Company granted WK Technology Fund a
fully vested warrant to purchase up to 360,000 shares of the Company's common
stock at $0.05 per share upon successfully obtaining an outside director in
February 1998. The fair market value of the Company's common stock on the date
of this grant was $0.05 per share. During August 1998, WK Technology Fund
exercised the option to purchase 360,000 shares of the Company's common stock
under this warrant.

Note 8. Income Taxes

  The Company's pretax income/(loss) from operations includes approximately
$(14.8) million, $279,000 and $81,000 related to non-US operations for 2000,
1999 and 1998, respectively.

  The provision for income taxes consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                               December 31,
                                                            -------------------
                                                             2000    1999  1998
                                                            -------  ----- ----
   <S>                                                      <C>      <C>   <C>
   Federal:
     Current............................................... $ 1,954  $ --  $ --
     Deferred..............................................  (1,454)   --    --
                                                            -------  ----- ----
                                                                500    --    --
   Foreign:
     Current...............................................     424    132   40
                                                            -------  ----- ----
       Total provision for income taxes.................... $   924  $ 132 $ 40
                                                            =======  ===== ====
</TABLE>


                                      58
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

  The provision for income taxes differs from the amount computed by applying
the statutory federal income tax rate (35% for 2000 and 1999 and 34% for 1998)
to income before taxes. The sources and tax effects of the differences are as
follows (in thousands):

<TABLE>
<CAPTION>
                                                         December 31,
                                                   ---------------------------
                                                     2000      1999     1998
                                                   --------  --------  -------
   <S>                                             <C>       <C>       <C>
   Tax (benefit) at Federal statutory rate........ $(18,612) $(10,653) $(1,969)
   Loss for which no benefit is currently
    recognizable..................................      --     10,653    1,969
   Benefit of loss carryforwards utilized.........   (6,033)      --       --
   Non-deductible acquisition costs...............   11,509       --       --
   Non-deductible in-process R&D..................    5,926       --       --
   Foreign losses not benefited...................    5,652       --       --
   Non-deductible stock compensation expense......    1,750       --       --
   Foreign income at other than U.S. rates........      (45)      132       40
   Other, net.....................................      777       --       --
                                                   --------  --------  -------
     Total provision.............................. $    924  $    132  $    40
                                                   ========  ========  =======
</TABLE>

  Significant components of the Company's deferred tax assets are as follows
(in thousands):

<TABLE>
<CAPTION>
                                                               December 31,
                                                             ------------------
                                                               2000      1999
                                                             --------  --------
   <S>                                                       <C>       <C>
   Deferred tax assets:
     Net operating loss carryforwards....................... $ 43,813  $  5,760
     Tax credit carryforwards...............................    2,146       900
     Deferred revenue.......................................      506     1,761
     Deferred compensation..................................   13,297     3,166
     Accounts receivable reserve............................    3,443     2,163
     Accruals and reserves not currently deductible.........    8,269     1,835
                                                             --------  --------
   Gross deferred tax assets................................   71,474    15,585
   Valuation allowance......................................  (55,486)  (15,585)
                                                             --------  --------
       Total deferred tax assets............................ $ 15,988  $    --
                                                             ========  ========
   Deferred tax liabilities:
     Acquired intangibles...................................   14,534       --
                                                             --------  --------
       Total deferred tax liabilities....................... $ 14,534  $    --
                                                             ========  ========
</TABLE>

  Financial Accounting Standards Board Statement No. 109 provides for the
recognition of deferred tax assets if realization of such assets is more
likely than not. Based upon the weight of available evidence, which includes
the Company's historical operating performance and the carryback potential,
the Company has determined that a valuation allowance continues to be
necessary.

  As of December 31, 2000, the Company had federal and state net operating
loss carryforwards of approximately $115 million and $16 million,
respectively. As of December 31, 2000, the Company also had federal and state
research and development tax credit carryforwards of approximately $1.1
million and $1 million, respectively. The net operating loss and tax credit
carryforwards will expire at various dates beginning in 2004 through 2020, if
not utilized. Utilization of the net operating loss and tax credit
carryforwards may be subject to annual limitations due to the ownership change
limitations provided by the Internal Revenue Code and similar state
provisions.

                                      59
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The valuation allowance increased by $39.9 million and $12.4 million during
the years ended December 31, 2000 and 1999, respectively. Substantially all of
the valuation allowance is related to stock option deductions, the benefit of
which will be credited to additional paid in capital when realized.

Note 9. Commitments and Contingencies

  The Company leases its principal office facilities under noncancelable
operating lease agreements that have initial terms ranging from three to ten
years. As of December 31, 2000, minimum lease payments under all noncancelable
lease agreements with initial terms in excess of one year were as follows (in
thousands):

<TABLE>
<CAPTION>
                                                                       Operating
   Year ended December 31,                                              Leases
   -----------------------                                             ---------
   <S>                                                                 <C>
   2001...............................................................  $11,851
   2002...............................................................   12,486
   2003...............................................................   11,801
   2004...............................................................    8,987
   2005...............................................................    6,330
   Thereafter.........................................................   25,821
                                                                        -------
     Total minimum lease payments.....................................  $77,276
                                                                        =======
</TABLE>

  Rent expense was approximately $5.2 million, $2 million and $492,000 for the
years ended December 31, 2000, 1999 and 1998, respectively.

  From time to time, the Company may be subject to claims, which arise in the
normal course of business. Depending on the amount and timing, an unfavorable
resolution of a matter could materially affect the Company's future results of
operations or cash flows in a particular period.

Note 10. Stockholders' Equity

Preferred Stock

  The Company's Certificate of Incorporation authorizes 5 million shares of
preferred stock. There was no preferred stock issued at December 31, 2000 or
1999.

Common Stock

  In July 1996, 5.4 million shares of common stock were issued to the
Company's two remaining founders. The outstanding shares were subject to
transfer restrictions through June 1999 and were subject to repurchase at the
issuance price upon the occurrence of certain events, including termination of
employment. The Company's right of repurchase expired in July 2000.

  In July and November 1999, the Company completed initial and secondary
public offerings, respectively. The initial public offering raised net
proceeds of $62.7 million from issuance of 4.6 million shares of common stock,
and included 600,000 over-allotment shares at $15.00 per share. Upon the
closing of the initial public offering, approximately 6.9 million shares of
the Company's convertible preferred stock were automatically converted into
approximately 13.8 million shares of common stock. Net proceeds from the
secondary offering were $239.9 million from the issuance of approximately 3
million shares of common stock, including 128,125 over-allotment shares at
$85.00 per share.

                                      60
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  In February, 2000 the Company's stockholders authorized an amendment to the
restated certificate of incorporation to increase the authorized number of
shares of common stock to 200 million from 50 million shares. A total of 13.5
million shares are reserved for issuance under employee benefit plans.

Note 11. Employee Benefit Plans

Stock Option Plans

  The Company's 1999 Amended and Restated Equity Incentive Plan ("the 1999
incentive plan") was adopted in 1996. As of December 31, 2000 an aggregate of
16,792,465 shares of common stock were authorized for issuance under the 1999
incentive plan. In addition, a total of 1,235,795 shares of common stock were
authorized for issuance under other employee option plans assumed with the
acquisition of ACT Networks, Inc. in August 2000.

  The provisions of the 1999 incentive plan automatically increase the number
of shares available for issuance by 2.5% per year, or a lesser amount as
determined by the Board of Directors. The calculation is based upon the
outstanding shares of Clarent common stock on January 31 of each year from
2000 through 2004. The 1999 incentive plan provides for the grant of incentive
stock options, non-statutory stock options, restricted stock purchase awards,
stock bonuses and stock appreciation rights to Clarent's and its affiliates'
employees, including officers and employee directors. Non-statutory stock
options are available to be granted to consultants and non-employee directors.
As of December 31, 2000 no restricted stock purchase awards, stock bonuses or
stock appreciation rights are granted and outstanding under the 1999 incentive
plan.

  Under the 1999 incentive plan, options to purchase common stock may be
granted at no less than the fair market value on the date of the grant (110%
of fair market value in certain instances,) as determined by the Board of
Directors, based upon the closing sale price of the Company's common stock on
the Nasdaq National Market. The Company executes individual option agreements
under the plan and the shares underlying the options generally vest either at
25% of the total grant after the completion of the first twelve full months of
employment with the remainder vesting monthly over three years thereafter or
vesting is monthly over a four year period. Options generally have a 10 year
life. Certain stock options ("Performance Options") issued under the 1999
incentive plan vest over a time period determined by the Board of Directors;
however, under the terms of the original option agreements, the vesting could
be accelerated based on achievement of certain performance criteria. For the
years ended December 31, 1999 and 1998 the Board of Directors granted
Performance Options to purchase 279,500 and 492,000 shares of common stock to
certain employees at an exercise price equal to the fair market value on the
date of grant. These options vest in seven years, but the vesting could be
accelerated based on the achievement of the performance criteria. The
accelerated vesting schedule provides that the grants will vest over a 48
month term. There were no performance options granted during 2000. At December
31, 2000 there were 12.7 million shares of common stock reserved for issuance
under employee option plans.

  In July 1999, the Company adopted the 1999 Non-employee Directors' Equity
Incentive Plan ("directors' plan") to provide for the automatic grant of
options to purchase shares of common stock to the Company's non-employee
directors who are not any of the Company's affiliates' employees or
consultants ("non-employee director"). The directors' plan is administered by
the Board, and may be delegated to a committee. Options granted under the
directors' plan are at 100% of the fair market value of the common stock on
the date of grant. The aggregate number of shares of common stock to be issued
under the directors' plan was increased to 500,000 shares in June 2000. Under
the terms of the directors' plan, as amended in June 2000, each non-employee
director, shall, upon the date of initial appointment, be granted an option to
purchase 35,000 shares of common stock. In addition, on the day following each
annual meeting of stockholders, each non-employee director shall be granted an
option to purchase 15,000 shares of common stock. This annual grant shall be
reduced pro rata for each quarter during the preceding year that was prior to
the non-employee director's appointment. The options

                                      61
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

granted under the terms of the amended directors' plan vest and become
exercisable at the rate of 1/24 per month over a two year period.

  The terms of the plan prior to the June, 2000 amendment, provided for each
non-employee director to be granted automatically, an option to purchase 5,000
shares upon their appointment and 2,000 shares of common stock for each
regular meeting, commencing with the third regular meeting subsequent to the
date of appointment. Prior to the amendment, options granted under the
directors' plan were fully vested and became exercisable upon the date of
grant. As of December 31, 2000 there have been approximately 135,000 non-
statutory stock options granted under the directors' plan and there were
approximately 365,000 shares of common stock reserved for future issuance
under the directors' plan.

  A summary of option plan activity follows (in thousands except price per-
share amounts):

<TABLE>
<CAPTION>
                                                          Options Outstanding
                                                        ------------------------
                                               Shares               Weighted-
                                              Available Number of    Average
                                              for Grant  Shares   Exercise Price
                                              --------- --------- --------------
   <S>                                        <C>       <C>       <C>
   Balance at December 31, 1997..............    2,180    5,019       $ 0.03
     Additional shares reserved..............    3,303      --
     Granted.................................   (3,031)   3,031       $ 0.62
     Exercised...............................      --    (1,065)      $ 0.04
     Canceled................................      511     (511)      $ 0.13
                                               -------   ------
   Balance at December 31, 1998..............    2,963    6,474       $ 0.31
     Additional shares reserved..............    1,155      --
     Granted.................................   (3,082)   3,082       $20.78
     Exercised...............................      --    (1,362)      $ 0.14
     Canceled................................       98      (98)      $18.90
                                               -------   ------
   Balance at December 31, 1999..............    1,134    8,096       $ 7.90
     Additional shares reserved..............    6,870      --
     Granted or assumed with acquisition.....   (6,690)   6,795       $52.05
     Exercised...............................      --    (3,225)      $ 1.74
     Canceled................................      986     (986)      $45.27
     Repurchased.............................  105,000      --        $ 0.05
                                               -------   ------
   Balance at December 31, 2000..............    2,405   10,680       $34.40
                                               =======   ======
</TABLE>

  The following table summarizes information concerning options outstanding
and exercisable at December 31, 2000 (in thousands except contractual life and
prices):

<TABLE>
<CAPTION>
                                    Options Outstanding       Options Exercisable
                              ------------------------------- -------------------
                                                   Weighted-
                                        Weighted-   Average             Weighted-
                                         Average   Remaining             Average
                              Number of Exercise  Contractual Number of Exercise
   Range of Exercise Prices    Shares     Price      Life      Shares     Price
   ------------------------   --------- --------- ----------- --------- ---------
                                                  (in years)
   <S>                        <C>       <C>       <C>         <C>       <C>
   $ 0.02-$  1.50..........     2,790    $ 0.06      7.33         908    $ 0.36
   $ 1.51-$ 26.00..........     2,710    $14.27      7.58       1,007    $14.62
   $26.01-$ 46.90..........     2,670    $39.57      9.18         233    $35.44
   $46.91-$125.00..........     2,510    $88.30      9.14         396    $91.89
                               ------                           -----
   $ 0.02-$125.00..........    10,680    $34.41      8.28       2,544    $23.47
                               ======                           =====
</TABLE>

                                      62
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  At December 31, 1999, options to purchase 1,662,000 shares were exercisable
at a weighed average exercise price of $0.91. Options to purchase 1,236,000
shares were exercisable at December 31, 1998 at a weighted average exercise
price of $0.05.

Employee Stock Purchase Plan

  In July 1999, the Company adopted the 1999 Employee Stock Purchase Plan
("Purchase Plan"). Under the Purchase Plan, the Board of Directors or a
committee may authorize participation by eligible employees, including
officers, in periodic offerings following the adoption of the Purchase Plan.
Eligible employees can elect to contribute a percentage of up to 10% of their
gross earnings during each purchase period, subject to the IRS annual
limitation. The offering period for any offering will be no more than 27
months. The price of common stock purchased under the Purchase Plan will be
equal to 85% of the lower of the fair market value of the common stock on the
commencement date of each offering period or the relevant purchase date.
Pursuant to the Purchase Plan, the Company issued 46,926 shares in 1999 and
162,587 in 2000. At December 31, 2000 there were 390,487 shares reserved for
future issuance under the Purchase Plan.

  In the event of certain changes in control, the Board of Directors has
discretion to provide that each right to purchase common stock will be assumed
or an equivalent right will be substituted by the successor corporation, or
that such rights may continue in full force and effect, or that all sums
collected by payroll deductions be applied to purchase stock immediately prior
to the change in control. The Purchase Plan will terminate at the Board's
discretion or when all of the shares reserved for issuance under the Purchase
Plan have been issued.

Employee 401(k) Plans

  The Company has pretax savings plans that qualify under Section 401(k) of
the Internal Revenue Code. Under the plans, participating employees may defer
up to 25% of their pretax salary but not more than statutory limits. The
Company may elect to make matching contributions to the plans. For the year
ended December 31, 2000 the Company contributed approximately $200,000 in
matching contributions. For the years ended December 31, 1999 and 1998 the
Company made no matching contributions and incurred immaterial expenses
related to the plans.

Amortization of Compensation

  The Company has recorded amortization of compensation charges of
approximately $6.2 million, $19.4 million and $879,000 for the years ended
December 31, 2000, 1999 and 1998, respectively. Amortization of compensation
resulted from the granting of stock options and warrants to purchase common
stock at prices below the deemed fair value of Clarent's common stock
including those granted in conjunction with assuming stock option plans in an
acquisition. The compensation related to stock options is being amortized
using the graded method over the vesting periods of the individual stock
options, generally four years.

Pro Forma Disclosure of the Effect of Stock-Based Compensation

  The Company has elected to follow APB 25 and related interpretations in
accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under FAS 123 requires use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, when the exercise price of the Company's employee
stock options equals the market price of the underlying stock on the date of
grant, no compensation expense is recognized.

                                      63
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The fair value of each option grant prior to the initial public offering was
estimated on the date of grant using the minimum value method. Options granted
subsequent to the initial public offering were valued using the Black-Scholes
valuation model. The following weighted average assumptions were used:

<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                               2000  1999  1998
                                                               ----  ----  ----
   <S>                                                         <C>   <C>   <C>
   Expected dividend yield....................................   0%    0%     0%
   Risk-free interest rate.................................... 5.5%  5.8%   5.4%
   Expected life of option in years........................... 4.0   4.0   4.21
   Volatility................................................. 172%   60%     0%
</TABLE>

  If compensation cost for the Company's stock-based compensation plan had
been determined based on the fair value at the grant dates for awards under
this plan consistent with the method provided for under FAS 123, then the
Company's net loss and loss per share would have been as indicated in the pro
forma amounts below:

<TABLE>
<CAPTION>
                                                    Years ended December 31,
                                                  -----------------------------
                                                     2000      1999      1998
                                                  ---------- --------- --------
                                                      (in thousands, except
                                                       per share amounts)
   <S>                                            <C>        <C>       <C>
   Net loss as reported.......................... $ (54,101) $(30,783) $(5,832)
   Pro forma net loss............................ $(129,888) $(33,437) $(5,869)
   Net loss per share as reported, basic and
    diluted...................................... $   (1.54) $  (1.87) $ (1.65)
   Pro forma net loss per share.................. $   (3.70) $  (1.42) $ (1.66)
</TABLE>

  The weighted average fair value of options granted to employees during the
years ended December 31, 2000, 1999 and 1998, were approximately $53.51,
$10.75 and $0.125, respectively. For purposes of pro forma disclosures, the
minimum value of the stock grants and stock options is deemed amortized over
the grant vesting period.

Note 12. Segments of an Enterprise and Related Information

  The Company operates in one industry segment. The Company designs, develops
and sells Internet protocol telephony, or IP telephony systems. Net revenue
for non-U.S. locations are substantially the result of export sales from the
U.S.

                                      64
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Net revenue by geographic region based on customer location were as follows
(in thousands):

<TABLE>
<CAPTION>
                                                       Year ended December 31,
                                                       ------------------------
                                                         2000    1999    1998
                                                       -------- ------- -------
   <S>                                                 <C>      <C>     <C>
   Product and software:
     United States.................................... $ 34,695 $20,365 $ 6,716
     Asia Pacific.....................................   67,172  15,999   6,170
     Europe, Middle East & Africa.....................   25,373   6,819     725
     Other Americas...................................    9,747     999     199
                                                       -------- ------- -------
       Total product and software revenue............. $136,987 $44,182 $13,810
                                                       ======== ======= =======
   Services:
     United States.................................... $  6,728 $ 1,733 $   469
     Asia Pacific.....................................    3,837   1,417     332
     Europe, Middle East & Africa.....................    3,364     408      15
     Other Americas...................................      665      83      21
                                                       -------- ------- -------
       Total services revenue......................... $ 14,594 $ 3,641 $   837
                                                       ======== ======= =======
</TABLE>

  For the years ended December 31, 2000, 1999 and 1998, customers based in the
United States contributed 27%, 46% and 49% of total net revenue. During 2000,
customers based in Taiwan and Hong Kong accounted for 24% and 12% of total net
revenue. Also, customers located in Japan accounted for 21% of total revenue
in 1998.

Note 13. Net Loss Per Share

  The Company follows the provisions of Statement of Financial Accounting
Standards No. 128, "Earnings Per Share." Basic and diluted net loss per share
is computed by dividing net loss by the weighted average number of common
shares outstanding during the period less outstanding nonvested shares.
Outstanding nonvested shares are not included in the computations of basic and
diluted net loss per share until the time-based vesting restrictions have
lapsed.

  The following table sets forth the computation of basic and diluted earnings
per share (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                    Year ended December 31,
                                                   ---------------------------
                                                     2000      1999     1998
                                                   --------  --------  -------
   <S>                                             <C>       <C>       <C>
   Net loss (numerator)..........................  $(54,101) $(30,783) $(5,832)
                                                   ========  ========  =======
   Shares used in computing basic and diluted net
    loss per share (denominator):
     Weighted average common shares outstanding..    35,153    17,751    6,248
     Less shares subject to repurchase...........       (90)   (1,294)  (2,704)
                                                   --------  --------  -------
   Denominator for basic and diluted net loss per
    share........................................    35,063    16,457    3,544
                                                   --------  --------  -------
       Basic and diluted net loss per share......  $  (1.54) $  (1.87) $ (1.65)
                                                   ========  ========  =======
</TABLE>

  The Company has excluded all convertible preferred stock, warrants for
convertible preferred stock and common stock, outstanding stock options and
shares subject to repurchase from the calculation of diluted loss per common
share because all such securities are anti-dilutive for all periods presented.
The total number of

                                      65
<PAGE>

                              CLARENT CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

shares excluded from the calculations of diluted net loss per share, in
thousands, were 5,637, 8,718 and 24,158 for the years ended December 31, 2000,
1999 and 1998, respectively.

Note 14. Quarterly Financial Information (Unaudited)

  Summarized quarterly financial information for 2000 and 1999 is as follows
(in thousands, except per share data):

<TABLE>
<CAPTION>
                                               2000--Quarter Ended
                                    --------------------------------------------
                                    March 31  June 30   September 30 December 31
                                    --------  --------  ------------ -----------
   <S>                              <C>       <C>       <C>          <C>
   Net revenue..................... $24,583   $ 28,313    $ 45,523    $ 53,162
   Gross profit....................  14,634     17,213      25,257      34,630
   Loss from operations............  (4,806)    (3,912)    (44,089)    (17,467)
   Net income (loss)...............    (716)       228     (39,503)    (14,110)
   Basic and diluted net income
    (loss) per share............... $ (0.02)  $   0.01    $  (1.08)   $  (0.36)

<CAPTION>
                                               1999--Quarter Ended
                                    --------------------------------------------
                                    March 31  June 30   September 30 December 31
                                    --------  --------  ------------ -----------
   <S>                              <C>       <C>       <C>          <C>
   Net revenue..................... $ 6,714   $  9,304    $ 13,227    $ 18,578
   Gross profit....................   3,433      5,158       7,792      11,135
   Loss from operations............  (5,495)   (17,390)     (4,866)     (5,412)
   Net loss........................  (5,479)   (17,564)     (4,222)     (3,518)
   Basic and diluted net loss per
    share.......................... $ (1.00)  $  (2.73)   $  (0.17)   $  (0.13)
</TABLE>

Note 15. Subsequent Events--Stock cancellation and re-grant program

  On February 14, 2001, the Company cancelled approximately 2.89 million
outstanding options under a cancellation and re-grant program for employees
holding common stock options with an exercise price per share in excess of the
fair market price of the Company's common stock. Replacement options to
purchase common stock of approximately 635,000 shares were granted to
employees on February 15, 2001 at the fair market value of $13.625 per share.
These shares will vest in full on August 15, 2001 and will expire if
unexercised on November 15, 2001. The options granted on February 15 will be
subject to variable accounting in accordance with the requirements of FIN 44
(Note 1) until they are exercised or they expire. Additional options for
approximately 1.13 million shares are expected to be granted under the program
on August 16, 2001, at the then current fair market value. These additional
options will vest monthly over a 24 month period and will have a 10 year life.
The August grants will not be subject to variable accounting.

                                      66
<PAGE>

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

  None.

                                   PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

  The information required by this item is incorporated by reference from the
information under the captions "Information Concerning Solicitation and
Voting," "Election of Directors" and "Section 16(A) Beneficial Ownership
Reporting Compliance" contained in our definitive proxy statement to be filed
no later than April 30, 2001 in connection with solicitation of proxies for
our annual meeting of stockholders to be held June 7, 2001 (the "Proxy
Statement").

ITEM 11. EXECUTIVE COMPENSATION

  The information required by this item is incorporated by reference from the
information under the captions "Executive Compensation," "Compensation of
Directors" and "Employment Severance and Change of Control Agreements" and
"Option Repricing Information" contained in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  The information required by this item is incorporated by reference from the
information under the caption "Security Ownership of Certain Beneficial Owners
and Management" contained in the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  The information required by this item is incorporated by reference from the
information under the caption "Certain Transactions" contained in the Proxy
Statement.

                                      67
<PAGE>

                                    PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.

  (a)

    (1) Index to Financial Statements

    The Financial Statements required by this item are submitted in Part II,
  Item 8 of this report.

    (2) Financial Statements Schedules

  The following financial statement schedule of Clarent Corporation for the
years ended December 31, 2000, 1999 and 1998 should be read in conjunction
with the Consolidated Financial Statements of Clarent Corporation.

  Schedule II--Valuation and Qualifying Accounts

  Allowance For Doubtful Accounts (in thousands):

<TABLE>
<CAPTION>
                                                     Additions
                             Balances at Charged to Charged to              Balances at
                              Beginning  Costs and     Other    Deductions/   End of
   Year ended December 31,    of Period   Expenses  Accounts(*) Write-Offs    Period
   -----------------------   ----------- ---------- ----------- ----------- -----------
   <S>                       <C>         <C>        <C>         <C>         <C>
   2000....................    $2,314      $4,259     $2,737      $(1,665)    $7,645
                               ======      ======     ======      =======     ======
   1999....................    $  807      $1,523        --         $ (16)    $2,314
                               ======      ======     ======      =======     ======
   1998....................    $   38      $  803        --         $ (34)    $  807
                               ======      ======     ======      =======     ======
</TABLE>
--------
(*) Allowances assumed through acquisitions.

  All other schedules have been omitted because they are not applicable or are
not required or the information required to be set forth therein is included
in the Consolidated Financial Statements or Notes thereto.

  (3) Exhibits

<TABLE>
<CAPTION>
 Exhibit
 Number                                Description
 -------                               -----------
 <C>     <S>
   2.1   Agreement and Plan of Merger and Reorganization, dated as of May 1,
          2000, among Clarent Corporation, Copper Merger Sub, Inc. and ACT
          Networks, Inc.(1)(7)

   2.2   Amendment No. 1, dated as of June 30, 2000, to the Agreement and Plan
          of Merger and Reorganization(1)(7)

   3.1   Amended and Restated Certificate of Incorporation (including
          Certificate of Designation of Series A Junior Participating Preferred
          Stock), as amended, of the registrant(3)

   3.2   Bylaws of the registrant(2)

   4.1   Specimen Common Stock Certificate(2)

   4.2   Amended and Restated Investor Rights Agreement, dated June 11, 1998
          (as amended December 7, 1998 and April 8, 1999)(2)

   4.3   Founder Stock Purchase Agreement, dated July 2, 1996(2)

   4.4   Rights Agreement dated as of February 7, 2001 between the registrant
          and Wells Fargo Bank Minnesota, N.A.(3)

   4.5   Shareholders' Agreement dated as of July 24, 2000, by and among
          Clarent, Cadmium Acquisition Corp., certain shareholders of PEAK
          Software Solutions, Inc. and Larry Schwartz as Shareholders' Agent
          and Purchaser Representative(9)
</TABLE>


                                      68
<PAGE>

<TABLE>
<CAPTION>
 Exhibit
 Number                                Description
 -------                               -----------
 <C>     <S>
 10.1    Form of Indemnity Agreement between the registrant and its directors
          and officers(2)

 10.2    1999 Amended and Restated Equity Incentive Plan, as amended, and Form
          of Stock Option Grant Notice and Agreement(4)
 10.3    1999 Non-Employee Directors' Stock Option Plan, as amended, and Form
          of Nonstatutory Stock Option(4)

 10.4    1999 Employee Stock Purchase Plan and Offering Document(5)
 10.5    Employment Agreement, dated June 9, 1997, by and between the
          registrant and Mark E. McIlvane (as amended June 9, 1998)(2)

 10.6    Employment Agreement, dated August 1, 1998, by and between the
          Registrant and Richard J. Heaps(2)

 10.7**  OEM Purchase Agreement, dated effective as of December 1, 1998, by and
          between the registrant and AudioCodes, Ltd.(2)

 10.8    Master Maintenance and Support Services Agreement and Statement of
          Work, dated December 29, 1998, by and between the registrant and
          Equant Integration Services, Inc.(2)

 10.9    Lease Agreement, dated August 12, 1998, by and between the registrant
          and Seaport Center Associates, LLC(2)

 10.10   Sublease, dated May 27, 1998, by and between the registrant and
          Unwired Planet, Inc.(2)
 10.11   Customer Agreement, dated June 25, 1998, by and between the registrant
          and Technet International(2)

 10.12   General Agreement for the Procurement of Data Processing Equipment,
          Services and Supplies, the License of Software, dated as of September
          17, 1998 by and between the registrant and AT&T Corporation(2)
 10.13   Lease Agreement, dated March 31, 2000, by and between the registrant
          and Metropolitan Life Insurance Company(6)

 10.14   Lease Agreement, dated February 9, 2001, by and between the registrant
          and Metropolitan Life Insurance Company.
 10.15   Lease Agreement, dated April 28, 2000, by and between PEAK Software
          Solutions, Inc. and A & S Burger Investments, LLC.

 10.16   ACT Networks, Inc. 1987 Stock Option Plan(8)
 10.17   ACT Networks, Inc. 1993 Stock Option Plan(8)

 10.18   ACT Networks, Inc. 1995 Stock Option/Stock Issuance Plan(8)
 10.19   ACT Networks, Inc. 1997 Stock Incentive Plan(8)

 10.20   ACT Networks, Inc. 1997 Non-Executive Officer Stock Option/Stock
          Issuance Plan(8)
 10.21   Forms of Stock Option Agreement, Written Compensation Agreement and
          Addendum to Stock Option Agreement for certain non-plan stock option
          grants by ACT Networks, Inc. to Messrs. Sadr and Weisman(8)

 10.22   Office Lease dated April 15, 1999 by and between ACT Networks, Inc.
          and Malibu Canyon Office Partners, LLC.(10)
 21.1    Subsidiaries of the Registrant

 23.1    Consent of Ernst & Young LLP, Independent Auditors

 24.1    Power of Attorney (contained on the signature page)
</TABLE>
--------
 **Portions have been omitted pursuant to an application for confidential
   treatment

 (1) Exhibits to this agreement have been omitted but will be furnished to the
     Commission upon request.

                                       69
<PAGE>

 (2) Incorporated by reference to the Exhibits filed with the registrant's
     Registration Statement on Form S-1 (No. 333-76051).

 (3) Incorporated by reference to the Exhibits filed with the registrant's
     Current Report on Form 8-K filed with the Commission on February 15, 2001
     (No. 000-26441).

 (4) Incorporated by reference to the Exhibits filed with the registrant's
     Registration Statement on Form S-8 (No. 333-42812).

 (5) Incorporated by reference to the Exhibits filed with the registrant's
     Registration Statement on Form S-8 (No. 333-89139).

 (6) Incorporated by reference to the Exhibits filed with the registrant's
     Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.

 (7) Incorporated by reference to the Exhibits filed with the registrant's
     Registration Statement on Form S-4 (No. 333-38216).

 (8) Incorporated by reference to the Exhibits filed with the registrant's
     Registration Statement on Form S-8 (No. 333-44466).

 (9) Incorporated by reference to the Exhibits filed with the registrant's
     Quarterly Report on Form 10-Q for the quarter ended June 30, 2000.

(10) Incorporated by reference to the Exhibits filed with ACT Networks, Inc.'s
     Annual Report on Form 10-K for the fiscal year ended June 30, 1999.

  (b) Reports on Form 8-K

  Amendment No.1 to Form 8-K dated August 10, 2000, was filed by the
registrant on October 24, 2000 to report under Item 7 consolidated financial
statements of the registrant and ACT Networks, Inc.

                                      70
<PAGE>

                                  SIGNATURES

  Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this Annual Report on
Form 10-K to be signed on its behalf by the undersigned, thereunto duly
authorized, in the City of Redwood City, County of San Mateo, State of
California, on March 29, 2001.

                                          CLARENT CORPORATION

                                                /s/ Jerry Shaw-Yau Chang
                                          By: _________________________________
                                                    Jerry Shaw-Yau Chang
                                                  Chief Executive Officer,
                                                   President and Director

                               POWER OF ATTORNEY

  KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Jerry Shaw-Yau Chang and Simon Y. Wong, and
each of them, as his true and lawful attorneys-in-fact and agents, with full
power of substitution and resubstitution, for him and in his name, place, and
stead, 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, granting
unto said attorneys-in-fact and agents, and each of them, full power and
authority to do and perform each and every act and thing requisite and
necessary to be done in connection therewith, as fully to all intents and
purposes as he might or could do in person, hereby ratifying and confirming
that all said attorneys-in-fact and agents, or any of them or their or his
substitute or substitutes, may lawfully do or cause to be done by virtue
hereof.

  Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed below by the following persons on
behalf of the Registrant in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
             Signature                           Title                  Date
             ---------                           -----                  ----

<S>                                  <C>                           <C>
    /s/ Jerry Shaw-Yau Chang         Chief Executive Officer,      March 29, 2001
____________________________________  President and Director
        Jerry Shaw-Yau Chang          (Principal Executive
                                      Officer)

       /s/ Simon Y. Wong             Chief Financial Officer       March 29, 2001
____________________________________  (Principal Financial and
           Simon Y. Wong              Accounting Officer)

      /s/ Michael F. Vargo           Senior Vice President, Chief  March 29, 2001
____________________________________  Technology Officer and
          Michael F. Vargo            Director

      /s/ Barry I. Forman            Executive Chairman of Board   March 29, 2001
____________________________________  of Directors
          Barry I. Forman

        /s/ Wen Chang Ko             Director                      March 29, 2001
____________________________________
            Wen Chang Ko

      /s/ William R. Pape            Director                      March 29, 2001
____________________________________
          William R. Pape
</TABLE>

                                      71