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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

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

                                   FORM 10-K

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

    For the fiscal year ended: December 31, 2001

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934

                       Commission File Number: 000-30865

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

                              AVICI SYSTEMS INC.
            (Exact Name of registrant as specified in its charter)


                      Delaware                 02-0493372
                   (State or other
                   jurisdiction of          (I.R.S. Employer
                  incorporation or
                    organization)        Identification Number)

                             101 Billerica Avenue
                     North Billerica, Massachusetts 01862
                   (Address of principal executive offices)

      Registrant's telephone number, including area code: (978) 964-2000

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

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

          Securities registered pursuant to Section 12(g) of the Act:

                        Common Stock, $.0001 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 the preceding 12 months (or for such shorter period that the
registrant was required to file such report(s), 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 registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  [_]

   The aggregate market value of the voting stock held by non-affiliates of the
Registrant, as of March 15, 2002, was approximately $113,876,682 (based on the
closing price of the Registrant's Common Stock on March 15, 2002, of $2.43 per
share).

   The number of shares outstanding of the Registrant's $.0001 par value Common
Stock as of March 15, 2002 was 50,276,125.

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

                      DOCUMENT INCORPORATED BY REFERENCE

   The registrant intends to file a definitive proxy statement pursuant to
Regulation 14A within 120 days of the end of the fiscal year ended December 31,
2001. Portions of such proxy statement are incorporated by reference into Part
III of this Form 10-K.

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                              AVICI SYSTEMS INC.

                          ANNUAL REPORT ON FORM 10-K
                         YEAR ENDED DECEMBER 31, 2001

                               TABLE OF CONTENTS

<TABLE>
   <S>       <C>                                                         <C>
   PART I...............................................................  3
    ITEM 1.  BUSINESS...................................................  3
    ITEM 2.  PROPERTIES................................................. 10
    ITEM 3.  LEGAL PROCEEDINGS.......................................... 11
    ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........ 11
   PART II.............................................................. 12
    ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
             STOCKHOLDER MATTERS........................................ 12
    ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA....................... 13
    ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
             AND RESULTS OF OPERATIONS.................................. 14
    ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. 32
    ITEM 8.  CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA... 33
    ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
             ACCOUNTING AND FINANCIAL DISCLOSURE........................ 56
   PART III............................................................. 56
    ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......... 56
    ITEM 11. EXECUTIVE COMPENSATION..................................... 56
    ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
             MANAGEMENT................................................. 56
    ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............. 56
   PART IV.............................................................. 56
    ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
             FORM 8-K................................................... 56
   SIGNATURES........................................................... 59
</TABLE>

                                      2

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                    FACTORS THAT MAY AFFECT FUTURE RESULTS

   Our prospects are subject to certain uncertainties and risks. This Annual
Report on Form 10-K contains certain forward-looking statements within the
meaning of the federal securities laws that also involve substantial
uncertainties and risks. Our future results may differ materially from our
historical results and actual results could differ materially from those
projected in the forward-looking statements as a result of certain risk
factors. Readers should pay particular attention to the considerations
described in the section of this report entitled "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Factors That May
Affect Future Results." Readers should also carefully review the risk factors
described in the other documents that we file from time to time with the
Securities and Exchange Commission.

                                    PART I

ITEM 1.   BUSINESS

Overview

   Avici Systems Inc., a Delaware corporation, was incorporated in 1996. We
provide high-speed data networking equipment that enables telecommunications
companies and Internet service providers to transmit high volumes of
information across their networks. Our high-performance routing solution is
being marketed to telecommunications companies and Internet service providers,
referred to as carriers, that are creating or expanding networks to address the
increasing data traffic across the Internet. The Avici routing product family,
including the Terabit Switch Router product (TSR(R)) and the Stackable Switch
Router product (SSR(TM)), is designed to provide:

  .   capital and operational cost savings;

  .   high-speed/high-volume capacity;

  .   high levels of operational availability and redundancy, which we refer to
      as carrier-class reliability; and

  .   the ability to incrementally add capacity to the network without
      disrupting network performance, which we refer to as in-service
      scalability.

   Our products also optimize bandwidth by dynamically managing and
prioritizing network traffic, thereby enabling carriers to provision new
revenue-generating services. Our products provide these benefits through our
proprietary technologies, including our application specific integrated
circuits, or ASICs, and distributed system design, as well as our patented
Composite Link(TM) technology, which enables carriers to combine multiple lower
speed connections to create a single high-speed connection. AT&T has deployed
the TSR in its North American IP backbone network. The TSR has also been
deployed by France Telecom in the VTHD R&D network, by Chung Hwa Telecom in its
Next Generation Test Bed Network, by several agencies of the United States
government and by the DARPA-funded National Transparent Optical Network. The
TSR and SSR are also currently in trials and tests with additional prospective
customers, both domestically and internationally. Deployment of our products is
dependent upon the successful completion of field trials with prospective
customers.

Industry Background

   Demand for Data Services is Fueling Network Growth

   Data traffic over communications networks continues to grow despite capital
expenditure constraints in the telecommunications industry. This increase of
data traffic is being driven by a number of factors, including increases in the
number of Internet users worldwide and business use of the Internet for
applications such as e-commerce, content delivery, and virtual private
networks. To keep pace with the growing demand, transmission speeds have
increased and require higher speed scalable routing platforms to cost
effectively manage growth.

                                      3

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   Limitations of the Existing Public Network Infrastructure

   The existing public networks are largely built on technologies that were
originally designed to provide only voice services. These networks are based on
circuit switch technology, which dedicates an individual connection or part of
the network for the duration of a call even while there are pauses in the
conversation. Although adequate for voice traffic, circuit switch technology is
inefficient for the transmission of large volumes of data traffic, which tends
to occur in large, intermittent bursts.

   Carriers have sought to increase the efficiency of data transmission by
adopting packet switching technologies, such as Internet Protocol, or IP, which
divides data traffic into individual packets and transmits them independently
over the network. Packet-switching technologies enable carriers to send data to
multiple sources on the same connection, thereby substantially reducing the
bandwidth wasted using circuit switch technology. As carriers have migrated to
IP, they may be currently using multiple data networks, each utilizing
different data transmission protocols. As a result, carriers are evaluating
their networks for ways to make them more operationally efficient, more
responsive, and cost effective across the routing and optical domains. Carriers
that currently have multiple networks to support their data services may
utilize IP/Multi-protocol Label Switching (MPLS) enabled scalable and reliable
routers to converge the number of networks required. Utilizing MPLS traffic
engineering and Quality of Service (QoS) mechanisms, carriers can provide many
value-added services on a common IP/MPLS network.

   Carriers are also seeking to make the interaction between the optical
transport network and IP layers more efficient. Optical switch vendors and
router vendors are working together to improve signaling and interactions
between these two networks. The goal is to simplify service provisioning,
eliminate redundant network functions, and optimize network protection and
restoration schemes. Improved communication across the optical and IP domains
can enable service providers to realize capital expenditure reductions,
operational efficiencies, and improved reliability and customer service level
agreement support.

   Limitations of Existing Routers

   Legacy or traditional router offerings employ a centralized design, which
inherently limits the number of interfaces available in a single router. This
limitation requires that carriers either inefficiently cluster multiple routers
to emulate the functionality of a single large router with greater capacity or
repeatedly undertake disruptive and expensive large-scale upgrades, known as
forklift upgrades, to address the increases in transmission speeds and
capacities.

   At the same time, traditional routers are unable to communicate efficiently
with optical transmission equipment to dynamically change bandwidth or enable
the provisioning of new services without disrupting the entire network. This
limitation increases the time and effort required for carriers to deliver new
services or reconfigure the network in the event of sudden changes in bandwidth
demand.

   Carrier Requirements for a New Architecture

   To respond to the challenges created by the increasing volume of data
traffic on the existing public networks, carriers are not only focused on
optimizing their networks for more efficient data transmission, but are also
searching for a means to rapidly provision new revenue-generating services. As
a result, carriers are demanding solutions with the following attributes:

   Reduced Network Cost and Complexity. A major portion of expenditures
relating to the deployment of routers is dedicated to the interconnection of
multiple, fixed configuration routers in order to provision the required
amounts of bandwidth. This is costly in terms of capital and, more importantly,
increases the ongoing costs of running a network. Each router must be managed
as an independent element of the network, and with each addition of capacity
increasing the complexity of network design and management, the number of
personnel needed to manage the network increases. The personnel involved with
these configuration changes are often among the carrier's best IP resources and
could be better utilized to design and deliver new services. Carriers are
demanding scalable solutions that reduce the number of devices and complexity
of operating large capacity networks.

                                      4

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   Carrier-Class Reliability. The equipment that carriers deploy within their
networks must offer the highest level of up-time and redundancy. To meet this
requirement, known as carrier-class reliability, router designs must minimize
any single point of failure and provide automatic recovery from network
failures and device errors.

   Increased Service Velocity. Networks and network demands are changing
rapidly, and carriers want a cost-effective means of increasing capacity on a
continual basis. As a key building block of the public network, routers must
therefore have the ability to expand capacity without the costly delays of
forklift upgrades, complex network reconfigurations, or other significant
disruptions of the network.

   Quality of Service (QoS).  As carriers consolidate existing services on the
IP backbone, as well as offer new services, they must deliver quality of
service, or the ability to assign different priorities to different traffic
types. QoS is crucial to the delivery of time-sensitive data streams, such as
voice and video. Routers must provide quality of service functionality over IP
without adversely affecting performance. In addition to prioritizing packets,
routers must be able to manage and control network congestion to enable
carriers to deliver service level guarantees to their customers.

   High Performance. In order to support service requirements, carriers demand
high levels of performance and flexibility. Although there are different
measures for determining performance of routers, we believe the most critical
measure is the ability to process and forward packets at transmission rates
even as advanced features such as QoS are utilized.

   Interoperability. Due to economic constraints associated with upgrading an
entire network to accommodate new technologies, it is critical that new network
equipment support the protocols and devices already deployed in carrier
networks.

   Instead of trying to adapt older technologies or interim solutions that
provide only incremental increases in capacity, carriers are now seeking
solutions that will enable them to cost-effectively build networks designed to
capitalize on the opportunities created by the growth of the Internet and the
proliferation of data traffic.

The Avici Solution

   Our high-performance TSR and SSR products are engineered to provide a
long-term solution for carrier networks by providing a platform for growth and
control of increasing volumes of data traffic. Our solution is designed to
provide the following key benefits:

   Cost-Effective Network Expansion and Operation. By providing a system that
scales from small configurations to the industry's largest capacity router,
Avici enables customers to design router-based networks that can grow as the
demand for capacity grows without the need for constant re-engineering of the
network. The scalable architecture of our TSR and SSR reduces the number of
interface cards needed when compared with solutions using small, fixed
configuration devices. By minimizing the need for inefficient clustering,
continuous network upgrades and layers of legacy equipment, our products reduce
the overall cost of expanding and operating the network.

   Carrier-Class Reliability. The TSR and SSR have been designed and
manufactured to be highly reliable in the core of the carrier network. We
believe our products' technologically advanced features, such as our
distributed switch fabric architecture, Velociti(TM), and Composite Links, will
enhance the reliability and performance of carrier networks.

   Rapid Response to Network Demands. The scalability of the TSR and SSR
enables carriers to incrementally add capacity in a cost-effective,
non-disruptive manner. This capability for dynamic bandwidth provisioning
enables carriers to service existing customers while rapidly adapting to
changes in bandwidth demand, new service offerings and increased usage. Our
products have also been designed to meet the current and evolving

                                      5

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performance and bandwidth requirements at the core of carriers' networks. Our
products enable in-service scalability as demand increases, thereby eliminating
expensive clustering designs and forklift upgrades. We believe that this
scalability and flexibility position our products as a long-term solution for
carriers.

   Ability to Support Existing and New Revenue-Generating Services. Our TSR and
SSR provide an effective foundation for the delivery of existing and new data
communication services. Our products enable carriers to add capacity to support
services and customers without network disruption and to prioritize data
traffic to effectively provide quality of service guarantees.

   Ability to Support High Volumes of Network Traffic with Existing Interfaces.
Our TSR and SSR, through our Composite Link technology, are capable of
processing data packets at virtual line rates exceeding 10 gigabits per second,
thereby achieving virtual performance beyond OC-192. In addition, our products
provide the ability to prioritize IP traffic through quality of service
features without any loss of transmission speeds.

Strategy

   Our goal is to design, develop and provide highly reliable, scalable, and
cost effective high-speed data networking equipment that will power the core of
carriers' networks and establish new standards for carrier class routing. The
key elements of our strategy are to:

   Extend Technological Capabilities. We have developed a product architecture
designed specifically for the core of the carriers' networks. We plan to
continue to invest heavily in research and development to satisfy the
requirements of carrier networks. We plan to enhance the features of the TSR
and SSR and bring to market new, complementary products. During 2001, we
delivered a major software release that increased functionality in reliability,
scalability, and service support, three new line card modules increasing
density and port offerings for OC48c, OC-192c, and Gigabit Ethernet, and our
SSR platform. We take a leading role in industry standard-setting forums and
promote the interoperability of our products with those of key optical switch
and router vendors.

   Continue Penetration of Key Carrier Accounts. We strive to capture the
market opportunity presented by carriers demanding additional capacity as well
as carriers seeking to cost effectively support new and existing services. We
initially focused on a select group of leading carriers with the TSR, and we
are currently participating in a number of customer trials. With the
introduction of the SSR in October 2001, we have expanded our total addressable
market to include smaller service providers, metropolitan area network cores,
and international carriers. The SSR is also currently participating in a number
of customer trials. We plan to expand our direct sales force, domestically and
internationally, which will work together with our established customer service
organization, and our existing partners, Samsung in the Republic of Korea and
Itochu (CTC) in Japan. We also plan to pursue new partnerships with
international distributors, third-party service and support organizations and
complementary product companies to expand our market presence.

   Enable New Carrier Service Offerings. We work closely with our customers and
prospective customers to understand their network requirements. We use this
knowledge to develop new features and functionality to enable carriers to
support their customers. For example, our MPLS enables carriers to control
traffic flow and to offer services such as virtual private networks. We will
seek opportunities to enhance our product features and promote the TSR and SSR
as an effective means for carriers to capitalize on new service opportunities.

   Rely on Strategic Outsourcing. Our outsourcing strategy enables us to focus
our resources on our core competencies of product design and development, sales
and marketing. Although we design and develop our ASICs and other proprietary
technologies, we select and work closely with ASIC fabrication and electronics
manufacturing services providers to promote the cost-effective, timely and
reliable manufacture and testing of our products. To complement our internal
customer service organization, we have entered into global service and support
arrangements for our products with third parties.

                                      6

<PAGE>

Products and Technology

   Product Architecture

   Our TSR and SSR have been designed to provide critical functions for
carriers seeking to build reliable IP-based networks. We utilize a parallel and
distributed design to address the large volume of packet forwarding and
increasing traffic volume requirements of the Internet. By using a distributed
architecture that incorporates processing and packet routing functionality in
our line card ASICs, our products are designed to provide carriers with a
smooth upgrade path from OC-48c (2.5 Gbps) to speeds of OC-192c (10 Gbps),
OC-768 (40 Gbps), and higher by changing or bundling line card modules as they
become available rather than upgrading the entire chassis. Accordingly, this
architecture provides in-service scalability and preserves the initial
investment in our products.

   IPriori Carrier System Control Software

   IPriori is an advanced software system that has been developed to optimize
and control switching and routing in the TSR and SSR. IPriori is built on a
distributed model, which uses multiple processor units to provide increased
levels of reliability and scalability, and is specifically designed to address
the system requirements arising from a large number of ports. Through our
extensive field testing and network deployments, we have successfully
demonstrated our interoperable implementations of standard protocols such as
BGP, OSPF, and IS-IS.

   Composite Links

   The Avici TSR and SSR products connect to the transport network layer
through many physical connections. Physical connections between our two
products can be combined into a single virtual network interface to provide a
carrier with a high-capacity connection. This single network connection is
called a Composite Link. Composite Link technology enables carriers to add
additional lines or increase or decrease transmission speeds on a particular
Composite Link without disrupting the network. This enables carriers to meet
increases in bandwidth demand and to offer new services to their customers more
quickly and efficiently. Each Composite Link can be configured with up to 64
network interfaces. With this feature, our products can adapt to heavy or light
traffic demand in the network by adding or removing physical connections from
the composite group. Because our Composite Links operate with no network
disruption, they enable the rapid provisioning of additional bandwidth while
maintaining a stable and reliable environment for IP services.

   We have complemented our Composite Links with MPLS functionality to provide
traffic engineering capabilities and enable carriers to control and efficiently
balance data traffic across their networks. We believe MPLS is a key component
of differentiated IP-based services and, when combined with other quality of
service mechanisms, will enable carriers to support their service requirements.

   Velociti Switch Fabric

   Our Velociti switch fabric is the mechanism that transfers data from an
input line card to specific output cards in the TSR and SSR. This direct
communication provides high-speed data transfer and, as additional capacity is
needed, enables cost-effective addition of line cards. Because all data
handling, switching and packet processing has been incorporated into the line
cards, carriers are able to support higher speed line cards without forklift
upgrades. The Velociti switch fabric also gives our products a high level of
reliability by creating multiple connections between pairs of input and output
line cards. In the event one path fails, one of the backup paths is selected to
continue data transmission, thereby substantially reducing the risk of
disruption to the network.

   ASIC-based Packet Routing Technology

   We have consolidated all data-flow and control processes, including packet
input and output framing, forwarding, scheduling, and switching into our
application specific integrated circuits, or ASICs. All of our ASICs reside on
each line card module and with the addition of each line card module in our TSR
or SSR, the overall capacity of our product increases. Our ASIC design and
distributed switch fabric provide packet forwarding performance regardless of
packet address and route table size. We also work with leading component
manufacturers in the areas of field programmable gate arrays (FPGAs), network
processors, and framers.

                                      7

<PAGE>

Sales, Marketing, and Customer Service and Support

   We sell and market our products primarily through our direct sales force,
systems integrators, and distributors. Our sales cycle to carriers typically is
a lengthy and deliberate process. After preliminary discussions with our sales
organization, prospective customers may receive evaluation equipment to
encourage formal testing. The sales cycle normally includes laboratory testing
in which the TSR and SSR are evaluated against competing products for
performance, scalability, reliability, interoperability, and other measures.
Upon completion of the laboratory tests, one product is typically selected for
field trials in which the product is deployed in a carrier's network in a
limited and controlled fashion. Only after successful completion of field
trials will carriers place orders for commercial deployment across their
networks over time.

   Our marketing objectives include building market awareness and acceptance of
Avici and the Avici TSR and SSR as well as generating qualified customer leads.
In addition to traditional marketing activities, we are working closely with
standards bodies such as the Optical Internetworking Forum (OIF), IEEE, and
IETF to promote the interoperation of our routers with optical equipment from
other vendors.

   Our international sales are conducted through a direct sales force, systems
integrators, and distributors. We have regional partners in Japan, the Republic
of Korea, and Southeast Asia. In addition, in order to further our
international sales objectives, we will continue identifying and establishing
relationships with additional country-specific distributors.

   We believe that a broad range of support services is critical to the
successful installation and ongoing support of the TSR and SSR, the development
of long-term relationships with customers and the generation of additional
sales of our products to our customers. We are committed to providing our
customers with the highest levels of service and support.

Customers

   Our target end-user customers include incumbent local exchange carriers,
inter-exchange carriers, postal telephone and telegraph operators or PTTs
(international incumbent operators), international competitive carriers,
Internet service providers, and agencies of the United States government.
During the second half of 2001, continuing unfavorable economic conditions
caused a sudden decrease in capital spending as well as delays in purchasing
decisions by telecommunications service providers. These conditions are
expected to continue in the near term.

   During 2000, we entered into procurement agreements with AT&T Corp.
("AT&T"), Qwest Communications ("Qwest"), Williams Communications ("Williams"),
and Enron Broadband Services ("Enron"). The procurement agreements generally
describe the terms and conditions under which these customers may purchase
equipment from us.

   Our procurement agreement with AT&T has no minimum purchase commitment level
and expires in December 2003. AT&T has deployed the TSR in seven locations
within its North American IP backbone network and we expect continued
deployments in additional locations.

   Our procurement agreement with Qwest provides for an undisclosed minimum
purchase commitment and expires in July 2003. As of December 31, 2001, Qwest
had cumulative purchases from us of approximately $14 million. Deployment of
our products by Qwest is dependent upon the successful completion of ongoing
competitive trials, which we expect to be completed during 2002. There can be
no assurance, however, as to the timing of the completion of these trials or
that their outcome will be favorable.

   In December 2001, we amended our procurement agreement with Williams to
extend the term through December 2003. The amended agreement provided for a
current cash payment of $8.5 million, which we received in December 2001, and
included $2.7 million for product deliveries made in the fourth quarter of 2001

                                      8

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and $5.8 million in lieu of remaining purchase commitments in the original
agreement totaling $25 million. The $5.8 million may be used as a credit,
applied at varying rates, against future purchases through 2003. As of December
31, 2001, Williams had cumulative purchases from us of approximately $5 million.

   Our procurement agreement with Enron had a previously disclosed purchase
commitment of $15 million. Enron recently filed for United States bankruptcy
protection. As of December 31, 2001, Enron had cumulative purchases from us of
approximately $11 million. We do not expect to generate additional revenue from
Enron. Furthermore, at December 31, 2001 there were no outstanding amounts owed
by Enron to us for product shipped by the Company.

   The TSR has also been deployed by France Telecom in its VTHD R&D network, by
Chung Hwa Telecom in its Next Generation Test Bed Network, by several agencies
of the United States government, and by the DARPA-funded National Transparent
Optical Network. Our TSR and SSR products are currently in various stages of
trials and tests with prospective customers, both internationally and
domestically. There can be no assurance as to the timing of the completion of
these trials and tests or that their outcome will be favorable.

   During each of 2000 and 2001, AT&T, Qwest, and Enron each accounted for
greater than 10% of our net revenue.

Research and Development

   We have a team of skilled engineers responsible for product design and
development, quality assurance, and documentation with significant experience
in optics, hardware and software, and with particular strengths in the areas of
high speed interconnect, scalable connection fabrics, ASIC development and
Internet routing protocols. We believe that strong product development
capabilities are essential to our strategy of enhancing our core technology and
developing additional applications in an effort to maintain the competitiveness
of our product offerings. We have made, and will continue to make, a
substantial investment in research and development. Research and development
expenses were $61.5 million for the year ended December 31, 2001, $54.1 million
for the year ended December 31, 2000, and $36.8 million for the year ended
December 31, 1999.

Competition

   The market for carrier-class data networking equipment is intensely
competitive, subject to rapid technological change and significantly affected
by new product introductions and other market activities of industry
participants. This market historically has been dominated by Cisco Systems,
which as a result of its early leadership position in the market has been able
to develop and promote a broad product line of routers. We also compete with
other established companies such as Juniper Networks. We may experience a
reluctance by our prospective customers to replace or expand their current
infrastructure solutions, which may be supplied by these competitors, with our
products. In addition, some of our competitors have significantly broader
product lines than we do and may bundle their products with other networking
products in a manner that may discourage prospective customers from purchasing
our products. In order to compete effectively, we must deliver a product that
is superior in meeting the needs of carriers and:

  .   scales easily and efficiently with minimum disruption to the network;

  .   interoperates with existing network designs and equipment;

  .   provides extremely high network reliability; and

  .   provides a cost-effective solution for our target customers.

   Many of our current and potential competitors have greater selling and
marketing, technical, manufacturing, financial and other resources, more
customers, greater market recognition and more established relationships and
alliances in the industry. As a result, these competitors may be able to
develop, enhance and expand their product offerings more quickly, adapt more
swiftly to new or emerging technologies and changes in customer demands, devote
greater resources to the marketing and sale of their offerings, pursue
acquisitions and other opportunities more readily and adopt more aggressive
pricing policies.

                                      9

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Intellectual Property

   Our success and ability to compete are dependent on our ability to develop
and maintain the proprietary aspects of our technology and operate without
infringing on the proprietary rights of others. We rely on a combination of
patent protection, copyrights, trademarks, trade secret laws, and contractual
restrictions on disclosure and other methods to protect the proprietary aspects
of our technology. These legal protections afford only limited protection for
our technology. We presently have three patents granted in the United States
and greater than 14 patent applications pending in the United States and
related foreign patent applications pending. We cannot be certain that patents
will be granted based on these or any other applications, or that, even if
issued, the patents will adequately protect our technology. We seek to protect
our source code for our software, documentation and other written materials
under trade secret and copyright laws, and we seek to limit disclosure of our
intellectual property by requiring employees, consultants, and any third-party
with access to our proprietary information to execute confidentiality
agreements with us.

   While we rely on patent, copyright, trade secret and trademark law to
protect our technology, we also believe that factors such as the technological
and creative skills of our personnel, new product developments, frequent
product enhancements and reliable product maintenance are essential to
establishing and maintaining a technology leadership position. There can be no
assurance that others will not develop technologies that are similar or
superior to our technology.

   Our success will depend upon our ability to obtain necessary intellectual
property rights and protect our intellectual property rights. We cannot be
certain that we will be able to obtain the necessary intellectual property
rights or that other parties will not contest our intellectual property rights.

Manufacturing

   We outsource the manufacture and assembly of our products to contract
manufacturers. We primarily use Celestica Corporation and Sanmina-SCI
Corporation, both of which provide comprehensive manufacturing services,
including assembly, test and control and procurement of material, on our
behalf. We design product tests that are conducted using our test equipment by
the contract manufacturer. We believe that the outsourcing of our manufacturing
will enable us to conserve the working capital that would be required to
purchase capital equipment, will allow us to adjust manufacturing volumes to
meet changes in demand and will enable us to more quickly deliver products.

Employees

   As of December 31, 2001, we had a total of 293 employees. Our future success
will depend in part on our ability to attract, retain and motivate highly
qualified technical, sales and management personnel, for whom competition is
intense. Our employees are not represented by any labor union. We believe our
relations with our employees are good.

ITEM 2.   PROPERTIES

   Our headquarters are currently located in two leased facilities situated in
the same office complex in North Billerica, Massachusetts, consisting of
approximately 81,000 and 51,000 under leases that expire in October 2007 and
July 2004, respectively. In the third quarter of 2001, we recorded a
restructuring charge which included all remaining lease payments associated
with an 18,000 square foot facility located in the same office complex and we
are attempting to sublease this facility. We also lease sales office space in
several locations in the United States and in Europe.

   The commercial real estate market in the Boston area is unpredictable in
terms of available space, rental and occupancy rates and preferred locations.
However, we expect our current space is adequate to support our targeted growth
for the next twelve to eighteen months.

                                      10

<PAGE>

ITEM 3. LEGAL PROCEEDINGS

   During the period April through June 2001, the Company was named as a
defendant in twelve shareholder class action litigations that have been filed
in federal court in New York City against the Company and certain of its
current and former officers and the underwriters of the Company's initial
public offering (IPO). The lawsuits allege violations of the federal securities
laws and have been docketed in the U.S. District Court for the Southern
District of New York as: Felzen, et al. v. Avici Systems Inc., et al., C.A. No.
01-CV-3363; Lefkowitz, et al. v. Avici Systems Inc., et al., C.A. No.
01-CV-3541; Lewis, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3698;
Mandel, et. al v. Avici Systems Inc., et al., C.A. No. 01-CV-3713; Minai, et
al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3870; Steinberg, et al. v.
Avici Systems Inc., et al., C.A. No. 01-CV-3983; Pelissier, et al. v. Avici
Systems Inc., et al., C.A. No. 01-CV-4204; Esther, et al. v. Avici Systems
Inc., et al., C.A. No. 01-CV-4352; Zhous, et al. v. Avici Systems Inc. et al.,
C.A. No. 01-CV-4494; Mammen, et al. v. Avici Systems Inc., et. al., C.A. No.
01-CV-5722; Lin, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-5674; and
Shives, et al. v. Banc of America Securities, et al., C.A. No. 01-CV-4956.
These lawsuits, allege, among other things, that the underwriters of the
Company's IPO improperly required their customers to pay the underwriters
excessive commissions and to agree to buy additional shares of the Company's
stock in the aftermarket as conditions of receiving shares in the Company's
IPO. The lawsuits further claim that these supposed practices of the
underwriters should have been disclosed in the Company's IPO prospectus and
registration statement. The suits seek rescission of the plaintiff's alleged
purchases of the Company's stock as well as unspecified damages. The Company
understands that various other plaintiffs have filed substantially similar
class action cases against approximately 300 other publicly traded companies
and their IPO underwriters in New York City, which along with the cases against
the Company have all been transferred to a single federal district judge for
purposes of coordinated case management. The Company believes that the claims
against the Company lack merit, and intends to defend the litigation
vigorously.

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

   No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this report.

                                      11

<PAGE>

                                    PART II

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

Price Range of Common Stock

   Our common stock has been traded on the Nasdaq National Market under the
symbol "AVCI" since July 28, 2000. Prior to that time, there was no public
market for our stock. The following table sets forth, for the periods
indicated, the high and low sale prices as reported on the Nasdaq National
Market.

<TABLE>
<CAPTION>
                                                    High    Low
                                                   ------- ------
              <S>                                  <C>     <C>
              Fiscal 2000
               Third Quarter (since July 28, 2000) $174.50 $86.72
               Fourth Quarter..................... $ 95.95 $16.25
              Fiscal 2001
               First Quarter...................... $ 39.13 $ 7.38
               Second Quarter..................... $ 16.25 $ 5.04
               Third Quarter...................... $  8.84 $ 1.10
               Fourth Quarter..................... $  4.12 $ 1.22
</TABLE>

   As of March 15, 2002, there were approximately 998 stockholders of record.

Dividend Policy

   We have never paid or declared any cash dividends on our common stock or
other securities and do not anticipate paying cash dividends in the foreseeable
future. Any future determination to pay cash dividends will be at the
discretion of the board of directors and will be dependent upon our financial
condition, results of operations, capital requirements, general business
condition and such other factors as the board of directors may deem relevant.

                                      12

<PAGE>

ITEM 6.   SELECTED CONSOLIDATED FINANCIAL DATA

   The following selected consolidated financial data should be read in
conjunction with the consolidated financial statements and notes thereto and
with "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and other financial data included elsewhere in this report. The
statement of operations data for the years ended December 31, 2001, 2000 and
1999 and the balance sheet data as of December 31, 2001 and 2000 are derived
from our audited consolidated financial statements which are included elsewhere
in this report. The statement of operations data for the years ended December
31, 1998 and 1997 and the consolidated balance sheet data as of December 31,
1999, 1998 and 1997 are derived from our audited consolidated financial
statements which are not included in this report. The historical results are
not necessarily indicative of results to be expected for any future period.

<TABLE>
<CAPTION>
                                                                 Year Ended December 31,
                                               ----------------------------------------------------------
                                                 1997         1998          1999          2000         2001
                                               --------    ----------    ----------    -----------  -----------
                                                     (in thousands, except share and per share data)
<S>                                            <C>         <C>           <C>           <C>          <C>
Statement of Operations Data:
Gross revenue................................. $     --    $       --    $       --    $    15,887  $    56,643
Common stock warrant discount.................       --            --            --            817        3,267
                                               --------    ----------    ----------    -----------  -----------
       Net revenue............................       --            --            --         15,070       53,376
Cost of revenue...............................       --            --            --         11,157       51,973
                                               --------    ----------    ----------    -----------  -----------
       Gross margin...........................       --            --            --          3,913        1,403
Operating expenses:
   Research and development...................    4,168        27,357        36,821         54,056       61,527
   Sales and marketing........................       --         1,630         5,601         12,717       19,818
   General and administrative.................      858         2,010         3,041          4,770        9,538
   Stock-based compensation...................      325            60         3,171         18,659       15,003
   Restructuring charges......................       --            --            --             --        1,062
   Common stock warrant expense...............       --            --            --          2,400           --
   Purchased in-process research and
     development..............................       --            --            --          4,000           --
                                               --------    ----------    ----------    -----------  -----------
       Total operating expenses...............    5,351        31,057        48,634         96,602      106,948
                                               --------    ----------    ----------    -----------  -----------
Loss from operations..........................   (5,351)      (31,057)      (48,634)       (92,689)    (105,545)
Interest income...............................      272         1,301         1,533          8,735       10,698
Interest expense..............................      (85)         (362)         (689)          (733)        (645)
                                               --------    ----------    ----------    -----------  -----------
Net loss...................................... $ (5,164)   $  (30,118)   $  (47,790)   $   (84,687) $   (95,492)
                                               ========    ==========    ==========    ===========  ===========
Basic and diluted net loss per share.......... $ (34.71)   $   (19.05)   $   (13.99)   $     (3.69) $     (1.94)
                                               ========    ==========    ==========    ===========  ===========
Weighted average common basic and diluted
  shares......................................  148,785     1,581,038     3,416,534     22,938,383   49,258,306
                                               ========    ==========    ==========    ===========  ===========
Pro forma basic and diluted net loss per share
  (unaudited).................................                                         $     (2.03)
                                                                                       ===========
Pro forma weighted average common basic and
  diluted shares (unaudited)..................                                          41,763,735
                                                                                       ===========
</TABLE>

   Prior to the Company's initial public offering which was consummated on
August 2, 2000, weighted average common shares used in computing basic and
diluted net loss per share exclude unvested shares of common stock subject to
repurchase rights, as well as shares issuable upon conversion of redeemable
convertible preferred stock. Weighted average common shares used in computing
pro forma basic and diluted net loss per share includes the weighted average
effect of the foregoing unvested restricted shares of common stock as well as
shares issuable upon conversion of redeemable convertible preferred stock from
the respective dates of

                                      13

<PAGE>

issuance. Basic and diluted net loss per share are the same because all
outstanding common stock options have been excluded, as they are considered
antidilutive (see footnote 1(i) of the Notes to the Consolidated Financial
Statements).

<TABLE>
<CAPTION>
                                                          As of December 31,
                                            ----------------------------------------------
                                             1997      1998      1999      2000     2001
                                            -------  --------  --------  -------- --------
                                                           ( in thousands )
<S>                                         <C>      <C>       <C>       <C>      <C>
Balance Sheet Data:
Cash, cash equivalents and investments..... $ 6,870  $ 23,192  $ 47,917  $254,931 $164,441
Working capital............................   5,825    17,822    40,863   225,340  116,672
Total assets...............................   8,903    31,359    61,839   302,088  220,277
Long-term obligations, less current portion   1,471     5,521     6,390     3,072      753
Redeemable convertible preferred stock.....  11,017    55,098   123,441        --       --
Total stockholders' equity (deficit).......  (4,917)  (35,080)  (79,746)  267,878  193,687
</TABLE>

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

   The following discussion and analysis should be read in conjunction with
"Selected Consolidated Financial Data" and our consolidated financial
statements and the related notes thereto included elsewhere herein. This
discussion contains forward-looking statements that involve risks and
uncertainties. Our actual results could differ materially from those
anticipated in the forward-looking statements as a result of certain factors
including those discussed in "Factors That May Affect Future Results" included
elsewhere herein.

Overview

   Avici Systems provides high-speed data networking equipment that enables
telecommunications companies and Internet service providers to transmit high
volumes of information across their networks.

   Since our inception, we have incurred significant losses. As of December 31,
2001, we had an accumulated deficit of $263.8 million. Our operating activities
from inception through 1999 were primarily devoted to research and development,
including the design and development of our proprietary application specific
integrated circuits, or ASICs, and software, and system testing the Avici
Terabit Switch Router product, or TSR. Revenue was first recognized during the
first quarter of 2000. We have also built our administrative, marketing, sales,
customer support and manufacturing organizations and developed strategic
relationships with systems integrators, distributors, customers and
complementary vendors. We have not achieved profitability on a quarterly or an
annual basis and anticipate that we will continue to incur significant
operating losses in the foreseeable future. We have a lengthy sales cycle for
our products and, accordingly, we expect to incur significant selling and other
expenses before we realize the related revenue. We expect to incur significant
sales and marketing, research and development and general and administrative
expenses as we expand our business and, as a result, we will need to generate
significant revenues to achieve and maintain profitability.

   The TSR became commercially available in the fourth quarter of 1999. During
2001 we introduced the Avici Stackable Switch Router product, or SSR, a
rack-mountable scalable router for carriers and service providers with smaller
core networks. The first SSR sale occurred during the fourth quarter of 2001.
We currently market our products to major carriers in North America through a
direct sales force. We also market our products internationally through systems
integrators, distributors, and a direct sales force in Europe. We currently
provide product installation and customer field support through our internal
customer service organization and third-party support organizations.

   Our target end-user customers include incumbent local exchange carriers,
inter-exchange carriers, postal telephone and telegraph operators or PTTs
(international incumbent operators), international competitive carriers,
Internet service providers, and agencies of the United States government.

                                      14

<PAGE>

   During 2000, the Company entered into procurement agreements with AT&T Corp.
("AT&T"), Williams Communications ("Williams"), Qwest Communications ("Qwest"),
and Enron Broadband Services ("Enron"). The procurement agreements generally
describe the terms and conditions under which these customers may purchase
equipment from us.

   Our procurement agreement with AT&T has no minimum purchase commitment level
and expires in December 2003. AT&T has deployed the TSR in seven locations
within its North American IP backbone network and the Company expects continued
deployments in additional locations.

   The Company's procurement agreement with Qwest provides for an undisclosed
minimum purchase commitment and expires in July 2003. As of December 31, 2001,
Qwest had cumulative purchases from us of approximately $14 million. Deployment
of the Company's products by Qwest is dependent upon the successful completion
of ongoing competitive trials, which the Company expects to be completed during
2002. There can be no assurance as to the timing of the completion of these
trials and tests or that their outcome will be favorable.

   In December 2001, the Company amended its procurement agreement with
Williams extending its term through December 2003. The amended agreement
provided for a current cash payment of $8.5 million, which we received in
December 2001 and included $2.7 million for product deliveries made in the
fourth quarter of 2001 and $5.8 million in lieu of remaining purchase
commitments in the original agreement totaling $25 million. The $5.8 million
can be used as a credit, applied at varying rates, against future purchases
through 2003. As of December 31, 2001, Williams had cumulative purchases from
us of approximately $5 million.

   The Company's procurement agreement with Enron had a previously disclosed
purchase commitment of $15 million. Enron recently filed for United States
bankruptcy protection. As of December 31, 2001, Enron had cumulative purchases
from us of approximately $11 million. The Company does not expect to generate
additional revenue from Enron. Furthermore, at December 31, 2001 there were no
outstanding amounts owed by Enron to the Company for product shipped by the
Company.

   The TSR has also been deployed by France Telecom in its VTHD R&D research
network, by Chung Hwa Telecom in its Next Generation Test Bed Network, by
several agencies of the United States government, and by the DARPA-funded
National Transparent Optical Network. The Company's TSR and SSR products are
currently in various stages of trials and tests with prospective customers,
both internationally and domestically. There can be no assurance as to the
timing of the completion of these trials and tests or that their outcome will
be favorable.

   From the first quarter of fiscal 2000 through the second quarter of fiscal
2001 our net revenues increased sequentially each quarter. However, our gross
revenue decreased 52% from the second quarter to third quarter of fiscal 2001
due to unfavorable economic conditions followed by a significant decrease in
capital spending by telecommunications service providers. In response to these
conditions, the Company implemented restructuring programs during the third and
fourth fiscal quarters of 2001 designed to decrease operating expenses and
align resources with future growth opportunities. The restructuring programs
included workforce reductions totaling 95 employees, or approximately 24% of
the workforce. The affected employees are entitled to severance and other
benefits pursuant to a benefits program. The Company recorded charges totaling
$0.9 million for these termination benefits during the third and fourth fiscal
quarters of 2001. Approximately $0.6 million in termination benefits was paid
during 2001 and the remaining $0.2 million is expected to be paid during the
first quarter of 2002. In addition, the Company recorded a charge of $1.7
million to dispose of redundant assets and to accrue lease payments associated
with excess facility space.

                                      15

<PAGE>

   The Company's restructuring related reserves at December 31, 2001 are
summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                                             Restructuring
                                                                              Accrual at
                                                   Total    Noncash   Cash   December 31,
                                                   Charge   Charges  Payment     2001
                                                   -------  -------  ------- -------------
<S>                                                <C>      <C>      <C>     <C>
Workforce reduction............................... $   869  $    --   $631       $238
Consolidation of facilities and disposal of assets   1,718    1,330     53        335
Reversal of stock based compensation..............  (1,525)  (1,525)    --         --
                                                   -------  -------   ----       ----
   Total.......................................... $ 1,062  $  (195)  $684       $573
                                                   =======  =======   ====       ====
</TABLE>

   The workforce reduction resulted in the forfeiture of employee stock
options. The restructuring charge includes the reversal of $1.5 million of
non-cash stock based compensation expense previously recorded for the forfeited
options.

   Additionally, the Company recorded a charge of $17.2 million as an element
of cost of sales to reflect a write down of inventories and inventory
commitments for long lead time items which were considered to be in excess of
foreseeable demand. The write down was necessitated by the sudden and
significant decline in carrier demand experienced during the third quarter and
the resultant delays in carrier purchasing decisions. Accordingly, the Company
adjusted future demand forecasts, and performed a detailed review of inventory
on hand, and inventory commitments with suppliers. As a result of this review,
commitments to suppliers including ASICs, module components, and TSR bay
components totaling approximately $9.6 million and inventory components and
finished goods on hand relating to the TSR product, totaling approximately $7.6
million were identified as in excess of forecasted demand for the next 12
months. During the fourth quarter of fiscal 2001, the Company paid $7.0 million
to settle inventory commitments with suppliers, and the Company expects to
substantially pay the remaining $2.6 million of accrued supplier commitments
during the first quarter of 2002. Approximately $2.0 million of excess
inventory on hand was discarded during the fourth quarter of fiscal 2001. Based
on our current demand forecasts, the Company does not currently anticipate that
the remaining $5.6 million of excess inventory will be used at a later date.

   Although the Company expects telecommunications service providers to
continue to maintain conservative levels of capital spending in the near term,
we do not anticipate that further charges for restructuring actions and excess
inventory will be required in the next twelve months. However, should
deterioration in the telecommunications equipment market continue, resulting in
carrier purchases not meeting our expectations, inventory may become obsolete
or unusable, requiring additional charges, which may have an adverse impact on
the financial results and financial condition of the Company.

   We outsource our manufacturing operations to contract manufacturers that
assemble and test our products in accordance with our specifications.
Accordingly, a significant portion of our cost of revenue involves payment to
these entities. Our cost of revenue also includes payments to LSI Logic, which
develops several of our proprietary ASICs. These proprietary ASICs are very
complex and LSI Logic is currently our sole source supplier for them. Our cost
of revenue also includes overhead costs, primarily for material procurement
associated with our manufacturing. Warranty costs and inventory provisions are
expensed as cost of revenue.

   Research and development expenses consist primarily of salaries and related
employee costs, prototype equipment, materials costs and third-party costs and
fees related to the development and prototyping of our proprietary technology,
including our ASICs. We expense research and development costs as incurred. We
expect that research and development expenses will increase in absolute dollars
as demand for our products, features and functionality increases.

   Sales and marketing expenses consist primarily of salaries and related
employee costs, sales commissions, travel, public relations, training and other
costs associated with marketing material and tradeshows. We expect that sales
and marketing expenses will increase in absolute dollars as we broaden our
sales infrastructure, establish sales offices in new locations domestically and
internationally and initiate new marketing programs.

                                      16

<PAGE>

   General and administrative expenses consist primarily of salaries and
related costs for executive, finance, legal, facilities, human resources and
information technology personnel and professional fees. In the near term, we
expect that general and administrative expenses will decrease in absolute
dollars due to cost reduction programs implemented by the Company. Longer term,
we expect that general and administrative expenses will increase in absolute
dollars as we add personnel and incur additional costs related to the growth of
our business.

   In December 2000, in connection with the execution of a nonexclusive systems
and services agreement, the Company issued a warrant to AT&T to purchase
850,000 shares of the Company's common stock at a per-share exercise price of
$27.73. The agreement between the Company and AT&T provides AT&T with the
ability, but not the obligation, to purchase equipment and services from the
Company. The warrant is nonforfeitable, fully exercisable and has a term of
five years from the date of issuance. The fair value of the warrant was
calculated using the Black-Scholes valuation model to be $9.8 million. The fair
value of the warrant has been deferred as a reduction to equity and is
currently being amortized as an offset to gross revenue on a straight-line
basis over the three-year term of the agreement. As of December 31, 2001,
approximately $4.1 million has been amortized, $0.8 million in 2000 and $3.3
million in 2001.

   During the years ended December 31, 1999, 2000, and 2001, the Company
recorded non-cash deferred compensation of approximately $10.4 million, $34.7
million, and $1.2 million, respectively, as an element of stockholders' equity.
These amounts represent the aggregate difference between the deemed fair value
of the Company's common stock and the exercise price of stock options and the
selling price of restricted stock sold. All stock options granted and
restricted stock sold prior to 1999 were at fair market value, as determined by
the Board of Directors, and, therefore, did not result in deferred
compensation. The deferred compensation is being recognized as an expense over
the vesting period of the stock options and restricted stock. During the years
ended December 31, 1999, 2000 and 2001, the Company recorded approximately $3.2
million, $18.7 million, and $15.0 million, respectively, of stock based
compensation expense. Stock based compensation expense includes the value of
stock options granted to consultants totaling $0.2 million in 1999 and $1.3
million in 2000. The Company expects to recognize compensation expense of
approximately $6.3 million, $2.6 million and $0.6 million during the years
ended December 31, 2002, 2003, 2004, respectively, based on stock options and
restricted stock issued prior to December 31, 2001.

Critical Accounting Policies

   The Company considers certain accounting policies related to revenue
recognition, inventory and warranty liabilities to be critical accounting
policies due to the estimation processes involved in each.

   The Company recognizes revenue from product sales upon shipment, provided
that a purchase order has been received or a contract has been executed, there
are no uncertainties regarding customer acceptance, the sales price is fixed or
determinable and collectibility is deemed probable. If uncertainties regarding
customer acceptance exist, the Company recognizes revenue when those
uncertainties are resolved. For arrangements that include the delivery of
multiple elements, revenue is allocated to the various elements based on
vendor-specific objective evidence of fair value (VSOE). The Company uses the
residual method when VSOE does not exist for one of the delivered elements in
an arrangement. We also generate revenue from support and maintenance as well
as installation and service. We defer revenue from support and maintenance
contracts and recognize it ratably over the period of the related agreements.
We recognize revenue from installation and other services as the work is
performed. Amounts collected or billed prior to satisfying the above revenue
recognition criteria are recorded as deferred revenue.

   We value our inventory at the lower of our actual cost or the current
estimated market value. We regularly review inventory quantities on hand and
inventory commitments with suppliers and record a provision for excess and
obsolete inventory based primarily on our estimated forecast of product demand
for the next twelve months. As demonstrated during 2001, demand for our
products can fluctuate suddenly and significantly due to changes in economic
and business conditions. A significant increase in demand for our products
could result in a short-

                                      17

<PAGE>

term increase in the cost of inventory purchases while a significant decrease
in demand could result in an increase in the amount of excess inventory on hand
and at suppliers. In addition, our industry is characterized by rapid
technological change, frequent new product development, and rapid product
obsolescence that could result in an increase in the amount of obsolete
inventory on hand and at suppliers. Therefore, although we make every effort to
ensure the accuracy of our forecasts of future product demand, any significant
unanticipated changes in demand or technological developments could have a
significant impact on the value of our inventory and our reported operating
results.

   Our warranties require us to repair or replace defective product returned to
us during the warranty period at no cost to the customer. We record an estimate
for warranty-related costs based on our actual historical return rates and
repair costs at the time of sale. While our warranty costs have historically
been within our expectations and the provisions established, we cannot
guarantee we will continue to experience the same warranty return rates or
repair costs that we have in the past. A significant increase in product return
rates, or a significant increase in the costs to repair our products, could
have a material adverse impact on future operating results for the period or
periods in which such returns or additional costs materialize and thereafter.

Results of Operations

  Fiscal Year ended December 31, 2001 Compared to Fiscal Year Ended December
  31, 2000

   Net Revenue. Net revenue was $53.4 million for the year ended December 31,
2001, as compared to $15.1 million for the year ended December 31, 2000. The
increase is a result of higher unit sales of bays and modules, and higher
service revenue from maintenance and support. Revenue is recorded net of common
stock warrant discount which totaled $3.3 million in 2001 and $0.8 million in
2000. During 2001 and 2000, shipments to three customers accounted for 47%, 23%
and 13% of net revenues and 32%, 25% and 15% of net revenues, respectively.
Service revenues in 2001 and 2000 were less than 10% of net revenues.

   Cost of Revenue. Cost of revenue was $52.0 million for the year ended
December 31, 2001, an increase of $40.8 million over 2000. Cost of revenue for
2001 includes the $17.2 million charge for excess and obsolete inventory. Cost
of revenue as a percentage of gross and net revenue for the year ended December
31, 2001 was approximately 92% and 97%, respectively, compared to 70% and 74%
for the prior fiscal year. The higher percentage in 2001 reflects the impact of
the charge for excess and obsolete inventory. Excluding the charge for excess
and obsolete inventory, cost of revenue as a percentage of gross and net
revenue for the year ended December 31, 2001 was approximately 61% and 65%,
respectively, compared to 70% and 74% for the prior fiscal year. The lower
percentage reflects the spreading of fixed overhead costs over a larger revenue
base, a shift in product mix in 2001 to higher margin modules versus bays, and
certain cost reductions achieved with key suppliers. We anticipate cost of
revenue, as a percentage of both gross and net revenue, and after excluding the
impact of the charge for excess and obsolete inventory, to decrease on a year
over year basis as the future revenue mix continues to shift to higher margin
modules and as fixed overhead costs are spread over an even greater revenue
base.

   Research and Development. Research and development expenses increased $7.4
million from $54.1 million in 2000 to $61.5 million in 2001. The increase was
due to an increase of $7.7 million in salary and salary-related expenses
associated with increased staffing, increased depreciation expense of $9.8
million associated with the build out of the Company's internal development
network, and an increase of $1.7 million in other research and development
costs. These increases were offset by an $11.8 million decrease in outside
service and supply costs incurred to develop the initial TSR.

   Sales and Marketing. Sales and marketing expenses increased $7.1 million
from $12.7 million in 2000 to $19.8 million in 2001. The increase was due to an
increase of $4.3 million in salary and salary-related expenses associated with
increased staffing, increased depreciation expense of $2.0 million associated
with the build out of the Company's customer support infrastructure and an
increase in other sales-related expenses of $0.8 million.

                                      18

<PAGE>

   General and Administrative. General and administrative expenses increased
$4.7 million from $4.8 million in 2000 to $9.5 million in 2001. The increase
was due to an increase of $1.6 million in salary and salary-related expenses
associated with increased staffing, an increase in costs relating to a new
business systems of $1.1 million and other costs of $2.0 million necessary to
support the growing scale of operations, and operate as a public company.

   Stock-Based Compensation. Stock-based compensation expense decreased from
$18.7 million in 2000 to $15.0 million in 2001 due to certain option grants
becoming fully vested, and the related compensation expense becoming fully
amortized.

   Common Stock Warrant Expense. Common stock warrant expense represents the
Black-Scholes value of a warrant issued to a potential customer. Common stock
warrant expense was $2.4 million for fiscal 2000. The Company had no common
stock warrant expense in fiscal 2001.

   Purchased In-Process Research and Development. The Company's in-process
research and development ("IPR&D") is comprised of a single research and
development project which is focused on certain aspects of optical switching
technology. At the date of purchase, the project was estimated to be 13%
complete and continuing research and development commitments to complete the
project were expected to approximate $1.5 million. As of December 31, 2001, the
project was estimated to be 32% complete and remaining research and development
commitments were estimated to be approximately $1.2 million.

   The $4.0 million value assigned to the purchased IPR&D was determined by
estimating the costs to develop the purchased technology into a commercially
viable optical application, estimating the resulting cash flows from the
application and discounting the net cash flows to their present value. At the
date of acquisition, this project had not yet reached technological feasibility
and the IPR&D had no alternative future uses. Revenue projections used to value
the IPR&D project are based on estimates of relevant market size and growth
factors, expected trends in technology and the nature and expected timing of
new product introductions by the Company and its competitors.

   The rate used to discount the net cash flows to their present value was 35%
based on cost of capital considerations adjusted for certain risks associated
with the in-process technology.

   Interest Income. Interest income increased from $8.7 million in 2000 to
$10.7 million in 2001 due to an increase in weighted average cash balances
available for investment.

   Interest Expense. Interest expense decreased from $0.7 million in 2000 to
$0.6 million in 2001 due to decreases in equipment financed through capital
leases.

  Fiscal Year ended December 31, 2000 Compared to Fiscal Year Ended December
  31, 1999

   Net Revenue. Net revenue was $15.1 million for the year ended December 31,
2000. Revenue is recorded net of common stock warrant discount which totaled
$0.8 million. The Company had no revenue in 1999. During 2000, shipments to
three customers accounted for 32%, 25% and 15% of net revenues. Service revenue
for fiscal 2000 was insignificant.

   Cost of Revenue. Cost of revenue was $11.2 million for the year ended
December 31, 2000. Cost of revenue as a percentage of gross and net revenue for
fiscal 2000 was approximately 70% and 74%, respectively. The Company had no
revenue or cost of revenue in 1999.

   Research and Development. Research and development expenses increased $17.3
million from $36.8 million in 1999 to $54.1 million in 2000. This increase was
due to an increase of $11.1 million in salary and salary-related expenses
associated with increased staffing, an increase of $1.3 million in outside
service and supply costs associated with the development of the TSR and an
increase of $4.9 million in facilities and other research and development
related costs.

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<PAGE>

   Sales and Marketing. Sales and marketing expenses increased $7.1 million
from $5.6 million in 1999 to $12.7 million in 2000, due to an increase of $5.9
million in salary and salary-related expenses associated with increased
staffing, and an increase of $1.2 million in other sales-related expenses.

   General and Administrative. General and administrative expenses increased
$1.8 million from $3.0 million in 1999 to $4.8 million in 2000 due to an
increase of $0.7 million in salary and salary-related expenses associated with
increased staffing, and an increase of $1.1 million in other expenses necessary
to support the growing scale of operations.

   Stock-Based Compensation. Stock-based compensation expense increased from
$3.2 million in 1999 to $18.7 million in 2000 in connection with restricted
stock and stock options granted during those periods at prices subsequently
deemed to be below fair market value on the date of grant.

   Common Stock Warrant Expense. Common stock warrant expense represents the
Black-Scholes value of a warrant issued to a potential customer. Common stock
warrant expense was $2.4 million for fiscal 2000. The Company had no common
stock warrant expense in fiscal 1999.

   Purchased In-Process Research and Development. The Company's in-process
research and development ("IPR&D") is comprised of a single research and
development project which is focused on certain aspects of optical switching
technology. At the date of purchase, the project was estimated to be 13%
complete and continuing research and development commitments to complete the
project were expected to be approximately $1.5 million.

   The $4.0 million value assigned to the purchased IPR&D was determined by
estimating the costs to develop the purchased technology into a commercially
viable optical application, estimating the resulting cash flows from the
application and discounting the net cash flows to their present value. At the
date of acquisition, this project had not yet reached technological feasibility
and the IPR&D had no alternative future uses. Revenue projections used to value
the IPR&D project are based on estimates of relevant market size and growth
factors, expected trends in technology and the nature and expected timing of
new product introductions by the Company and its competitors.

   The rate used to discount the net cash flows to their present value was 35%
based on cost of capital considerations adjusted for certain risks associated
with the in-process technology.

   Interest Income. Interest income increased from $1.5 million in 1999 to $8.7
million in 2000. The increase was due to increases in cash balances available
for investment.

   Interest Expense. Interest expense approximated $0.7 in 1999 and 2000.

Net Operating Loss and Tax Credit Carryforwards

   We have not recorded a provision for income taxes because we have
experienced net losses from our inception. As of December 31, 2001, we had net
operating loss and tax credit carryforwards of approximately $215.8 million and
$7.4 million, respectively. Approximately $9.4 million of the Company's net
operating loss carryforwards relate to deductions associated with the Company's
stock option plans, which will be benefited through stockholder's equity if
realized. These carryforwards will expire at various dates through 2021, if not
utilized. Utilization of the net operating losses and tax credits may be
subject to a substantial annual limitation due to the ownership change
limitations contained in the Internal Revenue Code and similar state
provisions. The annual limitation may result in the expiration of the net
operating loss and credits before utilization. Due to the uncertainty that
exists regarding the recoverability of the associated deferred tax assets, a
full valuation allowance has been recorded against these assets.

                                      20

<PAGE>

Liquidity and Capital Resources

   Since our inception, we have financed our operations through an initial
public offering in July 2000, private sales of equity securities, and, to a
lesser extent, equipment lease financing. From inception through December 31,
2001, we raised approximately $410.3 million from these equity offerings.
During the year ended December 31, 2001, we used $53.5 million in cash for
operating activities, compared to $57.6 million used in the year ended December
31, 2000, and $41.0 million used in the year ended December 31, 1999. The
decrease in cash usage from 2000 to 2001 resulted principally from decreased
investments in working capital. The increase in cash usage from 1999 to 2000
resulted principally from the ongoing research and development costs of the
TSR, including personnel and material costs. We expect working capital
requirements will increase if product sales increase, creating larger customer
receivable balances and the need to build inventory in advance of shipment. In
addition, we will selectively invest in infrastructure costs needed to support
the scale of operations. We also anticipate that accruals for employee
severance and inventory commitments in excess of foreseeable future
requirements totaling $2.8 million will be substantially liquidated during the
quarter ending March 31, 2002.

   Purchases of property and equipment were $37.7 million for the year ended
December 31, 2001, $20.1 million for the year ended December 31, 2000, and $4.6
million for the year ended December 31, 1999, and consisted primarily of
purchases of application software, test equipment and computer equipment,
including workstations, servers and laboratory equipment primarily to support
our increased research and development activities, customer support
infrastructure and establish management information systems. We financed $1.7
million during the year ended December 31, 2000 and $4.4 million for the year
ended December 31, 1999 through capital lease arrangements. As of December 31,
2001, our future minimum lease payment obligations were $3.3 million under
capital leases which require annual payments of $2.5 million in 2002, $738,000
in 2003 and $46,000 in 2004. The timing and amount of future capital
expenditures will depend primarily on our future growth. The Company expects
that its capital expenditures will be approximately $20.0 million in 2002. In
addition, our future minimum lease payment obligations under operating leases
is $7.6 million which require payments of $1.8 million in 2002, $1.6 million in
2003, $1.3 million in 2004, $1.1 million in 2005 and 2006 and $0.7 million in
2007.

   The Company outsources the manufacture and assembly of its products. During
the normal course of business, in order to maintain competitive lead times for
customers and adequate components supply, the Company enters into agreements
with certain suppliers to procure inventory based upon criteria as defined by
the Company. As of December 31, 2001, the Company was committed to purchase
approximately $3.4 million of inventory based upon such criteria.

   We also borrowed $1.3 million to fund software purchases under a term-loan
agreement with a leasing company that is also a stockholder. This loan was
repaid in 30 monthly installments through December 2001 of approximately
$49,000, including principal and interest, plus a final payment in the amount
of $187,500. The loan was paid in full at December 31, 2001. The effective
annual interest rate of this loan was 17%.

   Other than obligations under capital leases, minimum payments under
operating leases and certain commitments to vendors for long lead time
inventory items, the Company has no additional debt for which it is a guarantor
or direct obligor.

   We expect that working capital and capital expenditure requirements may
increase if product sales increase, creating larger customer receivable
balances, the need to build inventory in advance of shipment and the need for
increased levels of test and management information systems equipment. At
December 31, 2001, the Company had cash and cash equivalents of $65.4 million,
short-term investments of $63.6 million, and long-term investments of $35.5
million. We believe that our existing cash, cash equivalents and investments,
together with cash flows from operations, will be sufficient to meet our normal
operating and capital requirements for the next 24 months. However, we could be
required, or could elect, to raise additional funds during that period and we
may need to raise additional capital in the future. We may not be able to
obtain additional capital on terms

                                      21

<PAGE>

favorable to us or at all. The issuance of additional equity or equity-related
securities will be dilutive to our stockholders. If we cannot raise funds on
acceptable terms, or at all, we may not be able to develop or enhance our
products or respond appropriately to competitive pressures, which would
seriously limit our ability to increase our revenue and grow our business.

Recent Accounting Pronouncements

   During 1998, 1999 and 2000, the Financial Accounting Standards Board (FASB)
issued Statement of Financial Accounting Standards (SFAS) Nos. 133, 137 and
138, respectively, relating to the accounting for derivative instruments and
hedging activities. The Company currently does not have any derivative
instruments. The Company adopted the provisions of these standards in 2001. The
adoption of these standards did not have a material impact on the Company's
consolidated financial condition or results of operations.

   In July 2001, the FASB issued SFAS No. 141, Business Combinations. SFAS No.
141 requires that all business combinations be accounted for under a single
method, the purchase method. This statement is effective for all business
combinations initiated after June 30, 2001.

   In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets. This statement applies to intangibles and goodwill acquired after June
30, 2001, as well as goodwill and intangibles previously acquired. Under this
statement goodwill as well as other intangibles determined to have an
indefinite life will no longer be amortized; however these assets will be
reviewed for impairment on a periodic basis, at least annually. This statement
is effective for the Company beginning January 1, 2002. As of December 31,
2001, the Company had no intangible or goodwill assets impacted by this
statement.

   In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS No. 144 addresses the reporting for the
impairment or disposal of long-lived assets and does not apply to goodwill or
intangible assets that are not being amortized and certain other long-lived
assets. This Statement supersedes SFAS No. 121, Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and reporting
provisions of APB Opinion No. 30, Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions, for the disposal of
a segment of a business (as previously defined in that Opinion). This Statement
also amends ARB No. 51, Consolidated Financial Statements, to eliminate the
exception to consolidation for a subsidiary for which control is likely to be
temporary. SFAS No. 144 is effective for financial statements issued for fiscal
years beginning after December 15, 2001. Management adopted this standard as of
January 1, 2002, and it did not have a material impact on the Company's
consolidated financial position and results of operations.

Factors That May Affect Future Results

   We expect that substantially all of our revenues will be generated from a
limited number of customers. Our revenues will not grow if our products are not
selected for or do not successfully pass field trial tests.

   We currently have a limited number of customers. We expect that in the
foreseeable future substantially all of our revenues will continue to depend on
sales of our TSR and SSR products to these customers and a limited number of
potential new customers. Our sales cycle typically involves a lengthy sales
consultation process followed by laboratory testing in which our product is
evaluated against competing products. If our product is selected for field
trials after laboratory testing, our product is then tested in an operational
environment. Generally, our customers do not contractually commit to purchase
any minimum quantities of products from us until we have successfully
demonstrated specific performance criteria in these field trials. We cannot
predict whether our products will successfully complete laboratory tests or
field trials with particular customers or whether these customers will order
and commercially deploy our products in meaningful volumes. The failure of
current or prospective customers to purchase our products for any reason,
including the failure to pass field trials,

                                      22

<PAGE>

any determination not to install our products in their networks or any downturn
in their business, would seriously harm our ability to build a successful
business. Even if we are successful in promoting the adoption of our products,
customers usually test, purchase and deploy competitive products for various
segments of their networks. Accordingly, we will likely face additional
competitive challenges in further penetrating customer accounts.

   The TSR and SSR are currently our only products and our future revenues
depend on enhancements to these products and their commercial success.

   Our future growth and our future revenue depend on the commercial success of
our TSR and SSR, which are the only products that we currently offer. We have
shipped our products to a limited number of current and prospective customers.
These entities are currently using our products in their internal networks
only, except for AT&T, which has deployed our TSR in its North American IP
backbone network. Our other customers have not yet fully deployed our products
in large network environments and may not choose to do so. Even if these
customers do fully deploy our products, they may not operate as expected. The
failure of our products to operate as expected could delay or prevent their
adoption. We must also continue to enhance the features and functionality of
the TSR and SSR to meet customer requirements. In addition, the failure of
these planned product enhancements to operate as expected could delay or
prevent future sales of our products. If our target customers do not adopt,
purchase and successfully deploy our TSR or SSR and our planned product
enhancements, our revenues will not increase significantly.

   We are exposed to general economic and industry conditions which have
adversely affected our business since the third quarter of 2001.

   Our business is subject to the effects of general economic conditions in the
United States and globally, and in particular, to market conditions in the
telecommunications and networking industries. During the second half of 2001,
continuing unfavorable economic conditions caused a sudden decrease in capital
spending by telecommunications service providers, resulting in longer selling
cycles with extended trial periods for new equipment purchases and delays in
purchasing decisions. If economic conditions do not improve, or if we
experience a worsening in the economic or industry downturn, our business,
results of operations and financial condition will be harmed.

   Our failure to increase our revenues would prevent us from achieving and
maintaining profitability.

   We have incurred significant losses in each quarterly and annual period
since inception and expect to continue to incur significant losses in the
future. As of December 31, 2001, we had an accumulated deficit of $263.8
million. We began recognizing revenues during the year ended December 31, 2000.
We cannot be certain that our revenues will increase or that we will generate
sufficient revenues to achieve profitability. We plan to continue product
development and to selectively increase the number of our engineering, sales,
marketing and administrative employees. These efforts will require significant
expenditures, a substantial portion of which we will make long before any
significant revenue related to these expenditures may be realized. In addition,
our operating expenses are based largely on anticipated revenue trends and a
significant portion of our expenses, such as personnel and real estate
facilities costs, is fixed. As a result, we will need to generate significant
revenues to achieve and maintain profitability. If we fail to achieve
significant increases in our revenues, the size of our operating losses may be
larger than expected. We may never achieve profitability or generate positive
cash flows from operations. If we do achieve profitability or positive cash
flows from operations in any period, we may not be able to sustain or increase
profitability or positive cash flows on a quarterly or annual basis.

   We rely on sole or limited source suppliers for several key components. If
we are unable to purchase these components on a timely basis, we will not be
able to deliver our products to our customers within the timeframes required
and we may experience order cancellations.

   We currently specify and purchase through our contract manufacturers several
key components from sole or limited sources. We purchase application specific
integrated circuits, or ASICs, from LSI Logic, and field

                                      23

<PAGE>

programmable gate arrays, or FPGAs, from Xilinx. Our ASICs and FPGAs are very
complex, and LSI Logic and Xilinx are our sole source supplier for them,
respectively. We do not have a long-term, fixed-price or minimum volume of
supply agreement with either LSI Logic or Xilinx. Alternative sources for our
ASICs and FPGAs may require significant development time to meet our required
specifications. If we are unable to procure our ASICs from LSI Logic, or our
FPGAs from Xilinx, we could experience significant delays in our ability to
deliver products to our customers, which may result in the cancellation of
orders for our products.

   We also purchase other critical components and assemblies, including optical
components, framers, and memory from sole or limited sources, and at times some
of these components are subject to allocation. Although we believe that there
are alternative sources for many of these components, in the event of a
disruption in supply, we may not be able to develop an alternate source in a
timely manner or at favorable prices, which could hurt our ability to deliver
products to our customers and may result in the cancellation of orders for our
products.

   We typically specify and purchase through our contract manufacturers all of
our components under purchase orders placed from time to time. We do not carry
significant inventories of components and have no guaranteed supply
arrangements with our vendors. If we are unable to purchase our critical
components at times and in volumes as our business requirements necessitate, we
will not be able to manufacture and deliver our products to our customers in
accordance with their volume and schedule requirements. If we are not able to
satisfy the delivery requirements of our customers, they may reduce any future
orders or eliminate our status as a vendor. Our reputation also would likely be
harmed and, given the limited number of customers in our target market, we may
not be able to replace any lost business with new customers. In addition, even
if we are able to obtain these critical components in sufficient volume and on
schedules that permit us to satisfy our delivery requirements, we have little
control over their cost. Accordingly, the lack of alternative sources for these
components may force us to pay higher prices. If we are unable to obtain these
components from our current suppliers or others at economical prices, our
margins would be adversely impacted unless we could raise the prices of our
products in a commensurate manner. The existing competitive conditions may not
permit us to do so, in which case we may suffer increasing losses or reduced
profits.

   We have been in business for a short period of time and your basis for
evaluating us is limited.

   We were founded in November 1996, our TSR became commercially available
during the fourth quarter of 1999, and our SSR became commercially available
during the fourth quarter of 2001. Accordingly, we have limited meaningful
historical financial data upon which to base projected revenues and planned
operating expenses and upon which investors may evaluate us and our prospects.
In addition, our limited operating history means that we have less insight into
how technological and market trends may affect our business. The revenue and
income potential of our business, and in particular the TSR and SSR, is
unproven and the market that we are addressing is rapidly evolving. Our ability
to sell our products depends on, among other things, the level of demand for
intelligent high-speed routers. You should consider our business and prospects
in light of the risks and difficulties frequently encountered by companies like
ours in the early stages of development.

   The long and variable sales cycle for our products may cause revenues and
operating results to vary unexpectedly from quarter to quarter, which could
affect the market price of our common stock.

   A customer's decision to purchase our products involves a significant
commitment of its resources and a lengthy evaluation, testing and product
qualification process. As a result, our sales cycle is likely to be lengthy.
Throughout the sales cycle, we spend considerable time and expense educating
and providing information to prospective customers about the use and features
of our products. Even after our customers make a decision to purchase, we
believe that our customers will deploy our products slowly and deliberately.
The timing of deployment can vary widely and depends on the skills of the
customer, the size of the network deployment, the complexity of the customer's
network environment and the degree of hardware and software configuration
necessary. Customers with significant or complex networks usually expand their
networks in large increments on a periodic basis. Accordingly, we expect to
receive purchase orders on an irregular and unpredictable basis.

                                      24

<PAGE>

Because of our limited operating history and the nature of our business, we
cannot predict these sales and deployment cycles. These long sales cycles, as
well as our expectation that customers will tend to sporadically place large
orders with short lead times, may cause our revenues and results of operations
to vary significantly and unexpectedly from quarter to quarter.

   Our complex products may have errors or defects or may not interoperate
within the networks of our customers, which could result in reduced demand for
our products or costly litigation against us.

   Our products are complex and are designed to be deployed in large and
complex networks with large volumes of traffic. Accordingly, our products can
only be fully tested when completely deployed in these types of networks. To
date, AT&T has deployed our TSR product in its North American IP backbone
network and other customers are using our products solely in test networks.
Despite this deployment and internal testing, our customers may discover errors
or defects in the hardware or the software, or the product may not operate as
expected even after it has been fully deployed. In addition, many of our
customers will require that our products be designed to interface with their
existing networks, each of which may have different specifications and utilize
multiple protocol standards. Our customers' networks contain multiple
generations of products that have been added over time as these networks have
grown and evolved. Our products must interoperate with many of the products
within these networks as well as future products in order to meet the
requirements of our customers. Because our products are critical to the
networks of our customers, any significant interruption in their service as a
result of defects in our product or the failure of our product to interoperate
within our customers' networks could result in lost profits or damage to these
customers. These problems could cause us to incur significant service and
warranty costs, divert engineering personnel from product development efforts
and significantly impair our ability to maintain existing customer relations
and attract new customers. Although our contracts with our customers generally
contain provisions designed to limit our exposure to potential product
liability claims, such as disclaimers of warranties and limitations on
liability for special, consequential and incidental damages, a court might not
enforce a limitation on our liability, which could expose us to financial loss.
In addition, a product liability claim, whether successful or not, would likely
be time consuming and expensive to resolve and would divert management time and
attention. Further, if we are unable to fix the errors or other problems that
may be identified in full deployment, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.

   Our failure to compete effectively, particularly against Cisco Systems,
Juniper Networks, and other established participants with greater financial and
other resources than ours, could limit our ability to increase our market share.

   The competition in the network infrastructure equipment market is intense.
This market historically has been dominated by Cisco Systems, although we also
compete with other companies such as Juniper Networks. Our prospective
customers may be reluctant to replace or expand their current infrastructure
solutions, which may be supplied by one or more of these more established
competitors, with our products. Further, many of our competitors have greater
selling and marketing, technical, manufacturing, financial and other resources,
more customers, greater market recognition and more established relationships
and alliances in the industry. As a result, these competitors may be able to
develop, enhance and expand their product offerings more quickly, adapt more
swiftly to new or emerging technologies and changes in customer demands, devote
greater resources to the marketing and sale of their offerings, pursue
acquisitions and other opportunities more readily and adopt more aggressive
pricing policies. In addition, established or emerging network equipment
vendors may also focus on our target market, thereby further intensifying
competition. In order to compete effectively with these competitors, we must
demonstrate that our products are superior in meeting the needs of carriers and
provide high levels of reliability, scalability and interoperability in a
cost-effective manner.

   In addition, we believe that understanding the infrastructure requirements
of telecommunications carriers and other service providers, experience in
working with these providers to develop new services for their

                                      25

<PAGE>

customers and an ability to provide vendor-sponsored financing are important
competitive factors in our market. We have limited experience in working with
telecommunications carriers and other service providers. In addition, we do not
currently have the ability to provide vendor-sponsored financing and this may
influence the purchasing decision of prospective customers, which may decide to
purchase products from one of our competitors that offers such financing.

   If we are unable to compete successfully against our current and future
competitors, we could experience order cancellations and price reductions. If
this occurs, our revenues may not grow, our gross margins could decrease and we
could experience additional losses.

   We are likely to face difficulties in obtaining and retaining customers if
we do not expand our sales organization and our customer service and support
operations.

   Our TSR and SSR products require a sophisticated sales effort targeted at a
limited number of key individuals within our target customers' organizations.
This effort requires specialized sales personnel and systems engineers. We
continue to staff our direct sales force and plan to hire additional qualified
sales personnel and systems engineers. The competition for these individuals is
intense, and we might not be able to hire the type and number of sales
personnel and systems engineers that we need to be successful. In addition, we
believe that our future success, particularly in international markets, is
dependent upon our ability to establish successful relationships with a variety
of systems integrators and distribution partners. To date, we have entered into
agreements with only a small number of systems integrators and distribution
partners. These systems integrators and distribution partners are not
prohibited from selling products that compete with our products. We cannot be
certain that we will be able to reach agreement with additional systems
integrators and distribution partners on a timely basis or at all, or that our
systems integrators and distribution partners will devote adequate resources to
selling our product. If we are unable to expand our direct and indirect sales
operations, we may not be able to increase market awareness or sales of our
product, which may prevent us from achieving and maintaining profitability.

   The complexity of our products and the difficulty of installing them also
require highly trained customer service and support personnel. We will need to
effectively utilize our customer service and support organization to support a
broader base of customers. Hiring customer service and support personnel is
very competitive in our industry because there are a limited number of people
available with the necessary technical skills and understanding of our market.
In addition, once we hire these personnel, they may require extensive training
in our product. If we are unable to expand our customer service and support
organization and train them rapidly, or engage, manage and retrain third-party
service and support organizations, we may not be able to increase sales of our
product.

   We depend upon contract manufacturers and any disruption in these
relationships may cause us to fail to meet the demands of our customers and
damage our customer relationships.

   We do not have internal manufacturing capabilities. We rely on a small
number of contract manufacturers to manufacture our products in accordance with
our specifications and to fill orders on a timely basis. These contract
manufacturers procure material on our behalf and provide comprehensive
manufacturing services, including assembly, test and control. We have
historically been dependent on two contract manufacturers, Sanmina-SCI
Corporation and Celestica Corporation. We may not be able to effectively manage
our relationships with these contract manufacturers and they may not meet our
future requirements for timely delivery and quality. If we experience increased
demand for our products, the challenges we face in managing our relationships
with these manufacturers will be increased. Each of our contract manufacturers
also builds products for other companies, and we cannot be certain that they
will always have sufficient quantities of inventory available to fill orders
placed by our customers, or that they will allocate their internal resources to
fill these orders on a timely basis. Qualifying a new contract manufacturer and
commencing volume production is expensive and time consuming and could result
in a significant interruption in the supply of our product. If we are required
or choose to change one or both of our contract manufacturers, we may lose
revenue and damage our customer relationships.

                                      26

<PAGE>

   If we fail to accurately predict our manufacturing requirements, we could
incur additional costs or experience manufacturing delays.

   Our contract manufacturers are not obligated to supply products to us for
any specific period, in any specific quantity or at any certain price, except
as may be provided in a particular purchase order. We generally provide
forecasts of our demand to these manufacturers up to 12 months prior to
scheduled delivery of product to our customers. If we overestimate our
requirements, our manufacturers may have excess inventory, which would increase
our costs as we have additional charges for excess and obsolete inventory. If
we underestimate our requirements, our manufacturers may have an inadequate
inventory, which could result in delays in delivery to our customers and
recognition of revenue. In addition, the lead times for materials and
components we order vary significantly and depend on factors such as the
specific supplier, contract terms and demand for each component at a given
time. For example, our ASICs have a lead time of up to 20 weeks. We also may
experience shortages of other components from time to time, which also could
delay the manufacturing of our products.

   The unpredictability of our quarterly results of operations may adversely
affect the trading price of our common stock.

   Our quarterly operating results are likely to vary significantly in the
future based on a number of factors related to our industry, the markets for
our products and how we manage our business. We have little or no control over
many of these factors and any of these factors could cause the price of our
common stock to fluctuate significantly. In addition to the risks discussed
elsewhere in this section, the following may also adversely affect the trading
price of our common stock:

  .   fluctuations in the demand for high-speed routers, including our TSR and
      SSR;

  .   the timing and size of customer orders for our products or cancellations
      of orders;

  .   the timing of product acceptance by customers;

  .   the timing and level of research and development and prototype expenses;

  .   the distribution channels through which we sell our products; and

  .   general economic conditions, as well as conditions specific to the
      telecommunications industry.

   We plan to selectively increase our operating expenses to fund greater
levels of research and development, expand our sales and marketing operations,
broaden our customer support capabilities, and develop new distribution
channels in line with projected growth. Our operating expenses are largely
based on anticipated organizational growth and revenue trends and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, if revenue for a particular quarter is below our
expectations for any of the reasons set forth above, or for any other reason,
we could not proportionately reduce operating expenses for that quarter.
Accordingly, this revenue shortfall would have a disproportionate effect on our
expected operating results for that quarter, which could result in significant
variations in our operating results from quarter to quarter.

   Due to the foregoing factors, we believe that quarter-to-quarter comparisons
of our operating results are not a good indication of our future performance.
You should not rely on our results or growth for any single quarter as an
indication of our future performance. It is likely that in some future
quarters, our operating results may be below the expectations of public market
analysts and investors. In this event, the price of our common stock may fall.

   If we do not respond effectively and on a timely basis to rapid
technological changes, our products could become obsolete and we would probably
be unable to attract new customers.

   The market for high-speed router products is likely to be characterized by
rapid technological change, evolving industry standards and frequent new
product introductions. The introduction of new products by competitors, market
acceptance of products based on new or alternative technologies or the
emergence of new

                                      27

<PAGE>

industry standards could render our existing or future products obsolete.
Accordingly, we may be required to make significant and ongoing investments in
future periods in order to remain competitive. The development of new products
or technologies is a complex and uncertain process that requires the accurate
anticipation of technological and market trends. We may be unable to respond
quickly or cost-effectively to these developments, and we may not be able to
obtain the necessary funds to develop or acquire new technologies or products
needed to compete. We also cannot assure you that any products we do develop
will gain market acceptance.

   In addition, in order to introduce products incorporating new technologies
and new industry standards, we must be able to gain access to the latest
technologies used by our customers, our suppliers and other network vendors.
Any failure to gain access to the latest technologies could impair our ability
to develop competitive products.

   Cisco's leadership position in our market could create technical challenges
to our ability to sell our products.

   In developing our products, we have made, and will continue to make,
assumptions about the standards that may be adopted by our customers and
competitors. If the standards adopted are different from those that we have
chosen to support, market acceptance of our products would likely be
significantly reduced and our business will be seriously harmed. Because Cisco
maintains a leadership position in selling products that currently comprise the
infrastructure of the Internet, Cisco may have the ability to establish de
facto standards within the industry. Any actions by Cisco that diminish
compliance by our products with industry or de facto standards or the ability
of our products to interoperate with other Internet-related products would be
damaging to our reputation and our ability to generate revenue.

   Customer requirements are likely to evolve, and we will not retain customers
or attract new customers if we do not anticipate and meet specific customer
requirements.

   Our future success will also depend upon our ability to develop and manage
key customer relationships in order to introduce a variety of new products and
product enhancements that address the increasingly sophisticated needs of our
customers. Our current and prospective customers may require product features
and capabilities that our products do not have. We must effectively anticipate
and adapt to customer requirements and offer products that meet those demands
in a timely manner. Our failure to develop products that satisfy customer
requirements would seriously harm our ability to achieve market acceptance for
our products. In addition, we may experience design, manufacturing, marketing
and other difficulties that could delay or prevent our development,
introduction or marketing of new products and enhancements. Material delays in
introducing new products may cause customers to forego purchases of our
products and purchase those of our competitors, which could seriously harm our
business. The introduction of new or enhanced products also requires that we
manage the transition from older products in order to minimize disruption in
customer ordering patterns and ensure that adequate supplies of new products
can be delivered to meet anticipated customer demand. Our inability to
effectively manage this transition would cause us to lose current and
prospective customers.

   If we are unable to manage our planned growth effectively, we may incur
increased costs and place too many demands upon our management team.

   Until the third quarter of 2001, we had expanded our operations rapidly
since our inception. In the third and fourth quarters of 2001, we reduced the
number of our employees by 24% as a result of unfavorable economic conditions
in the telecommunications industry. We expect to selectively increase the size
and scope of our operations, both domestically and internationally. Our ability
to successfully offer our products and implement our business plan in a rapidly
evolving market requires an effective planning and management process. We
expect that we will need to continue to improve our financial, managerial and
manufacturing controls and information systems, and to continue to train,
manage and selectively expand our work force. We may not be able to implement
adequate control and reporting systems in an efficient and timely manner. We
also expect that

                                      28

<PAGE>

we will be required to manage multiple relationships with various customers and
third parties. Further, the management of our operations in diverse locations
may also complicate the task of managing our growth. Our failure to manage our
growth effectively could increase our costs, adversely affect our relations
with customers and suppliers and adversely affect our revenues and operating
margins.

   Our ability to develop, market and support products depends on retaining our
management team and attracting and retaining highly qualified individuals in
our industry.

   Our future success depends on the continued services of our management team,
which has significant experience with the data communications,
telecommunications and Internet infrastructure markets, as well as
relationships with many of the communications service providers and business
partners that we currently or may in the future rely on in implementing our
business plan. The loss of the services of our management team or any key
executive could have a significant detrimental effect on our ability to execute
our business strategy.

   Our future success also depends on our continuing ability to selectively
identify, hire, train, assimilate and retain large numbers of highly qualified
engineering, sales, marketing, managerial and support personnel. The demand for
qualified personnel is high and competition for their services is intense. The
competition for qualified employees in our industry is particularly intense in
the Boston, Massachusetts area where our principal operations are located. We
have from time to time experienced, and we expect to continue to experience in
the future, difficulty in hiring and retaining highly skilled employees with
appropriate qualifications. In particular, we have experienced difficulty in
hiring qualified ASIC, software, systems and test and customer support
engineers. The loss of the services of any of our key employees, the inability
to attract or retain qualified personnel in the future or delays in hiring
required personnel, particularly engineers and sales personnel, could delay the
development and introduction of and negatively impact our ability to sell our
products.

   We face risks associated with our international expansion that could impair
our ability to grow our revenues abroad.

   We intend to further expand our presence in international markets. We
currently have sales representatives and sales engineers in Europe and Asia.
Our international sales are conducted through a direct sales force, systems
integrators, and distributors. We have regional partners in Japan, the Republic
of Korea, and Southeast Asia. In addition to our direct sales force in Europe,
we have established a partnership with Dimension Data, a leading systems
integrator of carrier equipment, to provide support services. In order to
further our international sales objectives, we intend to continue to identify
and establish relationships with additional country-specific distributors. We
will require significant management attention and financial resources to
successfully develop our direct and indirect international sales and support
channels.

   We have limited experience in marketing and distributing our products
internationally and we expect that we will need to develop versions of our
product that comply with local standards. We may not be able to develop
international market demand for our products. In addition, our international
operations will expose us to a number of risks that we do not have to address
in our domestic operations, including:

  .   greater difficulty in collecting accounts receivable and longer
      collection periods;

  .   greater difficulty in enforcing agreements;

  .   differences in technology standards;

  .   difficulties and costs of staffing and managing foreign operations;

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

  .   unexpected changes in regulatory requirements;

  .   certification requirements;

                                      29

<PAGE>

  .   foreign currency exchange rate fluctuations;

  .   reduced protection for intellectual property rights in some countries;

  .   potentially adverse tax consequences; and

  .   political and economic instability.

   We expect that our international sales will be generally denominated in
United States dollars. As a result, increases in the value of the United States
dollar relative to foreign currencies would cause our products to become less
competitive in international markets and could result in limited, if any, sales
and profitability. To the extent that we denominate sales in foreign currencies
or incur significant operating expenses denominated in local currencies, we
will be exposed to increased risks of currency fluctuations.

   We may experience difficulty in identifying, acquiring and integrating
acquisition candidates.

   If we were to supplement our internal growth by acquiring complementary
businesses, technologies or product lines, we may not be able to identify and
acquire suitable candidates on reasonable terms. We would be competing for
acquisition candidates with other companies that have substantially greater
financial, management and other resources than we do. If we did complete an
acquisition, integrating newly acquired organizations and products and services
is likely to be expensive, time consuming and a strain on our managerial
resources. Acquisitions, in particular, multiple acquisitions over a short
period of time, involve a number of risks that may result in our failure to
achieve the desired benefits of the transaction.

   We may finance any such acquisitions by issuing shares of our common stock,
which could dilute our existing stockholders. We may also use cash or incur
additional debt to pay for such acquisitions. In addition, we may be required
to expend substantial funds to develop acquired technologies. We may also be
required to amortize significant intangible assets in connection with future
acquisitions, which could adversely affect our operating results.

   Our intellectual property protection may be inadequate to protect our
proprietary rights, and we may be subject to infringement claims that could
subject us to significant liability and divert the time and attention of our
management.

   We regard our products and technology as proprietary. We attempt to protect
them through a combination of patent protection, copyrights, trademarks, trade
secret laws, contractual restrictions on disclosure and other methods. These
methods may not be sufficient to protect our proprietary rights. We presently
have three patents granted in the United States and more than 14 patent
applications pending in the United States and related foreign patent
applications pending. We cannot be certain that patents will be granted based
on these or any other applications, or that, even if issued, the patents will
adequately protect our technology. We also generally enter into confidentiality
agreements with our employees, consultants and customers, and generally control
access to and distribution of our documentation and other proprietary
information. Despite these precautions, it may be possible for a third party to
copy or otherwise misappropriate and use our products or technology without
authorization, particularly in foreign countries where the laws may not protect
our proprietary rights to the same extent as do the laws of the United States,
or to develop similar technology independently. We may need to resort to
litigation in the future to enforce our intellectual property rights, to
protect our trade secrets or to determine the validity and scope of the
proprietary rights of others. This litigation could result in substantial costs
and diversion of resources and could harm our business.

   We also license technologies from third parties, some of which we license
without indemnification from the licensor for infringement of third party
intellectual property rights. We are continuing to develop and acquire
additional intellectual property. Although we have not been involved in any
litigation relating to our intellectual property, including intellectual
property that we license from third parties, we expect that participants in our

                                      30

<PAGE>

markets will be increasingly subject to infringement claims. Third parties may
try to claim our products infringe their intellectual property. Any claim,
whether meritorious or not, could be time consuming, result in costly
litigation and/or require us to enter into royalty or licensing agreements.
Although we carry general liability insurance, our insurance may not cover
potential claims of this type or may not be adequate to indemnify us for all
liability that may be imposed. In addition, any royalty or licensing agreements
might not be available on terms acceptable to us or at all, in which case we
would have to cease selling, incorporating or using the products that
incorporate the challenged intellectual property and expend substantial amounts
of resources to redesign our products. If we are forced to enter into
unacceptable royalty or licensing agreements or to redesign our products, our
business and prospects would suffer.

   We are uncertain of our ability to obtain additional financing for our
future capital needs.

   We expect our current cash, cash equivalents and investments will meet our
normal working capital and capital expenditure needs for at least the next
twenty-four months. We may need to raise additional funding at that time or
earlier if we decide to undertake more rapid expansion, including acquisitions
of complementary products or technologies, or if we increase our marketing
and/or research and development efforts in order to respond to competitive
pressures. We cannot be certain that we will be able to obtain additional
financing on favorable terms, if at all. We may obtain additional financing by
issuing shares of our common stock, which could dilute our existing
stockholders. If we cannot raise needed funds on acceptable terms, or at all,
we may not be able to develop or enhance our products or respond appropriately
to competitive pressures, which would seriously harm our business.

   The market price of our common stock may be materially adversely affected by
market volatility.

   The price at which our common stock trades is highly volatile and fluctuates
substantially. Given the limited amount of our product sales and our limited
number of customers, the announcement of any significant customer developments,
awards or losses or of any significant partnerships or acquisitions by us or
our competitors could have a material adverse effect on our stock price. In
addition, the stock market in general has, and technology companies in
particular have, from time to time experienced extreme price and volume
fluctuations that have often been unrelated or disproportionate to the
operating performance or prospects of such companies.

   In the past, securities class action litigation has often been brought
against companies following periods of volatility in the market price of their
securities. Those companies, like us, that are involved in rapidly changing
technology markets are particularly subject to this risk. Twelve purported
securities class action lawsuits have been filed against the Company and
several of its officers and directors in the United States District Court for
the Southern District of New York. We believe that the claims in those cases
against the Company lack merit, and intend to defend the litigation vigorously.
The litigation process can be protracted and expensive, however, and defense of
the litigation may require the continuing expenditure of substantial resources
of the Company. Furthermore, while we believe that the claims lack merit, the
litigation process is inherently uncertain and we can make no guarantee as to
its ultimate outcome or ultimate financial impact, if any, on the Company.

   The market price of our common stock might decline due to future non-cash
charges to earnings.

   We have recorded and begun to amortize non-cash charges to earnings as a
result of options and restricted stock granted prior to the closing of our
initial public offering to employees and consultants at prices deemed to be
below fair market value on the dates of grant. Our future operating results
will reflect the continued amortization of those charges over the vesting
period of the options and restricted stock. These charges will negatively
impact future operating results. It may not be possible to calculate the future
impact with respect to consultant grants as the amount of these charges to
earnings fluctuates with the price of our common stock and other factors. It is
possible that some investors might consider this impact on operating results to
be material, which could result in a decline in the price of our common stock.
In addition, in 2000 we incurred non-cash charges relating to the issuance of
common stock warrants to a customer. Approximately $5.7 million of the value of
these warrants will be amortized against revenue over the next seven quarters.

                                      31

<PAGE>

   Our charter documents, shareholder rights plan, and Delaware law could
inhibit a takeover that some stockholders may consider favorable.

   There are provisions of Delaware law and our charter, by-laws, and
shareholder rights plan that could make it more difficult for a third party to
acquire us, even if doing so would be beneficial to some of our stockholders.
If a change of control or change in management is delayed or prevented, the
market price of our common stock could be affected.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   The following discussion about our market risk involves forward-looking
statements. Actual results could differ materially from those projected in the
forward-looking statements. We are exposed to market risk related to changes in
interest rates and foreign currency exchange rates. We do not use derivative
financial instruments for speculative or trading purposes.

Interest Rate Sensitivity

   We maintain an investment portfolio consisting mainly of investment grade
money market funds, corporate obligations, federal agency obligations, state
and municipal bonds with a weighted-average maturity of less than one year.
These held-to-maturity securities are subject to interest rate risk and will
fall in value if market interest rates increase. If market interest rates were
to increase immediately and uniformly by 10% from levels at December 31, 2001,
the fair market value of these investments would decline by an immaterial
amount. We have the ability to hold our fixed income investments until
maturity. Therefore, we would not expect our operating results or cash flows to
be affected to any significant degree by a sudden change in market interest
rates on our securities portfolio. The following table provides information
about our investment portfolio. For investment securities, the table presents
principal cash flows and related weighted average interest rates by expected
maturity dates.

<TABLE>
<CAPTION>
                                       Carrying
                                       Value at
                                     December 31,
                                         2001
                                     ------------
      <S>                            <C>          <C>         <C>
                                           Maturing in
                                     ------------------------
                                         2002        2003     Grand total
                                     ------------ ----------- ------------
      Cash and Cash Equivalents..... $ 65,383,028 $        -- $ 65,383,028
      Weighted Average Interest Rate        2.12%          --        2.12%
      Investments................... $ 63,552,119 $35,506,292 $ 99,058,411
      Weighted Average Interest Rate        3.76%       4.16%        3.90%
         Total Portfolio............ $128,935,147 $35,506,292 $164,441,439
      Weighted Average Interest Rate        2.93%       4.16%        3.19%
</TABLE>

Exchange Rate Sensitivity

   We operate primarily in the United States, and all sales to date have been
made in U.S. dollars. Accordingly, there has not been any material exposure to
foreign currency rate fluctuations.

   The Company has no off-balance sheet concentrations such as foreign exchange
contracts, option contracts, or other foreign hedging arrangements.


                                      32

<PAGE>

ITEM 8.   CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                              Page
-                                                                                             ----
<S>                                                                                           <C>
Report of Independent Public Accountants.....................................................  34

Consolidated Balance Sheets..................................................................  35

Consolidated Statements of Operations........................................................  36

Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders' (Deficit)
  Equity.....................................................................................  37

Consolidated Statements of Cash Flows........................................................  38

Notes to Consolidated Financial Statements...................................................  39
</TABLE>

                                      33

<PAGE>

                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Stockholders of
Avici Systems Inc.:

   We have audited the accompanying consolidated balance sheets of Avici
Systems Inc. (a Delaware corporation) and subsidiaries as of December 31, 2000
and 2001, and the related consolidated statements of operations, redeemable
convertible preferred stock and stockholders' (deficit) equity and cash flows
for each of the three years in the period ended December 31, 2001. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements 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 consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Avici Systems Inc. and subsidiaries as of December 31, 2000 and 2001, and
the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2001, in conformity with accounting
principles generally accepted in the United States.

                                          ARTHUR ANDERSEN LLP

Boston, Massachusetts
January 22, 2002


                                      34

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
                                                                                             December 31,
                                                                                     ----------------------------
<S>                                                                                  <C>              <C>
                                                                                          2000             2001
                                                                                     -------------    -------------
ASSETS
Current Assets:
  Cash and cash equivalents......................................................... $ 126,455,226    $  65,383,028
  Investments.......................................................................   106,937,148       63,552,119
  Inventories.......................................................................    14,978,760        8,109,324
  Trade accounts receivable.........................................................     6,340,587        2,830,242
  Prepaid expenses and other current assets.........................................     1,766,234        2,634,445
                                                                                     -------------    -------------
    Total current assets............................................................   256,477,955      142,509,158
                                                                                     -------------    -------------
Property and Equipment, at cost:....................................................
  Equipment under capital lease.....................................................    14,121,692       12,510,310
  Computer equipment................................................................    10,113,729       25,214,984
  Research, development and test equipment..........................................     6,809,354       25,385,603
  Leasehold improvements............................................................     2,153,819        4,919,641
  Furniture and fixtures............................................................       578,779        1,017,901
                                                                                     -------------    -------------
                                                                                        33,777,373       69,048,439
Less--Accumulated depreciation and amortization.....................................     9,997,066       27,321,070
                                                                                     -------------    -------------
                                                                                        23,780,307       41,727,369
                                                                                     -------------    -------------
Other Assets:
  Investments.......................................................................    21,538,936       35,506,292
  Restricted cash...................................................................       290,875          534,238
                                                                                     -------------    -------------
    Total other assets..............................................................    21,829,811       36,040,530
                                                                                     -------------    -------------
                                                                                     $ 302,088,073    $ 220,277,057
                                                                                     =============    =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
  Current maturities of long-term obligations....................................... $   4,259,308    $   2,318,601
  Accounts payable..................................................................    16,510,229        5,901,471
  Accrued payroll and payroll-related...............................................     3,338,423        3,523,017
  Accrued supplier commitments......................................................            --        2,635,993
  Accrued other.....................................................................     1,000,000        3,204,190
  Deferred revenue..................................................................     6,030,460        8,253,813
                                                                                     -------------    -------------
    Total current liabilities.......................................................    31,138,420       25,837,085
                                                                                     -------------    -------------
Long-term obligations, less current maturities......................................     3,071,556          752,956
                                                                                     -------------    -------------
Commitments and contingencies (Notes 6 and 9)

Stockholders' Equity:
  Preferred stock, $0.01 par value-
    Authorized 5,000,000 shares at December 31, 2000 and 2001
    Issued and outstanding--none....................................................            --               --
  Common stock, $0.0001 par value-
    Authorized--250,000,000 shares at December 31, 2000 and 2001
    Issued and outstanding--48,287,714 shares at December 31, 2000 and 50,289,099
     shares at December 31, 2001....................................................         4,829            5,029
  Additional paid-in capital........................................................   459,986,783      462,961,208
  Common stock warrants.............................................................    12,398,000       12,200,000
  Subscriptions receivable..........................................................    (2,500,000)      (2,500,000)
  Deferred compensation and other consideration.....................................   (33,696,576)     (15,172,360)
  Accumulated deficit...............................................................  (168,314,939)    (263,806,861)
                                                                                     -------------    -------------
    Total stockholders' equity......................................................   267,878,097      193,687,016
                                                                                     -------------    -------------
                                                                                     $ 302,088,073    $ 220,277,057
                                                                                     =============    =============
</TABLE>

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

                                      35

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
                                                                      Years Ended December 31,
                                                            --------------------------------------------
                                                                 1999            2000          2001
                                                            ---------------  ------------  -------------
<S>                                                         <C>              <C>           <C>
Gross revenue..............................................  $           --  $ 15,886,597  $  56,642,617
Common stock warrant discount..............................              --       816,666      3,266,667
                                                            ---------------  ------------  -------------
       Net revenue.........................................              --    15,069,931     53,375,950
Cost of Revenue (1)........................................              --    11,157,347     51,973,272
                                                            ---------------  ------------  -------------
       Gross margin........................................              --     3,912,584      1,402,678
                                                            ---------------  ------------  -------------
Operating Expenses:
   Research and development (2)............................      36,821,219    54,055,443     61,527,303
   Sales and marketing (2).................................       5,601,384    12,717,199     19,818,123
   General and administrative (2)..........................       3,040,732     4,770,449      9,537,737
   Stock-based compensation................................       3,170,549    18,659,175     15,002,941
   Restructuring charges (Note 5)..........................              --            --      1,061,599
   Common stock warrant expense (Note 4(d))................              --     2,400,000             --
   Purchased in-process research and development (Note 7)..              --     4,000,000             --
                                                            ---------------  ------------  -------------
       Total operating expenses............................      48,633,884    96,602,266    106,947,703
                                                            ---------------  ------------  -------------
       Loss from operations................................     (48,633,884)  (92,689,682)  (105,545,025)
Interest Income............................................       1,532,751     8,735,216     10,697,996
Interest Expense...........................................        (688,795)     (732,934)      (644,893)
                                                            ---------------  ------------  -------------
       Net loss............................................  $  (47,789,928) $(84,687,400) $ (95,491,922)
                                                            ===============  ============  =============
Net Loss per Share:
   Basic and diluted.......................................  $       (13.99) $      (3.69) $       (1.94)
                                                            ===============  ============  =============
   Pro forma basic and diluted (unaudited).................                  $      (2.03)
                                                                             ============
Weighted Average Shares Used in Computing Net Loss per
  Share:
   Basic and diluted.......................................       3,416,534    22,938,383     49,258,306
                                                            ===============  ============  =============
   Pro forma basic and diluted (unaudited).................                    41,763,735
                                                                             ============
--------
(1) Includes excess and obsolete inventory charge (Note 5).  $           --  $         --  $  17,165,208
                                                            ===============  ============  =============
(2) Excludes noncash, stock-based compensation, as follows:

   Research and development................................  $    2,373,939  $ 12,372,846  $   9,697,847
   Sales and marketing.....................................         636,028     3,712,785      3,895,107
   General and administrative..............................         160,582     2,573,544      1,409,987
                                                            ---------------  ------------  -------------
                                                             $    3,170,549  $ 18,659,175  $  15,002,941
                                                            ===============  ============  =============
</TABLE>

  The accompanying notes are an integral part of these consolidated financial
                                  statements

                                      36

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               December 31, 2001
     Consolidated Statements of Redeemable Convertible Preferred Stock and
                        Stockholders' (Deficit) Equity
<TABLE>
<CAPTION>
                                                Redeemable Convertible
                                                    Preferred Stock                      Common Stock
                                              --------------------------              ------------------

                                                                                                  $0.0001  Additional
                                               Number of    Redemption     Warrants    Number       Par     Paid-in
                                                Shares        Value       Outstanding of Shares    Value    Capital
                                              -----------  -------------  ----------- ----------  ------- ------------
<S>                                           <C>          <C>            <C>         <C>         <C>     <C>
Balance, December 31, 1998...................  21,652,650  $  55,098,270    198,000    5,903,112  $  590  $    675,510
 Sale of Series C Redeemable Convertible
  Preferred Stock, net of issuance costs of
  $17,855....................................     500,000      4,000,000         --           --      --            --
 Sale of Series D Redeemable Convertible
  Preferred Stock, net of issuance costs of
  $19,344....................................     542,850      4,342,800         --           --      --            --
 Sale of Series E Redeemable Convertible
  Preferred Stock, net of issuance costs of
  $169,528...................................   7,185,627     59,999,985         --           --      --            --
 Deferred compensation related to stock
  options and stock grants...................          --             --         --           --      --    10,405,923
 Amortization of deferred compensation.......          --             --         --           --      --            --
 Exercise of common stock options............          --             --         --      158,739      16       111,017
 Issuance of common stock....................          --             --         --       56,500       6       122,994
 Issuance of restricted stock................          --             --         --       10,000       1        39,999
 Repurchase of restricted stock..............          --             --         --      (74,653)     (7)         (700)
 Expense related to grant of stock options to
  nonemployees...............................          --             --         --           --      --       120,500
 Net loss....................................          --             --         --           --      --            --
                                              -----------  -------------   --------   ----------  ------  ------------
Balance, December 31, 1999...................  29,881,127    123,441,055    198,000    6,053,698     606    11,475,243
 Sale of Series F Redeemable Convertible
  Preferred Stock, net of issuance costs of
  $50,000....................................   2,969,769     44,546,535         --           --      --            --
 Deferred compensation related to stock
  options and stock grants...................          --             --         --           --      --    34,665,160
 Amortization of deferred compensation.......          --             --         --           --      --            --
 Stock purchased by an officer...............          --             --         --      100,000      10     2,499,990
 Issuance of common stock related to
  concurrent private placements..............          --             --         --      322,582      32     9,999,989
 Issuance of common stock at initial public
  offering, net of issuance costs of
  $1,907,221.................................          --             --         --    8,050,000     805   230,173,474
 Exercise of common stock options............          --             --         --    1,085,904     109     2,012,689
 Payment of subscription receivable..........          --             --         --           --      --            --
 Issuance of common stock warrants...........          --             --         --           --      --            --
 Amortization related to warrants............          --             --         --           --      --            --
 Issuance of restricted common stock.........          --             --         --        3,000      --        12,000
 Repurchase of restricted stock..............          --             --         --     (178,366)    (18)     (114,450)
 Conversion of convertible preferred stock
  into common stock.......................... (32,850,896)  (167,987,590)        --   32,850,896   3,285   167,984,305
 Conversion of preferred stock warrants into
  common stock warrants......................          --             --   (198,000)          --      --            --
 Expense related to grant of stock options to
  non-employees..............................          --             --         --           --      --     1,278,383
 Net loss....................................          --             --         --           --      --            --
                                              -----------  -------------   --------   ----------  ------  ------------
Balance, December 31, 2000...................          --             --         --   48,287,714   4,829   459,986,783
 Amortization relating to warrants...........          --             --         --           --      --            --
 Issuance of stock relating to the Employee
  Stock Purchase Plan........................          --             --         --      283,428      28     2,782,972
 Issuance of restricted common stock to
  employees..................................                         --         --      543,733      55     1,227,977
 Exercise of common stock options............          --             --         --      908,468      90     1,790,494
 Forfeiture of stock options due to
  restructuring..............................          --             --         --           --      --    (3,034,322)
 Amortization of deferred compensation.......          --             --         --           --      --            --
 Exercise of common stock warrants...........          --             --         --      265,756      27       207,304
 Net loss....................................          --             --         --           --      --            --
                                              -----------  -------------   --------   ----------  ------  ------------
Balance, December 31, 2001...................          --  $          --         --   50,289,099  $5,029  $462,961,208
                                              ===========  =============   ========   ==========  ======  ============
</TABLE>
<TABLE>
<CAPTION>



                                                                           Deferred                       Total
                                                Common                   Compensation                 Stockholders'
                                                Stock      Subscriptions   and Other    Accumulated     (Deficit)
                                               Warrants     Receivable   Consideration    Deficit        Equity
                                              -----------  ------------- ------------- -------------  -------------
<S>                                           <C>          <C>           <C>           <C>            <C>
Balance, December 31, 1998................... $        --   $  (175,000) $         --  $ (35,580,884) $(35,079,784)
 Sale of Series C Redeemable Convertible
  Preferred Stock, net of issuance costs of
  $17,855....................................          --            --            --        (17,855)      (17,855)
 Sale of Series D Redeemable Convertible
  Preferred Stock, net of issuance costs of
  $19,344....................................          --            --            --        (19,344)      (19,344)
 Sale of Series E Redeemable Convertible
  Preferred Stock, net of issuance costs of
  $169,528...................................          --            --            --       (169,528)     (169,528)
 Deferred compensation related to stock
  options and stock grants...................          --            --   (10,405,923)            --            --
 Amortization of deferred compensation.......          --            --     2,977,049             --     2,977,049
 Exercise of common stock options............          --            --            --             --       111,033
 Issuance of common stock....................          --            --            --             --       123,000
 Issuance of restricted stock................          --       (40,000)           --             --            --
 Repurchase of restricted stock..............          --            --            --             --          (707)
 Expense related to grant of stock options to
  nonemployees...............................          --            --            --             --       120,500
 Net loss....................................          --            --            --    (47,789,928)  (47,789,928)
                                              -----------   -----------  ------------  -------------  ------------
Balance, December 31, 1999...................          --      (215,000)   (7,428,874)   (83,577,539)  (79,745,564)
 Sale of Series F Redeemable Convertible
  Preferred Stock, net of issuance costs of
  $50,000....................................          --            --            --        (50,000)      (50,000)
 Deferred compensation related to stock
  options and stock grants...................          --            --   (34,665,160)            --            --
 Amortization of deferred compensation.......          --            --    17,380,792             --    17,380,792
 Stock purchased by an officer...............          --    (2,500,000)           --             --            --
 Issuance of common stock related to
  concurrent private placements..............          --            --            --             --    10,000,021
 Issuance of common stock at initial public
  offering, net of issuance costs of
  $1,907,221.................................          --            --            --             --   230,174,279
 Exercise of common stock options............          --      (180,722)           --             --     1,832,076
 Payment of subscription receivable..........          --       286,031            --             --       286,031
 Issuance of common stock warrants...........  12,200,000            --    (9,800,000)            --     2,400,000
 Amortization related to warrants............          --            --       816,666             --       816,666
 Issuance of restricted common stock.........          --            --            --             --        12,000
 Repurchase of restricted stock..............          --       109,691            --             --        (4,777)
 Conversion of convertible preferred stock
  into common stock..........................          --            --            --             --   167,987,590
 Conversion of preferred stock warrants into
  common stock warrants......................     198,000            --            --             --       198,000
 Expense related to grant of stock options to
  non-employees..............................          --            --            --             --     1,278,383
 Net loss....................................          --            --            --    (84,687,400)  (84,687,400)
                                              -----------   -----------  ------------  -------------  ------------
Balance, December 31, 2000...................  12,398,000    (2,500,000)  (33,696,576)  (168,314,939)  267,878,097
 Amortization relating to warrants...........          --            --     3,266,667             --     3,266,667
 Issuance of stock relating to the Employee
  Stock Purchase Plan........................          --            --            --             --     2,783,000
 Issuance of restricted common stock to
  employees..................................          --            --    (1,228,032)            --            --
 Exercise of common stock options............          --            --            --             --     1,790,584
 Forfeiture of stock options due to
  restructuring..............................          --            --     1,482,640             --    (1,551,682)
 Amortization of deferred compensation.......          --            --    15,002,941             --    15,002,941
 Exercise of common stock warrants...........    (198,000)           --            --             --         9,331
 Net loss....................................          --            --            --    (95,491,922)  (95,491,922)
                                              -----------   -----------  ------------  -------------  ------------
Balance, December 31, 2001................... $12,200,000   $(2,500,000) $(15,172,360) $(263,806,861) $193,687,016
                                              ===========   ===========  ============  =============  ============
</TABLE>

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


                                      37

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                                  For the Years Ended December 31,
                                                            -------------------------------------------
                                                                1999          2000            2001
                                                            ------------  -------------  --------------
<S>                                                         <C>           <C>            <C>
Cash flows from operating activities:
 Net loss.................................................. $(47,789,928) $ (84,687,400)  $ (95,491,922)
 Adjustments to reconcile net loss to net cash used in
   operating activities--
   Depreciation and amortization...........................    3,147,557      5,273,678      18,060,761
   Amortization of deferred financing costs................       50,000         48,000              --
   Loss on disposal of property and equipment..............           --        145,570       1,330,111
   Compensation expense associated with issuance of stock
     options to employees and consultants..................    3,170,549     18,659,175      13,451,259
   Compensation expense associated with issuance of
     common stock warrants.................................           --      3,216,666       3,266,667
   Changes in current assets and liabilities--
     Inventories...........................................   (3,632,518)   (11,346,242)      6,869,436
     Trade accounts receivable.............................     (598,800)    (5,741,787)      3,510,345
     Prepaid expenses and other current assets.............     (118,469)    (1,396,483)       (868,211)
     Restricted cash.......................................       40,000       (102,875)       (243,363)
     Accounts payable......................................    4,007,405     10,676,862     (10,608,758)
     Accrued payroll and payroll related...................      397,191      2,522,704         184,594
     Accrued supplier commitments..........................           --             --       2,635,993
     Accrued other.........................................   (1,395,717)       815,702       2,204,190
     Deferred revenue......................................    1,753,400      4,277,060       2,223,353
                                                            ------------  -------------  --------------
       Net cash used in operating activities...............  (40,969,330)   (57,639,370)    (53,475,545)
                                                            ------------  -------------  --------------
Cash flows from investing activities:
   Proceeds from sale of property and equipment............           --             --         409,421
   Purchases of property and equipment.....................     (242,156)   (18,378,770)    (37,747,355)
   Purchases of investments................................  (13,674,979)  (131,986,179)   (196,757,942)
   Maturity of investments.................................           --     17,185,074     226,175,615
                                                            ------------  -------------  --------------
       Net cash used in investing activities...............  (13,917,135)  (133,179,875)     (7,920,261)
                                                            ------------  -------------  --------------
Cash flows from financing activities:
   Proceeds from sale of redeemable convertible preferred
     stock, net of issuance costs..........................   68,136,058     44,496,535              --
   Proceeds from sales of common stock, net of issuance
     costs.................................................           --    240,174,300       2,783,000
   Payments on long-term obligations.......................   (2,359,392)    (3,752,165)     (4,259,307)
   Payments on subscriptions receivable....................           --        286,031              --
   Repurchase of restricted stock..........................         (707)        (4,777)             --
   Proceeds from exercise of stock options and warrants....      161,034      1,832,076       1,799,915
                                                            ------------  -------------  --------------
       Net cash provided by financing activities...........   65,936,993    283,032,000         323,608
                                                            ------------  -------------  --------------
Net increase (decrease) in cash and cash equivalents.......   11,050,528     92,212,755     (61,072,198)
Cash and cash equivalents, beginning of year...............   23,191,943     34,242,471     126,455,226
                                                            ------------  -------------  --------------
Cash and cash equivalents, end of year..................... $ 34,242,471  $ 126,455,226   $  65,383,028
                                                            ============  =============  ==============
Supplemental disclosure of cash flow information:
 Cash paid during the year for--
   Interest................................................ $    638,795  $     692,590   $     465,706
                                                            ============  =============  ==============
Supplemental disclosure of non-cash investing and financing
  activities (Notes 4(c), 4(d) and 4(i)):
Equipment acquired under capital lease obligations......... $  4,400,454  $   1,736,276   $          --
                                                            ============  =============  ==============
</TABLE>

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

                                      38

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                               December 31, 2001


(1) OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

   Avici Systems Inc. (Avici) was incorporated in the State of Delaware on
November 12, 1996 and was organized to design and develop high-speed data
networking equipment for the carrier market. Avici's Terabit Switch Router
product (TSR) and Stackable Switch Router (SSR) are designed to
cost-effectively provide high-speed/high-volume capacity, carrier-class
reliability and in-service scalability, or the ability to incrementally add
capacity to the network without disrupting network performance.

   Avici and subsidiaries (the Company) are devoting significant efforts toward
product research and development. As such, it is subject to a number of risks
and challenges similar to other companies in a similar stage of development.
These risks include, but are not limited to, dependence on few customers,
dependence on key individuals, dependence on contract manufacturers and key
suppliers of integral components, the need to develop and market commercially
usable products, the ability to obtain adequate financing to support growth and
product development and competition from substitute products and larger
companies with greater financial, technical, management and marketing resources.

   The Company incurred net losses of approximately $47,800,000, $84,700,000
and $95,500,000 for the years ended December 31, 1999, 2000 and 2001,
respectively. At December 31, 2001, the Company had an accumulated deficit of
approximately $263,800,000 and has funded those losses through the sale of
redeemable convertible preferred stock, the proceeds from the sale of its
common stock and the issuance of certain long-term obligations. The Company is
dependent on the proceeds of these financings to meet its future working
capital and research and development needs.

   The accompanying consolidated financial statements reflect the application
of certain significant accounting policies as described in this note and
elsewhere in these notes to consolidated financial statements.

(a) Revenue Recognition

   The Company recognizes revenue from product sales upon shipment, provided
that a purchase order has been received or a contract has been executed, there
are no uncertainties regarding customer acceptance, the sales price is fixed or
determinable and collectibility is deemed probable. If uncertainties regarding
customer acceptance exist, the Company recognizes revenue when those
uncertainties are resolved. For arrangements that include the delivery of
multiple elements, revenue is allocated to the various elements based on
vendor-specific objective evidence of fair value (VSOE). The Company uses the
residual method when VSOE does not exist for one of the delivered elements in
an arrangement. Revenue from support and maintenance contracts is recognized
ratably over the period of the related agreements. Revenue from installation
and other services is recognized as the work is performed. Amounts collected or
billed prior to satisfying the above revenue recognition criteria are recorded
as deferred revenue.

   In December 1999, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 101, Revenue Recognition. This bulletin
summarizes certain views of the SEC on applying generally accepted accounting
principles to revenue recognition in financial statements. The Company believes
that its current revenue recognition policy complies with the guidelines in the
bulletin. The adoption of SAB No. 101 did not have any effect on the
accompanying consolidated financial statements.

   Warranty costs are estimated based on the Company's historical return rates
and repair costs and are recorded at the time of product revenue recognition.

   In December 2001, the Company amended its procurement agreement with
Williams Communications extending its term through December 2003. The amended
agreement provided for a current cash payment of $8.5 million, which was
received in December 2001 and included $2.7 million for product deliveries made
in the

                                      39

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001

fourth quarter of 2001 and $5.8 million in lieu of remaining purchase
commitments in the original agreement totaling $25 million. The $5.8 million,
which is included in the consolidated balance sheet in deferred revenue at
December 31, 2001, can be used as a credit, applied at varying rates, against
future purchases through 2003.

(b) Cash and Cash Equivalents and Investments

   The Company follows the provisions of Statement of Financial Accounting
Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity
Securities. The Company has classified its cash equivalents and investments as
held-to-maturity and recorded them at amortized cost, which approximates market
value. The Company considers all highly liquid investments with original
maturities of three months or less at the date of acquisition to be cash
equivalents. Cash and cash equivalents include money markets, certificates of
deposit and commercial paper. As of December 31, 2001, investments consisted of
the following:

<TABLE>
<CAPTION>
                                                 Average Remaining
Held to Maturity Securities                      Maturities (days) Amortized Cost
---------------------------                      ----------------- --------------
<S>                                              <C>               <C>
Commercial Paper................................        109         $ 10,935,502
U.S. Government Obligations.....................        288           48,969,892
Corporate Bonds.................................        304           39,153,017
                                                                    ------------
Total investments...............................                      99,058,411
Cash and cash equivalents.......................                      65,383,028
                                                                    ------------
   Total cash, cash equivalents and investments.                    $164,441,439
                                                                    ============
</TABLE>

(c) Use of Estimates

   The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

(d) Inventories

   Inventories are stated at the lower of cost (first-in, first-out) or market
and consist of the following:

<TABLE>
<CAPTION>
                                                   December 31,
                                              ----------------------
                                                 2000        2001
                                              ----------- ----------
           <S>                                <C>         <C>
           Finished goods and work in process $ 2,850,844 $5,201,881
           Raw materials.....................  12,127,916  2,907,443
                                              ----------- ----------
                                              $14,978,760 $8,109,324
                                              =========== ==========
</TABLE>

   We regularly review inventory quantities on hand and inventory commitments
with suppliers and record a provision for excess and obsolete inventory based
primarily on our estimated forecast of product demand for the next twelve
months.

(e) Depreciation, Amortization and Impairment

   Property and equipment are stated at cost, net of accumulated depreciation
and amortization. Expenditures for maintenance and repairs are charged to
expense as incurred, whereas major betterments are capitalized as additions to
property and equipment. The Company provides for depreciation and amortization
on the straight-line basis and charges to operations amounts that allocate the
cost of the assets over their estimated useful lives as follows:

                                      40

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


<TABLE>
<CAPTION>
         Asset Classification                     Estimated Useful Life
         --------------------                     ---------------------
         <S>                                      <C>
         Equipment under capital lease...........     Life of lease
         Computer equipment......................        3 years
         Research, development and test equipment       2-3 years
         Leasehold improvements..................        3 years
         Furniture and fixtures..................        5 years
</TABLE>

   In accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of (SFAS No. 121), the Company
periodically evaluates whether events and circumstances have occurred that
indicate that the remaining estimated useful life of property and equipment may
warrant revision or that the remaining balance of property and equipment may
not be recoverable. When factors indicate that property and equipment should be
evaluated for possible impairment, the Company uses an estimate of the related
undiscounted cash flows over the life of the property and equipment in
measuring whether the property and equipment is recoverable. If the sum of the
expected undiscounted cash flows is less than the carrying amount of the
related property and equipment, the Company would recognize an impairment loss.
At December 31, 2001, no events or circumstances existed that warranted
revision to the estimated useful life or recorded amount of property and
equipment for the Company, except as disclosed in Note 5 related to certain
restructuring activities undertaken during fiscal 2001.

(f) Concentrations of Credit and Other Risks

   SFAS No. 105, Disclosure of Information about Financial Instruments with
Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit
Risk, requires disclosure of any significant off-balance sheet and credit risk
concentrations. The Company's principal credit risk relates to its cash, cash
equivalents, investments and accounts receivable. The Company invests its
excess cash, cash equivalents and investments primarily in deposits with
commercial banks and high-quality corporate securities. Three customers
accounted for 47%, 23%, and 13% of net revenue in 2001 and 32%, 25% and 15% in
2000. At December 31, 2001, two customers accounted for 80% and 13% of trade
accounts receivable. At December 31, 2000, three customers accounted for 41%,
32% and 17% of trade accounts receivable.

   The Company has no off-balance sheet concentrations such as foreign exchange
contracts, option contracts, or other foreign hedging arrangements.

   Certain key components used in the Company's products are procured from
single or limited source suppliers, and the Company relies on single or limited
contract manufacturers for the assembly of its products. The failure of a
supplier, including a contract manufacturer, to deliver on schedule could delay
or interrupt the Company's delivery of products and thereby adversely affect
the Company's revenues and operating results.

(g) Fair Value of Financial Instruments

   The Company's financial instruments mainly consist of cash and cash
equivalents, investments, trade accounts receivable, subscriptions receivable
and accounts payable. The carrying amounts of these instruments approximate
their fair value based on their short-term maturity or quoted market prices.

(h) Research and Development and Software-Development Costs

   The costs of the development of hardware products and enhancements to
existing hardware products are expensed as incurred. The Company accounts for
its software development costs in accordance with SFAS No. 86, Accounting for
the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed.
Accordingly, the costs for the development of new software that are included in
the hardware products and substantial

                                      41

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001

enhancements to such existing software are expensed as incurred until
technological feasibility has been established, at which time any additional
costs would be capitalized. The Company determines technological feasibility
has been established at the time at which a working model of the software has
been completed. Because the Company believes its current process for developing
software is essentially completed concurrently with the establishment of
technological feasibility, no costs have been capitalized to date.

(i) Net Loss per Share and Pro Forma Net Loss per Share

   Basic and diluted net loss per share are presented in conformity with SFAS
No. 128, Earnings per Share, for all periods presented. In accordance with SFAS
No. 128, basic and diluted net loss per common share was determined by dividing
net loss available for common stockholders by the weighted average common
shares outstanding during the period, less shares subject to repurchase. Basic
and diluted net loss per share are the same because all outstanding common
stock options have been excluded, as they are considered antidilutive. Options
to purchase a total of 3,969,935, 10,684,510 and 5,407,210 common shares have
been excluded from the computations of diluted weighted average shares
outstanding for the years ended December 31, 1999, 2000 and 2001, respectively.
In addition, 543,733 unvested restricted common shares have been excluded from
the computation of diluted weighted average shares outstanding for the year
ended December 31, 2001. Shares of common stock issuable upon the conversion of
outstanding shares of redeemable convertible preferred stock have also been
excluded for all periods presented until such shares converted to common stock
upon completion of the Company's initial public offering (see Note 4(b)).

   In accordance with the SEC SAB No. 98, Earnings per Share in an Initial
Public Offering, the Company has determined that there were no nominal
issuances of the Company's common stock prior to the Company's initial public
offering.

   The Company's historical capital structure was not indicative of its capital
structure after its initial public offering due to the automatic conversion of
all shares of redeemable convertible preferred stock into common stock
concurrent with the closing of the Company's initial public offering and the
elimination of the Company's repurchase right related to restricted stock (see
Note 4(i)).

   Accordingly, unaudited pro forma net loss per share data has been presented
for the year ended December 31, 2000 assuming the conversion of all outstanding
shares of redeemable convertible preferred stock into common stock and the
elimination of the Company's repurchase right related to its restricted stock
outstanding upon the closing of the Company's initial public offering using the
if-converted method from the latter of January 1, 2000 or the respective date
of issuance.

   The following table reconciles the weighted average common shares
outstanding to the shares used in the computation of unaudited pro forma basic
and diluted net loss per share:

<TABLE>
<CAPTION>
                                                                                    Year Ended
                                                                                   December 31,
                                                                                       2000
                                                                                   ------------
<S>                                                                                <C>
Weighted average common shares outstanding........................................  22,938,383
Add--Weighted average common shares issued upon the conversion of redeemable
  convertible preferred stock (unaudited).........................................  17,699,247
Add--Acceleration of vesting of restricted stock (unaudited)......................   1,126,105
                                                                                    ----------
Pro forma basic and diluted weighted average common shares outstanding (unaudited)  41,763,735
                                                                                    ==========
</TABLE>


                                      42

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001

(j) Comprehensive Income (Loss)

   SFAS No. 130, Reporting Comprehensive Income, requires disclosure of all
components of comprehensive income on an annual and interim basis.
Comprehensive income is defined as the change in equity of a business
enterprise during a period from transactions and other events and circumstances
involving nonowner sources. During all periods presented, the Company did not
have any items of comprehensive income (loss) other than its reported net loss.

(k) Stock-Based Compensation

   The Company uses the intrinsic value-based method of Accounting Principles
Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, to
account for all of its employee stock-based compensation plans and uses the
fair value method of SFAS No. 123, Accounting for Stock-Based Compensation, to
account for all nonemployee stock-based compensation.

(l) Disclosures about Segments of an Enterprise

   SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information, establishes standards for reporting information regarding
operating segments and establishes standards for related disclosures about
products and services and geographic areas. Operating segments are identified
as components of an enterprise about which separate discrete financial
information is available for evaluation by the chief operating decision maker,
or decision making group, in making decisions regarding resource allocation and
assessing performance. To date, the Company has viewed its operations and
manages its business as principally one operating segment, the
telecommunications equipment industry. For the year ended December 31, 2001,
the geographic distribution of revenue was as follows: United States: 97%,
Asia: 2%, Europe: 1%. For the year ended December 31, 2000, the geographic
distribution of revenue was as follows: United States: 93%, Asia: 7%.
Long-lived assets consist of fixed assets and are principally located in the
United States for all periods presented.

(m) Principles of Consolidation

   The consolidated financial statements include the accounts of Avici Systems
Inc. and all of its wholly owned subsidiaries after elimination of intercompany
accounts and transactions.

(n) Recent Accounting Pronouncements

   During 1998, 1999 and 2000, the FASB issued SFAS Nos. 133, 137 and 138,
respectively, relating to the accounting for derivative instruments and hedging
activities. The Company currently does not have any derivative instruments. The
Company adopted the provisions of these standards in 2001. The adoption of
these standards did not have a material impact on the Company's consolidated
financial condition or results of operations.

   In July 2001, the FASB issued SFAS No. 141, Business Combinations. SFAS No.
141 requires that all business combinations be accounted for under a single
method, the purchase method. This statement is effective for all business
combinations initiated after June 30, 2001.

   In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets. This statement applies to intangibles and goodwill acquired after June
30, 2001, as well as goodwill and intangibles previously acquired. Under this
statement, goodwill as well as other intangibles determined to have an
indefinite life will no longer be amortized; however these assets will be
reviewed for impairment on a periodic basis, at least annually. This statement
is effective for the Company beginning January 1, 2002. As of December 31,
2001, the Company had no intangible or goodwill assets impacted by this
statement.

                                      43

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


   In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS No. 144 addresses the reporting for the
impairment or disposal of long-lived assets and does not apply to goodwill or
intangible assets that are not being amortized and certain other long-lived
assets. This Statement supersedes SFAS No. 121, and reporting provisions of APB
No. 30, Reporting the Results of Operations - Reporting the Effects of a
Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions, for the disposal of a segment of a business
(as previously defined in that Opinion). This Statement also amends ARB No. 51,
Consolidated Financial Statements, to eliminate the exception to consolidation
for a subsidiary for which control is likely to be temporary. SFAS No. 144 is
effective for financial statements issued for fiscal years beginning after
December 15, 2001. Management adopted this standard as of January 1, 2002, and
it did not have a material impact on the Company's consolidated financial
position and results of operations.

(o) Reclassifications

   Certain reclassifications have been made to prior year balances in order to
conform to the current year presentation.

(2) LONG TERM OBLIGATIONS

   Long-term obligations consist of the following:

<TABLE>
<CAPTION>
                                            December 31,
                                        ---------------------
                                           2000       2001
                                        ---------- ----------
                   <S>                  <C>        <C>
                   Capital leases...... $6,773,653 $3,071,557
                   Term loan...........    557,211         --
                                        ---------- ----------
                                         7,330,864  3,071,557
                   Less--Current amount  4,259,308  2,318,601
                                        ---------- ----------
                                        $3,071,556 $  752,956
                                        ========== ==========
</TABLE>

   The Company has a master lease agreement with a lender who is also a
stockholder. This agreement provides for up to $12,000,000 of lease financing
on certain types of equipment, as defined. On May 8, 2000, the Company amended
its master lease agreement. The amendment provides for an increase in the lease
financing available under the master lease agreement by $6,000,000. Leases
under the agreement have various terms ranging from 36 to 48 months and accrue
interest at annual effective rates between 8.03% and 9.23%. Equipment leased
under this agreement remains the property of the lender at the end of the term;
however, due to the length of the term, the leases are recorded as capital
lease obligations. As of December 31, 2001, approximately $400,000 was still
available under this master lease agreement.

   The Company also had a term loan agreement with this lender, which provided
for maximum borrowings of $1,250,000. The loan line was fully utilized to
purchase software. Repayment of advances were due in 30 monthly installments of
principal plus interest of approximately $49,000 per month beginning in July
1999, with a final payment of principal and interest in the amount of $187,500.
The loan was paid in full at December 31, 2001. The effective annual interest
rate under the loan was 17%.

   Future minimum payments due under master lease agreements at December 31,
2001 are as follows:

                                      44

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


<TABLE>
<CAPTION>
                                                           Capital
                                                           Leases
                                                          ----------
           <S>                                            <C>
           For the years ending,
            2002......................................... $2,475,840
            2003.........................................    737,513
            2004.........................................     46,380
                                                          ----------
              Total payments.............................  3,259,733
           Less--Amounts representing interest...........    188,176
                                                          ----------
           Present value of future minimum lease payments $3,071,557
                                                          ==========
</TABLE>

(3) INCOME TAXES

   The Company accounts for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes. Under SFAS No. 109, deferred tax assets or
liabilities are computed based on the difference between the financial
statement and income tax bases of assets and liabilities using currently
enacted tax rates. Deferred income tax expense or credits are based on changes
in the asset or liability from period to period.

   No provision for federal or state income taxes has been recorded, as the
Company has incurred net operating losses since inception. As of December 31,
2001, the Company had net operating loss carryforwards for federal and state
income tax purposes and tax credit carryforwards of approximately $215,845,000
and $7,441,000, respectively. Approximately $9,414,000 of the Company's net
operating loss carryforwards relate to deductions associated with the Company's
stock option plans, which will be benefited through stockholders' equity if
realized. The net operating loss carryforwards expire through 2021, and are
subject to review and possible adjustment by the Internal Revenue Service
(IRS). The Tax Reform Act of 1986 contains provisions that may limit the net
operating loss carryforwards available to be used in any given year in the
event of significant changes in ownership interest, as defined.

   The approximate income tax effects of each type of temporary differences and
carryforwards are as follows:

<TABLE>
<CAPTION>
                                                  December 31,
                                          ---------------------------
                                              2000          2001
                                          ------------  -------------
         <S>                              <C>           <C>
         Net operating loss carryforwards $ 64,196,000  $  86,338,000
         Research credit carryforwards...    6,278,000      7,441,000
         Other...........................    3,946,000      6,842,000
                                          ------------  -------------
          Gross deferred tax assets......   74,420,000    100,621,000
         Valuation allowance.............  (74,420,000)  (100,621,000)
                                          ------------  -------------
                                          $         --  $          --
                                          ============  =============
</TABLE>

   Due to the uncertainty surrounding the realization of the deferred tax
assets, the Company has provided a full valuation allowance against these
amounts at December 31, 2000 and 2001.


                                      45

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001

(4) STOCKHOLDER'S EQUITY

(a) Capitalization

   As of December 31, 2001, the Company has authorized capital stock, which
consists of 250,000,000 shares of common stock, $0.0001 par value per share and
5,000,000 shares of preferred stock, $0.01 par value per share that may be
issued by the Board of Directors from time to time in one or more series
without stockholder approval. As of December 31, 2001, the Company has
50,289,099 shares of common stock outstanding and no shares of preferred stock
outstanding.

(b) Initial Public Offering and Concurrent Private Placement

   On July 27, 2000, the Company's amended registration statement for the
initial public offering of 8,050,000 shares of its common stock, including the
underwriters' over-allotment option for 1,050,000 shares became effective. The
initial public offering price to the public was $31.00 per share. The offering
closed on August 2, 2000, and resulted in net proceeds to the Company of
approximately $232.1 million after deducting underwriting discounts and
commissions and before deducting expenses payable by the Company. As a result
of the initial public offering, 32,850,896 shares of common stock were issued
upon the conversion of all of the Company's redeemable convertible preferred
stock. Additionally, on August 2, 2000, the Company completed a private
placement for the issuance of 322,582 shares of its common stock concurrently
with the close of its initial public offering at the initial public offering
price of $31.00 per share, which resulted in proceeds to the Company of
approximately $10.0 million.

(c) Redeemable Convertible Preferred Stock

   In April 2000, the Company amended its certificate of incorporation to
authorize 3,333,333 shares of Series F redeemable convertible preferred stock.
Also, in April and May 2000, the Company sold 2,969,769 shares of Series F
redeemable convertible preferred stock for which it received gross proceeds of
approximately $44.5 million.

   The Company had a total of 32,850,896 shares of redeemable convertible
preferred stock outstanding, comprised of Series A, Series B, Series C-1,
Series C-2, Series C-3, Series D-1, Series D-2, Series D-3, Series E and Series
F, upon the closing of the Company's initial public offering. All outstanding
redeemable convertible preferred stock was automatically converted into
32,850,896 shares of common stock upon the closing of the initial public
offering of the Company's common stock on August 2, 2000.

(d) Common Stock Warrants

   In connection with the term loan and master lease agreement discussed in
Note 2, the Company issued two warrants to purchase an aggregate of 275,000
shares of Series B to the lender at an exercise price of $1.00 per share. The
deemed fair market value of these warrants using the Black-Scholes option
pricing model prescribed by SFAS No. 123 was recorded as deferred financing
costs and is being amortized over the life of the loans as interest expense. In
connection with the initial public offering, the warrants to purchase 275,000
shares of Series B redeemable convertible preferred stock automatically
converted into warrants to purchase 275,000 shares of the Company's common
stock. During 2001, all warrants were exercised in a cashless exercise
resulting in the issuance of 265,756 shares.

   On August 2, 2000, the Company issued a warrant to a potential customer to
purchase 100,000 shares of the Company's common stock at $31.00 per share. The
warrant is nonforfeitable, fully exercisable and has a term of five years from
the date of issuance. The potential customer had not purchased any product from
the Company

                                      46

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001

nor was it obligated to purchase any product or service from the Company as a
condition to granting of the warrant. Accordingly, the fair value of the
warrant, which was calculated using the Black-Scholes valuation model to be
$2.4 million, has been expensed in the accompanying consolidated statement of
operations for the year ending December 31, 2000.

   In December 2000, in connection with the execution of a nonexclusive systems
and services agreement (the Agreement), the Company issued a warrant to a
customer to purchase 850,000 shares of the Company's common stock at a
per-share exercise price of $27.73. The Agreement between the Company and the
customer provides the customer with the ability, but not the obligation, to
purchase equipment and services from the Company. The warrant is
nonforfeitable, fully exercisable and has a term of five years from the date of
issuance. The fair value of the warrant was calculated using the Black-Scholes
valuation model to be $9.8 million. The fair value of the warrant has been
deferred as a reduction to equity and is being amortized as an offset to gross
revenue on a straight-line basis over the three-year term of the Agreement. As
of December 31, 2001, $4,083,333 has been amortized.

(e) Equity-Based Compensation Plans

   In June 1997, the Company adopted the 1997 Stock Incentive Plan, which
provides for the issuance of up to 10,776,250 shares of common stock
incentives. During the year ended December 31, 2000, the Board of Directors
authorized an additional 5,000,000 shares. Following the Company's initial
public offering, no further grants of options or shares were permitted under
the 1997 Plan.

   In May 2000, the Board of Directors approved, subject to stockholder
approval, the 2000 Stock Option and Incentive Plan (collectively, the 1997
Stock Incentive Plan and the 2000 Stock Option and Incentive Plan, the Plans).
Stockholder approval was granted on June 28, 2000. Shares not yet issued under
the 1997 Stock Incentive Plan on or before the date of the Company's initial
public offering or shares subject to options outstanding on the date of the
Company's initial public offering which have been forfeited or terminated were
made available for issuance under the 2000 Stock Option and Incentive Plan.
During the year ended December 31, 2001, the Board of Directors authorized an
additional 5,000,000 shares, increasing the total authorized to 20,776,250
under the Plans.

   The Plans provide for the grant of stock-based awards to the Company's
employees, officers, directors, consultants and advisors. Under the Plans, the
Company may grant options that are intended to qualify as incentive stock
options within the meaning of Section 422 of the Internal Revenue Code, options
not intended to qualify as incentive stock options, restricted stock and other
stock-based awards. Incentive stock options may be granted only to employees of
the Company.

   As of December 31, 2001, 10,312,534 shares were available for future grant
under the Plans.

(f) 2000 Nonemployee Director Stock Option Plan

   In May 2000, the Board of Directors approved, subject to stockholder
approval, the 2000 Nonemployee Director Stock Option Plan, or Director Plan.
Stockholder approval was granted on June 28, 2000. A total of 400,000 shares of
common stock have been authorized for issuance under the Director Plan. On
January 1 of each year, commencing with January 1, 2001, the aggregate number
of shares available for grant under the plan will automatically increase by the
number of shares necessary to cause the total number of shares then available
for grant to be 400,000 shares.

   The Director Plan is administered by the compensation committee. Under the
Director Plan, each nonemployee director who becomes a member of the Board of
Directors after the date of the initial public

                                      47

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001

offering will be automatically granted on the date first elected to the Board
of Directors an option to purchase 35,000 shares of common stock, which will
vest in four equal installments over four years. In addition, provided that the
director continues to serve as a member of the Board of Directors, each
nonemployee director will be automatically granted on the date of each annual
meeting of stockholders following his or her initial option grant date an
option to purchase 15,000 shares of common stock, 5,000 shares of which will
vest immediately and 10,000 shares of which will vest in four equal
installments over four years. The Company granted a total of 200,000 options to
its nonemployee directors at the time of the Company's initial public offering.
Such options vest in four equal installments over four years.

   As of December 31, 2001, 290,000 shares were available for future grant.

(g) Option Exchange Program
   On October 1, 2001, the Company announced an offer to exchange outstanding
employee stock options having an exercise price of more than $ 5.00 per share.
In order to participate in the program, employees were required to tender for
exchange all options granted on or after April 1, 2001. In exchange for
eligible options, employees generally received a number of shares of restricted
stock and a commitment for new grants of non-qualified stock options
(collectively, the "New Grant") in accordance with the folowing exchange ratio:
<TABLE>
<CAPTION>
               Exercise Price of Options Tendered Exchange Ratio
               ---------------------------------- --------------
               <S>                                <C>
                         $5.00 or less...........        None
                         $5.01-$5.19.............   1.2 for 1
                         $5.20-$10.00............     1 for 1
                         $10.01-$40.00...........   .75 for 1
                         $40.01-$80.00...........    .5 for 1
                         $80.01or more...........    .2 for 1
</TABLE>

   One tenth (1/10) of the New Grant consisted of restricted stock (rounded up
to the nearest whole share) and nine-tenth (9/10) of the New Grant consisted of
new options exercisable for shares of common stock (rounded down to the nearest
whole share), subject to adjustments for any stock splits, stock dividents and
similar events. In order to address potential adverse tax consequences for
non-U.S. employess, those employees were allowed to forego the restricted stock
grants and receive all stock options.

   A total of 6,553,750 options were accepted for exchange under the offer and
accordingly, were canceled in October 2001. A total of 543,733 shares of
restricted stock were issued on October 30, 2001, and the Company recorded
deferred compensation of $1,228,000 related to these grants during the fourth
quarter of fiscal 2001. The deferred compensation costs will be amortized
ratably over the vesting periods of the restricted stock, generally over a
two-year period, with 50% of the shares vesting one year from the date of
grant, and 12.5% of the shares vesting in each three month period thereafter.
The Company intends to grant the new options, to purchase approximately
4,586,545 shares, on or about May 1, 2002 but no later than May 15, 2002. The
new options will have an exercise price equal to the last reported sale price
of the common stock on the Nasdaq National Market on the grant date. The new
options will have a term not to exceed 10 years and vest either 12.5% or 25% on
the date of grant, depending on the length of employement, and 2.0833% per
month thereafter.

                                      48

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


(h) Option Grants

   Option activity under all stock option plans is as follows:

<TABLE>
<CAPTION>
                                 Number of      Range of     Weighted Average
                                  Shares     Exercise Prices  Exercise Price
                                 ----------  --------------- ----------------
  <S>                            <C>         <C>             <C>
  Outstanding, December 31, 1998  1,682,850   $  0.01-2.00        $ 0.69
     Granted....................  2,572,850      2.00-4.00          3.15
     Exercised..................   (158,739)     0.10-3.00          0.70
     Forfeited..................   (127,026)     0.10-4.00          0.91
                                 ----------   ------------        ------
  Outstanding, December 31, 1999  3,969,935      0.01-4.00          2.28
     Granted....................  8,180,150    4.00-133.00         20.61
     Exercised.................. (1,085,904)    0.10-12.00          1.94
     Forfeited..................   (379,671)   0.10-133.00         11.02
                                 ----------   ------------        ------
  Outstanding, December 31, 2000 10,684,510    0.10-133.00         15.79
     Granted....................  4,832,575    1.37-33.938          7.63
     Exercised..................   (908,468)    0.01-12.00          2.12
     Forfeited--Cancelled....... (9,201,407)   0.10-133.00         19.33
                                 ----------   ------------        ------
  Outstanding, December 31, 2001  5,407,210   $ 0.10-88.38        $ 6.53
                                 ==========   ============        ======
  Exercisable, December 31, 2001  2,167,322                       $ 6.24
                                 ==========                       ======
  Exercisable, December 31, 2000    951,984                       $ 6.94
                                 ==========                       ======
  Exercisable, December 31, 1999    394,744                       $ 0.78
                                 ==========                       ======
</TABLE>

      The following table summarizes information relating to currently
   outstanding and exercisable stock options as of December 31, 2001:

<TABLE>
<CAPTION>
                             Options Outstanding                     Exercisable
                --------------------------------------------- --------------------------
                 Number of
                  Shares        Weighted
                Outstanding     Average
                    at         Remaining
                 December   Contractual Life Weighted Average Number of Weighted Average
Exercise Price   31, 2001      (In Years)     Exercise Price   Shares    Exercise Price
--------------  ----------- ---------------- ---------------- --------- ----------------
<S>             <C>         <C>              <C>              <C>       <C>
$  0.10-0.10        30,839        4.8             $ 0.10         30,005      $ 0.10
   0.50-0.50        72,316        5.6               0.50         56,375        0.50
   1.00-1.37       541,412        7.8               1.20        180,746        1.02
   2.00-3.00       524,683        7.3               2.32        243,173        2.25
   3.20-4.71     2,510,722        7.5               4.03      1,124,882        4.00
   5.02-7.45       343,900        9.4               5.57          5,000        6.51
  8.00-12.00       517,830        8.1               9.77        201,230       10.26
 13.62-19.81       660,307        7.6              16.77        257,483       16.99
 23.25-32.00       203,904        7.7              25.29         67,131       25.05
 40.00-40.00           166        0.9              40.00            166       40.00
 88.38-88.38         1,131        0.7              88.38          1,131       88.38
 ------------    ---------        ---             ------      ---------      ------
$ 0.10-88.38     5,407,210        7.7             $ 6.53      2,167,322      $ 6.24
 ============    =========        ===             ======      =========      ======
</TABLE>

                                      49

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


(i) Restricted Stock Grants

   Prior to the closing of the Company's initial public offering, restricted
stock grants were made to employees and entitled the participants to acquire
shares of common stock subject to repurchase by the Company and/or certain
other investors. Shares vested over a 48-month period. The Company was able to
repurchase unvested shares at their original issuance cost. Vested shares were
subject to the right of first refusal by the Company and certain other
investors. Upon closing of the Company's initial public offering on August 2,
2000, the Company's rights under restricted stock grants terminated and
employees became 100% vested.

   During 2000 the Company provided loans to a former officer and a former
employee in the amount of $286,031, bearing interest at 6% and 6.5%,
respectively, to fund their purchase of an aggregate of 164,865 shares of
restricted stock and the exercise of stock options. The vesting of certain of
these stock grants and options were accelerated in connection with the
individuals' termination of employment. Payment of the loans was unconditional
and the loans were partially secured by the personal assets of the individuals.
As of December 31, 2000, all of the loan amounts and interest has been repaid.
In connection with these transactions, compensation expense of $665,000 was
recorded in the accompanying consolidated statement of operations for the year
ending December 31, 2000.

   In fiscal 2000, the Company granted an officer the right to purchase 100,000
shares of restricted stock and, in connection with the purchase, loaned the
individual $2,500,000. These shares vested ratably over a 12 month period. The
loan is non-interest-bearing with limited recourse to the individual and is
secured by the restricted securities. The loan has a maturity of 10 years and
is to be repaid from the proceeds of the sale of the related restricted
securities, if such sale precedes the maturity date. The full amount of the
loan is outstanding at December 31, 2001 and has been recorded as a
subscription receivable within stockholders' equity in the accompanying
consolidated balance sheet. As a result of the limited recourse on this note,
the Company is accounting for this issuance similar to a stock option.

   As part of the option exchange program announced on October 1, 2001, 543,733
shares of restricted stock were issued. These restricted shares will vest over
a two-year period with 50% of the shares vesting one year from the date of
grant, and 12.5% of the shares vesting in each three-month period thereafter.

(j) 2000 Employee Stock Purchase Plan

   In May 2000, the Board of Directors approved, subject to stockholder
approval, the 2000 Employee Stock Purchase Plan. Stockholder approval was
granted on June 28, 2000. A total of 750,000 shares of common stock have been
reserved for issuance under this plan. The 2000 Employee Stock Purchase Plan
contains consecutive, overlapping, 24-month offering periods. Each offering
period includes four consecutive six-month purchase periods. Eligible employees
may purchase common stock at a price equal to 85% of the lower of the fair
market value of the common stock (i) at the beginning of the offering period or
(ii) at the end of the purchase period, whichever is lower, with the option
price at the beginning of the first offering period equal to 85% of the initial
public offering price. Participation is limited to 10% of the employees
eligible compensation, not to exceed $25,000 per calendar year or amounts
allowed by the Internal Revenue Code. On January 1 of each year, commencing
with January 1, 2001, the aggregate number of shares of common stock available
for purchase under the 2000 Employee Stock Purchase Plan will automatically
increase by the number of shares necessary to cause the total number of shares
then available for purchase to be 750,000 shares. During the year ended
December 31, 2001, the Company sold 283,428 common shares to employees under
the 2000 Employee Stock Purchase Plan.

                                      50

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


(k) Accounting for Stock-Based Compensation

   During the years ended December 31, 1999, 2000 and 2001 the Company recorded
non-cash deferred compensation of approximately $10,406,000, $34,665,000 and
$1,228,000 respectively as an element of stockholders' equity. These amounts
represent the aggregate difference between the deemed fair value of the
Company's common stock and the exercise price of stock options and restricted
stock granted and the selling price of stock sold. All stock options and
restricted stock granted prior to 1999 were at fair market value, as determined
by the Board of Directors, and, therefore, did not result in deferred
compensation. The deferred compensation will be recognized as an expense over
the vesting period of the stock options and restricted stock. During the years
ended December 31, 1999, 2000 and 2001 the Company recorded approximately
$2,977,000, $17,381,000, and $15,003,000, respectively, of compensation
expense. The Company expects to recognize compensation expense of approximately
$6,321,000, $2,553,000 and $582,000 during the years ended December 31, 2002,
2003 and 2004, respectively, based on stock options and restricted stock
granted prior to December 31, 2001.

   During 1999 and 2000, the Company issued options to consultants totaling
60,000 and 14,000, respectively. The Company values these options using the
Black-Scholes option pricing model. The Company recorded stock-based
compensation expense of approximately $194,000 and $1,278,000 for the years
ended December 31, 1999 and 2000, respectively, related to these options. In
accordance with Emerging Issues Task Force 96-18, Accounting for Equity
Instruments That Are Issued to Other Than Nonemployees For Acquiring, or in
Conjunction with Selling, Goods or Services, the Company will record the fair
value of these options as stock-based compensation expense over the period the
services are provided. As of December 31, 2000, all of these options were 100%
vested.

   SFAS No. 123 requires the measurement of the fair value of stock options or
warrants to be included in the consolidated statement of operations or
disclosed in the notes to the consolidated financial statements. The Company
has determined that it will continue to account for stock-based compensation
for employees under APB Opinion No. 25 and will elect the disclosure-only
alternative under SFAS No. 123, which requires disclosure of the pro forma
effects on earnings as if the fair-value-based method of accounting under SFAS
No. 123 had been adopted, as well as certain other information.

   The Company has computed the pro forma disclosures required under SFAS No.
123 for stock and option grants during 1999, 2000 and 2001, using the
Black-Scholes option pricing model prescribed by SFAS No. 123, using the
following assumptions:

<TABLE>
<CAPTION>
                                                  1999       2000       2001
                                               ---------- ---------- ----------
<S>                                            <C>        <C>        <C>
Risk-free interest rate....................... 4.91-6.19% 5.03-6.51% 3.54-4.98%
Expected dividend yield.......................         --         --         --
Expected lives................................  4.5 years  4.5 years  4.0 years
Expected volatility...........................        80%        80%       100%
Weighted average fair value of options granted      $2.08     $13.34      $5.44
</TABLE>


                                      51

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


   If compensation cost had been determined for stock and option grants to
employees based on the provisions of SFAS No. 123, the Company's net loss and
net loss per share for the years ended December 31, 1999, 2000 and 2001 would
have increased to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                           1999          2000          2001
                                       ------------  ------------  -------------
<S>                                    <C>           <C>           <C>
Net loss--
   As reported........................ $(47,789,928) $(84,687,400) $ (95,491,922)
   Pro forma..........................  (48,455,849)  (96,058,270) $(100,790,313)

Basic and diluted net loss per share--
   As reported........................ $     (13.99) $      (3.69) $       (1.94)
   Pro forma..........................       (14.18)        (4.19)         (2.05)
</TABLE>

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

(l) Stockholder Rights Plan

   On December 5, 2001, the Board of Directors enacted a stockholder rights
plan and declared a dividend of one preferred share purchase right for each
outstanding share of common stock outstanding at the close of business on
December 17, 2001 to the stockholders of record on that date. Each stockholder
of record as of December 17, 2001 received a summary of the rights and any new
stock certificates issued after the record date contain a legend describing the
rights. Each preferred share purchase right entitles the registered holder to
purchase from the Company one one-thousandth of a share of Series A Junior
Participating Preferred Stock, par value $0.01 per share, at a price of $40.00
per one one-thousandth of a Preferred Share, subject to adjustment, upon the
occurrence of certain triggering events, including the purchase of 15% or more
of the Company's outstanding common stock by a third party. Until a triggering
event occurs, the common stockholders have no right to purchase shares under
the stockholder rights plan. If the right to purchase the preferred stock is
triggered, the common stockholders will have the ability to purchase sufficient
stock to significantly dilute the 15% or greater holder.

(5)  RESTRUCTURING AND OTHER CHARGES

   During the third and fourth fiscal quarters of 2001, the Company implemented
cost reduction programs including workforce reductions totaling 95 employees,
or approximately 24%. The affected employees are entitled to severance and
other benefits pursuant to a benefits program. The Company recorded
restructuring charges totaling $0.9 million for these termination benefits
during the third and fourth fiscal quarters of 2001. In addition, the Company
recorded an additional restructuring charge of $1.7 million to dispose of
redundant assets and to accrue lease payments associated with excess facility
space.

                                      52

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001



   The Company's restructuring related accrual at December 31, 2001 are
summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                                              Restructuring
                                                                               Accrual at
                                                   Total    Noncash    Cash   December 31,
                                                   Charge   Charges  Payments     2001
                                                   -------  -------  -------- -------------
<S>                                                <C>      <C>      <C>      <C>
Workforce reduction............................... $   869  $    --    $631       $238
Consolidation of facilities and disposal of assets   1,718    1,330      53        335
Reversal of stock based compensation..............  (1,525)  (1,525)     --         --
                                                   -------  -------    ----       ----
 Total............................................ $ 1,062  $  (195)   $684       $573
                                                   =======  =======    ====       ====
</TABLE>

   The workforce reduction resulted in the forfeiture of employee stock
options. The restructuring charge included the reversal of $1.5 million of
stock based compensation expense previously recorded for the forfeited options.

   The restructuring accrual is included on the consolidated balance sheet in
accrued payroll and payroll-related liabilities. Substantially all remaining
cash expenditures relating to workforce reductions will be paid during the
first quarter of fiscal 2002. Amounts relating to the lease expense due to the
consolidation of facilities will be paid over the respective lease term through
June 2003.

   Additionally, the Company recorded a charge of $17.2 million as an element
of cost of sales to reflect a write down of inventories and inventory
commitments for long lead time items which were considered to be in excess of
foreseeable demand. The writedown was necessitated by the sudden and
significant decline in carrier demand experienced during the third quarter of
2001 and the resultant delays in carrier purchasing decisions. Accordingly, the
Company adjusted future demand forecasts, and performed a detailed review of
inventory on hand, and inventory commitments with suppliers. As a result of
this review, commitments to suppliers including ASICs, module components, and
TSR bay components totaling approximately $9.6 million and inventory components
and finished goods on hand relating to the TSR product, totaling approximately
$7.6 million were identified as in excess of forecasted demand for the next 12
months. During the fourth quarter of 2001, the Company paid $7.0 million to
settle inventory commitments with suppliers, and the Company expects to
substantially pay the remaining $2.6 million of accrued supplier commitments
during the first quarter of 2002. Approximately $2.0 million of excess
inventory on hand was discarded during the fourth quarter of fiscal 2001. Based
on our current demand forecasts, the Company does not currently anticipate that
the remaining $5.6 million of excess inventory will be used at a later date.

(6) COMMITMENTS

   The Company has operating lease commitments for its facilities that expire
in 2007. The approximate minimum future rent payments under these leases as of
December 31, 2001, are as follows:

<TABLE>
           <S>                                             <C>
           Years ending December 31,
              2002........................................ $1,805,000
              2003........................................  1,603,000
              2004........................................  1,308,000
              2005........................................  1,061,000
              2006........................................  1,115,000
              2007........................................    743,000
                                                           ----------
                  Total future minimum lease payments..... $7,635,000
                                                           ==========
</TABLE>


                                      53

<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


   Rent expense included in the accompanying consolidated statements of
operations was approximately $470,000, $901,000 and $2,299,000 for the years
ended December 31, 1999, 2000 and 2001, respectively. In connection with its
facilities leases, the Company provided letters of credit totaling $534,000 to
the lessor. The letters of credit are collateralized by cash of $534,000, which
is recorded as restricted in the accompanying consolidated balance sheet as of
December 31, 2001.

   The Company outsources the manufacture and assembly of its products. During
the normal course of business, in order to maintain competitive lead times for
customers and adequate components supply, the Company enters into agreements
with certain suppliers to procure inventory based upon criteria as defined by
the Company. As of December 31, 2001, the Company was committed to purchase
approximately $3.4 million of inventory based upon such criteria.

(7) PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT

   The Company entered into a perpetual nonexclusive license agreement with an
investor for the use of certain ideas, concepts and other intellectual
property. As consideration for the license, the Company paid the strategic
investor $4.0 million. The Company obtained an independent appraisal of this
intellectual property to assist in the allocation of the $4.0 million license
payment. Based on this appraisal, the Company expensed the license payment as
the purchase of in-process research and development (IPR&D) in the accompanying
consolidated statement of operations for the year ending December 31, 2000.

   The IPR&D is comprised of a single research and development project focusing
on certain effects of optical switching technology. At the date of purchase,
the project was estimated to be 13% complete and continuing research and
development commitments to complete the project were expected to approximate
$1.5 million. As of December 31, 2001, the project was estimated to be 32%
complete and remaining research and development commitments were estimated to
approximate $1.2 million.

   The $4.0 million value assigned to the purchased IPR&D was determined by
estimating the costs to develop the purchased technology into a commercially
viable optical application, estimating the resulting cash flows from the
application and discounting the net cash flows to their present value. At the
date of acquisition, this project had not yet reached technological feasibility
and the IPR&D had no alternative future uses. Revenue projections used to value
the IPR&D project are based on estimates of relevant market size and growth
factors, expected trends in technology and the nature and expected timing of
new product introductions by the Company and its competitors.

   The rate used to discount the net cash flows to their present value was 35%
based on cost of capital considerations adjusted for certain risks associated
with the in-process technology.

(8) EMPLOYEE BENEFIT PLAN

   The Company has a 401(k) Plan that provides for eligible employees to make
contributions on a tax-deferred basis. All employees on the first day of the
month following their date of employment are eligible to participate in the
401(k) Plan. Contributions are limited to 15% of their annual compensation, as
defined, subject to certain IRS limitations. The Company may contribute to the
Plan at its discretion. No employer contributions were made for all periods
presented.

                                      54

<PAGE>

                        AVICI SYSTEMS. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                               December 31, 2001


(9) LITIGATION

   During the period April through June 2001, the Company was named as a
defendant in twelve shareholder class action litigations that have been filed
in federal court in New York City against the Company and certain of its
current and former officers and the underwriters of the Company's initial
public offering (IPO). The lawsuits allege violations of the federal securities
laws and have been docketed in the U.S. District Court for the Southern
District of New York as: Felzen, et al. v. Avici Systems Inc., et al., C.A. No.
01-CV-3363; Lefkowitz, et al. v. Avici Systems Inc., et al., C.A. No.
01-CV-3541; Lewis, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3698;
Mandel, et. al v. Avici Systems Inc., et al., C.A. No. 01-CV-3713; Minai, et
al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3870; Steinberg, et al. v.
Avici Systems Inc., et al., C.A. No. 01-CV-3983; Pelissier, et al. v. Avici
Systems Inc., et al., C.A. No. 01-CV-4204; Esther, et al. v. Avici Systems
Inc., et al., C.A. No. 01-CV-4352; Zhous, et al. v. Avici Systems Inc. et al.,
C.A. No. 01-CV-4494; Mammen, et al. v. Avici Systems Inc., et. al., C.A. No.
01-CV-5722; Lin, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-5674; and
Shives, et al. v. Banc of America Securities, et al., C.A. No. 01-CV-4956.
These lawsuits, allege, among other things, that the underwriters of the
Company's IPO improperly required their customers to pay the underwriters
excessive commissions and to agree to buy additional shares of the Company's
stock in the aftermarket as conditions of receiving shares in the Company's
IPO. The lawsuits further claim that these supposed practices of the
underwriters should have been disclosed in the Company's IPO prospectus and
registration statement. The suits seek rescission of the plaintiff's alleged
purchases of the Company's stock as well as unspecified damages. The Company
understands that various other plaintiffs have filed substantially similar
class action cases against approximately 300 other publicly traded companies
and their IPO underwriters in New York City, which along with the cases against
the Company have all been transferred to a single federal district judge for
purposes of coordinated case management. The Company believes that the claims
against the Company lack merit, and intends to defend the litigation
vigorously. While the Company cannot predict the outcome of these actions, the
Company believes that the final result of these actions will have no material
impact on its consolidated financial condition or results of operations.

(10)  SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

                   Consolidated Statement Of Operations Data
                                (in thousands)

<TABLE>
<CAPTION>
                                     March 31, June 30,  September 30, December 31,
                                       2001      2001        2001          2001
                                     --------- --------  ------------- ------------
<S>                                  <C>       <C>       <C>           <C>
Net revenue......................... $ 14,894  $ 20,598    $  9,485      $  8,399
                                     ========  ========    ========      ========
Gross margin........................ $  5,918  $  8,826    $(15,609)     $  2,268
                                     ========  ========    ========      ========
Net loss............................ $(17,150) $(15,911)   $(41,237)     $(21,194)
                                     ========  ========    ========      ========
Basic and diluted net loss per share $  (0.35) $  (0.32)   $   (.83)     $  (0.43)
                                     ========  ========    ========      ========
</TABLE>


<TABLE>
<CAPTION>
                                     March 31, June 30,  September 30, Decembe 31,
                                       2000      2000        2000         2000
                                     --------- --------  ------------- -----------
<S>                                  <C>       <C>       <C>           <C>
Net revenue......................... $    504  $  2,217    $  4,356     $  7,993
                                     ========  ========    ========     ========
Gross margin........................ $     75  $    343    $  1,219     $  2,276
                                     ========  ========    ========     ========
Net loss............................ $(16,680) $(25,958)   $(23,644)    $(18,405)
                                     ========  ========    ========     ========
Basic and diluted net loss per share $  (3.68) $  (5.11)   $  (0.70)    $  (0.38)
                                     ========  ========    ========     ========
</TABLE>

                                      55

<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 10 is incorporated herein by reference
to our Definitive Proxy Statement with respect to our 2002 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission not later
than 120 days after the end of the fiscal year.

ITEM 11.   EXECUTIVE COMPENSATION

   The information required by this Item 11 is incorporated herein by reference
to our Definitive Proxy Statement with respect to our 2002 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission not later
than 120 days after the end of the fiscal year.

ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

   The information required by this Item 12 is incorporated herein by reference
to our Definitive Proxy Statement with respect to our 2002 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission not later
than 120 days after the end of the fiscal year.

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   The information required by this Item 13 is incorporated herein by reference
to our Definitive Proxy Statement with respect to our 2002 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission not later
than 120 days after the end of the fiscal year.

                                    PART IV

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

(a) The following documents are filed as a part of this Form 10-K:

   1. All Financial Statements. (see "Consolidated Financial Statements and
Supplementary Data" at Item 8 and incorporated herein by reference).

   2. Financial Statement Schedules. (Schedules to the Financial Statements
have been omitted because the information required to be set forth therein is
not applicable or is shown in the accompanying Consolidated Financial
Statements or notes thereto).

                                      56

<PAGE>

   3. Exhibits

The following exhibits are filed as part of and incorporated by reference into
this Form 10-K:

<TABLE>
<CAPTION>
Exhibit
Number                                        Description of Document
------                                        -----------------------
<C>     <S>
3.1     Fourth Amended and Restated Certificate of Incorporation (previously filed as Exhibit 3.2 to our
        Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by reference)
3.2     Amended and Restated By-Laws of the Registrant (previously filed as Exhibit 3.4 to our Registration
        Statement on Form S-1 (File No. 333-37316), which is incorporated herein by reference)
4.1     Specimen certificate representing the Registrant's Common Stock (previously filed as Exhibit 4.1 to
        our Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by
        reference)
10.1*   1997 Stock Incentive Plan (previously filed as Exhibit 10.1 to our Registration Statement on Form
        S-1 (File No. 333-37316), which is incorporated herein by reference)
10.2*   2000 Stock Option and Incentive Plan (original 2000 Stock Option and Incentive Plan filed as
        Exhibit 10.2 to our Registration Statement on Form S-1 (File No. 333-37316); 2000 Stock Option
        and Incentive Plan reflecting the amendments approved at the 2001 Annual Meeting of Stockholders
        incorporated by reference to our Definitive Proxy Statement for such meeting (File No. 000-30865))
10.3*   2000 Employee Stock Purchase Plan, as amended
10.4*   2000 Non-Employee Director Stock Option Plan (previously filed as Exhibit 10.4 to our Registration
        Statement on Form S-1 (File No. 333-37316), which is incorporated herein by reference)
10.5    Fifth Amended and Restated Investor Rights Agreement, by and among the registrant and the
        Investors and Founders listed therein, dated as of April 24, 2000, as amended (previously filed as
        Exhibit 10.5 to our Registration Statement on Form S-1 (File No. 333-37316), which is incorporated
        herein by reference)
10.6    Omnibus Agreement, dated August 26, 1999, between the Registrant and Nortel Networks Inc.
        (previously filed as Exhibit 10.6 to our Registration Statement on Form S-1 (File No. 333-37316),
        which is incorporated herein by reference)
10.7    Lease, dated June 2, 1998, between the Registrant and Y-CEE Investment Trust, as amended
        (previously filed as Exhibit 10.7 to our Registration Statement on Form S-1 (File No. 333-37316),
        which is incorporated herein by reference)
10.8    EMC Module Supply Agreement, dated May 1999, between the Registrant and Nortel Networks Inc.
        (previously filed as Exhibit 10.8 to our Registration Statement on Form S-1 (File No. 333-37316),
        which is incorporated herein by reference)
10.9+   Procurement Agreement, dated May 17, 2000, between the Registrant and Williams
        Communications, Inc. (previously filed as Exhibit 10.9 to our Registration Statement on Form S-1
        (File No. 333-37316), which is incorporated herein by reference),
10.10*  Offer letter, dated January 13, 2000, from the Registrant to Paul F. Brauneis (previously filed as
        Exhibit 10.11 to our Registration Statement on Form S-1 (File No. 333-37316), which is incorporated
        herein by reference)
10.11   Lease, dated June 8, 2000, between the Registrant and Yvon Cormier, Trustee of Y-C Investment
        Trust V (previously filed as Exhibit 10.12 to our Registration Statement on Form S-1 (File No. 333-
        37316), which is incorporated herein by reference)
10.12*  Offer letter, dated July 27, 2000 between the Registrant and Steven B. Kaufman (previously filed as
        Exhibit 10.1 to our Form 10-Q for the quarterly period ended September 30, 2000 filed with the
        Commission on November 13, 2000, which is incorporated herein by reference)
10.13   Lease, dated August 2, 2000, between the Registrant and Y-CEE Investment Trust (previously filed
        as Exhibit 10.2 to our Form 10-Q for the quarterly period ended September 30, 2000 filed with the
        Commission on November 13, 2000, which is incorporated herein by reference)
</TABLE>
<TABLE>
<C>    <S>
10.14* Offer letter, dated September 4, 2001, from the Registrant to Christopher Simpson
21.1   Subsidiaries of the Company
23.1   Consent of Arthur Andersen LLP
</TABLE>

                                      57

<PAGE>

<TABLE>
<C>  <S>
24.1 Power of Attorney (included as part of the signature page of this Report)
99.1 Letter of the Company to Securities and Exchange Commission pursuant to Temporary Note 3T, dated
     March 27, 2002
</TABLE>
--------
*  Indicates a management contract or any compensatory plan, contract or
   arrangement
+  Confidential treatment granted for certain portions of this Exhibit pursuant
   to Rule 406 promulgated under the Securities Act, which portions are omitted
   and filed separately with the Securities and Exchange Commission

   (b) Reports on Form 8-K

   We filed a current report on Form 8-K dated December 5, 2001 to report under
Item 5 the announcement of the issuance of a dividend of one preferred share
purchase right for each share of the Company's common stock. We also filed a
current report on Form 8-K dated December 7, 2001 to report under Item 5 the
announcement of a restructuring of the remaining purchase commitment under the
procurement agreement with Williams Communications, LLC.

                                      58

<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 report to be signed
on its behalf by the undersigned, thereunto duly authorized.

                                          AVICI SYSTEMS INC.

Date: March 27, 2002

                                               By:     /s/ Paul F. Brauneis
                                                   -----------------------------
                                                         Paul F. Brauneis
                                                     Chief Financial Officer,
                                                           Treasurer and
                                                     Senior Vice President of
                                                    Finance and Administration

                       POWER OF ATTORNEY AND SIGNATURES

   We, the undersigned officers and directors of Avici Systems Inc., hereby
severally constitute and appoint Paul F. Brauneis, our true and lawful
attorney, with full power to him, to sign for us in our names in the capacities
indicated below, any amendments to this Annual Report on Form 10-K (including
post-effective amendments), and to file the same, with all exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, and generally to do all things in our names and on our behalf in
our capacities as officers and directors to enable Avici Systems Inc., to
comply with the provisions of the Securities Act of 1933, as amended, hereby
ratifying and confirming our signatures as they may be signed by our said
attorneys, or any of them, to said Annual Report and all amendments thereto.

   Pursuant to the requirements of the Securities Act of 1933, this Annual
Report on Form 10-K has been signed by the following persons in the capacities
and on the date indicated.

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

    /s/  Steven B. Kaufman   President, Chief Executive        March 27, 2002
   -------------------------   Officer and Director (principal
       Steven B. Kaufman       executive officer)

     /s/  Paul F. Brauneis   Chief Financial Officer,          March 27, 2002
   -------------------------   Treasurer and Senior Vice
       Paul F. Brauneis        President of Finance and
                               Administration (principal
                               financial officer and principal
                               accounting officer)

     /s/  Surya R. Panditi   Chairman and Director             March 27, 2002
   -------------------------
       Surya R. Panditi

       /s/  Sanjiv Ahuja     Director                          March 27, 2002
   -------------------------
         Sanjiv Ahuja

    /s/  Stephen M. Diamond  Director                          March 27, 2002
   -------------------------
      Stephen M. Diamond

   /s/  Richard T. Liebhaber Director                          March 27, 2002
   -------------------------
     Richard T. Liebhaber

     /s/  James Mongiello    Director                          March 27, 2002
   -------------------------
        James Mongiello

     /s/  James R. Swartz    Director                          March 27, 2002
   -------------------------
        James R. Swartz

      /s/  Henry Zannini     Director                          March 27, 2002
   -------------------------
         Henry Zannini
</TABLE>

                                      59

<PAGE>

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
Exhibit
Number                                        Description of Document
------                                        -----------------------
<C>     <S>

 3.1    Fourth Amended and Restated Certificate of Incorporation (previously filed as Exhibit 3.2 to our
        Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by reference)

 3.2    Amended and Restated By-Laws of the Registrant (previously filed as Exhibit 3.4 to our Registration
        Statement on Form S-1 (File No. 333-37316), which is incorporated herein by reference)

 4.1    Specimen certificate representing the Registrant's Common Stock (previously filed as Exhibit 4.1 to
        our Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by
        reference)

 10.1*  1997 Stock Incentive Plan (previously filed as Exhibit 10.1 to our Registration Statement on Form S-
        1 (File No. 333-37316), which is incorporated herein by reference)

 10.2*  2000 Stock Option and Incentive Plan (original 2000 Stock Option and Incentive Plan filed as
        Exhibit 10.2 to our Registration Statement on Form S-1 (File No. 333-37316); 2000 Stock Option
        and Incentive Plan reflecting the amendments approved at the 2001 Annual Meeting of Stockholders
        incorporated by reference to our Definitive Proxy Statement for such meeting (File No. 000-30865))

 10.3*  2000 Employee Stock Purchase Plan, as amended

 10.4*  2000 Non-Employee Director Stock Option Plan (previously filed as Exhibit 10.4 to our Registration
        Statement on Form S-1 (File No. 333-37316), which is incorporated herein by reference)

 10.5   Fifth Amended and Restated Investor Rights Agreement, by and among the registrant and the
        Investors and Founders listed therein, dated as of April 24, 2000, as amended (previously filed as
        Exhibit 10.5 to our Registration Statement on Form S-1 (File No. 333-37316), which is incorporated
        herein by reference)

 10.6   Omnibus Agreement, dated August 26, 1999, between the Registrant and Nortel Networks Inc.
        (previously filed as Exhibit 10.6 to our Registration Statement on Form S-1 (File No. 333-37316),
        which is incorporated herein by reference)

 10.7   Lease, dated June 2, 1998, between the Registrant and Y-CEE Investment Trust, as amended
        (previously filed as Exhibit 10.7 to our Registration Statement on Form S-1 (File No. 333-37316),
        which is incorporated herein by reference)

 10.8   EMC Module Supply Agreement, dated May 1999, between the Registrant and Nortel Networks Inc.
        (previously filed as Exhibit 10.8 to our Registration Statement on Form S-1 (File No. 333-37316),
        which is incorporated herein by reference)

 10.9+  Procurement Agreement, dated May 17, 2000, between the Registrant and Williams
        Communications, Inc. (previously filed as Exhibit 10.9 to our Registration Statement on Form S-1
        (File No. 333-37316), which is incorporated herein by reference),

 10.10* Offer letter, dated January 13, 2000, from the Registrant to Paul F. Brauneis (previously filed as
        Exhibit 10.11 to our Registration Statement on Form S-1 (File No. 333-37316), which is incorporated
        herein by reference)

 10.11  Lease, dated June 8, 2000, between the Registrant and Yvon Cormier, Trustee of Y-C Investment
        Trust V (previously filed as Exhibit 10.12 to our Registration Statement on Form S-1 (File No. 333-
        37316), which is incorporated herein by reference)

 10.12* Offer letter, dated July 27, 2000 between the Registrant and Steven B. Kaufman (previously filed as
        Exhibit 10.1 to our Form 10-Q for the quarterly period ended September 30, 2000 filed with the
        Commission on November 13, 2000, which is incorporated herein by reference)
</TABLE>

                                      60

<PAGE>

<TABLE>
<CAPTION>
Exhibit
Number                                       Description of Document
------                                       -----------------------
<C>     <S>

10.13   Lease, dated August 2, 2000, between the Registrant and Y-CEE Investment Trust (previously filed
        as Exhibit 10.2 to our Form 10-Q for the quarterly period ended September 30, 2000 filed with the
        Commission on November 13, 2000, which is incorporated herein by reference)
10.14*  Offer letter, dated September 4, 2001, from the Registrant to Christopher Simpson
21.1    Subsidiaries of the Company
23.1    Consent of Arthur Andersen LLP
24.1    Power of Attorney (included as part of the signature page of this Report)
99.1    Letter of the Company to Securities and Exchange Commission pursuant to Temporary Note 3T,
        dated March 27, 2002
</TABLE>
--------
*  Indicates a management contract or any compensatory plan, contract or
   arrangement
+  Confidential treatment granted for certain portions of this Exhibit pursuant
   to Rule 406 promulgated under the Securities Act, which portions are omitted
   and filed separately with the Securities and Exchange Commission

                                      61