**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 year ended December 31, 2005** |
| o                                             | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile Number 000-30229**

**SONUS NETWORKS, INC.**

(Exact name of Registrant as specified in its charter)

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

 

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

(Address of principalexecutive offices, including zip code)

**(978) 614-8100**

(Registrant’s telephonenumber, including area code)

----

**Securities registeredpursuant to Section 12(b) of the Act:**

None

**Securities registeredpursuant to Section 12(g) of the Act:**

Common stock, $0.001 parvalue

Indicate by check mark ifthe Registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes x  Noo

Indicate by check mark ifthe Registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o  Nox

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  Noo

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of the Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

**Indicateby check mark whether the Registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler” in Rule 12b-2 of the Exchange Act. (Check one):**

Large acceleratedfiler x               Acceleratedfiler o               Non-acceleratedfiler o

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o  Nox.

The aggregatemarket value of the common stock held by non-affiliates of the Registrant wasapproximately $935,000,000 based on the closing price for the Common Stock onthe NASDAQ National Market on June 30, 2005. As of February 28, 2006,there were 250,336,250 shares of common stock, $0.001 par value per share,outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

Certain informationrequired in Part III of this report is incorporated by reference tospecified portions of the Registrant’s definitive Proxy Statement to be issuedin conjunction with the Registrant’s 2006 Annual Meeting of Shareholders,which is expected to be filed not later than 120 days after the Registrant’sfiscal year ended December 31, 2005.

 

----

**TABLE OF CONTENTS**

| **Item**          | ** ** | ** **                                                                                                         | ** ** | **Page** | ** ** |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **Part I**   |       |                                                                                                               |       |     |       |   |   |
| 1.                |       | Business                                                                                                           |       |     | 3          |   |   |
| 1A.               |       | Risk Factors.                                                                                                      |       |     | 17         |   |   |
| 1B.               |       | Unresolved Staff Comments                                                                                          |       |     | 29         |   |   |
| 2.                |       | Properties                                                                                                         |       |     | 29         |   |   |
| 3.                |       | Legal  Proceedings                                                                                                 |       |     | 30         |   |   |
| 4.                |       | Submission of Matters to a Vote of Security Holders                                                                |       |     | 32         |   |   |
|              |       | Executive Officers of the Registrant                                                                               |       |     | 33         |   |   |
| **Part II**  |       |                                                                                                               |       |     |       |   |   |
| 5.                |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       |     | 35         |   |   |
| 6.                |       | Selected  Financial Data                                                                                           |       |     | 36         |   |   |
| 7.                |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                   |       |     | 38         |   |   |
| 7A.               |       | Quantitative and Qualitative Disclosures about Market  Risk                                                        |       |     | 49         |   |   |
| 8.                |       | Financial Statements and Supplementary Data                                                                        |       |     | 50         |   |   |
| 9.                |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                         |       |     | 50         |   |   |
| 9A.               |       | Controls and Procedures                                                                                            |       |     | 50         |   |   |
| 9B.               |       | Other  Information                                                                                                 |       |     | 62         |   |   |
| **Part III** |       |                                                                                                               |       |     |       |   |   |
| 10.               |       | Directors and Executive Officers of the Registrant                                                                 |       |     | 63         |   |   |
| 11.               |       | Executive Compensation                                                                                             |       |     | 63         |   |   |
| 12.               |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       |     | 63         |   |   |
| 13.               |       | Certain Relationships and Related Transactions                                                                     |       |     | 63         |   |   |
| 14.               |       | Principal Accountant Fees and Services                                                                             |       |     | 63         |   |   |
| **Part IV**  |       |                                                                                                               |       |     |       |   |   |
| 15.               |       | Exhibits and Financial Statement Schedules                                                                         |       |     | 64         |   |   |
|              |       | Signatures                                                                                                         |       |     | 65         |   |   |
|              |       | Index to Consolidated Financial Statements                                                                         |       |     | F-1        |   |   |
|              |       | Exhibit Index                                                                                                 |       |     |       |   |   |

 

2

----

**PART I**

**ITEM 1.**                BUSINESS.

This Form 10-K,as well as all other reports filed with or furnished to the Securities andExchange Commission (SEC), are available free of charge through our Internetsite (http://www.sonusnet.com) as soon as reasonably practicable after weelectronically file such material with, or furnish it to, the SEC. The publicmay read and copy any materials we file with the SEC at the SEC’s PublicReference Room at 100 F Street, NE, Washington, DC 20549. The publicmay obtain information on the operation of the Public Reference Room bycalling the SEC at 1-800-SEC-0330. The SEC maintains anInternet site (http://www.sec.gov) that contains reports, proxy and informationstatements, and other information regarding issuers that file electronicallywith the SEC.

**Overview**

We are a leading provider of voice infrastructuresolutions for wireline and wireless service providers. Our products are a newgeneration of carrier-class switching equipment and software that enablesvoice services to be delivered over Internet protocol (IP) packet-basednetworks. Our target customers include both traditional and emergingcommunications service providers, including long distance carriers, localexchange carriers, Internet Service Providers, wireless operators, cableoperators, international telephone companies and carriers that provide servicesto other carriers. IP packet-based networks, which transport traffic insmall bundles, or “packets,” offer a significantly more flexible,cost-effective and efficient means for providing communications services thanexisting circuit-based networks, designed years ago to primarily delivertelephone calls.

Our suite of voice infrastructure solutions allowswireline and wireless operators to build converged voice over IP (VoIP)networks. Our products are built on the same principles outlined by the IPMultimedia Subsystem (IMS) architecture, as defined by the Third GenerationPartnership (or 3GPP) program. This IMS architecture is being embraced bynetwork operators globally as the common approach for building converged voice,data, wireline and wireless networks. The IMS architecture is based entirely onIP packets and the SIP protocol, which has been the foundation of our productssince our formation.

Our IMS-based solution product suite includes theGSX9000Ô Open ServicesSwitch, GSX4000Ô Open Services Switch,  SGXTM Signaling Gateway, the PSXTM Call RoutingServer, the ASX Call Feature Server, the NBS Network Border Switch, the SonusInsightÔ Management System, and the IMXTM ApplicationPlatform. Our products, designed for deployment as the platform of a service provider’svoice network, can significantly reduce the cost to build and operate voiceservices compared to traditional alternatives. Moreover, our products offer apowerful and open platform for network operators to increase their revenuesthrough the creation and delivery of new and innovative voice and dataservices. Our switching equipment and software can be rapidly and easilydeployed, and readily expanded to accommodate growth in traffic volume. Ourproducts also interoperate with network operators’ existing telephoneinfrastructure, allowing them to preserve the investment in their currentnetworks.

We have been recognized by independent market researchfirms as the worldwide market share leader in several key segments of thecarrier-class packet voice infrastructure equipment market. Our announcedcustomers include many of the world’s major service providers including: ANINetworks, Alestra (Mexico), America Online, at&t, Bell South, China Netcom(CNC), Cingular, EarthLink, Epana, Fusion Communications (Japan), GlobalCrossing, IDT Communications, Interoute (Europe), Intrado, JupiterCommunications (JCOM) (Japan), KDDI (Japan), Level 3, Marcatel (Mexico),Masergy, My People, NetVision (Israel), NTT Communications (Japan), Nuvox,Powercom, Qwest, Ranger Wireless, Slovak Telecom (Slovakia), Softbank Broadband(Japan), T-Systems International (a division of Deutsche Telekom Group), TimeWarner Telecom, Unefon (Mexico), USA Datanet, Verizon, Vistula, Vonage, 

3

----

Webex and XOCommunications. We sell our products principally through a direct sales forcein the United States, Europe, the Middle East and Africa (EMEA), Japan andAsia-Pacific. We have expanded our access to new geographies and into newmarkets through our relationship with Motorola and regional channel partners.We also collaborate with our customers to identify and develop new advancedservices and applications that they can offer to their customers.

Following a periodof restricted spending by communications providers, the telecommunicationsindustry witnessed growth in 2005 with the investment in new IP-based andwireless infrastructure technologies. Over the last two years, VoIP has beenwidely accepted as the protocol on which next generation networks will bebuilt. While it remains uncertain as to the speed and extent of the adoption ofcarrier packet voice infrastructure products by large carriers, we believe thatover time the market opportunity for packet voice solutions is substantial.Synergy Research Group projects that the market for service provider VoIPequipment and software will grow to approximately $3.2 billion in 2007.Our objective is to capitalize on our early technology and market lead andbuild a premier franchise in packet-based voice infrastructure solutions. The followingare key elements of our strategy:

·       leverageour award-winning technology solutions to achieve key network operator designwins;

·       continueto extend our product platforms and systems from the core of the network to theaccess edge;

·       embracethe principles outlined by the Third Generation Partnership (3GPP) and leveragethe compatibility of our product architecture and IMS;

·       supportthe convergence of wireline and wireless all IP networks;

·       expandand broaden our customer base by targeting specific market segments, includingnetwork border switching;

·       allowour customers to differentiate themselves by offering a sophisticatedapplication development platform and service creation environment;

·       expandour global sales, marketing, support and distribution capabilities;

·       growour base of software applications and development partners;

·       activelycontribute to the standards definition and adoption process; and

·       pursue strategicacquisitions and alliances.

**Industry Background**

The public telephone network is an integral part ofour everyday lives. For most of its history, the telephone industry has beenheavily regulated, which has slowed the evolution of its underlying circuit-switchingtechnologies and limited innovation in service offerings and the pricing oftelephone services. Two global forces—deregulation and the expansion of theInternet—have revolutionized the public telephone network worldwide.

Deregulation of the telephone industry acceleratedwith the passage of the Telecommunications Act of 1996. The barriers that oncerestricted service providers to a specific geography or service offering, suchas local or long distance, are disappearing. The opportunity created by openingup the telephone services market has encouraged new participants to enter themarket and incumbent service providers to expand into new markets, bothdomestically as well as internationally.

Competition between new players and incumbents isdriving down service prices. With limited ability to reduce the cost structureof the public telephone network, profit margins for traditional telephone 

4

----

services are eroding. Inresponse, service providers are seeking new, creative and differentiatedservices as a means to increase revenues and as an opportunity to reduce costs.

Simultaneously, the rapidadoption of the Internet and broadband connectivity has driven the dramaticgrowth of data traffic and the need for service providers to offerdifferentiated services to its customers. VoIP networks more efficiently fillavailable network bandwidth with packets of data and voice from many users. Asthe volume of data and voice traffic continues to increase with the growth ofbroadband access, service providers need to build large-scale, moreefficient packet networks.

**The Emergence of IMS**

For the first time in the history of thetelecommunications industry, both wireless and wireline network operators areconverging on a standard architecture to deliver on this vision of a singlecommunications network architecture. The IP Multimedia Subsystem, or IMS,architecture is a set of principles defined by the 3GPP program that describesa standard way of building telecommunication networks. In an IMS environmentnetwork switching elements are distributed and, applications, including voice,are entirely IP based.

We believe significant opportunities exist in unitingseparate, parallel networks into a new integrated public network capable oftransporting both voice and data traffic on wireless or wireline devices. IParchitectures are more efficient at moving data, and more flexible and reduceequipment and operating costs. Enormous potential savings can be realized byconverging voice and data networks and wireless and wireline, reducing networkoperating costs and eliminating redundant or overlapping equipment purchases.Also, combining traditional voice services with Internet or Web-based servicesin a single network is expected to enable new and powerful high-margin, revenue-generatingservice offerings such as voice virtual private networks (voice VPNs),one-number/follow-me services, unified messaging, conferencing, prepaid andpostpaid card services and sophisticated call centers and other IP centrexservices.

The publictelecommunications network is large, highly complex and generates significantrevenues, a substantial majority of which is derived from voice services. Givenservice providers’ substantial investment in, and dependence upon, traditionalcircuit-switched technology, their transition to VoIP and new IMSarchitectures will be gradual.

**Requirementsfor voice infrastructure products for VoIP and IMS-based networks**

Users demand high levels of quality and reliabilityfrom the public telephone network and service providers require acost-efficient network that enables new revenue-generating services. As aresult, leading carrier packet voice infrastructure products are being designedto meet some or all of the following requirements:

***An IMS-readyarchitecture.******  ***Increasingly, carriers recognize thebenefit of voice infrastructure solutions that align with the IMS architectureand can serve as the foundation for building next-generation networks. The IMSarchitecture enables network operators to converge voice, video and othermultimedia services to deliver innovative and compelling bundled solutions toconsumers. Designed to standardize the delivery of IP services, IMS defines astandard that is distributed and supports interoperability among networkcomponents. Accordingly, solutions must allow service providers to seamlesslyand cost-effectively migrate to the evolving IMS standards while maximizingtheir network investment by delivering converged multimedia services over theirexisting network.

***Carrier-classperformance.******  ***Service providers operate complex,mission-critical networks demanding clear infrastructure requirements.These include extremely high reliability, quality and interoperability. For 

5

----

example, service providerstypically require equipment that complies with their 99.999% availabilitystandard.

***Compatibility withstandards and existing infrastructure.******  ***Newinfrastructure equipment and software must support the full range of telephonenetwork standards, including signaling protocols such as SS7 or ISDN andinternational signaling variants, and various physical interfaces such as T1and E1. It must also support data networking protocols such as Internetprotocol, or IP, and asynchronous transfer mode, or ATM, as well as telephonyprotocols such as SIP, SIP-I, SIP-T, MGCP and H.323. Infrastructure solutionsmust also seamlessly integrate with service providers’ existing operationssupport systems.

***Scalability anddensity.******  ***Carrier voice infrastructure solutionsface challenging scalability requirements. Service providers’ central officestypically support tens or even hundreds of thousands of simultaneous calls. Inorder to be economically attractive, the new infrastructure must comparefavorably with existing networks in terms of cost per port, space occupied,power consumption and cooling requirements.

***Intelligentsoftware in an open and flexible platform.******  ***Thearchitecture of packet voice infrastructure solutions decouples thecapabilities of traditional circuit-switching equipment into robusthardware elements and highly intelligent software platforms that providecontrol, signaling and service creation capabilities. This approach is designedto transform the closed, proprietary circuit-switched public telephonenetwork into a flexible, open environment accessible to a wide range ofsoftware developers. The objective is to permit service providers and third-partyvendors to develop and implement new applications independent of switchvendors. Moreover, the proliferation of independent software providers promisesto drive the creation of innovative voice and data services that could expandservice provider revenues.

***Simple and rapid installation, deployment and support.******  ***Infrastructuresolutions must be easy to install, deploy, configure and manage. Theseattributes will enable rapid growth and effective management of dynamic andcomplex service provider networks.

**The Sonus Solution**

We develop, marketand sell a comprehensive suite of IMS-ready voice infrastructure products withan architecture aligned with the principles of IMS that are purpose-builtfor the deployment and management of voice and data services over carrierpacket networks. The Sonus solution consists of the following carrier-classproducts:

·       GSX9000Open Services Switch;

·       GSX4000Open Services Switch;

·       NBSNetwork Border Switch;

·       PSXCall Routing Server;

·       SGXSignaling Gateway;

·       ASXFeature Server;

·       IMXApplication Platform; and

·       SonusInsight Management System.

These products aredesigned to offer high reliability, toll-quality voice, improved economics,interoperability, rapid deployment and an open architecture enabling the designand implementation of new services and applications. Like the IMS architecture,our products are based on an open distributed 

6

----

IP-basedarchitecture. As shown in the following diagram, our existing products andproducts in development offer a IMS-ready solution:

***Carrier-classperformance.******  ***Our products are designed to offer thehighest levels of quality, reliability and interoperability, including:

·       fullredundancy, enabling 99.999% availability;

·       voicequality equal or superior to today’s circuit-switched network;

·       systemhardware designed for Network Equipment Building Standards, or NEBS Level 3,compliance;

·       networkmonitoring and provisioning designed for Operations System Modifications forthe Integration of Network Elements, or OSMINE, compliance;

·       acomplete set of service features, addressing those found in the existing voicenetwork and extending them to offer greater flexibility; and

·       sophisticatednetwork management and configuration capabilities.

***Compatibility with industry standards and existinginfrastructure.******  ***Our products are designed to becompatible with applicable voice and data networking standards and interfaces,including:

·       SS7and other telephone network signaling protocols, including internationalsignaling variants, advanced services and simple call management and routing;

·       IP,ATM, Ethernet and optical data networking standards;

·       callsignaling standards including SIP, SIP-I, SIP-T, MGCP and H.323 and others;

·       voicecoding standards such as G.711 and echo cancellation standard G.168; and

·       allcommon interfaces, including T1, T3, E1 and optical interfaces.

7

----

The Sonus solution is designed to interface withlegacy circuit-switching equipment, supporting the transparent flow ofcalls and other information between the circuit and packet networks. As aresult, our products allow service providers to migrate to a new packet voiceinfrastructure, while preserving their significant legacy infrastructureinvestments.

***Cost effectivenessand high scalability.******  ***The Sonus solution can be used tocost-effectively build packet-based switch configurations supporting arange from a few hundred calls to hundreds of thousands of simultaneous calls.In addition, the capital cost of our equipment is typically half that oftraditional circuit-switched equipment. At the same time, our GSX  Family of Open Services Switches offersunparalleled density, requires significantly less space than needed by typicalcircuit-switching implementations and requires significantly less powerand cooling. This makes possible a significant reduction in expensive centraloffice facilities cost and allows service providers to deploy our equipment inlocations where traditional circuit switches would not be an option given thelimited space and environmental services.

The GSX Family OpenServices Switch can create central office space savings as shown below.

******

***IMS architectureand flexible platform.******  ***Our solutionarchitecture aligns with the basic principles defined by the IMS architecturethat is being embraced by network operators globally as the common approach fornext generation networks. Our solution is based on a software-centricdesign and a flexible platform, allowing for the rapid development of newproducts and services. New services may be developed by us, by networkoperators or by any number of third parties including software developers andsystems integrators. The Sonus IMS architecture also facilitates the creationof services that were previously not possible on the circuit-switchednetwork. In addition, we have partnered with a number of third-partyapplication software developers in our Open Services Partner Alliancesm, or OSPAsm, to stimulate the growth of newapplications available for our platform.

***Ease of installation and deployment.******  ***Our equipmentand software can be installed and placed in service by our customers morequickly than circuit-switching equipment. By offering comprehensivetesting, configuration and management software, we expedite the deploymentprocess as well as the ongoing management and operation of our products. Webelieve that typical installations of our solution require just weeks of timefrom product arrival to final testing, thereby reducing the cost of deploymentand speeding the time to market for new services.

**The Sonus Strategy**

Our objective is to capitalize on our early technologyand market lead and build a premier franchise in packet-based carrier voiceinfrastructure solutions for wireline and wireless carriers. The following arekey elements of our strategy:

8

----

***Leverage ourtechnology leadership to achieve key service provider design wins.******  ***As one of thefirst companies to offer IMS-ready carrier-class packet voice infrastructureproducts, we have achieved key design wins with industry-leading serviceproviders as they develop the architecture for their new voice networks. Weexpect service providers to select vendors that deliver leading technology andthe ability to maintain that technology leadership. Our equipment is anintegral part of the network architecture and achieving design wins will enableus to expand our business as these networks are deployed. We have been awardedprojects by major service providers, including ANI Networks, Alestra (Mexico),America Online, at&t, Bell South, China Netcom (CNC), Cingular, EarthLink,Epana, Fusion Communications (Japan), Global Crossing, IDT Communications,Interoute (Europe), Intrado, Jupiter Communications (JCOM) (Japan), KDDI(Japan), Level 3, Marcatel (Mexico), Masergy, My People, NetVision (Israel),NTT Communications (Japan), Nuvox, Powercom, Qwest, Ranger Wireless, SlovakTelecom (Slovakia), Softbank Broadband (Japan), T-Systems International (adivision of Deutsche Telekom Group), Time Warner Telecom, Unefon (Mexico), USADatanet, Verizon, Vistula, Vonage, Webex and XO Communications. By workingclosely with our customers as they deploy these networks, we gain valuableknowledge regarding their requirements, positioning us to continue to developproduct enhancements and extensions that address the evolving requirements ofnetwork operators globally.

***Continue to extendour technology platform from the core of the network to the access edge.******  ***Our robust andsophisticated technology platform has been designed to operate at the heart ofthe largest telecommunications networks in the world. The migration to VoIPbegan at the core of network operators’ network and is evolving toward the edge(or access segment) of their networks. From our leadership position in thetrunking market, we are extending our reach by moving outward to the accesssegments of the network. We support multiple network operators’ applications ina single platform. These applications include long distance/internationalcalling, tandem switching, network border switching, business PBX access,residential access, H.323 termination, direct voice over broadband and enhancedservices. This approach will allow our customers to design and execute acoordinated migration and expansion strategy as they build entirely newnetworks or transition from their legacy circuit-switched infrastructureto a converged, IMS-ready architecture. We have deployed our ASX Feature Serverto provide full-featured access functionality with  at&t, America Online, EarthLink andMarcatel.

***Embrace theprinciples outlined by the 3GPP and deliver the industry’s most advancedIMS-ready product suite.***   When Sonus wasfounded in 1997, a standard architecture for IP-based networks did not yetexist. In order to deliver on the full promise of IP-based technologies, wedeveloped one. Today’s IMS architecture leverages many of the same principlesthat we used to develop our product framework. As a result, our customers donot need to undergo architectural upgrades to achieve IMS-compliance, but maystay current with emerging IMS protocols through software upgrades. Inrecognition of our leading position in IMS, Frost and Sullivan awarded us a2005 Technology Innovation Award for our IMS solution.

***Expand and broadenour customer base by targeting specific market segments, such as wirelessoperators.******  ***We plan to leverage our early successto penetrate new customer segments. We believe new and incumbent serviceproviders will build out their VoIP infrastructures at different rates. Thenext-generation service providers, who are relatively unencumbered by legacyequipment, have been among the initial purchasers of our equipment andsoftware. Other newer entrants, including wireless operators, cable operatorsand Internet service providers, or ISPs, have also been early adopters of ourproducts. Incumbents, including interexchange carriers, or IXCs, Regional BellOperating Companies, or RBOCs, and international operators are also adoptingpacket voice technologies over time.

***Assist ourcustomers’ ability to differentiate themselves by offering the industry’s mostsophisticated application development platform and service creationenvironment.***   Thecompetitive landscape in the communications industry has changed dramaticallyin the wake of the 1996 Telecommunications Act, the introduction of newtechnologies and the emergence of the IMS architecture. Today’s communicationsproviders face unprecedented challenges attracting and retaining customers anddriving revenue streams. 

9

----

Oneapproach to win new customers and foster loyalty among existing customers is tointroduce new services that redefine how users communicate. Our technologydrives down the cost of experimentation, stimulating new innovation. WithIP-based technologies and our IMX Application Platform, our customers havepowerful tools at their disposal for the development, integration, anddeployment of exciting new services.

***Expand oursolutions to address emerging IP-based markets, such as network borderswitching.******  ***To grow market presence and revenuesthrough VoIP services, telecommunications providers are expanding theirinternetworking beyond time-division multiplexing (TDM) connections via IP. WithIP Interconnect, service providers can quickly, effectively and flexibly deploycarrier-to-carrier connections as an alternative to TDM. IP Interconnect forcarrier-to-premises applications enables advanced services, such asVoice-over-broadband (VoBB), allowing carriers to lower their costs and deploynew services while ensuring control and security. To address this emergingneed, we deliver a comprehensive Network Border Switching solution that offerscontrol over interconnection, while reducing cost and complexity. Our NetworkBorder Switching solution supports a full range of IP signaling protocolsincluding SIP, SIP-I, SIP-T and H.323 as well as fax interworking andcodecs standards. We have sold our network border switching solution to severallarge service providers for deployment in their networks.

***Expand our globalsales, marketing, support and distribution capabilities.******  ***Becoming theprimary supplier of carrier packet voice infrastructure solutions will requirea strong worldwide presence. We are broadening our sales, marketing, supportand distribution capabilities to address this need. We have established officesthroughout the United States, in China, India, Japan, Malaysia, Singapore,Germany, the Czech Republic, France, and in the United Kingdom. In addition, wehave augmented our global direct sales effort with international distributionpartners and with our global partner, Motorola. As a carrier-classsolution provider, we are making a significant investment in professionalservices and customer support.

***Grow our base ofsoftware applications and development partners.******  ***We haveestablished and promote a partner program, the Open Services Partner Alliance,or OSPA, which brings together a broad range of development partners to provideour customers with a variety of advanced services, application options andinteroperability testing. Our OSPA partners, many of whom have completedinteroperability testing with Sonus solutions, include application developerssuch as BayPackets, Broadsoft, Iperia, IP Unity, Pactolus and Sylantro Systems.

***Actively contributeto the standards definition and adoption process.******  ***To advance ourtechnology and market leadership, we will continue to lead actively andcontribute to standards bodies such as the IMS Forum, formerly theInternational Packet Communications Consortium (IPCC), the Internet EngineeringTask Force and the International Telecommunications Union. The definition ofstandards for carrier packet voice infrastructure is in an early stage and weintend to drive these standards to meet the requirements for an open,accessible, scalable and powerful IMS infrastructure.

***Pursue strategic acquisitions and alliances.******  ***We intend toexpand our products and services through selected acquisitions and alliances.These may include acquisitions of complementary products, technologies andbusinesses that further enhance our technology leadership or product breadth.We also believe that teaming with companies providing complementary products orservices will enable us to bring greater value to our customers and extend ourlead over competitors.

**Sonus Products**

**GSX9000 Open Services Switch**

TheSonus GSX9000 Open Services Switch enables voice traffic to be transported overpacket networks. The GXX9000 is compliant with NEBS Level 3, the requirementfor telecommunications equipment used in the North American Public Switchedtelecommunications network. Its carrier-class 

10

----

hardware is designed to provide 99.999% availabilitywith no single point of failure offers optional full redundancy and fullhot-swap capability and upgrade to replace boards without turning off theequipment. It is powered from -48VDC sources standard in central officesand attaches to the central office timing network. The basic building block ofa GSX9000 is a shelf. Each shelf is 28” high, mounts in a standard 19” or 23”rack and provides 16 slots for server and adapter modules. The first two slotsare reserved for management modules, while the other 14 slots may be used forany mix of other module types. It supports the following interfaces:

| · T1;· T3;· E1;· OC3;· 100BaseT;· 1000BaseT; and· OC12c/STM-4. |  |
|--------------------------------------------------------------------------------------------------------------------------------------|--|

 

The GSX9000 is designed todeliver voice quality equal, or superior, to that of the legacy circuit-switchedpublic network. It is designed to support the multiple encoding schemes used incircuit switches such as G.711 and delivers a number of other voice compressionalgorithms. It also is designed to provide world-class echo cancellation,conforming to the latest G.168 standard, on every circuit port. Itautomatically disables echo cancellation when it detects a modem signal. TheGSX9000 is also designed to minimize delay, further enhancing perceived voicequality. The GSX9000 scales to the very large configurations required by majorservice providers. A single GSX9000 shelf can support up to 22,000 simultaneouscalls. A single GSX9000, consisting of multiple shelves, can support 100,000 ormore simultaneous calls. The GSX9000 is designed to operate with our PSX CallRouting Server and with softswitches and network products offered by othervendors.

**GSX4000Open Services Switch**

The GSX4000 Open ServicesSwitch is designed to deliver carrier-class functionality, reliability andmanageability. The GSX4000 was developed specifically for service providers toenable them to expand the reach of their core VoIP networks into newapplications, new geographic regions or to deploy IP-based multimedia services.Based on the award-winning GSX9000, the GSX4000 allows service providers tocost-effectively extend the reach of their network boundaries with the same carrier-classfunctionality that is the hallmark of our products.

The GSX4000 allows serviceproviders to realize the benefits of the GSX9000 on a platform that isright-sized for their immediate needs. By delivering the proven reliability ofthe GSX9000 in a smaller form factor, service providers are able tocost-effectively support a highly distributed subscriber base or create aninitial presence in a large market. The GSX family provides an expansion pathfrom several hundred ports to several million ports to meet the demand of theworldwide market. The GSX4000 was introduced with 24 T1/E1 interfaces. Further,by utilizing advanced digital signal processing (DSP) technology and softwaredeployed extensively in service provider networks, the GSX4000 is purpose-builtfor deployments within service providers’ networks worldwide.

**PSX Call RoutingServer**

The PSX Call RoutingServer is the primary module of our IMS architecture and plays an integral rolein all of our solutions. The PSX, which serves as the policy and databaseelement in the IMS architecture, 

11

----

providesthe network intelligence, including call control, service selection and routing.The PSX is based on a modular architecture that is designed for highperformance and scalability, as well as interoperability with third-partygateways, devices and services. The PSX supports many industry protocolsincluding SIP, SIP-I, SIP-T and H.323 for communications with a variety of IPnetwork devices. By supporting the H.323 protocol, the PSX can control andaccess H.323-based gateways and networks. The PSX supports third-partyapplication servers using the SIP protocol and third-party softswitches withthe SIP-T and SIP-I protocols.

**SGX SignalingGateway**

The SGX Gateway providesan integrated SS7 solution for Sonus’ IMS architecture. The SGX is a SS7/C7signaling gateway that interconnects Sonus-based packet solutions with legacySS7 networks. SS7/C7 signaling is the global standard for telecommunicationsprocedures and protocol by which network elements in the public switchedtelephone network exchange information over a digital signaling network toeffect wireless and wireline call setup, routing and control. The SGX Gatewayis deployed on a NEBS-compliantcomputing platform with T1, E1 and V.35 interfaces and supports a variety ofinternational signaling variants. The SGX Gateway can be deployed separately orwith the GSX9000 and the PSX Server in configurations that meet a wide range ofnetwork requirements.

**ASX Feature Server**

The ASX Feature Serverprovides functionality that extends our IMS architecture to the access part ofthe network. The ASX is a call agent that handles call setup and basic callfeatures. The ASX provides local area calling features for residential andenterprise markets and regulatory features such as emergency services andlawful intercept. The ASX connects to and can control a variety of networkendpoints, such as Integrated Access Devices (IADs), gateways, next-generationDigital Loop Carriers (DLCs) and other IP endpoints. The ASX allows the samefeatures to run over many different transport technologies including analoglines, Ethernet, voice over DSL, voice over cable or fixed wirelessinfrastructure. This flexibility enables a multitude of applications includingresidential access, cable access and business services such as Centrex andvoice virtual private networks (VPNs). The ASX also enables new featuresavailable only on packet-based networks such as unified messaging, multi-mediaconferencing and desktop integration capabilities.

**NBS Network BorderSwitch**

With the proliferation ofIP-based networks and industry convergence around IMS architectures, theability to securely interconnect between networks is paramount. The SonusNetworks NBS (Network Border Switch) is based on the GSX product family anddelivers secure connections to other carriers’ and enterprises’ IP networks.NBS is one of the only carrier-class solutions available today that providesIP-to-IP border control and PSTN media gateway capabilities—integratingsecurity, session control and media control.

**SonusIMX Application Platform**

The Sonus IMX ApplicationPlatform is a web-based multimedia environment that enables wireline andwireless service providers to develop, integrate, launch, and manage enhancedtelecommunication applications and services. The IMX combines Internet andtelephony application models, enabling the creation and delivery of voice,video, and data services in a scalable, standards-based platform. By providingthe ability to integrate with a service provider’s wireline or wireless network,this platform facilitates the development of new revenue-generatingapplications, improves time to market, and streamlines the delivery of existingor third-party next-generation services.

12

----

**Sonus Insight Management System**

Sonus Insight is acomplete, web-based management system designed to simplify the operation ofcarrier-class packet voice networks. Sonus Insight includes the ElementManagement System, or EMS, and the DataStream Integrator, or DSI, theSubscriber Management System, or SMS, the Network Traffic Manager, or NTM, andthe Sonus Insight Developer’s Kit, that together provide comprehensiveconfiguration, provisioning, security, alarm reporting, performance data andbilling mediation capabilities. Sonus Insight integrates with service providers’existing back-office systems, and offers many tools that enhance andconsolidate management functions, allowing service providers to streamline manyof today’s labor-intensive processes. Sonus Insight scales to supporthundreds of switches and concurrent users, and is based on industry standardsand protocols to facilitate management from any location worldwide.

**CustomerSupport and Professional Services**

We believe ourcomprehensive SonusCARE technical customer support and professional servicescapabilities are an important element of our solution for customers. SonusCAREcovers the full network lifecycle: planning, design, installation andoperations. We help our customers create or revise their business plans anddesign their networks and also provide the following:

·       turnkeynetwork installation services;

·       systemintegration and testing;

·       24-hourtechnical support; and

·       educationalservices to customer personnel on the installation, operation and maintenanceof our equipment.

We have technical assistance centers in Chelmsford,Massachusetts, Tokyo, Japan and the United Kingdom. The technical assistancecenters provide customers with around-the-clock technical support, as well asperiodic updates to our software and product documentation. We offer ourcustomers a variety of service plans. We also have established customer testand support centers in Richardson, Texas and Bangalore, India, and are in theprocess of establishing a customer support center in Prague, Czech Republic.

A key differentiator ofour support activities is our professional services group, many members ofwhich hold advanced technical degrees in electrical engineering or relateddisciplines. We offer a broad range of professional services, includingsophisticated network deployment, assistance with logistics and projectmanagement support. We also maintain a customer support laboratory in whichcustomers can test the utility of our products for their specific applicationsand in which they can gain an understanding of the applications enabled by theconverged network. Our approach to professional services is designed to ensurethat our products are integrated into our customers’ networks to meet theirspecific needs and that these customers realize the maximum value from theirnetworking technology investments. As of December 31, 2005, our customersupport and professional services organization consisted of 172 employees.

**Customers**

Our target customer base includes long distancecarriers, local exchange carriers, ISPs, wireless operators, cable operators,international telephone companies and carriers that provide services to othercarriers. We have shipped products to customers including:  ANI Networks, Alestra (Mexico), AmericaOnline, at&t, Bell South, China Netcom (CNC), Cingular, EarthLink, Epana,Fusion Communications (Japan), Global Crossing, IDT Communications, Interoute(Europe), Intrado, Jupiter Communications (JCOM) (Japan), KDDI (Japan), Level3, Marcatel (Mexico), Masergy, My People, NetVision (Israel), 

13

----

NTT Communications(Japan), Nuvox, Powercom, Qwest, Ranger Wireless, Slovak Telecom (Slovakia),Softbank Broadband (Japan), T-Systems International (a division of DeutscheTelekom Group), Time Warner Telecom, Unefon (Mexico), USA Datanet, Verizon,Vistula, Vonage, Webex and XO Communications.

For the year ended December 31,2005, one customer contributed 28% of our revenues. For the year ended December 31,2004, two customers contributed an aggregate of 29% of our revenues. For theyear ended December 31, 2003, four customers contributed an aggregate of57% of our revenues. As a result of the dynamic and challenging businessenvironment in the telecommunications industry, many service providers,including some of our customers, have experienced financial difficulties,restructuring of their businesses or bankruptcies; while others are in theprocess of being acquired or making significant acquisitions.

**Sales and Marketing**

We sell our products principally through a directsales force and, in some markets, through or with the assistance ofdistributors and resellers, such as China Putian (China), IBIL (Malaysia),Nissho Electronics Corporation (Japan), NK Networks (Germany), PT AbhimataCitra Abadi (Indonesia), Samsung Corporation (Korea), Sumitomo Corporation(Japan), and TNN (Israel). In February 2004, we established an originalequipment manufacturer relationship with Motorola, Inc., whereby theGSX9000 has been integrated with the Motorola SoftSwitch, creating a next generationswitching platform for wireless carriers around the world. We intend toestablish additional relationships with selected original equipmentmanufacturers and other marketing partners in order to serve particular marketsor geographies and provide our customers with opportunities to purchase ourproducts in combination with related services and products.

As of December 31,2005, our sales and marketing organization consisted of 126 employees, of whom36 were located in our corporate headquarters and 90 were located in sales andsupport offices in the United States and around the world.

**Research and Development**

We believe that strong product developmentcapabilities are essential to our strategy of enhancing our core technology,developing additional applications, incorporating that technology into newproducts and maintaining comprehensive product and service offerings. Ourresearch and development process is driven by the availability of newtechnology, market data and customer feedback. We have invested significanttime and resources in creating a structured process for undertaking all productdevelopment projects. In 2005, we delivered product enhancements in ourtrunking and access products, voice over broadband, network border switching,wireless and network management. We are developing and plan to introduce newproducts to address market and customer needs. Our research and developmentexpenses were $46.4 million, $36.2 million and $32.2 million for theyears ended December 31, 2005, 2004 and 2003, respectively.

We have assembled a teamof highly skilled engineers with significant telecommunications and networkingindustry experience. Our engineers have experience in, and have been drawnfrom, leading wireline and wireless telecommunications equipment suppliers,computer data networking and multimedia companies. As of December 31,2005, we had 327 employees responsible for research and development, of which296 were software and quality assurance engineers and 31 were hardwareengineers. Our engineering effort is focused on wireless product development,new applications and network access features, new network interfaces, improvedscalability, interoperability, quality, reliability and next generationtechnologies. We maintain research and development offices in Massachusetts,New Jersey, Texas and Virginia in the United States, Swindon, United Kingdomand Bangalore, India. We have 

14

----

recentlyestablished a technology development center in Bangalore, India. We have made,and intend to continue to make, a substantial investment in research anddevelopment.

**Competition**

The market for carrier packet voice infrastructuresolutions is intensely competitive worldwide, subject to rapid technologicalchange and significantly affected by new product introductions, changingcustomer demands, industry consolidation and other market activities ofindustry participants. We expect competition to persist and intensify in thefuture. Our primary sources of competition include vendors of networking andtelecommunications equipment, such as Cisco Systems, Ericsson, LucentTechnologies, NEC, Nortel Networks and Siemens. Some of our competitors havesignificantly greater financial resources than we do and are able to devotegreater resources to the development, promotion, sale and support of theirproducts. In addition, these competitors have more extensive customer bases andbroader customer relationships than we do, including relationships with ourpotential customers. Other smaller and typically private companies are also focusingon similar market opportunities.

In order to competeeffectively, we must deliver innovative products that:

·       provideextremely high network reliability and voice quality;

·       scaleeasily and efficiently;

·       interoperatewith existing network designs and other vendors’ equipment;

·       provideeffective network management;

·       areaccompanied by comprehensive customer support and professional services; and

·       provide a cost-effectiveand space-efficient solution for service providers.

**Intellectual Property**

Our success andability to compete are dependent on our ability to develop and maintain ourtechnology and operate without infringing on the proprietary rights of others.We rely on a combination of patent, trademark, trade secret and copyright lawand contractual restrictions to protect the proprietary aspects of ourtechnology. These legal protections afford only limited protection for ourtechnology. We presently hold eight U.S. patents with expiration dates rangingfrom April 2016 through January 2024, and have thirteen patentapplications pending in the United States, three of which are provisional. Inaddition, we hold four foreign patents, each of which expires in June 2019,and have fourteen patent applications pending abroad. We cannot be certain thatadditional patents will be granted based on these pending applications. We seekto protect our intellectual property by:

·       protectingour source code for our software, documentation and other written materialsunder trade secret and copyright laws;

·       licensingour software pursuant to signed license agreements, which impose restrictionson others’ ability to use our software; and

·       seekingto limit disclosure of our intellectual property by requiring employees andconsultants with access to our proprietary information to executeconfidentiality agreements.

We have incorporated third-partylicensed technology into our current products. From time to time, we may berequired to license additional technology from third parties to develop newproducts or product enhancements. Third-party licenses may not beavailable or continue to be available to us on commercially reasonable terms.The inability to maintain or re-license any third-party licenses requiredin our current products, or to obtain any new third-party licenses todevelop new products and product enhancements, 

15

----

couldrequire us to obtain substitute technology of lower quality or performancestandards or at greater cost, and delay or prevent us from making theseproducts or enhancements, any of which could seriously harm the competitivenessof our products.

**Manufacturing**

Currently, we outsource the manufacturing of ourproducts. Our contract manufacturers provide comprehensive manufacturingservices, including assembly and certain tests of our products and procurementof materials on our behalf. We believe that outsourcing our manufacturing willenable us to conserve working capital, better adjust manufacturing volumes tomeet changes in demand and more quickly deliver products. At present, wepurchase products from our outside contract manufacturers on a purchase orderbasis.

In 2006, we intend toconsolidate our manufacturing to a single contract manufacturer. We also intendto move our contract manufacturing to a lower cost, offshore facility, which weexpect will lower the cost of our manufacturing. As of December 31, 2005,we had 23 employees responsible for manufacturing, purchasing, final testingand assembly.

**Employees**

As of December 31,2005, we had a total of 719 employees, including 327 in research anddevelopment, 126 in sales and marketing, 172 in customer support andprofessional services, 23 in manufacturing, 36 in finance and 35 inadministration. Our employees are not represented by any collective bargainingunit. We believe our relations with our employees are good.

**Additional Information**

We were incorporated on August 7, 1997 as aDelaware corporation. Our principal executive offices are located at 250 ApolloDrive, Chelmsford, Massachusetts 01824. Our telephone number is 978-614-8100at our principal executive offices.

16

----

**ITEM 1A.**        RISKFACTORS.

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

***We have identified material weaknesses in our internalcontrol over financial reporting, which, if not remedied effectively, couldhave an adverse effect on the trading price of our common stock and otherwiseseriously harm our business.***

We have taken and continueto take significant steps to improve our overall control over financialreporting. In 2005, we remediated 7 of 10 material weaknesses in our internalcontrol over financial reporting that we had reported as of December 31,2004. However, there is additional work and focus required to address remainingdeficiencies in some of these areas. Management has concluded that our internalcontrol over financial reporting continue to have certain material weaknessesas of December 31, 2005 and that our disclosure controls and proceduresare ineffective. These certain weaknesses could have a material adverse effecton our business, results of operations and financial condition, as well asimpair our ability to meet our quarterly and annual reporting requirements in atimely manner. These effects could in turn adversely affect the trading priceof our common stock. Prior to the remediation of these remaining materialweaknesses, there remains risk that the processes and procedures on which wecurrently rely will fail to be sufficiently effective, which could result in amaterial misstatement of our financial position or results of operations. Inaddition, even if we are successful in strengthening our controls andprocedures, such controls and procedures may not be adequate to prevent oridentify irregularities or fraud or facilitate the fair presentation of ourfinancial statements, SEC reporting or other disclosures.

***Failure orcircumvention of our controls and procedures could seriously harm our business.***

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

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

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

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

Our director and officerliability insurance policies provide only limited liability protection relatingto the securities class action and derivative lawsuits against us and certainof our officers and directors. If these policies do not adequately coverexpenses and certain liabilities relating to these lawsuits, our results ofoperations and our financial position could be materially harmed. The factsunderlying the lawsuits have made director and officer liability insuranceextremely expensive for us, and may make such insurance 

17

----

coverageunavailable for us in the future. Increased premiums could materially harm ourfinancial results in future periods. The inability to obtain this coverage dueto its unavailability or prohibitively expensive premiums would make it moredifficult to retain and attract officers and directors and expose us topotentially self-funding any potential future liabilities ordinarily mitigatedby director and officer liability insurance.

***If we are notcurrent in our SEC filings, we will face several adverse consequences.***

In 2004, we were notcurrent in our SEC filings and, as a result our common stock was delisted fromthe NASDAQ National Market for a short period of time.

If we are unable to remaincurrent in our SEC filings, we will not be able to have a registrationstatement under the Securities Act of 1933, covering a public offering ofsecurities, declared effective by the SEC, and we will not be able to makeofferings pursuant to existing registration statements (including registrationstatements on Form S-8 covering employee stock plans), or pursuantto certain “private placement” rules of the SEC under Regulation D toany purchasers not qualifying as “accredited investors.” In addition, ouraffiliates will not be able to sell our securities pursuant to Rule 144under the Securities Act. Finally, we will not be eligible to use a “short form”registration statement on Form S-3 for a period of 12 monthsafter the time we become current in our filings and we will lose our status asa “well known seasoned issuer,” including the registration advantagesassociated with such status. These restrictions may impair our ability to raisecapital in the public markets should we desire to do so, and to attract andretain key employees.

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

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

Todate, we have shipped our products to a limited number of customers. We expectthat in the foreseeable future, the majority of our revenues will continue todepend on sales of our products to a limited number of customers. One customercontributed more than 10% of our revenues for fiscal 2005, which represented anaggregate of 28% of total revenues. Two and four customers each contributedmore than 10% of our revenues for fiscal 2004 and 2003, respectively, whichrepresented an aggregate of 29% and 57% of total revenues, respectively. Ourfuture success will depend on our ability to attract additional customersbeyond our current limited number. The growth of our customer base could beadversely affected by:

·       acquisitionsof or by our customers;

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

·       potentialcustomer concerns with selecting an emerging telecommunications equipmentvendor;

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

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

·       newproduct introductions by our competitors;

18

----

·       failureof our products to perform as expected; or

·       difficultieswe may incur in meeting customers’ delivery requirements.

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

***Our business has been adversely affected bydevelopments in the telecommunications industry and these developments maycontinue to affect our revenues and operating results.***

From our inception throughthe year 2000, the telecommunications market experienced rapid growth spurredby a number of factors, including deregulation in the industry, entry of alarge number of new emerging service providers, growth in data traffic and theavailability of significant capital from the financial markets. Commencing in2001, the telecommunications industry experienced a reversal of some of thesetrends, marked by dramatic reductions in capital expenditures, financialdifficulties, and, in some cases, bankruptcies of service providers. Theseconditions caused a substantial, unexpected reduction in demand fortelecommunications equipment, including our products.

Weexpect some of the developments described above to continue to affect ourbusiness in the following manner:

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

·       ourrevenues could be unexpectedly reduced; and

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

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

***Consolidation inthe telecommunications industry could harm our business.***

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

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

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

***If we do not anticipate and meet specific customerrequirements or if our products do not interoperate with our customers’existing networks, we may not retain current customers or attract newcustomers.***

To achieve marketacceptance for our products, we must effectively anticipate, and adapt in atimely manner to, customer requirements and offer products and services thatmeet changing customer demands. Prospective customers may require productfeatures and capabilities that our current products do not have. Theintroduction of new or enhanced products also requires that we carefully managethe transition from 

19

----

olderproducts in order to minimize disruption in customer ordering patterns andensure that adequate supplies of new products can be delivered to meetanticipated customer demand. If we fail to develop products and offer servicesthat satisfy customer requirements, or to effectively manage the transitionfrom older products, our ability to create or increase demand for our productswould be seriously harmed and we may lose current and prospective customers.

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

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

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

***We rely on distribution partners to sell our productsin certain markets, and disruptions to or our failure to effectively develop andmanage our distribution channel and the processes and procedures that supportit could adversely affect our ability to generate revenues from the sale of ourproducts in those markets.***

Our future success ishighly dependent upon establishing and maintaining successful relationshipswith a variety of value-added reseller and distribution partners. Aportion of our revenues is derived through distributors, many of which sellcompetitive products. Our revenues depend in part on sales by thesedistributors. The loss of or reduction in sales by these distributors couldmaterially reduce our revenues. If we fail to maintain relationships with thesedistribution partners, fail to develop new relationships with distributors innew markets, fail to manage, train, or provide incentives to existingdistributors effectively or if these partners are not successful in their salesefforts, sales of our products may decrease and our operating results couldsuffer.

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

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

Internationalrevenues, primarily attributable to Japan and Europe, were approximately $47.8 millionfor fiscal 2005, and we intend to expand our sales in international markets.This expansion will require significant management attention and financialresources to successfully develop direct and indirect international sales andsupport channels. In addition, we may not be able to develop internationalmarket demand for our products, which could impair our ability to grow ourrevenues. We have limited experience marketing, distributing and supporting ourproducts internationally and, to do so, we expect that we will need to developversions of our products that comply with local standards. Furthermore,international operations are subject to other inherent risks, including:

·       relianceon distributors and resellers;

20

----

·       greaterdifficulty collecting accounts receivable and longer collection cycle;

·       difficultiesand costs of staffing and managing international operations;

·       theimpact of differing technical standards outside the United States;

·       theimpact of recessions in economies outside the United States;

·       changesin regulatory requirements and currency exchange rates;

·       certificationrequirements;

·       reducedprotection for intellectual property rights in some countries;

·       potentiallyadverse tax consequences; and

·       political and economicinstability.

***We may not sustainprofitability.***

We have incurredsignificant losses since inception and, as of December 31, 2005, had anaccumulated deficit of $775.7 million. Although we achieved profitability on anannual basis in fiscal 2005 and 2004, we incurred a net loss in the first andthird quarters of fiscal 2005 and may incur additional losses in futurequarters and years. Our revenues may not grow and we may never generatesufficient revenues to return to or sustain profitability.

***Theunpredictability of our quarterly results may adversely affect the tradingprice of our common stock.***

Ourrevenues and operating results may vary significantly from quarter to quarterdue to a number of factors, many of which are outside of our control and any ofwhich may cause our stock price to fluctuate. Generally, purchases by serviceproviders of telecommunications equipment from manufacturers have beenunpredictable and clustered, rather than steady, as the providers build outtheir networks. The primary factors that may affect our revenues and operatingresults include the following:

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

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

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

·       thetiming of revenue recognition;

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

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

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

·       themix of product configurations sold;

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

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

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

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

21

----

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

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

As with othertelecommunications product suppliers, we may recognize a portion of our revenuein a given quarter from sales booked and shipped in the last weeks of thatquarter. As a result, delays in customer orders may result in delays inshipments and recognition of revenue beyond the end of a given quarter.

A significant portion ofour operating expenses is fixed in the short-term. If revenues for a particularquarter are below expectations, we may not be able to reduce operating expensesproportionally for the quarter. Any such revenue shortfall would, therefore,have a significant effect on our operating results for the quarter.

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

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

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

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

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

***If we fail to competesuccessfully, our ability to increase our revenues or return to profitabilitywill be impaired.***

Competition in thetelecommunications market is intense. This market has historically beendominated by large companies, such as Alcatel, Lucent Technologies, NEC, NortelNetworks, Siemens and Ericsson, all of which are our direct competitors. Wealso face competition from other large telecommunications and networkingcompanies, including Cisco Systems, some of which have entered our market byacquiring companies that design competing products. Because this market israpidly evolving, additional competitors with significant financial resourcesmay enter these markets and further intensify competition.

22

----

Many of our current and potential competitors havesignificantly greater selling and marketing, technical, manufacturing,financial and other resources. Further, some of our competitors sellsignificant amounts of other products to our current and prospective customersand have the ability to offer lower prices to win business. Our competitors’broad product portfolios, coupled with already existing relationships, maycause our customers to buy our competitors’ products or harm our ability toattract new customers.

To competeeffectively, we must deliver innovative products that:

·       provideextremely high reliability and voice quality;

·       scaleeasily and efficiently;

·       interoperatewith existing network designs and other vendors’ equipment;

·       provideeffective network management;

·       areaccompanied by comprehensive customer support and professional services;

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

·       meetprice competition from low cost equipment providers.

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

***Because ourproducts are sophisticated and designed to be deployed in complex environments,they may have errors or defects that we find only after full deployment, whichcould seriously harm our business.***

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

·       lossof, or delay in, revenues;

·       lossof customers and market share;

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

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

·       costly and time-consuminglegal actions by our customers.

***Because ourproducts are deployed in large, complex networks around the world, failure toestablish a support infrastructure and maintain required support levels couldseriously harm our business.***

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

23

----

world.If we are unable to provide the expected level of support and service to ourcustomers, we could experience:

·       lossof customers and market share;

·       afailure to attract new customers in new geographies;

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

·       network performancepenalties.

***We have experienced changes in our senior managementwhich could affect our business and operations.***

We have made significantchanges in our senior management team, including the hiring of a new VicePresident of Engineering in January 2006, a new Vice President, CorporateController and Principal Accounting Officer in August 2005, a VicePresident of Internal Operations in March 2005, and a new Chief FinancialOfficer in January 2005. Because of these significant changes, ourmanagement team may not be able to work together effectively to successfullydevelop and implement our business strategies and financial operations. Inaddition, management will need to devote significant attention and resources topreserve and strengthen relationships with employees, customers and theinvestor community. If our new management team is unable to achieve thesegoals, our ability to grow our business and successfully meet operationalchallenges could be impaired.

***If we fail to hireand retain needed personnel, the implementation of our business plan could slowor our future growth could halt.***

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

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

We may become subject toemployment claims in connection with employee terminations. In addition,companies in our industry whose employees accept positions with competitors mayclaim that their competitors have engaged in unfair hiring practices. Theseclaims may result in material litigation. We could incur substantial costsdefending ourselves or our employees against those claims, regardless of theirmerits. In addition, defending ourselves from those types of claims coulddivert our management’s attention from our operations. If we are found liablein connection with any employment claim, we may incur significant costs thatcould adversely impact our financial position and results of operations.

***We depend uponcontract manufacturers and any disruption in these relationships may cause usto fail to meet the demands of our customers and damage our customerrelationships.***

We rely on a small numberof contract manufacturers to manufacture our products according to ourspecifications and to fill orders on a timely basis. Our contract manufacturersprovide comprehensive manufacturing services, including assembly and certain testsof our products and procurement of materials. Each of our contractmanufacturers also builds products for other companies and may not always havesufficient quantities of inventory available to fill our orders or may notallocate their internal resources to fill these orders on a timely basis. We donot have long-term supply contracts with our manufacturers and they are notrequired to manufacture products for any specified period. We do not haveinternal 

24

----

manufacturingcapabilities to meet our customers’ demands. Qualifying a new contractmanufacturer and commencing commercial scale production is expensive and timeconsuming and could result in a significant interruption in the supply of ourproducts. If a change in contract manufacturers results in delays in ourfulfillment of customer orders or if a contract manufacturer fails to maketimely delivery of orders, we may lose revenues and suffer damage to ourcustomer relationships. In 2006, weintend to consolidate our manufacturing to a single contract manufacturer. Wealso intend to move our contract manufacturing to a lower cost, offshorefacility. If we do not manage this consolidation effectively, theseconsolidation activities could result in the disruption in the supply of ourproducts and in delays in our fulfillment of customer orders.

***We and our contractmanufacturers rely on single or limited sources for supply of some componentsof our products and if we fail to adequately predict our manufacturingrequirements or if our supply of any of these components is disrupted, we willbe unable to ship our products.***

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

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

***If we are not ableto obtain necessary licenses of third-party technology at acceptableprices, or at all, our products could become obsolete.***

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

25

----

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

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

·       lossof, or delay in, revenues;

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

·       networkperformance penalties.

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

·       lossof customers and market share; and

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

***Our ability tocompete and our business could be jeopardized if we are unable to protect ourintellectual property or become subject to intellectual property rights claims,which could require us to incur significant costs.***

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

In addition, wehave received inquiries from other patent holders and may become subject toclaims that we infringe their intellectual property rights. Any partiesasserting that our products infringe upon their proprietary rights could forceus to license their patents for substantial royalty payments or to defendourselves and possibly our customers or contract manufacturers in litigation.These claims and any resulting licensing arrangement or lawsuit, if successful,could subject us to significant royalty payments or liability for damages andinvalidation of our proprietary rights. Any potential intellectual propertylitigation also could force us to do one or more of the following:

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

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

·       redesignthose products that use any allegedly infringing technology.

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

26

----

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

We intend toconsider investing in, or acquiring, complementary products, technologies orbusinesses. In the event of future investments or acquisitions, we could:

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

·       reducesignificantly our cash and investments;

·       incurdebt or assume liabilities;

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

·       incursignificant amortization expenses related to purchased intangible assets; or

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

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

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

·       diversionof management’s attention from our core business;

·       adverseeffects on existing business relationships with suppliers and customers;

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

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

·       integrationof internal controls and financial systems.

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

***Recent rulemakingby the Financial Accounting Standards Board requires us to expense equitycompensation given to our employees and may reduce our ability to effectivelyutilize equity compensation to attract and retain employees.***

We historically have used stock options as asignificant component of our employee compensation program in order to alignemployees’ interests with the interests of our stockholders, encourage employeeretention, and provide competitive compensation packages. The FinancialAccounting Standards Board has adopted changes that require companies to recorda charge to earnings for employee stock option grants and other equityincentives effective January 1, 2006, which we have adopted. By causing usto incur significantly increased compensation costs, such accounting changesmay cause us to reduce the availability and amount of equity incentivesprovided to employees, which may make it more difficult for us to attract,retain and motivate key personnel.

In addition, in order toeliminate the compensation expense associated with unvested employee stockoptions with an exercise price of $4.00 or greater, in December 2005, weaccelerated the vesting on the majority of these options (see Note 1 (l) tothe Consolidated Financial Statements.) The acceleration of these unvested options may affect our ability toretain key personnel.

27

----

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

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

***We may seek toraise additional capital in the future, which may not be available to us, andif it is available, may dilute the ownership of our common stock.***

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

·       fundongoing operations and capital requirements;

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

·       developnew products; or

·       respondto competitive pressures.

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

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

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

·       theaddition or loss of any major customer;

·       consolidationin the telecommunications industry;

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

·       quarterlyvariations in our operating results;

·       changesin financial estimates by securities analysts;

·       speculationin the press or investment community;

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

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

·       securitiesand other litigation;

28

----

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

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

·       worldwide economicinstability.

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

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

***Provisions of ourcharter documents and Delaware law may have anti-takeover effects that couldprevent a change of control.***

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

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS.

We do not have anyunresolved comment letters from the SEC staff.

**ITEM 2.**                PROPERTIES.

Our corporate headquarters is located in a leasedfacility in Chelmsford, Massachusetts, consisting of 144,000 square feet undera sublease that expires in January 2007. We have additional facilities inLittleton, Massachusetts, consisting of 9,000 square feet under a sublease thatexpires in December 2008, in Richardson, Texas, consisting of 27,000square feet under a lease expiring in October 2010 and in Bangalore, India,consisting of approximately 16,000 square feet under a lease expiring inJanuary 2008. We also lease short-term office space in Colorado, NewJersey, Virginia, China, Czech Republic, France, Germany, Hong Kong, Japan,Malaysia, Singapore and the United Kingdom. We believe our existing facilitiesare adequate for our current needs and that suitable additional space will beavailable as needed.

In February 2006, we entered into a lease to moveour corporate headquarters to Westford, Massachusetts. The facility consists of130,000 square feet with the lease expiring in July 2012. We expect tomove to the Westford building in January 2007.

29

----

**ITEM 3.**                LEGALPROCEEDINGS.

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

Beginning in July 2002, several purchasers of ourcommon stock filed complaints in the United States District Court for theDistrict of Massachusetts against us, certain officers and directors and aformer officer under Sections 10(b) and 20(a) and Rule 10b-5of the Securities Exchange Act of 1934 (Class Action Complaints). Thepurchasers seek to represent a class of persons who purchased our common stockbetween December 11, 2000 and January 16, 2002, and seek unspecifiedmonetary damages. The Class Action Complaints were essentially identicaland alleged that we made false and misleading statements about our products andbusiness. On March 3, 2003, the plaintiffs filed a Consolidated AmendedComplaint. On April 22, 2003, we filed a motion to dismiss theConsolidated Amended Complaint on various grounds. On May 11, 2004, thecourt held oral argument on the motion, at the conclusion of which the courtdenied our motion to dismiss. The plaintiffs filed a motion for classcertification on July 30, 2004. On February 16, 2005, the courtcertified the class and appointed a class representative. On March 9,2005, the court appointed lead counsel. After the court requested additionalbriefing on the adequacy of the class representative, the class representativewithdrew. Lead counsel then filed a motion to substitute a new plaintiff as theclass representative. On May 19, 2005, the court held a hearing on themotion and took the matter under advisement. On August 15, 2005, the courtissued an order decertifying the class and requiring the parties to submit ajoint report informing the court whether the cases have been settled andwhether defendants would be seeking to recover attorney’s fees from theplaintiffs. On September 30, 2005, the plaintiffs filed motions tovoluntarily dismiss their complaints with prejudice. On October 5, 2005,the court entered an order dismissing the cases. On October 21, 2005, the 

30

----

defendants filed a motionseeking the recovery of attorneys’ fees from plaintiffs. The plaintiffs haveopposed the motion. No hearing date has been scheduled.

On January 6, 2006, a purchaser of our commonstock filed a complaint in the United States District Court for the District ofMassachusetts that is essentially identical to the Class Action Complaintspreviously filed against the defendants. At least one other purchaser has filedan identical complaint. We have not yet responded to the complaint. There is noassurance we will prevail in defending these actions. A judgment or asettlement of the claims against the defendants could have a material impact onSonus’ financial results. It is too early to determine the ultimate outcome orpotential range of loss, if any.

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against us and certain of our currentofficers and directors. On June 28, 2004, the court consolidated theclaims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the SecuritiesExchange Act of 1934 and Sections 11, 12(a), and 15 of the Securities Act of1933, relating to our restatement of our financial results for 2001, 2002, andthe first three quarters of 2003. Specifically, the complaint alleges that weissued a series of false or misleading statements to the market concerning ourrevenues, earnings, and financial condition. Plaintiffs contend that suchstatements caused our stock price to be artificially inflated. The complaintseeks unspecified damages on behalf of a purported class of purchasers of ourcommon stock during the period from March 28, 2002, through March 26,2004. On January 28, 2005, we filed a motion to dismiss the Section 10(b) and12(a) claims and joined the motion to dismiss the Section 11 claimfiled by the individual defendants. On June 1, 2005, the court held ahearing on the motion and allowed the plaintiff to file an amended complaint. Theplaintiff filed an Amended Complaint that included the same claims and substantiallysimilar allegations as set forth in the prior Complaint. On September 12,2005, the defendants filed motions to dismiss this Amended Complaint. On December 10,2005, the Court held a hearing on the motions and took the matter underadvisement. We believe that we have substantial legal and factual defenses tothe claims, which we intend to pursue vigorously. There is no assurance we willprevail in defending these actions. A judgment or a settlement of the claimsagainst the defendants could have a material impact of Sonus’ financialresults. It is too early to determine the ultimate outcome or potential rangeof loss, if any.

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

31

----

actions. Sonus does notexpect these shareholder derivative claims will have a material impact on itsfinancial results.

In December 2004, a purchaser of our common stockfiled a complaint in the circuit court in Will County, Illinois, against us,one of our officers, and a former officer alleging misrepresentation and fraudin connection with the plaintiff’s purchase of our stock. The Complaint seeksunspecified damages. We filed a motion to dismiss the complaint. On May 5,2005, the plaintiff filed an amended complaint. On October 26, 2005, thecourt held a hearing on the motion during which it dismissed the federal claimswithout prejudice and dismissed the state claims without prejudice. On November 23,2005, the plaintiff filed a second amended complaint with essentially the sameallegations as in the prior complaints. The defendants renewed their motions todismiss with respect to the second amended complaint. On March 9, 2006,the court held a hearing on the defendants’ motions during which he entered anorder dismissing the second amended complaint with prejudice.

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

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.

The 2005 Annual Meeting of Shareholders of SonusNetworks, Inc. was held on October 12, 2005 at the Radisson HotelChelmsford, 10 Independence Drive in Chelmsford, Massachusetts 01824. Of the248,820,513 shares outstanding as of August 23, 2005, the record date,222,464,463 shares (89%) were present or represented by proxy at the meeting.The only proposal before the Annual Meeting was the election of directors.

Thetable below presents the results of the election to our board of directors:

| **Nominee**         | ** ** | ** **  | ** ** | **Votes For** | ** ** | **Votes  Withheld** | ** ** |
|---------------------|------------|-------------|------------|--------------------|------------|---------------------|------------|
| Hassan M. Ahmed     |       | 221,382,611 |       | 1,081,852          |       |
| John P.  Cunningham |       | 218,638,976 |       | 3,825,487          |       |
| Paul J. Severino    |       | 215,030,529 |       | 7,433,934          |       |

 

The terms for Edward T.Anderson, Howard E. Janzen and Albert A. Notini expire in 2006; and the termfor H. Brian Thompson expires in 2007.

32

----

**EXECUTIVEOFFICERS OF THE REGISTRANT**

Thefollowing table sets forth our executive officers and their respective ages andpositions as of January 31, 2006:

| **Name**           | ** ** | ** ** | ** ** | **Age**                                                                       | ** ** | **Position** |
|--------------------|------------|------------|------------|-------------------------------------------------------------------------------|------------|--------------|
| Hassan M. Ahmed    |       | 48         |       | Chief Executive Officer  and Chairman of the Board of Directors               |
| Albert A. Notini   |       | 48         |       | President, Chief  Operating Officer and Director                              |
| Ellen B. Richstone |       | 54         |       | Chief Financial Officer                                                       |
| Steve Edwards      |       | 47         |       | Vice President and Chief  Marketing Officer                                   |
| Paul K. McDermott  |       | 44         |       | Vice President of Finance,  Corporate Controller and Chief Accounting Officer |
| Gary A. Rogers     |       | 50         |       | Vice President of Worldwide Sales                                             |

 

***Hassan M. Ahmed***hasbeen our Chief Executive Officer and a member of our board of directors since November 1998and Chairman of our board of directors since April 2004. From November 1998to April 2004, he was also our President. From July 1998 to November 1998,Mr. Ahmed was Executive Vice President and General Manager of the CoreSwitching Division of Ascend Communications, Inc., a provider of wide areanetwork switches and access data networking equipment, and from July 1997until July 1998 was a Vice President and General Manager of the CoreSwitching Division. From June 1995 to July 1997, Mr. Ahmed wasChief Technology Officer and Vice President of Engineering for CascadeCommunications Corp., a provider of wide area network switches. From 1993 untilJune 1995, Mr. Ahmed was a founder and President of WaveAccess, Inc.,a supplier of wireless communications. Prior to that, he was an Associate Professorat Boston University, Engineering Manager at Analog Devices, a chipmanufacturer, and director of VSLI Systems at Motorola Codex, a supplier ofcommunications equipment. Mr. Ahmed holds a B.S. and an M.S. inengineering from Carleton University and a Ph.D. in engineering from StanfordUniversity.

***Albert A. Notini***has been our President and Chief Operating Officer since April 2004 and adirector since March 2003. Until becoming President and Chief OperatingOfficer in April 2004, Mr. Notini also served as chairman of theboard’s audit committee. Mr. Notini served as a director and the ChiefFinancial Officer of Manufacturers’ Services Limited, a global electronics andsupply chain services company, from October 2000 to March 2004.Manufacturers Services Limited was acquired by Celestica Inc. in March 2004.He joined Manufacturers’ Services Limited in May 2000 as Executive VicePresident, Business Development and General Counsel and served in that capacityuntil October 2000. From January 1999 to June 1999, Mr. Notiniwas the Executive Vice President, Corporate Development and Administration andGeneral Counsel of Wang Global, a worldwide provider of network services. WangGlobal was acquired by Getronics NV in June 1999 and Mr. Notiniserved as Executive Vice President of Getronics until February 2000. Hejoined Wang Global in February 1994 as Senior Vice President and GeneralCounsel. Prior to joining Wang, he was a Senior Partner at Hale and Dorr LLP, alaw firm now known as Wilmer Cutler Pickering Hale and Dorr LLP. Mr. Notinihas a B.A. from Boston College, an M.A. from Boston University and a J.D. fromBoston College Law School.

***Ellen B. Richstone***joined as our Chief Financial Officer in January 2005. From December 2002to January 2005, Ms. Richstone was President and Chief ExecutiveOfficer of Entrepreneurial Resources Group, an international professionalservices firm that provides operational and financial services. From 1998 to November 2002,Ms. Richstone was the Senior Vice President, Finance &Administration and Chief Financial Officer of Brooks Automation, Inc., aworldwide manufacturer of automation hardware and software for thesemiconductor industry. Prior to that, she also served as the CFO of severalother technology corporations, including Augat, Inc., Rohr Aerospace, andHoneywell Bull. Additionally, 

33

----

Ms. Richstone hasheld executive positions with Data General Corporation and PolaroidCorporation. Ms. Richstone holds a bachelor’s degree from Scripps Collegeand a master’s degree of international affairs and a master’s degree of law anddiplomacy with a specialty in international business law from the FletcherSchool of Law and Diplomacy at Tufts University. She also holds an advancedprofessional certificate in finance from the New York University’s Stern Schoolof Business. She serves on the board of directors of American Power ConversionCorp and also on its audit committee as the audit committee financial expert,and a member of the compensation committee. She also serves on the board ofdirectors of Blueshift Technology, a venture-backed start-up, and also is thechairman of the audit committee.

***Steve Edwards***has been our Vice President and Chief Marketing Officer since July 2004.From 2001 to 2003, Mr. Edwards was the Vice President of Indirect Salesand Strategic Partnerships at AT&T, a global communications company. From1998 to 2001, Mr. Edwards held executive positions with Concert, a globaljoint venture company, including Chief Operating Officer for Global Servicesand Vice President of Service Delivery. In addition, Mr. Edwards heldvarious positions in engineering, product development and product marketing atBritish Telecommunications (BT) and was the President of BT Visual Images, avideoconferencing start-up, through its IPO in 1997. Mr. Edwards holds abachelors degree in electrical and computer systems engineering fromLoughborough University of Technology (UK).

***Paul K. McDermott***has been our Vice President, Finance and Corporate Controller since August 2005.From 2002 to 2005, Mr. McDermott was the Chief Financial Officer,Treasurer and Secretary at Network Intelligence Corporation, a provider ofappliance-based security event management products. From 1999 to 2002, heserved as the Chief Financial Officer, Vice President of Finance &Administration, Treasurer and Secretary of Firepond, a provider of interactivesales software solutions. Mr. McDermott holds a bachelors degree inaccounting from Duquesne University and an M.B.A. from the University ofPittsburgh.

***Gary A. Rogers***has been our Vice President of Worldwide Sales since March 1999. From March 1999to December 2000, Mr. Rogers was also our Vice President ofMarketing. From February 1997 to March 1999, Mr. Rogers wasSenior Vice President of Worldwide Sales and Operations at Security Dynamics, Inc.,now RSA Security, Inc., a supplier of network security products.Previously, he served at Bay Networks, Inc., as Vice President ofInternational Sales from July 1996 to February 1997 and as VicePresident of Europe, Middle East and Africa from 1994 until July 1996.Prior to that, he held sales and marketing positions with InternationalBusiness Machines Corporation. Mr. Rogers holds a B.A. in mathematics fromDartmouth College and an M.B.A. from the University of Chicago.

34

----

**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES.

Our common stock is quoted on the NASDAQ NationalMarket under the symbol “SONS.” All companies listed on the NASDAQ NationalMarket are required to comply with certain continued listing standards.

Thefollowing table sets forth, for the time periods indicated, the high and lowsales prices of our common stock as reported on the NASDAQ National Market.

| ** **        | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------|------------|----------|------------|---------|------------|
| **Fiscal 2005:**  |       |     |       |    |       |
| First quarter     |       | $        | 6.43       |    | $          | 4.12 |   |
| Second quarter    |       | 5.08     |       | 3.16    |       |
| Third quarter     |       | 5.80     |       | 4.50    |       |
| Fourth quarter    |       | 5.99     |       | 3.54    |       |
| **Fiscal  2004:** |       |     |       |    |       |
| First quarter     |       | $        | 10.00      |    | $          | 3.65 |   |
| Second quarter    |       | 5.64     |       | 3.45    |       |
| Third quarter     |       | 6.36     |       | 2.94    |       |
| Fourth quarter    |       | 7.02     |       | 4.70    |       |

 

We have never declared or paid cash dividends and haveno present intention to pay cash dividends in the foreseeable future. At January 31,2006, there were 654 holders of record of our common stock.

35

----

**ITEM 6.**                SELECTEDFINANCIAL DATA.

Thefollowing selected consolidated financial data of Sonus should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and our consolidated financial statements and notesto those statements included elsewhere in this report.

| ** **                                                | ** ** | **Year ended December 31,**                         | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statement of  Operations Data:**           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenues                                                  |       | $                                                                  | 194,610    |   | $ | 170,738 |   | $ | 93,210 |   | $ | 93,917 |   | $ | 128,800 |   |
| Cost of  revenues(1)                                      |       | 77,520                                                             |       | 50,567 |   | 37,909 |   | 51,576 |   | 62,778 |   |
| Gross profit                                              |       | 117,090                                                            |       | 120,171 |   | 55,301 |   | 42,341 |   | 66,022 |   |
| Operating expenses:                                       |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development(1)                               |       | 46,385                                                             |       | 36,174 |   | 32,190 |   | 44,591 |   | 63,896 |   |
| Sales and marketing(1)                                    |       | 44,246                                                             |       | 34,969 |   | 23,169 |   | 27,786 |   | 40,876 |   |
| General and administrative(1)                             |       | 26,848                                                             |       | 24,595 |   | 10,475 |   | 5,248 |   | 12,827 |   |
| Stock-based compensation                                  |       | 20                                                                 |       | 671 |   | 3,418 |   | 16,871 |   | 74,132 |   |
| Amortization of goodwill and purchased intangible  assets |       | —                                                             |       | 2,402 |   | 2,408 |   | 4,229 |   | 70,551 |   |
| Write-off of goodwill and purchased intangible  assets    |       | —                                                             |       | — |   | — |   | 10,950 |   | 392,387 |   |
| Restructuring charges, net                                |       | —                                                             |       | — |   | — |   | 7,739 |   | 7,321 |   |
| In-process research and development                       |       | —                                                             |       | — |   | — |   | — |   | 44,600 |   |
| Total operating  expenses                                 |       | 117,499                                                            |       | 98,811 |   | 71,660 |   | 117,414 |   | 706,590 |   |
| (Loss) income  from operations                            |       | (409                                                               | )          | 21,360 |   | (16,359 | ) | (75,073 | ) | (640,568 | ) |
| Interest income,  net                                     |       | 9,388                                                              |       | 3,804 |   | 1,525 |   | 1,318 |   | 4,949 |   |
| Income (loss)  before income taxes                        |       | 8,979                                                              |       | 25,164 |   | (14,834 | ) | (73,755 | ) | (635,619 | ) |
| Provision for  income taxes                               |       | 611                                                                |       | 687 |   | 302 |   | 86 |   | — |   |
| Net income (loss)                                         |       | $                                                                  | 8,368      |   | $ | 24,477 |   | $ | (15,136 | ) | $ | (73,841 | ) | $ | (635,619 | ) |
| Net income (loss) per  share(2):                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic and diluted                                         |       | $                                                                  | 0.03       |   | $ | 0.10 |   | $ | (0.07 | ) | $ | (0.39 | ) | $ | (3.68 | ) |
| Shares used in  computing net income (loss) per share(2): |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                     |       | 248,584                                                            |       | 245,830 |   | 220,696 |   | 191,008 |   | 172,905 |   |
| Diluted                                                   |       | 253,024                                                            |       | 253,816 |   | 220,696 |   | 191,008 |   | 172,905 |   |

 

36

----

 

| ** **                                                                    | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                    | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                    | ** ** | **(in thousands)** | ** ** |
| **Consolidated Balance Sheet Data:**                                          |       |                    |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents,  marketable debt securities and long-term investments |       | $                       | 314,241    |   | $ | 313,105 |   | $ | 305,392 |   | $ | 118,138 |   | $ | 125,013 |   |
| Working capital                                                               |       | 280,698                 |       | 271,584 |   | 260,962 |   | 60,946 |   | 81,895 |   |
| Total assets                                                                  |       | 456,557                 |       | 393,828 |   | 358,424 |   | 153,517 |   | 216,206 |   |
| Long-term deferred  revenue, net of current portion                           |       | 34,561                  |       | 25,960 |   | 24,302 |   | 8,024 |   | 3,942 |   |
| Long-term liabilities,  net of current portion                                |       | 485                     |       | 613 |   | 829 |   | 3,293 |   | 1,289 |   |
| Convertible subordinated  note                                                |       | 10,000                  |       | 10,000 |   | 10,000 |   | 10,000 |   | 10,000 |   |
| Total stockholders’  equity                                              |       | 280,165                 |       | 265,040 |   | 234,435 |   | 56,421 |   | 110,566 |   |
|                                                                               |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Excludes non-cash, stock-basedcompensation expense as follows:

| ** **                  | ** ** | **December 31,**   | ** ** |
|-----------------------------|------------|-------------------------|------------|
| ** **                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                  | ** ** | **(in thousands)** | ** ** |
| Cost of revenues            |       |                    | $          | — |   |   | $ | 18 |   | $ | 45 |   | $ | 235 |   | $ | 1,304 |   |
| Research and development    |       |                    | —     |   |   | 240 |   | 1,180 |   | 8,930 |   | 42,764 |   |
| Sales and  marketing        |       |                    | 20         |   |   | 311 |   | 1,542 |   | 4,941 |   | 17,968 |   |
| General and  administrative |       |                    | —     |   |   | 102 |   | 651 |   | 2,765 |   | 12,096 |   |
|                        |       |                    | $          | 20 |   |   | $ | 671 |   | $ | 3,418 |   | $ | 16,871 |   | $ | 74,132 |   |

 

(2)          See Note 1 (n) toour consolidated financial statements for an explanation of the method ofcalculation.

37

----

**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

*The following discussion should be read in conjunctionwith our consolidated financial statements and notes to those statements andother financial information appearing elsewhere in this report. The followingdiscussion contains forward looking information that involves risks anduncertainties. Our actual results could differ materially from thoseanticipated in the forward looking statements as a result of a number offactors, including the risks discussed in Item 1A. “Risk Factors” and elsewherein this report.*

**Overview**

We are a leading supplier of packet voiceinfrastructure solutions for wireline and wireless service providers. Ourproducts are a new generation of carrier class switching equipment and softwarethat enable voice services to be delivered over packet-based networks. Ourvoice solutions allow wireline and wireless operators to build convergednetworks based on the same principles as IMS, which is becoming the commonstandard for constructing next generation networks.

We began shipping product to customers during thefourth quarter of fiscal 1999 and recorded our first revenues of$51.8 million in fiscal 2000 and revenues of $128.8 million in fiscal2001, $93.9 million in fiscal 2002, $93.2 million in fiscal 2003,$170.7 million in fiscal 2004 and $194.6 million in fiscal 2005.Significant declines in capital spending by telecommunications serviceproviders, and financial difficulties, including in some cases bankruptcies,experienced by certain emerging service providers, including some of ourcustomers, contributed to the reduction in our revenues in 2002 relative to theprior year. In response to the unfavorable economic conditions, commencing in thethird quarter of fiscal 2001 and continuing through fiscal 2002, we implementedrestructuring plans designed to reduce expenses and align our cost structurewith our revised business outlook. The restructuring plans included worldwideworkforce reductions, consolidation of excess facilities and the write-off ofexcess inventory and purchase commitments. In 2003, the challenging businessenvironment in the telecommunications industry continued to affect the spendingby service providers for products such as those we offer.

In 2004 and continuing through 2005, there wasincreased interest and activity in the market for packet-based voiceinfrastructure products. This has shown in our order activity as we achievedrecord orders in the fourth quarter of fiscal 2004 and on an annual basis infiscal 2005 as orders exceeded revenue. While it remains uncertain as to thespeed and extent of the adoption of carrier packet voice infrastructureproducts by large carriers, we believe that over time the market opportunityfor packet voice solutions is substantial. For fiscal 2005, revenues were$194.6 million compared to $170.7 million in fiscal 2004, reflectingcontinuing improvements in the market for packet-based voiceinfrastructure products, as well as increased service revenues resulting from agrowing installed base of our products.

We sell our products primarily through a direct salesforce and, in some markets, through or with the assistance of resellers anddistributors. Customers’ decisions to purchase our products to deploy incommercial networks involve a significant commitment of resources and a lengthyevaluation, testing and product qualification process. We believe our revenuesand results of operations may vary significantly and unexpectedly from quarterto quarter as a result of long sales cycles, our expectation that customerswill tend to sporadically place large orders with short lead times, and theapplication of complex revenue recognition rules to certain transactions,which may result in customer shipments and orders from multiple quarters beingrecognized as revenue in one quarter. We expect to recognize revenues from alimited number of customers for the foreseeable future.

Our success depends on our ability to continue toprovide innovative products to our customers and to deliver quality service andsupport as our customers build out their next generation voice networks. Ourreported financial performance depends both on growing our business withexisting and new customers, and our ability to convert the business intorevenue.

38

----

Since our inceptionthrough December 31, 2003, we incurred significant losses. As of December 31,2005, we had an accumulated deficit of $775.7 million. Although weachieved profitability on an annual basis in fiscal year 2005 and 2004, weincurred a net loss in the first and third quarters of fiscal 2005 and mayincur additional losses in future quarters and years. We have a lengthy salescycle for our products and, accordingly, we expect to incur sales and otherexpenses before we realize the related revenues. We expect to continue to incursignificant sales and marketing, research and development and general andadministrative expenses, many of which are fixed prior to the beginning of anyparticular fiscal period and, as a result, we will need to generate significantrevenues to maintain profitability.

**CriticalAccounting Policies and Estimates**

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

·       Revenuerecognition,

·       Deferredrevenue,

·       Allowancefor doubtful accounts,

·       Inventoryreserves,

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

·       Stock-basedcompensation, and

·       Accountingfor income taxes.

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

Many of our sales involve complex contractual,multiple-element arrangements. When a sale includes multiple elements, such asproducts, maintenance and/or professional services, we recognize revenue usingthe residual method. Revenues associated with undelivered elements that areconsidered not essential to the functionality of the product and for which VSOEhas been established, are deferred based on the VSOE value and any remainingarrangement fee is then allocated to, and recognized as, product revenue.   VSOE is determined based upon the price chargedwhen the same element is sold separately or established by the relevant pricingauthority. If we cannot establish VSOE for each undelivered element, includingspecified upgrades, we defer revenue on the entire arrangement until VSOE forall undelivered elements is known or all elements are delivered and all otherrevenue recognition criteria are met.

39

----

Maintenance and support services are recognizedratably over the service period, ranging from one to five years. Earnedmaintenance revenues are typically deferred until the associated productrevenue is accepted and all other revenue recognition criteria is met. Maintenanceand support services include telephone support, return and repair support andunspecified rights to product upgrades and enhancements.

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

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

We sell the majority of our products directly toend-users. For products sold to resellers and distributors, we recognizerevenue on a sell-through basis utilizing information provided to us from ourresellers and distributors. To date, no revenues have been recognized on asell-in basis due to the limited history of shipments to resellers and distributors.

***Deferred Revenue.******  ***We record deferred revenuefor product delivered or services performed for which collection of the amountbilled is either probable or has been collected but other revenue recognitioncriteria have not been satisfied. Deferred revenues include customer depositsand amounts associated with maintenance contracts. Deferred revenues expectedto be recognized as revenue more than one year subsequent to the balance sheetdate are classified as long-term deferred revenues.

We defer recognition of incremental direct costs, suchas cost of goods, royalties, commissions and third-party installationcosts, until satisfaction of the criteria for recognition of the relatedrevenue.

***Allowance forDoubtful Accounts.******  ***We establish billing terms at thetime we negotiate purchase agreements with our customers. We continuallymonitor for timely payments and potential collection issues. Allowance fordoubtful accounts is estimated based on our detailed assessment of the collectibilityof specific customer accounts.

***Inventory Reserves.******  ***Inventorypurchases and commitments are based upon estimated future demand for ourproducts. We value inventory at the lower of cost on a first-in, first-outbasis or net realizable value. We provide inventory reserves based on excessand obsolete inventory determined primarily by future demand forecasts andestimated returns of defective product, and record charges to cost of revenues.We assess such demand forecasts and return history on at least a quarterlybasis. If we record a charge to reduce inventory to its estimated netrealizable value, we do not increase its carrying value due to subsequentchanges in demand forecasts or product repairs. Accordingly, if inventorypreviously reserved for is subsequently sold, we may realize improved grossprofit margins on those transactions in the period the related revenue isrecognized.

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

***Warranty Reserve.******  ***Our productsare covered by a standard warranty of 90 days for software and one yearfor hardware or a warranty for longer periods under certain customer contracts.In addition, certain customer contracts include warranty-type provisions forepidemic or similar product failures, generally for the contractual period orthe life of the product in accordance with published telecommunicationsstandards**.**We accrue for warranty obligationswhen the occurrence of such obligation is probable and the amount of suchobligation is reasonably estimable. We have not incurred significant costsrelated to such 

40

----

obligations. Our customerstypically purchase maintenance and support contracts, which encompass ourwarranty obligations. Our estimates of warranty obligations are primarily basedon historical information and future forecasts.

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

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

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

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

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

Beginning on January 1, 2006, we adoptedSFAS 123(R), *Share-Based Payment*,which is a revision of SFAS No. 123 and supersedes APB Opinion No. 25.SFAS 123(R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in the incomestatement based on their fair values at the date of grant in fiscal yearsbeginning after June 15, 2005, and eliminates pro forma disclosure in thenotes to the financial statements. As a result of the adoption of SFAS 123(R),we expect stock-based compensation expense to reduce diluted net income pershare by approximately $0.03 to $0.05 per share for fiscal 2006. However,our assessment of the estimated compensation charges is affected by our stockprice as well as assumptions regarding a number of complex and subjectivevariables and the related tax impact. These variables include, but are notlimited to, the volatility of our stock price and employee stock optionexercise behaviors.

41

----

***Accounting for Income Taxes.******  ***We provide fordeferred income taxes resulting from temporary differences between financialand taxable income. Such differences arise primarily from depreciation,accruals and reserves, deferred revenue, capitalized software costs, taxcarryforwards, and allowances for accounts receivable. We record valuationallowances to reduce deferred tax assets to the amount that is more likely thannot to be realized. We have not provided for U.S. income taxes on theundistributed earnings of non-U.S. subsidiaries, as these earnings have beenpermanently reinvested or would be principally offset by foreign tax credits.Cumulative undistributed foreign earnings were approximately $550,000 atDecember 31, 2005.

**Results of Operations**

***Years Ended December 31, 2005 and 2004***

***Revenues.******  ***Revenues forthe years ended December 31, 2005 and 2004 were as follows, in thousands:

| ** **     | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| **Revenues:**  |       |     |       |     |       |
| Product        |       | $        | 134,812    |     | $          | 124,087 |   |
| Service        |       | 59,798   |       | 46,651   |       |
| Total revenues |       | $        | 194,610    |     | $          | 170,738 |   |

 

Product revenues comprise sales of our voiceinfrastructure products, including our GSX9000 Open Services Switch, PSX, SGX,ASX, Sonus Insight Management System and related product offerings. Productrevenues for fiscal 2005 increased 9% from fiscal 2004. The increase in productrevenues was primarily due to an increase in orders during 2004 that were notconverted to revenue as of December 31, 2004 as compared to 2003, and theconversion of those orders into revenue in 2005, as well as a higher percentageof product orders converted to revenue in the year they were received in fiscal2005 as compared to fiscal 2004. We can provide no assurance that orders willincrease in 2006 or that we will be able to convert orders into revenue in anyparticular fiscal quarter or year.

Service revenues primarily comprise hardware andsoftware maintenance and support, network design, installation and otherprofessional services. Service revenues for fiscal 2005 increased 28% fromfiscal 2004. The increase in service revenues was primarily due to an increasein maintenance revenue as a result of the growing installed customer base.

Cingular Wireless, Global Crossing and QwestCommunications each contributed more than 10% of our revenues during one ormore of the years ended December 31, 2005 and 2004.

International revenues, primarily from Japan andEurope, were 25% and 17% of revenues for the years ended December 31, 2005and 2004. International revenues increased as a percentage of total revenuesprimarily due to an increase in orders during 2004 that were not converted torevenue as of December 31, 2004 as compared to 2003, and the conversion ofa significant portion of such business into revenue in fiscal 2005. The rate ofconverting orders to revenue from international customers is generally longerthan the conversion time for domestic customers. We expect that internationalrevenues will remain uneven as a percentage of revenue from quarter to quarter.

Our deferred product revenue was $54.8 millionand $46.2 million as of December 31, 2005 and 2004, respectively. Ourdeferred service revenue was $67.3 million and $44.9 million as of December 31,2005 and 2004, respectively. Our deferred revenue increased due to the deferralof service revenue for future service and support obligations to our customers,and an increase in deferred product revenue due to the timing of ordersreceived in 2005 and our ability to recognize such orders to revenue. Ourdeferred revenue balance may fluctuate as a result of the timing of revenuerecognition, customer payments, maintenance contract renewals, contractualbilling rights, customer creditworthiness and maintenance 

42

----

revenue deferrals includedin multiple element arrangements. As of December 31, 2005 and 2004,deferred revenue and accounts receivable excluded $5.3 million and $6.5million, respectively, related to products shipped and billed to customerswhich are collectible under extended payment terms or for which revenue isrecognized as cash is collected.

***Cost of Revenues/Gross Profit.******  ***Our cost ofrevenues consists primarily of amounts paid to third party manufacturers forpurchased materials and services, royalties, manufacturing and professionalservices personnel and related costs and inventory obsolescence. Cost ofrevenues and gross profit as a percentage of revenues for the years ended December 31,2005 and 2004 were as follows (in thousands, except percentages):

| ** **                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| **Cost of revenues:**                                |       |     |       |     |       |
| Product                                              |       | $        | 53,622     |     | $          | 32,911 |   |
| Service                                              |       | 23,898   |       | 17,656   |       |
| Total cost of revenues                               |       | $        | 77,520     |     | $          | 50,567 |   |
| **Gross  profit margin (% of respective revenues):** |       |     |       |     |       |
| Product                                              |       | 60       | %          | 73       | %          |
| Service                                              |       | 60       |       | 62       |       |
| Total gross  profit margin                           |       | 60       |       | 70       |       |

 

The decrease in product gross profit as a percentageof revenues was primarily due to customer and product mix. The product grossmargins achieved in 2004 were the result of a customer and product mix we donot expect to repeat. Our customer mix is the most significant determinant ofour product gross margin percentage due to the concentrated nature of ourcustomer base and the variance in pricing we realize for certain customers. Toa lesser extent, the decrease was also due to a renegotiation of maintenanceand support contracts with two customers resulting in a reduction in productrevenues and gross margin of $4.7 million in fiscal 2005, an incrementalbenefit decrease in fiscal 2005 of $1.3 million from the sale of inventorypreviously written down and a $1.9 million benefit from the reduction ofwarranty reserves in the fourth quarter of 2004. The benefit from the reductionof warranty reserves represented changes in estimates due to the ongoing re-evaluationof expected future warranty requirements. Product margins for fiscal 2005 wereconsistent with our long-term financial model of 58-62%.

The decrease in service gross profit as a percentageof service revenues was primarily due to increased investment in our serviceorganization to support the expansion of our installed base, partially offsetby our higher volume of service revenues attributable to our increasinginstalled product base. Our service cost of revenues is predominantly fixed innature and, therefore, changes in service revenue will have a significantimpact on service gross profit percentage.

***Research andDevelopment Expenses.******  ***Research and development expensesconsist primarily of salaries and related personnel expenses and prototypecosts related to the design, development, testing and enhancement of ourproducts. Research and development expenses were $46.4 million for fiscal2005, an increase of $10.2 million, or 28%, from $36.2 million infiscal 2004. The increase primarily reflects higher salary and related expensesassociated with increased headcount and additional depreciation expensesassociated with new capital expenditures. During 2005, additional investmentswere directed primarily toward the growth of our access, wireless andinternational businesses as well as the expansion of our research anddevelopment operations in India. Some aspects of our research and developmentefforts require significant short-term expenditures, the timing of which cancause significant variability in our expenses. We believe that rapidtechnological innovation is critical to our long-term success and we intend tocontinue to make substantial investments to enhance our products andtechnologies to meet the requirements of our customers and market. We believethat our research and development expenses for 

43

----

fiscal 2006 will increasefrom fiscal 2005 primarily as a result of continued investment in new products,including the continued expansion of our research and development operations inIndia.

***Sales and MarketingExpenses.******  ***Sales and marketing expenses consistprimarily of salaries and related personnel costs, commissions, travel andentertainment expenses, promotions, customer evaluations inventory and othermarketing and sales support expenses. Sales and marketing expenses were$44.2 million for fiscal 2005, an increase of $9.2 million, or 26%,from $35.0 million in fiscal 2004. The increase is primarily due to highersalaries and travel expenses associated with increased headcount related to theexpansion of our worldwide sales and sales support coverage and an increase incommissions associated with increased revenues from the prior year. Theincrease is partially offset by a decrease in evaluation equipment expenses. Webelieve that our sales and marketing expenses in fiscal 2006 will increase fromthe fiscal 2005 level primarily as a result of our continued internationalexpansion and an increase in commissions. The magnitude of the increase will bedependent upon our level of revenues in fiscal 2006 as commission expensesfluctuate primarily based on revenue levels.

***General andAdministrative Expenses.******  ***General andadministrative expenses consist primarily of salaries and related personnelcosts for executive and administrative personnel, recruiting expenses,professional fees and directors and officers insurance. General andadministrative expenses were $26.8 million for fiscal 2005, an increase of$2.2 million, or 9%, from $24.6 million in fiscal 2004. The increaseprimarily reflects an increase in salary and related expenses associated withincreased headcount and an increase in professional fees incurred to performthe assessment and audit of our internal control over financial reportingrequired under Section 404 of the Sarbanes-Oxley Act of 2002 for2005 and to remedy identified material weaknesses in our internal controlenvironment. The increase was partially offset by a decrease in professionalfees incurred as part of our restatement and investigation into accountingmatters during 2004. We believe that our general and administrative expenses infiscal 2006 will decrease from the fiscal 2005 level primarily as a result of adecrease in professional fees to assess and audit our internal control overfinancial reporting and a decrease in directors and officers insurance costs.

***Stock-basedCompensation Expenses.******  ***Stock-basedcompensation expenses include the amortization of stock compensation chargesresulting from the granting of stock options, restricted common stock andgranting of stock options to non-employees. Stock-based compensationexpenses were $20,000 for fiscal 2005, compared to $671,000 in fiscal 2004. Thedecrease is primarily due to deferred stock-based compensation being fullyamortized as of December 31, 2004.

***Amortization ofPurchased Intangible Assets.******  ***In fiscal2001, we acquired certain intellectual property, in-process research anddevelopment and intangible assets in connection with our acquisitions of TTIand Linguateq, Inc. As of December 31, 2004, the purchased intangibleassets were fully amortized, therefore there was no amortization expense infiscal 2005. Amortization of purchased intangible assets was $2.4 millionfor fiscal 2004.

***Interest Income,net.******  ***Interest income consists of interestearned on our cash equivalents, marketable debt securities and long-terminvestments. Interest expense consists of interest incurred on a convertiblesubordinated note and capital lease obligations. Interest income, net ofinterest expense, was $9.4 million for fiscal 2005, an increase of$5.6 million from $3.8 million in fiscal 2004. The increase primarilyreflects the benefit of the increase in the yield on our portfolio due to anincreasing interest rate environment.

 

44

----

***Income Taxes.******  ***Provisions forincome taxes were $611,000 in 2005 and $687,000 in 2004, which are primarilyattributable to foreign income taxes and state and federal income taxes in theU.S. As of December 31, 2005, we had net operating loss carryforwards forfederal and state income tax purposes of approximately $158 million and$94 million, respectively. The federal net operating loss carryforwardsexpire at various dates from 2019 through 2023. The state net operating losscarryforwards expire at various dates from 2006 through 2023. We have recordeda full valuation allowance for the related federal and state net deferred taxasset due to the uncertainty of realizing the benefit of this asset. We haverecorded a foreign deferred income tax asset of $519,000 with no valuationallowance as of December 31, 2005 as it is more likely than not that itwill be realized.

***Years Ended December 31, 2004 and 2003***

***Revenues.******  ***Revenues forthe years ended December 31, 2004 and 2003 were as follows, in thousands:

| ** **     | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| **Revenues:**  |       |     |       |     |       |
| Product        |       | $        | 124,087    |     | $          | 60,851 |   |
| Service        |       | 46,651   |       | 32,359   |       |
| Total revenues |       | $        | 170,738    |     | $          | 93,210 |   |

 

Product revenues for fiscal 2004 increased 104% fromfiscal 2003. The higher revenues in fiscal 2004 were primarily the result ofimproved market conditions in 2004 for the sale of voice over IP infrastructureproducts to telecommunications service providers.

Service revenues for fiscal 2004 increased 44% fromfiscal 2003. The increase in service revenues was primarily due to an increasein maintenance revenue as a result of the growing installed customer base.

Cingular Wireless, Global Crossing, QwestCommunications and Verizon Global Networks each contributed more than 10% ofour revenues during one or more of the years ended December 31, 2004 and2003. International revenues, primarily from Japan and Europe, were 17% and 21%of revenues for the years ended December 31, 2004 and 2003.

***Cost of Revenues/Gross Profit.******  ***Cost ofrevenues and gross profit as a percentage of revenues for the years ended December 31,2004 and 2003 were as follows (in thousands, except percentages):

| ** **                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| **Cost of revenues:**                                |       |     |       |     |       |
| Product                                              |       | $        | 32,911     |     | $          | 23,575 |   |
| Service                                              |       | 17,656   |       | 14,334   |       |
| Total cost of revenues                               |       | $        | 50,567     |     | $          | 37,909 |   |
| **Gross  profit margin (% of respective revenues):** |       |     |       |     |       |
| Product                                              |       | 73       | %          | 61       | %          |
| Service                                              |       | 62       |       | 56       |       |
| Total gross  profit margin                           |       | 70       |       | 59       |       |

 

The increase in product gross profit as a percentageof revenues was primarily due to customer and product mix and, to a lesserextent, improved utilization of fixed costs associated with increased productrevenues. The product gross margins achieved in 2004 were the result of acustomer and product mix we do not expect to repeat. Our customer mix is themost significant determinant of our product gross margin percentage due to theconcentrated nature of our customer base and the variance in pricing we realizefor each customer. In fiscal 2004 we realized a $3.0 million benefit fromthe sale of inventory previously written down, as compared to a benefit of$5.6 million realized in fiscal 2003. We also realized a 

45

----

$1.9 million benefitfrom the reduction of warranty reserves in the fourth quarter of 2004. Thebenefit from the reduction of warranty reserves represented changes inestimates due to the ongoing re-evaluation of expected future warrantyrequirements. The increase in service gross profit as a percentage of servicerevenues was primarily due to the higher volume of service revenuesattributable to our increasing installed product base and a greater mix ofhigher margin professional and installation services.

***Research andDevelopment Expenses.******  ***Researchand development expenses were $36.2 million for fiscal 2004, an increaseof $4.0 million, or 12%, from $32.2 million in fiscal 2003. Theincrease primarily reflects an increase in salaries and related expensesassociated with increased headcount and increased costs associated with newproduct introductions, including project materials and third-party softwarecosts. These costs were partially offset by a reduction in depreciation expenseassociated with fully depreciated assets and a change in the methodology bywhich corporate-wide overhead costs are allocated.

***Sales and MarketingExpenses.******  ***Salesand marketing expenses were $35.0 million for fiscal 2004, an increase of$11.8 million, or 51%, from $23.2 million in fiscal 2003. Theincrease is due primarily to increases in salaries and travel costs associatedwith increased headcount, increases in commissions due to higher revenues,shipments of evaluation equipment to potential customers and increased tradeshow and promotional activity in 2004.

***General andAdministrative Expenses.******  ***Generaland administrative expenses were $24.6 million for fiscal 2004, anincrease of $14.1 million, or 134%, from $10.5 million in fiscal2003. The increase primarily reflects the professional fees incurred as partof: our restatement and investigation into accounting matters, audit andinternal control improvement process; an increase in directors and officersinsurance costs; and, to a lesser extent, increases in salaries and relatedexpenses associated with increased headcount and a change in the methodology bywhich corporate-wide overhead costs are allocated, partially offset byreductions in depreciation expense due to fully depreciated assets.

***Stock-basedCompensation Expenses.******  ***Stock-basedcompensation expenses were $671,000 for fiscal 2004, a decrease of$2.7 million, or 79%, from $3.4 million in fiscal 2003. The decreaseis primarily due to lowered deferred compensation balances resulting from ourpolicy of accelerating amortization of deferred compensation under FIN 28.

***Amortization ofPurchased Intangible Assets.******  ***Amortizationof purchased intangible assets was $2.4 million for both fiscal 2004 and2003 related to certain intellectual property, in-process research anddevelopment and intangible assets in connection with our acquisitions of TTIand Linguateq.

***Interest Income,net.******  ***Interest income, net of interestexpense, was $3.8 million for fiscal 2004, an increase of $2.3 millionfrom $1.5 million in fiscal 2003. The increase primarily reflects thebenefit of the increase in our marketable debt securities balances from the proceeds from our public offerings ofcommon stock in April and September of 2003 and an increase in ouryield on our portfolio due to an increasing interest rate environment.

***Income Taxes.******  ***Provisions forincome taxes in the amounts of $687,000 in 2004 and $302,000 in 2003 have beenrecorded, which are primarily attributable to foreign income taxes and stateand federal minimum income taxes in the U.S. Our effective tax rate is notmeaningful due to net operating loss carryforwards which reduce current taxableincome.

**Off-Balance Sheet Arrangements**

We have no off-balancesheet arrangements that have or are reasonably likely to have a current orfuture material effect on our financial position, changes in financialposition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources.

46

----

**Liquidity and Capital Resources**

At December 31, 2005, our principal source ofliquidity was our cash, cash equivalents, marketable debt securities andlong-term investments that totaled $314.2 million.

Our cash flow from operating activities was$9.2 million in fiscal 2005, as compared to $11.1 million in fiscal2004. The decrease in cash provided by operating activities in 2005 wasprimarily due to lower net income for fiscal 2005 as compared to the prioryear, increases in accounts receivable, inventory and other current assets,partially offset by increases in deferred revenue, accounts payable and accruedexpenses.

Net cash provided by investing activities was$18.4 million for fiscal 2005, as compared to net cash used in investingactivities of $28.1 million for fiscal 2004. Net cash provided byinvesting activities for fiscal 2005 primarily reflects net maturities ofmarketable debt securities and long-term investments of $32.6 million andcapital expenditures of $14.2 million. Net cash used in investingactivities for fiscal 2004 primarily reflects net purchases of marketable debtsecurities of $19.5 million and purchases of property and equipment of$9.0 million. We expect approximately $12.0 to $15.0 million incapital expenditures during fiscal 2006.

Net cash provided by financingactivities was $6.7 million for fiscal 2005, as compared to$5.2 million for fiscal 2004. The net cash provided by financingactivities for both periods resulted primarily from the sale of common stock inconnection with our employee stock purchase plan and proceeds from the exerciseof stock options.

Thefollowing summarizes our future contractual obligations, both principle andinterest, as of December 31, 2005, in thousands:

| ** **                   | ** ** | **Payment Due By Period** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **Total**                                | ** ** | **2006** | ** ** | **2007 and   2008** | ** ** | **2009 and   2010** | ** ** |
| **Contractual Obligations:** |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Long-term  debt obligations  |       | $                                        | 10,238     |   | $ | 10,238 |   |   | $ | — |   |   |   | $ | — |   |   |
| Capital lease  obligations   |       | 127                                      |       | 55 |   |   | 69 |   |   |   | 3 |   |   |
| Operating lease  obligations |       | 5,782                                    |       | 1,998 |   |   | 2,332 |   |   |   | 1,452 |   |   |
| Purchase  commitments        |       | 26,511                                   |       | 26,511 |   |   | — |   |   |   | — |   |   |
| Total                        |       | $                                        | 42,658     |   | $ | 38,802 |   |   | $ | 2,401 |   |   |   | $ | 1,455 |   |   |

 

In February 2006, we entered into a lease to moveour corporate headquarters to Westford, Massachusetts. The sublease iseffective January 2007 and expires in July 2012. Future contractualobligations under the lease are approximately $1.2 million annually from 2007-2011and $670,000 in 2012.

Based on currentexpectations, we believe our current cash, cash equivalents, marketable debtsecurities and long-term investments will be sufficient to meet our anticipatedcash needs for working capital and capital expenditures for at least12 months. In addition, we have a convertible subordinated note with acustomer that is due to mature on May 1, 2006 for which we expect to makea payment of $10,000,000 plus accrued interest. Although it is difficult topredict future liquidity requirements with certainty, the rate at which we willconsume cash will be dependent on the cash needs of future operations,including changes in working capital, which will, in turn, be directly affectedby the levels of demand for our products, the timing and rate of expansion ofour business, the resources we devote to developing our products and anylitigation settlements. We anticipate devoting substantial capital resources tocontinue our research and development efforts, to maintain our sales, supportand marketing, to improve our controls environment and for other generalcorporate activities, as well as to vigorously defend against existing andpotential litigation. See Note 8 to our consolidated financial statements.

47

----

***Recent Accounting Pronouncements***

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs, an Amendment of AccountingResearch Bulletin (ARB) No. 43, Chapter 4.*SFAS No. 151amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing” toclarify that abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage) should be recognized as current-periodcharges. In addition, SFAS No. 151 requires that allocation of fixedproduction overhead to the costs of conversion be based on the normal capacityof the production facilities. The provisions of SFAS No. 151 areeffective for fiscal years beginning after June 15, 2005. The adoption ofSFAS No. 151 will not have a material impact on our financialposition, results of operations or cash flows.

In December 2004, theFASB issued SFAS 123(R), *Share-BasedPayment*, which revises SFAS No. 123, *Accounting for Stock-Based Compensation*, supersedesAPB Opinion No. 25, *Accounting forStock Issued to Employees* and its related interpretations, andamends SFAS No. 95, *Statement of CashFlows*. SFAS 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe income statement based on their fair values at the date of grant. Pro formadisclosure is no longer an alternative. SFAS 123(R) is effective forfiscal years beginning after June 15, 2005. We adopted SFAS 123(R) onJanuary 1, 2006. SFAS 123(R) permits public companies to adoptits requirements using one of two methods: a “modified prospective” method, inwhich compensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS 123(R) for all share-based paymentsgranted after the effective date, and (b) based on the requirements ofSFAS 123 for all awards granted to employees prior to the effective dateof SFAS 123(R) that remain unvested on the effective date; or a “modifiedretrospective” method, which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS 123 for purposes of proforma disclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption. We will be using the modifiedprospective method in adopting SFAS 123(R). As a result of the adoption ofSFAS 123(R), we expect stock-based compensation expense to reduce basic anddiluted net income per share by approximately $0.03 to $0.05 per share for theyear ending December 31, 2006. However, our assessment of the estimatedcompensation charges is affected by our stock price as well as assumptionsregarding a number of complex and subjective variables and the related taximpact. These variables include, but are not limited to, the volatility of ourstock price and employee stock option exercise behaviors.  The adoption of SFAS 123(R) willhave no material impact on our net cash flows or overall financial position.

**Explanationof Use of Non-GAAP Financial Results**

In addition to our audited financial results whichhave been prepared in accordance with accounting principles generally acceptedin the United States of America (GAAP), to assist investors we may on occasionprovide certain non-GAAP financial results as an alternative means to explainour periodic results. The non-GAAP financial results typically may excludenon-cash, stock compensation expense or one-time charges or benefits.

Our management uses the non-GAAP financial resultsinternally as an alternative means for assessing our results of operations. Byexcluding non-cash charges such as stock-based compensation, amortizationof purchased intangible assets, impairment of goodwill and purchased intangibleassets and in-process research and development expenses, our management canevaluate our operations excluding these non-cash charges and can compare itsresults on a more consistent basis to the results of other companies in ourindustry. By excluding one-time charges such as restructuring charges(benefits) and inventory write-offs, our management can compare our ongoingoperations to prior quarters where such items may be materially different andto ongoing operations of other companies in our industry who may havematerially different one-time charges. Our management recognizes that non-GAAPfinancial results are not a 

48

----

substitute for GAAPresults, and believes that non-GAAP measures are helpful in assisting them inunderstanding and managing our business.

Our management believes that the non-GAAP financialresults may also provide useful information to investors. Non-GAAP results mayalso allow investors and analysts to more readily compare our operations toprior financial results and to the financial results of other companies in theindustry who similarly provide non-GAAP results to investors and analysts.Investors may seek to evaluate our business performance and the performance ofour competitors as they relate to cash. Excluding one-time and non-cash chargesmay assist investors in this evaluation and comparisons.

We intend to continue toassess the potential value of reporting non-GAAP results consistent withapplicable rules and regulations.

**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

This report contains forward-looking statementsthat involve substantial risks and uncertainties. In some cases you canidentify these statements by forward-looking words such as “anticipate,”“believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,”and “would” or similar words. You should read statements that contain thesewords carefully because they discuss future expectations, contain projectionsof future results of operations or of financial position or state other“forward-looking” information. The important factors listed above in thesection captioned “Item 1A. Risk Factors,” as well as any cautionary languagein this report, provide examples of risks, uncertainties and events that maycause the actual results to differ materially from the expectations describedin these forward-looking statements. You should be aware that theoccurrence of the events described in the risk factors and elsewhere in thisreport could have a material adverse effect on our business, results of operationsand financial position.

Any forward-lookingstatements in this report are not guarantees of future performances, and actualresults, developments and business decisions may differ from those anticipatedby such forward-looking statements, possibly materially. We disclaim anyduty to update any forward-looking statements, all of which are expresslyqualified by the statements in this section.

**ITEM7A.**        QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK.

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

Exposure to market rate risk for changes in interestrates relates to our investment portfolio. We have not used derivativefinancial instruments in our investment portfolio. We place our investmentswith high-quality issuers and have policies limiting, among other things, theamount of credit exposure to any one issuer. We seek to limit default risk by purchasingonly investment-grade securities. We manage potential losses in fair value byinvesting in relatively short term investments thereby allowing us to hold ourinvestments to maturity. Our investments have an average remaining maturity ofapproximately three months and are primarily fixed-rate debt instruments. Basedon a  hypothetical 10% adverse movementin interest rates, the potential losses in future earnings and cash flows areestimated to be $1,300,000.

Beginning in the thirdquarter of 2005, we entered into foreign exchange contracts to hedge againstcurrency fluctuations related to a particular account receivable and ordersdenominated in Japanese Yen. Such transactions do not qualify for hedgeaccounting. The foreign exchange exposure from a 10% movement of currencyexchange rates on our financial position is not significant. Based on a hypothetical10% adverse movement in all foreign currency exchange rates, our revenue wouldnot be materially affected and our net income would be adversely affected byapproximately $200,000 although the actual effects may differ materially fromthe hypothetical analysis.

49

----

**ITEM8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA.

The consolidated financialstatements of Sonus Networks, Inc. are filed as a part of this AnnualReport on Form 10-K beginning on page F-1 and areincorporated herein by reference.

**ITEM9.**                CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

None.

**ITEM9A.**        CONTROLS AND PROCEDURES

**Remediationof Previously Reported Material Weaknesses in Internal Control over FinancialReporting**

In Item 9A (Controls andProcedures) of our Annual Report on Form 10-K for the year ended December 31,2004, we reported ten (10) material weaknesses in our internal controlover financial reporting (as defined in Rule 13a-15(f) underthe Securities Exchange Act of 1934 (the Exchange Act)). As a result of thesematerial weaknesses in our internal control over financial reporting, weconcluded that our disclosure controls and procedures were not effective as of December 31,2004. These material weaknesses included both entity-level controlweaknesses as well as weaknesses in process, transaction and applicationcontrols as defined in the Committee of Sponsoring Organizations of theTreadway Commission (COSO) criteria.

In an effort to remediatethese material weaknesses, in 2005, we made changes that materially affectedour internal control over financial reporting, including several that occurredduring the quarter ended December 31, 2005. We have taken and continue totake significant steps to improve our overall control over financial reporting.As discussed below, of the ten (10) material weaknesses noted in ourreport as of December 31, 2004, seven (7) of these items, while stillrequiring additional work and focus to address remaining deficiencies, aresufficiently improved that they no longer constitute material weaknesses as of December 31,2005.  In addition, within the three (3) itemswhich we believe still constitute material weaknesses, we have made significantimprovement and a number of material changes to controls within those areas. Adiscussion of the material changes and their impact on our previously reportedmaterial weaknesses is as follows:

***1.   Inadequateentity-level controls***

In ourreport as of December 31, 2004, we reported ineffective entity levelcontrols as defined in the COSO framework, including weaknesses (i) in thecontrol environment, (ii) in risk assessment controls, (iii) overcontrol activities, (iv) over information and communication controls, and (v) inmonitoring controls. We have made the following material changes to our entitylevel controls:

·       Madeand continue to make improvements to our entity level controls including,ongoing communications from senior management to employees regarding theimportance of internal controls, the development and issuance of key policiesover authorization and approval of transactions and expenditures, revisions touser access privileges and job responsibilities and the addition of accounting,finance and information systems resources to further improve the level ofexperience and quality of our systems in these departments.

·       Hiredadditional personnel in our accounting, finance and information systemsorganizations, including a Chief Information Officer (CIO) who started in December of2005, information systems business analyst, revenue controllers and an externalreporting manager, to increase the overall expertise of our personnel in thesedepartments, provide reasonable assurance of compliance with our policies ontransaction approval, and to improve segregation of duties. Where necessary, weengaged outside experts to address significant matters relating to internalcontrol, accounting and financial reporting issues.

50

----

·       Weconduct weekly meetings among the Chief Operating Officer, Chief FinancialOfficer, Corporate Controller, Vice President Business Operations and InternalAudit Director to monitor the implementation of the corrective action plan toaddress our control deficiencies and make decisions to execute the plan. Thesemeetings have been and will continue to be ongoing as we implement ourremediation plans.

·       Weconduct regular meetings with the Audit Committee to review the implementationof the corrective action plan. These meetings have been and will continue to beongoing as we implement our remediation plans.

·       Implementeda required process of annual certifications from our worldwide employee base ofcompliance with our code of conduct.

·       Implementedan annual ethics-training program for the worldwide employee base,conducted ethics training for all new employees and established in January 2006an anonymous hotline for code of conduct complaints.

·       Instituteda process of obtaining certifications from our sales force regarding the statusof our customer arrangements.

·       Institutedenhanced business planning and forecasting processes to help provide reasonableassurance that financial, operational, regulatory, compliance and commercialrisks are identified and addressed. Periodic business reviews are conductedwith functional managers that specifically highlighted risks to achievement ofstated objectives. We prepare a formal risk assessment document analyzing risksover financial reporting to provide reasonable assurance that appropriatemitigating actions are taken to address identified risks.

·       Aspart of the annual assessment of internal control over financial reporting,business process owners now complete a “Control and Risk Assessment,” whichidentifies key controls and financial reporting risks. As part of thisassessment, business process fraud risk is specifically considered, with aparticular focus on account balances, classes of transactions or operatinglocations for which a risk of fraud may be more likely to exist, includingnon-routine transactions, significant judgments and estimates or accounts that couldbe subject to management override. As noted below, there continue to bedeficiencies in this area such that entity-level controls is still consideredto be a material weakness.

·       Enhancedour enterprise resource planning (ERP) software functionality to streamline andautomate key business processes and provide a more defined documentation andapproval trail, which was implemented in the four quarter of 2005.

·       ImplementedCOBIT-based IT general controls, including controls over application developmentand change management, problem management and access controls.

·       Implementednew security measures to restrict access to our headquarters facility.

·       Developedan internal audit plan related to the Company as a whole and performed auditsof the two most significant remote locations to provide reasonable assurancethat company level controls were operating effectively.

·       Conductedan employee survey to help understand employee’s perceptions of our controlenvironment and developed an action plan to identify necessary improvements. Weintend to continue to monitor our workforce through the use of surveys,interviews, meetings and other tools.

Although significant stepshave been taken in this area, many of the changes made to our entity levelcontrols were implemented late in the year.  In addition, further work is required todevelop appropriate controls in some aspects of entity level control to providereasonable assurance that controls are designed 

51

----

in the most effective andefficient manner possible. Therefore, while we believe these changes will beeffective at mitigating risk of material error, there continues to beadditional work required for us to conclude that all five of these controlareas are operating effectively. Therefore, as noted in *Management’sReport on Internal Control over Financial Reporting* below, weconsider three of the areas within entity level control to collectivelyconstitute a material weakness.

***2.***   Inadequate businessprocesses and information systems.

·       Enhancedour Oracle ERP software functionality to streamline and automate key businessprocesses and provide a more well-defined documentation and approval trail,which was completed in the fourth quarter of 2005.

·       Implementeda new sales forecasting tool and process to more accurately quantify potentialbookings and to support material requirements purchases.

·       Hireda Vice President of Internal Business Operations, a new senior managementposition, to assist with implementing the changes to our infrastructure andrelated processes to address the deficiencies underlying the materialweaknesses described in our Annual Report on Form 10-K for the yearended December 31, 2004.

·       Hiredadditional personnel in our accounting, finance and information systemsorganizations, including an information systems business analyst, revenuecontrollers and external reporting manager, to increase the overall expertiseof our personnel in these departments and improve segregation of duties.

·       Designed and implemented system-based detailsub-ledgers related to revenue, deferred revenue, costs of revenue andinventory transactions to help provide reasonable assurance that balances areproperly summarized and posted to our general ledger.

***3.   Inadequaterevenue recognition procedures and controls.***

·       Hiredrevenue controllers with relevant industry experience to evaluate our customerarrangements and apply relevant revenue-recognition criteria.

·       Hireda sales operations director.

·       Implementeda program to conduct ongoing training sessions for our sales and marketing,finance and professional services organizations regarding revenue recognition rules andbest practices.

·       Establisheda bids and proposals group to add visibility, structure and consistency toproposals for major customer engagements. Implemented a process for executivelevel deal review on large and/or complex deals.

·       Updatedour Revenue Recognition Policy and Bookings Policy and implemented a ContractReview and Approval Policy and a Credit Review and Approval Policy to formallydocument our policies and practices related to acceptance of quotes and orders,the granting of credit, the execution of contracts and the recognition ofrevenue.

·       Designedand implemented a quote and proposal review and approval process which providesan enhanced level of management and cross-functional review for customer quotesand proposals before submission to our customers, captures the relevant data toidentify all commitments made to customers for our financial reporting anddefine, automates and documents the required approvals.

·       Enhancedour process of analyzing and documenting customer arrangements to help providereasonable assurance that all elements of the deal are understood, documented,reconciled to accounting records and properly assessed for revenue recognition.

52

----

·       Enhancedand implemented processes and controls to help identify other commitments andconcessions, including quarterly review of maintenance renewals and “vendorspecific objective evidence” of maintenance services, a new tracking system tohelp provide reasonable assurance that all commitments to customers for futurefeature development are adequately reviewed, approved, captured and reportedand review and approval of evaluation equipment provided to customers.

·       Establisheda lockbox for receipt of customer payments to help provide reasonable assurancethat we have appropriate segregation of responsibilities between custody andrecording of cash receipts.

·       Designedand implemented system-based detail sub-ledgers related to revenue, deferredrevenue, costs of revenue and inventory transactions to help provide reasonableassurance that balances are properly summarized and posted to our generalledger.

Although significant stepshave been taken in this area, many of the changes made to our revenuerecognition procedures and controls were implemented late in the year. Therefore,while we believe they will be effective at mitigating risk of material error,there has been insufficient time for us to conclude that they are operatingeffectively. Therefore, as noted in *Management’s Report onInternal Control over Financial Reporting*below, we consider thisarea to still be a material weakness.

***4.***   Inadequate segregationof duties and information systems users.

·       Redesignedand restructured the finance organization to better align duties andresponsibilities and enhance segregation of duties.

·       Hiredadditional, experienced personnel in our accounting, finance and informationsystems organizations, including an information systems business analyst,revenue controllers and an external reporting manager, to increase the overallexpertise of our personnel in these departments and improve segregation ofduties.

·       Implemented policiesrequiring that business process owners review system user access permissionssemi-annually and update as required. In addition, business process owners, aspart of their ongoing internal control assessment, assess each employee’s jobresponsibilities to provide reasonable assurance that proper segregation ofduties is in place. User profiles and roles and responsibilities were changedas required so that proper segregation of duties could be assured. We continueto work in this area to remediate remaining significant deficiencies.

***5.   Inadequatefinancial statement preparation and review procedures.***

·       Implementedprocesses to improve the financial reporting of our business at the close ofeach quarter, including the issuance of policies and procedures coveringaccount reconciliations, journal entries, supporting documentation and analysisfor all key accounts.

·       Addedto our review procedures on, and documentation of, our accounts, including thepreparation of memoranda to support our significant judgments and estimateseach quarter.

·       Assessedour international accounting services providers and engaged new firms. Modifiedthe monthly reporting packages from our subsidiaries and implemented reviewprocedures each month to help provide reasonable assurance that amounts arefairly stated in accordance with our policies.

·       Hireda Chief Financial Officer, a Tax Director, a Manufacturing and ServicesController and a Manager of External Reporting, as well as other experiencedpersonnel into our finance and accounting organization.

·       Implementedprocesses and procedures related to reserves and accruals including enhancingthe level of analysis and supporting documentation for amounts reported in thefinancial statements.

53

----

·       Implementedprocesses and procedures to help provide reasonable assurance that inventoryaccounts are properly analyzed and that any resulting adjusting entries areaccurately and timely recorded in our general ledger and then our financialstatements.

·       Automatedroyalty accounting and manufacturing overhead accounting, which was implementedin the fourth quarter of 2005.

·       Implementedcontrols to address deficiencies related to the payroll cycle, which wereimplemented in the fourth quarter of 2005.

·       Beganthe process to analyze and identify all key transaction flows and designed anddocumented control objectives and activities for each significant transactionalflow. As a result, we now have twelve (12) major business processes for whichdocumentation and design steps are underway.

Although significant stepshave been taken in this area, many of the changes made to our controls in thisarea were implemented late in the year. In addition, further work is requiredto develop appropriate controls in some aspects of control over our financialstatement preparation and review process to provide reasonable assurance thatcontrols are designed in the most effective and efficient manner possible. Therefore,while we believe these changes will be effective at mitigating risk of materialerror, there continues to be additional work required for us to conclude thatreasonable assurance has been obtained that all controls are operatingeffectively. Therefore, as discussed in *Management’s Report onInternal Control over Financial Reporting* below, we consider thisarea to still be a material weakness.

***6.***   Inadequate controlsover cash receipts.

·       Implementedcontrols over cash receipts, including the implementation of a lockbox andreassignment of responsibilities to provide reasonable assurance that all cashis accurately and timely deposited and recorded in our general ledger.

·       Made changes in our cashreceipts processes to segregate the custody of cash receipts from the recordingresponsibilities.

***7.   Inadequatecontrols over equity transactions.***

·       Implementedenhanced documentation and review and supervision processes and procedures overequity-related reconciliations and analyses, to provide reasonable assurancethat equity transactions are being properly monitored.

·       Established a Stock Compensation Committee tocoordinate the efforts of our finance, legal and human resources departments inreviewing and addressing stock compensation issues and to assist and makerecommendations to the Compensation Committee of our Board of Directors onstock compensation issues.

***8.   Inadequatepurchasing controls.***

·       Implementedan automated procurement tool, which routes purchasing requests to appropriatelevels of management for approval based on an authorization matrix. Alsoimplemented functionality to “auto populate” the purchase order from theapproved requisition to provide reasonable assurance of the accuracy andvalidity of purchase orders.

·       Implementeda Signature Authorization Policy outlining specific authority prior to anycommitment of our funds for various classes of transactions. This policy isbeing communicated and enforced worldwide.

·       Implementeda new sales forecasting tool and process to more accurately quantify potentialbookings, to support material requirements purchases and to formalize authorizationrequirements 

54

----

for procurement ofproduction materials. Implemented a materials resource planning softwareprogram to help automate the materials requirements planning process.

·       Reassignedroles and responsibilities to provide reasonable assurance of the propersegregation of duties within the Purchasing, Manufacturing and Accounts Payablefunctions. Updated ERP user permissions to align with job responsibilities tominimize the risk that an error could occur and not be detected. These changeswere implemented in the fourth quarter of 2005.

·       Created reports andimplemented processes to monitor changes to vendor master files, open purchaseorder reports, purchase orders created without approved requisitions and otheractivities. These changes were implemented in the fourth quarter of 2005.

***9.   Inadequatecontrols over inventory and cost of revenues.***

·       Hireda Manufacturing and Services Controller and two cost accountants.

·       Implementedprocesses and procedures related to reserves and accruals, including enhancingthe level of analysis, system reports and other supporting documentation foramounts reported in the financial statements.

·       Implementedprocesses and procedures to provide reasonable assurance that inventoryvaluation accounts are properly analyzed and that any resulting adjusting entriesare accurately and timely recorded in our general ledger.

·       Enhancedprocesses and controls to provide reasonable assurance that cost of goods soldis recorded in the period in which the related revenue is recognized.

·       Establishedimproved receiving and shipping controls and cutoff procedures for receipts andshipments to provide reasonable assurance of recording in the proper period.

·       Automatedroyalty accounting and manufacturing overhead accounting, which was implementedin the fourth quarter of 2005.

·       Enhanced physical inventoryprocedures and controls. Implemented monthly confirmation procedures withcontract manufacturers and spares hubs, which was implemented in the fourthquarter of 2005.

***10.   Inadequateinformation systems procedures and controls.***

·       Implementedprocesses and procedures over our information systems control environmentintended to provide assurance that changes to financial applications areproperly authorized and tested and that access to our information systems andfinancial applications are appropriately restricted including a networkspassword policy.

·       Establishedan IT Audit and Security function to provide reasonable assurance that changesto financial applications are properly authorized and tested and that access toour information systems and financial applications are appropriatelyrestricted.

·       Updatedour information systems user profiles to improve access controls.

·       Implementedimprovements to our information systems to further address controldeficiencies.

55

----

**Evaluationof Disclosure Controls and Procedures as of December 31, 2005**

Our management, with the participation of ourprincipal executive officer and principal financial officer, has evaluated theeffectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934 (the Exchange Act)) as of December 31,2005, which included an evaluation of disclosure controls and proceduresapplicable to the period covered by the filing of this periodic report. Theterm “disclosure controls and procedures,” as defined in Rule 13a-15(e),means controls and other procedures of a company that are designed to ensurethat information required to be disclosed by a company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms. Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is accumulated andcommunicated to the company’s management, including its principal executive andprincipal financial officers, as appropriate to allow timely decisionsregarding required disclosure.

As described in our accompanying *Management’sReport on Internal Control over Financial Reporting*, we haveidentified three (3) remaining material weaknesses in internal controlover financial reporting. Because of these remaining material weaknesses, weconcluded that, as of December 31, 2005, our internal control overfinancial reporting was not effective based on the criteria outlined in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission. Accordingly,we have also concluded that our disclosure controls and procedures were noteffective as of December 31, 2005.

We intend to implement procedures and controls in 2006to remediate the remaining material weaknesses to our entity level, revenuerecognition, and financial statement preparation and review procedures andcontrols. In addition, we will continue to make additional changes to ourinfrastructure and related processes that we believe are also reasonably likelyto strengthen and materially affect our internal control over financialreporting.

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

The certifications of ourprincipal executive officer and principal financial officer required inaccordance with Rule 13a-14(a) under the Exchange Act and Section 302of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this AnnualReport on Form 10-K. The disclosures set forth in this Item 9Acontain information concerning (i) the evaluation of our disclosurecontrols and procedures, and changes in internal control over financialreporting, referred to in paragraph 4 of the certifications, and (ii) materialweaknesses in the design or operation of our internal control over financialreporting, referred 

56

----

to in paragraph 5of the certifications. Those certifications should be read in conjunction withthis Item 9A for a more complete understanding of the matters covered by thecertifications.

**Management’sReport on Internal Control Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rule 13a-15(f). Under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, we conducted an evaluation of the effectiveness ofour internal control over financial reporting as of December 31, 2005based on the framework in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO).

Based on our assessment, we identified the followingmaterial weaknesses in our internal control over financial reporting as of December 31,2005. As defined in the COSO framework, these material weaknesses include bothentity-level control weaknesses as well as weaknesses in process,transaction and application controls. The nature of each of these materialweaknesses in our internal control over financial reporting is described belowalong with the actual or potential effects on our financial statements issuedduring the existence of the material weakness.

***Inadequate entity-levelcontrols.******  ***(1) Risk Assessment—We haveestablished a risk assessment process, driven by management and the board ofdirectors intended to identify and address risks faced by the Company. However,this process is not yet comprehensive of all risks faced by the Company, suchas risk of fraud or management override, and is not yet fully functional. Therefore,we are unable to obtain evidence sufficient to provide reasonable assurancethat these controls are operating effectively, or that our risk programs areadequately addressing our identified control objectives. (2) Informationand Communication—We have ineffective communication and information flowthroughout the organization to provide reasonable assurance that appropriateinformation is disseminated to all employees in order for them to understandour corporate policies thoroughly, and to understand and accomplish theirassigned duties, including their internal control responsibilities. (3) Monitoring—Wehave ineffective monitoring controls to provide reasonable assurance thatadequate oversight of our business is maintained, including remote and foreignlocations.

***Inadequate revenuerecognition procedures and controls.******  ***Certain of oursystems and controls related to understanding and documenting our customerarrangements to provide reasonable assurance that our revenue recognitioncriteria are satisfied and that all undelivered elements have beendelivered prior to revenue being recognized have not been in place for asufficient period of time for us to confirm the effectiveness of theiroperation. In addition, we have not yet made fully operational certaintransaction processing control elements of our revenue cycle that will providereasonable assurance that all control objectives are met relating to theaccurate and timely generation and recording of all invoices and customercredit memos and the timely and accurate application of cash receipts tocustomer accounts.

Material post-closing adjustments related to revenuereflected in the accompanying consolidated financial statements for the yearended December 31, 2005, had the effect of materially decreasing revenue,decreasing cost of revenues, and increasing deferred revenue.

***Inadequate financial statement preparation and reviewprocedures.******  ***Certain of our procedures and controlsrelating to financial statement preparation and review are not yet fullyeffective or have not been fully tested in their operation to providereasonable assurance that the following control objectives have been met:

·       thecompleteness, accuracy and review of transactions, account reconciliations, andjournal entries recorded in our financial statements, including monitoring oftransactions occurring at our foreign subsidiaries;

57

----

·       theappropriate presentation of investments in our consolidated balance sheets andstatements of cash flow;

·       the validity, completenessand accuracy of property and equipment and accumulated depreciation balances inour general ledger and financial statements;

·       the validity, completeness,accuracy and proper financial statement presentation of commission transactionsin our general ledger and financial statements;

·       the completeness, accuracy,review and timely recording of tax transactions in our general ledger andfinancial statements and assessment of potential tax exposure;

·       the accuracy andreconciliation of manual spreadsheets and the related access controls; and

·       theoverall appropriate design and documentation of controls for all businessprocess cycles.

Material post-closing adjustments reflected in theaccompanying consolidated financial statements for the year ended December 31,2005, had the effect of  materiallyreducing cash and increasing marketable securities, increasing accountsreceivable, inventory, other current assets, reducing property and equipment,reducing certain accrued expenses, increasing deferred revenue and decreasingother long-term obligations. In addition, they had the effect of materiallyreducing revenue, decreasing cost of revenues and operating expenses anddecreasing net income.

Because of the material weakness described above,management concluded that, as of December 31, 2005, our internal controlover financial reporting was not effective based on the criteria established in*Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that: (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis. Also, projectionsof any evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

Management’s assessment of the effectiveness of ourinternal control over financial reporting as of December 31, 2005 has beenaudited by Deloitte & Touche LLP, an independent registered publicaccounting firm, as stated in their report, which is included on pages 59-61 ofthis Annual Report on Form 10-K.

58

----

**Report of Independent Registered Public AccountingFirm**

To the Board of Directors and Stockholders ofSonus Networks, Inc.:

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control over Financial Reporting,that Sonus Networks, Inc. and subsidiaries (the “Company”) did notmaintain effective internal control over financial reporting as of December 31,2005, because of the effect of the material weaknesses identified in management’sassessment based on criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission. The Company’s management is responsible for maintainingeffective internal control over financial reporting and for its assessment ofthe effectiveness of internal control over financial reporting. Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the Company’s internal control over financialreporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operating effectivenessof internal control, and performing such other procedures as we considerednecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinions.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of the company;and (3) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis. Also, projectionsof any evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

A material weakness is a significant deficiency, orcombination of significant deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. The following material weaknesseshave been identified and included in management’s assessment:

***Inadequate entity-levelcontrols.******  ***(1) Risk Assessment—The Company hasestablished a risk assessment process, driven by management and the board ofdirectors intended to identify and address risks faced by the Company. However,this process is not yet comprehensive of all risks faced by the Company, suchas risk of fraud or management override, and is not yet fully functional. Therefore,the Company is unable to 

59

----

obtain evidence sufficientto provide reasonable assurance that these controls are operating effectively,or that its risk programs are adequately addressing their identified controlobjectives. (2) Information and Communication—The Company has ineffectivecommunication and information flow throughout the organization to providereasonable assurance that appropriate information is disseminated to allemployees in order for them to understand the Company’s corporate policiesthoroughly, and to understand and accomplish their assigned duties, includingtheir internal control responsibilities. (3) Monitoring—The Company hasineffective monitoring controls to provide reasonable assurance that adequateoversight of its business is maintained, including remote and foreignlocations.

***Inadequate revenuerecognition procedures and controls.******  ***Certain of theCompany’s systems and controls related to understanding and documenting itscustomer arrangements to provide reasonable assurance that its revenuerecognition criteria are satisfied and that all undelivered elements havebeen delivered prior to revenue being recognized have not been in place for asufficient period of time for the Company to confirm the effectiveness of theiroperation. In addition, the Company has not yet made fully operational certaintransaction processing control elements of its revenue cycle that may providereasonable assurance that all control objectives are met relating to theaccurate and timely generation and recording of all invoices and customercredit memos and the timely and accurate application of cash receipts tocustomer accounts.

Material post-closing adjustments related to revenuereflected in the accompanying consolidated financial statements for the yearended December 31, 2005, had the effect of materially decreasing revenue,decreasing cost of revenues, and increasing deferred revenue.

***Inadequate financial statement preparation and reviewprocedures.******  ***Certain of the Company’s proceduresand controls relating to financial statement preparation and review are not yetfully effective or have not been fully tested in their operation to providereasonable assurance that the following control objectives have been met:

·       thecompleteness, accuracy and review of transactions, account reconciliations, andjournal entries recorded in the financial statements, including monitoring oftransactions occurring at foreign subsidiaries;

·       theappropriate presentation of investments in the consolidated balance sheets andstatements of cash flow;

·       the validity, completenessand accuracy of property and equipment and accumulated depreciation balances inthe general ledger and financial statements;

·       the validity, completeness,accuracy and proper financial statement presentation of commission transactionsin the general ledger and financial statements;

·       the completeness, accuracy,review and timely recording of tax transactions in the general ledger and financialstatements and assessment of potential tax exposure;

·       the accuracy andreconciliation of manual spreadsheets and the related access controls; and

·       theoverall appropriate design and documentation of controls for all businessprocess cycles.

Material post-closing adjustments reflected in theaccompanying consolidated financial statements for the year ended December 31,2005, had the effect of materially reducing cash and increasing marketablesecurities, increasing accounts receivable, inventory, other current assets,reducing property and equipment, reducing certain accrued expenses, increasingdeferred revenue and decreasing other long-term obligations. In addition, theyhad the effect of materially reducing revenue, decreasing cost of revenues andoperating expenses and decreasing net income.

60

----

These material weaknesses were considered indetermining the nature, timing, and extent of audit tests applied in our auditof the consolidated financial statements of the Company as of and for the yearended December 31, 2005, and this report does not affect our report onsuch financial statements.

In our opinion, management’s assessment that theCompany did not maintain effective internal control over financial reporting asof December 31, 2005, is fairly stated, in all material respects, based onthe criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission. Also in our opinion, because of the effect of the materialweaknesses described above on the achievement of the objectives of the controlcriteria, the Company has not maintained effective internal control overfinancial reporting as of December 31, 2005, based on the criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated financial statements of the Company as of andfor the year ended December 31, 2005, and our report dated March 13,2006 expressed an unqualified opinion on those financial statements.

/s/ Deloitte &Touche LLPBoston, MassachusettsMarch 13, 2006

61

----

**ITEM 9B.**       OTHERINFORMATION

None.

62

----

**PART III**

**ITEM 10.**         DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT.

A portion of theinformation required by this Item 10 is included in Part I of this AnnualReport on Form 10-K under the caption “Executive Officers of theRegistrant” and is incorporated herein by reference. The remaining informationrequired by this Item 10 is included under the captions “Election of Directors,”“Section 16(a) Beneficial Ownership Reporting Compliance,” “Code ofBusiness Conduct and Ethics” and “Board Meetings and Committees” in ourdefinitive Proxy Statement with respect to our 2006 Annual Meeting ofShareholders to be filed with the SEC not later than 120 days after theend of the fiscal year and is incorporated herein by reference.

**ITEM 11.**         EXECUTIVECOMPENSATION.

The information requiredby this Item 11 is included under the captions “Director Compensation,” “Summaryof Executive Compensation,” “Stock Option Grants,” “Option Holdings,” “Employmentand Change-in-Control Arrangements” and “Compensation Committee Interlocks andInsider Participation” in our definitive Proxy Statement with respect to our2006 Annual Meeting of Shareholders to be filed with the SEC not later than120 days after the end of the fiscal year and is incorporated herein byreference.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS.

The information requiredby this Item 12 is included under the captions “Beneficial Ownership ofSecurities” and “Equity Compensation Plan Information” in our definitive ProxyStatement with respect to our 2006 Annual Meeting of Shareholders to be filedwith the SEC not later than 120 days after the end of the fiscal year andis incorporated herein by reference.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS.

The information requiredby this Item 13 is included, as applicable, under the captions “Employment andChange-in-Control Agreements” and “Indemnification Agreements” in ourdefinitive Proxy Statement with respect to our 2006 Annual Meeting ofShareholders to be filed with the SEC not later than 120 days after theend of the fiscal year and is incorporated herein by reference.

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES.

The information requiredby this Item 14 is included under the captions “Fees for Independent RegisteredPublic Accounting Firm during Fiscal Years Ended December 31, 2005 and2004” and “Policy on Audit Committee Pre-approval of Audit and Non-auditServices” in our definitive Proxy Statement with respect to our 2006 AnnualMeeting of Shareholders to be filed with the SEC not later than 120 daysafter the end of the fiscal year and is incorporated herein by reference.

63

----

**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULES.

**Documentsfiled as part of this Annual Report on Form 10-K:**

**1)****               FinancialStatements.**

The following consolidated financial statements andnotes thereto are included in Part II, Item 8 filed as part of thisreport:

·       Reportsof Independent Registered Public Accounting Firms

·       ConsolidatedBalance Sheets

·       ConsolidatedStatements of Operations

·       ConsolidatedStatements of Stockholders’ Equity and Comprehensive Income (Loss)

·       ConsolidatedStatements of Cash Flows

·       Notesto Consolidated Financial Statements

**2)****               FinancialStatement Schedules.**

None. All schedules are omitted because they are notapplicable, not required under the instructions or because the information isreflected in the consolidated financial statements or notes thereto.

**3)****               Listof Exhibits.**

The Exhibits filed as part of this Annual Report on Form 10-Kare listed in the Exhibit Index immediately preceding such Exhibits, whichExhibit Index is incorporated herein by reference.

64

----

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, in the Town ofChelmsford, Commonwealth of Massachusetts, on this 13th day of March, 2006.

|        |   | SONUS NETWORKS, INC. |
|--------|--------|---------------------------|
|   |   | By:                       |   | /s/ HASSAN M. AHMED |
|   |   |                      |   | Hassan M. Ahmed |
|   |   |                      |   | *Chairman of the Board of Directors and Chief  Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated:

|                         | **Signature** | ** **                                                   | ** ** |                     | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|-------------------------|---------------|--------------------------------------------------------------|------------|---------------------|-----------|------------|------------|--|----------|------------|
| /s/ HASSAN M.  AHMED    |          | Chairman of the  Board of Directors and Chief                |       | March 13, 2006 |
| Hassan  M. Ahmed        |          | Executive Officer  (Principal Executive Officer)             |       |                |
| /s/ ELLEN B. RICHSTONE  |          | Chief Financial  Officer (Principal Financial                |       | March 13, 2006 |
| Ellen  B. Richstone     |          | Officer)                                                     |       |                |
| /s/ PAUL K.  MCDERMOTT  |          | Vice President of  Finance, Corporate Controller             |       | March 13, 2006 |
| Paul  K. McDermott      |          | and Chief Accounting  Officer (Principal Accounting Officer) |       |                |
| /s/ ALBERT A.  NOTINI   |          | President and  Chief Operating Officer, and                  |       | March 13, 2006 |
| Albert  A. Notini       |          | Director                                                     |       |                |
| /s/ EDWARD T.  ANDERSON |          | Director                                                     |       | March 13, 2006 |
| Edward  T. Anderson     |          |                                                         |       |                |
| /s/ JOHN P.  CUNNINGHAM |          | Director                                                     |       | March 13, 2006 |
| John  P. Cunningham     |          |                                                         |       |                |
| /s/ HOWARD E.  JANZEN   |          | Director                                                     |       | March 13, 2006 |
| Howard  Janzen          |          |                                                         |       |                |
| /s/ PAUL J.  SEVERINO   |          | Director                                                     |       | March 13, 2006 |
| Paul  J. Severino       |          |                                                         |       |                |
| /s/ H. BRIAN  THOMPSON  |          | Director                                                     |       | March 13, 2006 |
| H. Brian Thompson       |          |                                                         |       |                |

 

 

65

----

**SONUSNETWORKS, INC.**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                                                       | ** ** | **Page** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------|------------|
| Reports of Independent Registered Public Accounting  Firms                            |       |     | F-2        |   |   |
| Consolidated Balance Sheets                                                           |       |     | F-4        |   |   |
| Consolidated Statements of Operations                                                 |       |     | F-5        |   |   |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income (Loss) |       |     | F-6        |   |   |
| Consolidated Statements of Cash Flows                                                 |       |     | F-7        |   |   |
| Notes to Consolidated Financial Statements                                            |       |     | F-8        |   |   |

 

F-1

----

**Report of Independent Registered Public AccountingFirm**

To the Board of Directorsand Stockholders ofSonus Networks, Inc.:

We have audited the accompanying consolidated balancesheet of Sonus Networks, Inc. and subsidiaries (the “Company”) as of December 31,2005, and the related consolidated statements of operations, stockholders’equity and comprehensive income (loss), and cash flows for the year then ended.These financial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of SonusNetworks, Inc. and subsidiaries as of December 31, 2005, and theresults of their operations and their cash flows for the year then ended, inconformity with accounting principles generally accepted in the United Statesof America.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2005, basedon the criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission and our report, dated March 13, 2006, expressed anunqualified opinion on management’s assessment of the effectiveness of theCompany’s internal control over financial reporting and an adverse opinion onthe effectiveness of the Company’s internal control over financial reportingbecause of material weaknesses.

/s/ Deloitte & ToucheLLPBoston, MassachusettsMarch 13, 2006

 

F-2

----

**Reportof Independent Registered Public Accounting Firm**

To the Board of Directors and Stockholders ofSonus Networks, Inc.:

We have audited the accompanying consolidated balancesheet of Sonus Networks, Inc. as of December 31, 2004 and the relatedconsolidated statements of operations, stockholders’ equity and comprehensiveincome (loss) and cash flows for each of the two years in the period ended December 31,2004. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

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

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Sonus Networks, Inc. at December 31,2004, and the consolidated results of its operations and its cash flows foreach of the two years in the period ended December 31, 2004, in conformitywith U.S. generally accepted accounting principles.

/s/ Ernst & Young LLPBoston, MassachusettsMarch 14, 2005 

 

F-3

----

**SONUSNETWORKS, INC.Consolidated Balance Sheets(In thousands, except share data)**

| ** **                                                                                                                                                                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                       | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                                                                       | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Current assets:**                                                                                                                                                                              |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                        |       | $                     | 155,679    |   | $ | 121,931 |   |
| Marketable debt securities                                                                                                                                                                       |       | 140,569               |       | 170,145 |   |
| Accounts receivable, net                                                                                                                                                                         |       | 72,321                |       | 32,486 |   |
| Inventory, net                                                                                                                                                                                   |       | 37,831                |       | 28,346 |   |
| Other current assets                                                                                                                                                                             |       | 15,833                |       | 10,891 |   |
| Deferred income taxes                                                                                                                                                                            |       | 519                   |       | — |   |
| Total current assets                                                                                                                                                                             |       | 422,752               |       | 363,799 |   |
| **Property  and equipment, net**                                                                                                                                                                 |       | 15,181                |       | 8,217 |   |
| **Long-term  investments**                                                                                                                                                                       |       | 17,993                |       | 21,029 |   |
| **Deposits**                                                                                                                                                                                     |       | 631                   |       | 783 |   |
|                                                                                                                                                                                             |       | $                     | 456,557    |   | $ | 393,828 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Current liabilities:**                                                                                                                                                                         |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                 |       | $                     | 20,408     |   | $ | 8,654 |   |
| Accrued expenses                                                                                                                                                                                 |       | 23,204                |       | 18,240 |   |
| Accrued restructuring expenses                                                                                                                                                                   |       | 195                   |       | 186 |   |
| Current portion of deferred revenue                                                                                                                                                              |       | 88,199                |       | 65,105 |   |
| Convertible subordinated note                                                                                                                                                                    |       | 10,000                |       | — |   |
| Current portion of long-term liabilities                                                                                                                                                         |       | 48                    |       | 30 |   |
| Total current liabilities                                                                                                                                                                        |       | 142,054               |       | 92,215 |   |
| **Long-term  deferred revenue**                                                                                                                                                                  |       | 33,853                |       | 25,960 |   |
| **Long-term  liabilities****, net of current portion**                                                                                                                                           |       | 485                   |       | 613 |   |
| **Convertible  subordinated note**                                                                                                                                                               |       | —                |       | 10,000 |   |
| Total liabilities                                                                                                                                                                                |       | 176,392               |       | 128,788 |   |
| **Commitments  and contingencies (Note 8)**                                                                                                                                                      |       | —                |       | — |   |
| **Stockholders’ equity:**                                                                                                                                                                   |       |                  |       |   |   |
| Preferred stock, $0.01 par value; 5,000,000 shares  authorized, none issued and outstanding                                                                                                      |       | —                |       | — |   |
| Common stock, $0.001 par value; 600,000,000 shares  authorized, 251,730,706 and 249,755,118 shares issued and 249,433,796 and  247,458,208 shares outstanding at December 31, 2005 and 2004 |       | 252                   |       | 250 |   |
| Additional paid-in capital                                                                                                                                                                       |       | 1,055,941             |       | 1,049,142 |   |
| Accumulated deficit                                                                                                                                                                              |       | (775,717              | )          | (784,085 | ) |
| Accumulated other comprehensive loss                                                                                                                                                             |       | (44                   | )          | — |   |
| Treasury stock, at cost; 2,296,910 common shares at  December 31, 2005 and 2004                                                                                                        |       | (267                  | )          | (267 | ) |
| Total stockholders’ equity                                                                                                                                                                  |       | 280,165               |       | 265,040 |   |
|                                                                                                                                                                                             |       | $                     | 456,557    |   | $ | 393,828 |   |

 

See notes to the consolidated financial statements.

F-4

----

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

| ** **                                                 | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Revenues:**                                              |       |                                       |       |   |   |   |   |
| Product                                                    |       | $                                          | 134,812    |   | $ | 124,087 |   | $ | 60,851 |   |
| Service                                                    |       | 59,798                                     |       | 46,651 |   | 32,359 |   |
| Total revenues                                             |       | 194,610                                    |       | 170,738 |   | 93,210 |   |
| **Cost of revenues**(1):                                   |       |                                       |       |   |   |   |   |
| Product                                                    |       | 53,622                                     |       | 32,911 |   | 23,575 |   |
| Service                                                    |       | 23,898                                     |       | 17,656 |   | 14,334 |   |
| Total cost of revenues                                     |       | 77,520                                     |       | 50,567 |   | 37,909 |   |
| **Gross  profit**                                          |       | 117,090                                    |       | 120,171 |   | 55,301 |   |
| **Operating expenses:**                                    |       |                                       |       |   |   |   |   |
| Research and development(1)                                |       | 46,385                                     |       | 36,174 |   | 32,190 |   |
| Sales and marketing(1)                                     |       | 44,246                                     |       | 34,969 |   | 23,169 |   |
| General and administrative(1)                              |       | 26,848                                     |       | 24,595 |   | 10,475 |   |
| Stock-based compensation                                   |       | 20                                         |       | 671 |   | 3,418 |   |
| Amortization of purchased intangible assets                |       | —                                     |       | 2,402 |   | 2,408 |   |
| Total operating expenses                                   |       | 117,499                                    |       | 98,811 |   | 71,660 |   |
| **(Loss)  income from operations**                         |       | (409                                       | )          | 21,360 |   | (16,359 | ) |
| Interest expense                                           |       | (491                                       | )          | (479 | ) | (610 | ) |
| Interest income                                            |       | 9,879                                      |       | 4,283 |   | 2,135 |   |
| **Income  (loss) before income taxes**                     |       | 8,979                                      |       | 25,164 |   | (14,834 | ) |
| Provision for  income taxes                                |       | 611                                        |       | 687 |   | 302 |   |
| **Net income (loss)**                                      |       | $                                          | 8,368      |   | $ | 24,477 |   | $ | (15,136 | ) |
| **Net  income (loss) per share:**                          |       |                                       |       |   |   |   |   |
| Basic and diluted                                          |       | $                                          | 0.03       |   | $ | 0.10 |   | $ | (0.07 | ) |
| **Shares  used in computing net income (loss) per share:** |       |                                       |       |   |   |   |   |
| Basic                                                      |       | 248,584                                    |       | 245,830 |   | 220,696 |   |
| Diluted                                                    |       | 253,024                                    |       | 253,816 |   | 220,696 |   |

----

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

| Cost of revenues           |   | $      | — |   | $      | 18    |   | $ | 45    |   |
|----------------------------|--------|--------|--------|--------|--------|-------|--------|---|-------|--------|
| Research and development   |   | — |   | 240    |   | 1,180 |   |
| Sales and marketing        |   | 20     |   | 311    |   | 1,542 |   |
| General and administrative |   | — |   | 102    |   | 651   |   |
|                       |   | $      | 20     |   | $      | 671   |   | $ | 3,418 |   |

 

See notes to the consolidated financial statements.

F-5

----

**SONUSNETWORKS, INC.Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)(In thousands, except shares)**

| ** **                                                                                                                 | ** ** | **Common Stock** | ** ** | **Capital in** | ** ** | ** **                         | ** ** | ** **               | ** ** | **Accumulated  Other ** | ** ** | **Treasury Stock**      | ** ** | **Total**  | ** ** | **Comprehensive ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|---------------------|------------|------------------------------------|------------|--------------------------|------------|------------------------------|------------|-------------------------|------------|------------|------------|-------------------------|------------|
| ** **                                                                                                                 | ** ** | **Shares**       | ** ** | **Par  Value**      | ** ** | **Excess of  Par Value** | ** ** | **Accumulated  Deficit** | ** ** | **Deferred  Compensation**   | ** ** | **Comprehensive  Loss** | ** ** | **Shares** | ** ** | **Cost**                | ** ** | **Stockholders'  Equity** | ** ** | **Income  (Loss)** | ** ** |
| **Balance, January 1, 2003**                                                                                               |       | 206,866,358      |       |                | $          | 207                                |       |                     | $          | 853,560                      |       |                    | $          | (793,426   | )          |                    |       | $ | (3,659 | ) |   |   | $ | — |   |   | 2,266,810 |   | $ | (261 | ) |   | $ | 56,421 |   |   |   | $ | — |   |   |
| Sale of common stock, net of issuance costs of $9,932                                                                      |       | 37,000,000       |       |                | 37         |                               |       | 182,781                  |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   |   |   |   | 182,818 |   |   |   | — |   |   |
| Issuance of common stock in connection with employee  stock purchase plan                                                  |       | 1,085,750        |       |                | 1          |                               |       | 965                      |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 966 |   |   |   | — |   |   |
| Exercise of stock options                                                                                                  |       | 2,194,369        |       |                | 2          |                               |       | 5,952                    |       |                         | —     |                    |       |       | —     |                    |       |   |   |   |   | — |   | — |   |   | 5,954 |   |   |   | — |   |   |
| Amortization of deferred compensation                                                                                      |       | —           |       |                | —     |                               |       | —                   |       |                         | —     |                    |       |       | 3,039      |                    |       |   | — |   |   | — |   | — |   |   | 3,039 |   |   |   | — |   |   |
| Deferred compensation for terminated employees                                                                             |       | —           |       |                | —     |                               |       | (285                     | )          |                         | —     |                    |       |       | 56         |                    |       |   | — |   |   | — |   | — |   |   | (229 | ) |   |   | — |   |   |
| Compensation expense related to issuance of common  stock options to non-employees and modifications of stock awards  |       | —           |       |                | —     |                               |       | 608                      |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 608 |   |   |   | — |   |   |
| Repurchase of common stock                                                                                                 |       | —           |       |                | —     |                               |       | —                   |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | 30,100 |   | (6 | ) |   | (6 | ) |   |   | — |   |   |
| Net loss                                                                                                                   |       | —           |       |                | —     |                               |       | —                   |       |                         | (15,136    | )                       |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | (15,136 | ) |   |   | (15,136 | ) |   |
| Comprehensive loss for the year ended December 31,  2003                                                                   |       | —           |       |                | —     |                               |       | —                   |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | — |   |   |   | $ | (15,136 | ) |   |
| **Balance, December 31, 2003**                                                                                             |       | 247,146,477      |       |                | 247        |                               |       | 1,043,581                |       |                         | (808,562   | )                       |       |       | (564       | )                       |       |   | — |   |   | 2,296,910 |   | (267 | ) |   | 234,435 |   |   |   | $ | — |   |   |
| Issuance of common stock in connection with employee  stock purchase plan                                                  |       | 1,384,356        |       |                | 2          |                               |       | 1,719                    |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 1,721 |   |   |   | — |   |   |
| Exercise of stock options                                                                                                  |       | 1,224,285        |       |                | 1          |                               |       | 3,668                    |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 3,669 |   |   |   | — |   |   |
| Amortization of deferred compensation                                                                                      |       | —           |       |                | —     |                               |       | —                   |       |                         | —     |                    |       |       | 564        |                    |       |   | — |   |   | — |   | — |   |   | 564 |   |   |   | — |   |   |
| Compensation expense related to modifications of  stock awards                                                        |       | —           |       |                | —     |                               |       | 107                      |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 107 |   |   |   | — |   |   |
| Tax benefit from stock options exercised                                                                                   |       | —           |       |                | —     |                               |       | 67                       |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 67 |   |   |   | — |   |   |
| Net income                                                                                                                 |       | —           |       |                | —     |                               |       | —                   |       |                         | 24,477     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 24,477 |   |   |   | 24,477 |   |   |
| Comprehensive income for the year ended December 31,  2004                                                                 |       | —           |       |                | —     |                               |       | —                   |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | — |   |   |   | $ | 24,477 |   |   |
| **Balance, December 31, 2004**                                                                                             |       | 249,755,118      |       |                | 250        |                               |       | 1,049,142                |       |                         | (784,085   | )                       |       |       | —     |                    |       |   | — |   |   | 2,296,910 |   | (267 | ) |   | 265,040 |   |   |   | $ | — |   |   |
| Issuance of common stock in connection with employee  stock purchase plan                                                  |       | 1,131,641        |       |                | 1          |                               |       | 4,516                    |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 4,517 |   |   |   | — |   |   |
| Exercise of stock options                                                                                                  |       | 843,947          |       |                | 1          |                               |       | 2,263                    |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 2,264 |   |   |   | — |   |   |
| Compensation expense related to non-employee stock  awards                                                                 |       | —           |       |                | —     |                               |       | 20                       |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 20 |   |   |   | — |   |   |
| Currency translation adjustment                                                                                       |       | —           |       |                | —     |                               |       | —                   |       |                         | —     |                    |       |       | —     |                    |       |   | (44 | ) |   | — |   | — |   |   | (44 | ) |   |   | (44 | ) |   |
| Net income                                                                                                                 |       | —           |       |                | —     |                               |       | —                   |       |                         | 8,368      |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | 8,368 |   |   |   | 8,368 |   |   |
| Comprehensive income for the year ended December 31,  2005                                                                 |       | —           |       |                | —     |                               |       | —                   |       |                         | —     |                    |       |       | —     |                    |       |   | — |   |   | — |   | — |   |   | — |   |   |   | $ | 8,324 |   |   |
| **Balance,  December 31, 2005**                                                                                            |       | 251,730,706      |       |                | $          | 252                                |       |                     | $          | 1,055,941                    |       |                    | $          | (775,717   | )          |                    |       | $ | — |   |   |   | $ | (44 | ) |   | 2,296,910 |   | $ | (267 | ) |   | $ | 280,165 |   |   |   |   |   |   |

 

See notes to the consolidated financial statements.

F-6

----

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

| ** **                                                                           | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Cash flows from operating  activities:**                                           |       |                                       |       |   |   |   |   |
| Net income (loss)                                                                    |       | $                                          | 8,368      |   | $ | 24,477 |   | $ | (15,136 | ) |
| Adjustments to  reconcile net income (loss) to cash flows from operating activities: |       |                                       |       |   |   |   |   |
| Depreciation and amortization of property and  equipment                             |       | 7,976                                      |       | 5,796 |   | 9,724 |   |
| Tax benefit from stock options exercised                                             |       | —                                     |       | 67 |   | — |   |
| Stock-based compensation                                                             |       | 20                                         |       | 671 |   | 3,418 |   |
| Amortization of purchased intangible assets                                          |       | —                                     |       | 2,402 |   | 2,408 |   |
| Loss on disposal of property and equipment                                           |       | 142                                        |       | — |   | — |   |
| Deferred income taxes                                                                |       | (519                                       | )          | — |   | — |   |
| Changes in current  assets and liabilities:                                          |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                  |       | (40,019                                    | )          | (8,732 | ) | (19,132 | ) |
| Inventory                                                                            |       | (11,321                                    | )          | (14,607 | ) | (3,290 | ) |
| Other current assets                                                                 |       | (4,342                                     | )          | (3,956 | ) | (3,419 | ) |
| Accounts payable                                                                     |       | 11,955                                     |       | 5,406 |   | (377 | ) |
| Accrued expenses and accrued restructuring expenses                                  |       | 3,895                                      |       | (4,490 | ) | 3,381 |   |
| Deferred revenue                                                                     |       | 33,067                                     |       | 4,065 |   | 27,248 |   |
| Cash flows provided by operating activities                                          |       | 9,222                                      |       | 11,099 |   | 4,825 |   |
| **Cash flows from investing  activities:**                                           |       |                                       |       |   |   |   |   |
| Purchases of property and equipment                                                  |       | (14,229                                    | )          | (9,004 | ) | (3,187 | ) |
| Maturities of available-for-sale marketable debt  securities                         |       | 254,525                                    |       | 163,061 |   | 9,200 |   |
| Purchases of available-for-sale marketable debt  securities                          |       | (207,485                                   | )          | (165,304 | ) | (127,250 | ) |
| Maturities of held-to-maturity marketable debt  securities and long-term investments |       | 48,216                                     |       | 23,479 |   | 16,571 |   |
| Purchases of held-to-maturity marketable debt securities  and long-term investments  |       | (62,644                                    | )          | (40,733 | ) | (9,338 | ) |
| Increase in restricted cash                                                          |       | (591                                       | )          | — |   | — |   |
| Changes in other assets                                                              |       | 656                                        |       | 410 |   | (757 | ) |
| Cash flows provided by (used in) investing activities                                |       | 18,448                                     |       | (28,091 | ) | (114,761 | ) |
| **Cash flows from financing  activities:**                                           |       |                                       |       |   |   |   |   |
| Net proceeds from sale of common stock                                               |       | —                                     |       | — |   | 182,818 |   |
| Sale of common stock in connection with employee  stock purchase plan                |       | 4,517                                      |       | 1,721 |   | 966 |   |
| Proceeds from exercise of stock options                                              |       | 2,264                                      |       | 3,669 |   | 5,954 |   |
| Payments of long-term liabilities                                                    |       | (87                                        | )          | (182 | ) | (3,359 | ) |
| Repurchase of common stock                                                           |       | —                                     |       | — |   | (6 | ) |
| Cash flows provided by financing activities                                          |       | 6,694                                      |       | 5,208 |   | 186,373 |   |
| **Effect of exchange rate changes on cash and cash  equivalents**                    |       | (616                                       | )          | — |   | — |   |
| **Net increase (decrease) in cash and cash  equivalents**                            |       | 33,748                                     |       | (11,784 | ) | 76,437 |   |
| **Cash and cash equivalents, beginning of year**                                     |       | 121,931                                    |       | 133,715 |   | 57,278 |   |
| **Cash and cash equivalents, end of year**                                           |       | $                                          | 155,679    |   | $ | 121,931 |   | $ | 133,715 |   |
| **Supplemental disclosure of cash  flow information:**                               |       |                                       |       |   |   |   |   |
| Interest paid                                                                        |       | $                                          | 483        |   | $ | 479 |   | $ | 610 |   |
| Income taxes paid                                                                    |       | 820                                        |       | 441 |   | 91 |   |
| Income tax refunds received                                                          |       | (428                                       | )          | — |   | — |   |
| Non-cash purchases of property and equipment.                                        |       | 1,047                                      |       | — |   | — |   |
| Property and equipment acquired under capital lease                                  |       | 174                                        |       | — |   | — |   |
| Leasehold  improvements and equipment purchases for the Company by landlord          |       | 965                                        |       | — |   | — |   |

 

See notes to the consolidated financial statements.

F-7

----

**SONUS NETWORKS, INC. Notes to Consolidated Financial Statements**

**(1) Operationsand Significant Accounting Policies**

Sonus Networks, Inc. (Sonus) was incorporated in August 1997and is a leading provider of voice infrastructure solutions for wireline andwireless service providers. Sonus offers a new generation of carrier-classswitching equipment and software that enable voice services to be deliveredover packet-based networks.

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

**(a) Principlesof Consolidation**

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

The presentation ofmarketable debt securities in the consolidated statements of cash flows for theyears ended December 31, 2004 and 2003 have been adjusted to conform tothe current year presentation.

**(b) Use ofEstimates and Judgments**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting periods, actual results may differ. Significant estimates andjudgments relied upon in preparing these financial statements include revenuerecognition for multiple element arrangements, allowances for doubtfulaccounts, estimated fair value of investments, inventory reserves, expectedfuture cash flows used to evaluate the recoverability of long-lived assets,restructuring and other related charges, contingencies associated with revenuecontracts, contingent liabilities, and recoverability of Sonus’ net deferredtax assets and related valuation allowance. Although Sonus regularly assessesthese estimates, actual results could differ materially from these estimates.Changes in estimates are recorded in the period in which they become known.Sonus bases its estimates on historical experience and various other assumptionsthat it believes to be reasonable under the circumstances.

**(c) CashEquivalents, Marketable Debt Securities and Long-Term Investments**

Cash equivalents are stated at cost, whichapproximates fair value, and have remaining maturities of three months or lessat the date of purchase.

Cash equivalents and marketable debt securities areinvested in high quality debt instruments, primarily U.S. Government, municipaland corporate obligations. Investments in U.S. Government and corporateobligations are classified as held-to-maturity, as Sonus has the intent andability to hold them to maturity. Held-to-maturity marketable debt securitiesare reported at amortized cost. Investments in municipal obligations areclassified as available-for-sale and are reported at fair value. Unrealizedgains and losses from available-for-sale marketable debt securities were notmaterial for all periods presented. The unrealized losses related to thesesecurities at December 31, 2005 are not considered to be a permanentdecline in the fair value of such securities. There have been no materialrealized gains or losses 

F-8

----

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

**(1) Operationsand Significant Accounting Policies (Continued)**

to date. Currentmarketable debt securities include held-to-maturity investments with remainingmaturities of less than one year as of the balance sheet date andavailable-for-sale investments that are expected to be sold in the currentperiod or to be used in current operations. Long-term investments includeheld-to-maturity investments with remaining maturities of one to five years asof the balance sheet date.

As of December 31,2005 and 2004, marketable debt securities consisted of the following, inthousands:

| ** **                      | ** ** | **December 31, 2005** | ** ** |
|---------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**             | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| *Marketable debt securities*    |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Available-for-sale:             |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| State and municipal obligations |       | $                               | 97,875     |   |   | $ | — |   |   |   | $ | — |   |   | $ | 97,875 |   |
| Held-to-maturity:               |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency notes    |       | 16,643                          |       |   | — |   |   |   | (88 | ) |   | 16,555 |   |
| Corporate debt securities       |       | 18,503                          |       |   | — |   |   |   | (79 | ) |   | 18,424 |   |
| Commercial paper                |       | 5,950                           |       |   | — |   |   |   | (13 | ) |   | 5,937 |   |
| Certificates of deposit         |       | 1,598                           |       |   |   |   |   |   | (4 | ) |   | 1,594 |   |
|                            |       | $                               | 140,569    |   |   | $ | — |   |   |   | $ | (184 | ) |   | $ | 140,385 |   |
| *Long-term investments*         |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity:               |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government  agency notes   |       | $                               | 17,993     |   |   | $ | — |   |   |   | $ | (48 | ) |   | $ | 17,945 |   |

 

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

 

As of December 31,2005, Sonus had $591,000 in restricted cash, which is used to collateralizestandby letters of credit. Restricted cash is included in other current assetson the consolidated balance sheet.

F-9

----

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

**(1) Operationsand Significant Accounting Policies (Continued)**

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

The financial instruments that potentially subjectSonus to concentrations of credit risk are cash, cash equivalents, marketabledebt securities, accounts receivable and long-term investments. Sonus’ cash,cash equivalent and investment portfolio holdings were diversified among fivefinancial institutions at December 31, 2005. Beginning in the thirdquarter of 2005, Sonus entered into foreign exchange contracts to hedge againstcurrency fluctuations related to a particular account receivable and ordersdenominated in Japanese Yen. Sonus records changes in fair value of foreignexchange contracts to general and administrative expenses in the consolidatedstatement of operations, which totaled a gain of $177,000 for the year ended December 31,2005.

Thefollowing customers contributed 10% or more of Sonus’ revenues in the yearsended December 31, 2005, 2004 and 2003:

| **Customer**  | ** ** | ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|
| A   |       |       | 28         | %        |       |     | *          |     |       |   | 13 | % |   |
| B   |       |       | *          |     |       |     | 12         | %        |       |   | 11 |   |   |
| C   |       |       | *          |     |       |     | 17         |     |       |   | 18 |   |   |
| D   |       |       | *          |     |       |     | *          |     |       |   | 15 |   |   |

 

*                    Representsless than 10% of revenues.

As of December 31, 2005 and 2004, two customerseach accounted for 10% more of Sonus’ accounts receivable balance, representingan aggregate of 43% and 53% of Sonus’ accounts receivable balance. Sonusperforms ongoing credit evaluations of its customers and generally does notrequire collateral on accounts receivable. Sonus maintains an allowance forpotential doubtful accounts and such losses have been within management’sexpectations.

Thefollowing table shows percentage of revenue by region for the years ended December 31:

| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| United States                   |       |     | 75         | %        |       |     | 83         | % |   |   | 79 | % |   |
| Japan                           |       |     | 13         |     |       |     | 9          |   |   |   | 9 |   |   |
| Other Asia  Pacific             |       |     | 6          |     |       |     | 2          |   |   |   | 4 |   |   |
| Europe, Middle  East and Africa |       |     | 4          |     |       |     | 5          |   |   |   | 5 |   |   |
| Other                           |       |     | 2          |     |       |     | 1          |   |   |   | 3 |   |   |
|                            |       |     | 100        | %        |       |     | 100        | % |   |   | 100 | % |   |

 

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

F-10

----

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

**(1) Operationsand Significant Accounting Policies (Continued)**

**(e) ForeignCurrency Translation**

Sonus’ functional currency is the U.S. dollar. Forforeign subsidiaries where the functional currency is the local currency,assets and liabilities are translated into U.S. dollars at the current exchangerate on the balance sheet date. Revenue and expenses are translated at averagerates of exchange prevailing during each period. Translation adjustments forthese subsidiaries are accumulated in other comprehensive income (loss), acomponent of stockholders’ equity.

For foreign subsidiaries where the functional currencyis the U.S. dollar, monetary assets and liabilities are translated into U.S.dollars at the exchange rate on the balance sheet date. Nonmonetary assets andliabilities are remeasured into U.S. dollars at historical exchange rates. Revenueand expense items are translated at average rates of exchange prevailing duringeach period. Translation adjustments are included in the consolidated statementof operations. Translation adjustments for these subsidiaries were not materialfor any year presented.

During 2005, Sonus changedthe functional currency for its Japan and India subsidiaries from the U.S.dollar to local currency as significant changes in economic facts andcircumstances transpired during the year.

**(f) UnearnedAccounts Receivable**

Accounts receivable, net,include unearned accounts receivable which represent products shipped tocustomers where Sonus has a contractual right to bill the customer andcollectibility is probable under ordinary collection terms prior to satisfyingSonus’ revenue recognition criteria.

**(g) Inventory**

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

Unearned inventory represents deferred cost ofrevenues prior to satisfaction of Sonus’ revenue recognition criteria.

Inventory purchases and commitments are based uponestimated future demand for Sonus’ products. Sonus values inventory at thelower of cost on a first-in, first-out basis or net realizable value. Sonusprovides inventory reserves based on excess and obsolete inventory determinedprimarily by future demand forecasts and estimated returns of defectiveproduct, and record charges to cost of revenues. Sonus assesses such demandforecasts and return history on at least a quarterly basis. If Sonus records acharge to reduce inventory to its estimated net realizable value, Sonus doesnot increase its carrying value due to subsequent changes in demand forecastsor product repairs. Accordingly, if inventory previously reserved for is subsequentlysold, Sonus may realize improved gross profit margins on those transactions inthe period the related revenue is recognized.

Sonus also records a fullinventory reserve for evaluation equipment at the time of shipment to ourcustomers as a charge to sales and marketing expense as it is probable that theinventory value will not be realizable. If these evaluation shipments are laterpurchased by Sonus’ customers, Sonus reclassifies amounts previously charged tosales and marketing expenses to cost of revenues in the period all revenuerecognition criteria are met.

F-11

----

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

**(1) Operationsand Significant Accounting Policies (Continued)**

**(h) Propertyand Equipment**

Property and equipment arestated at cost, net of accumulated depreciation. Expenditures for maintenanceand repairs are charged to expense as incurred. Depreciation is computed usingthe straight-line method over the estimated useful life of the related assets,which range from two to five years. Leasehold improvements are amortized overthe lesser of the lease term or five years. When an item is sold or retired,the cost and related accumulated depreciation or amortization is eliminated,and the resulting gain or loss, if any, is recognized in income (loss) fromoperations in the consolidated statement of operations.

**(i) RevenueRecognition**

Sonus’ products are primarily marketed based on thesoftware elements contained herein. In addition, hardware sold generally cannot be used apart from the software. Therefore, the Company considers itsprincipal products to be software related. Sonus recognizes revenue fromproduct sales when persuasive evidence of an arrangement exists, delivery hasoccurred, the sales price is fixed or determinable, and collectibility of therelated receivable is probable under ordinary payment terms. When Sonus hasfuture obligations, including a requirement to deliver additional elementswhich are essential to the functionality of the delivered elements or for whichvendor specific objective evidence of fair value (VSOE) does not exist orcustomer acceptance is required, Sonus defers revenue recognition and relatedcosts until those obligations are satisfied. The ordering patterns and saleslead times associated with customer orders may vary significantly from periodto period.

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

Maintenance and support services are recognized ratablyover the life of the service period, ranging from one to five years. Earnedmaintenance revenues are typically deferred until the associated productrevenue is accepted and all other revenue recognition is met. Maintenance andsupport services include telephone support, return and repair support andunspecified rights to product upgrades and enhancements.

Installation servicerevenues which are considered to be perfunctory are generally recognized whenthe service is complete. Other professional services for which VSOE has beenestablished are typically recognized based on the proportional performancemethod as the services are delivered.

Consulting, customdevelopment and other professional service only engagements are recognized asservices are completed.

F-12

----

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

**(1) Operationsand Significant Accounting Policies (Continued)**

Sonus sells the majority of its products directly toend-users. For products sold to resellers and distributors, Sonus recognizesrevenue on a sell-through basis utilizing information provided to Sonus fromits resellers and distributors. To date, no revenues have been recognized on asell-in basis due to the limited history of shipments to resellers anddistributors.

Sonus records deferred revenue for product deliveredor services performed for which collection of the amount billed is eitherprobable or has been collected but other revenue recognition criteria have notbeen satisfied. Deferred revenue includes customer deposits and amounts associatedwith maintenance contracts. Deferred revenue expected to be recognized asrevenue more than one year subsequent to the balance sheet date is classifiedas long-term deferred revenue.

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

**(j) SoftwareDevelopment Costs**

The costs for thedevelopment of new software and substantial enhancements to existing softwareare expensed as incurred until technological feasibility has been established,at which time any additional costs would be capitalized. Sonus has determinedthat technological feasibility is established at the time a working model of thesoftware is completed. Because Sonus believes its current process fordeveloping software is essentially completed concurrently with theestablishment of technological feasibility, no costs have been capitalized todate.

**(k) Stock-basedCompensation**

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

Sonushas computed the pro forma disclosures, intended to show the effects of using afair value model to measure stock compensation using the Black-Scholes option pricingmodel under the following assumptions for the years ended December 31:

| ** **                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**     | ** ** |
|---------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Risk-free  interest rate                                                        |       | 4.0      | %          | 3.2      | %          | 3.0          | %          |
| Expectant  dividend yield                                                       |       | 0.0      | %          | 0.0      | %          | 0.0          | %          |
| Expected  volatility                                                            |       | 117      | %          | 127      | %          | 137          | %          |
| Expected life  (years)                                                          |       | 4.0      |       | 5.0      |       | 4.0–5.0 |       |
| Weighted average fair  value of options/purchase rights granted during the year |       | $        | 3.70       |     | $          | 4.18         |       | $ | 3.76 |   |
|                                                                                 |            |          |            |          |            |              |            |  |  |  |

 

F-13

----

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

**(1) Operationsand Significant Accounting Policies (Continued)**

For shares purchased under the 2000 Employee StockPurchase Plan (ESPP), Sonus uses a Black-Scholes option-pricing model, with arange used for the majority of assumptions. In valuing the ESPP, Sonus used anassumed risk-free interest rate of 1.3%-3.6% for 2005, 1.0%-3.0%for 2004 and 1.1%-4.7% for 2003, expected volatility of 57%-154%for 2005, 26%-164% for 2004 and 137%-150% for 2003, and an expectedlife from six months to two years, with the assumption that dividends will notbe paid.

Thefollowing table shows Sonus’ pro forma net income (loss) and net income (loss)per share as if the Company had used the fair value model to measure andaccount for stock compensation to employees:

| ** **                                                                                                                                  | ** ** | **Year ended December 31,**                         | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                  | ** ** | **(in thousands, except per share data)** | ** ** |
| **Net income (loss)**                                                                                                                       |       |                                                               |       |   |   |   |   |
| As reported                                                                                                                                 |       | $                                                                  | 8,368      |   | $ | 24,477 |   | $ | (15,136 | ) |
| Plus: Employee stock-based compensation  expense included in net income (loss) under intrinsic value method related to  options, net of tax |       | 19                                                                 |       | 570 |   | 2,589 |   |
| Less: Employee stock-based compensation under  fair value method, net of tax                                                                |       | (97,662                                                            | )          | (48,022 | ) | (43,404 | ) |
| Pro forma                                                                                                                                   |       | $                                                                  | (89,275    | ) | $ | (22,975 | ) | $ | (55,951 | ) |
| **Basic  and diluted net income (loss) per share—**                                                                                    |       |                                                               |       |   |   |   |   |
| As reported                                                                                                                                 |       | $                                                                  | 0.03       |   | $ | 0.10 |   | $ | (0.07 | ) |
| Pro forma                                                                                                                                   |       |        (0.36                         | )          | (0.09 | ) | (0.25 | ) |

 

On December 21, 2005,Sonus’ Board of Directors approved accelerating the vesting ofout-of-the-money, unvested stock options held by all current employees, subjectto employee approval to the extent accelerating of vesting would create achange in classification of any grant from an incentive stock option to anon-qualified incentive stock option. Non-employee members of the Board ofDirectors were excluded from the acceleration. Unvested options having anexercise price of $4.00 per share or greater, representing the right topurchase a total of approximately 18.9 million shares, became exercisable as aresult of the vesting acceleration. All other terms and conditions in theoriginal grants remain unchanged. The acceleration of vesting did not result inthe recognition of compensation expense in fiscal 2005 as the exercise price ofthe accelerated stock options exceeded the fair market value of the underlyingcommon stock on the date of modification. The pro forma results reported forfiscal 2005 include approximately $63.8 million of pro forma compensationexpense, net of tax, resulting from the vesting acceleration. The decision toaccelerate vesting of these stock options was made primarily to reducecompensation expense that would otherwise be recognized after the adoption ofSFAS No. 123(R) on January 1, 2006.

**(l) Fair Valueof Financial Instruments**

The carrying amounts ofSonus’ financial instruments, which include cash equivalents, marketable debtsecurities, long-term investments, accounts receivable, accounts payable,long-term liabilities, foreign exchange contracts and the convertiblesubordinated note, approximate their fair value.

F-14

----

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

**(1) Operationsand Significant Accounting Policies (Continued)**

**(m) Disclosuresabout Segments of an Enterprise**

Operating segments areidentified as components of an enterprise about which separate discretefinancial information is available for evaluation by the chief operatingdecision maker in making decisions regarding resource allocation and assessingperformance. To date, the chief operating decision maker has made suchdecisions and assessed performance at the company level.

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

Dilutivepotential common shares consist of common stock issuable upon the exercise ofstock options and conversion of a convertible subordinated note. For the yearsended December 31, 2004 and 2003, dilutive potential common shares alsoincludes restricted common stock.

| ** **                                                             | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Weighted average  common shares outstanding                            |       | 248,584                                    |       | 246,175 |   | 224,529 |   |
| Less weighted  average restricted common shares outstanding            |       | —                                     |       | (345 | ) | (3,833 | ) |
| Weighted average  shares used in computing basic per share calculation |       | 248,584                                    |       | 245,830 |   | 220,696 |   |
| Add effect of  dilutive potential common shares                        |       | 4,440                                      |       | 7,986 |   | — |   |
| Weighted average shares  used in dilutive per share calculation        |       | 253,024                                    |       | 253,816 |   | 220,696 |   |

 

Excluded from the sharesused in the calculations above are options to purchase shares of common stockand shares of common stock issuable upon conversion of convertible subordinatednotes representing an aggregate of 13,405,274, 3,890,329 and 28,469,634 as ofDecember 31, 2005, 2004 and 2003, respectively, as their effects wouldhave been anti-dilutive.

**(o) LossContingencies**

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

***Allowance forDoubtful Accounts.******  ***Sonus establishes billing termsat the time it negotiates purchase agreements with its customers. Sonuscontinually monitors for timely payments and potential collection issues. Anallowance for doubtful accounts is estimated based on Sonus’ assessment of thecollectibility of specific customer accounts.

F-15

----

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

**(1) Operations andSignificant Accounting Policies (Continued)**

***Warranty Reserve.******  ***Sonus’products are covered by a standard warranty of 90 days for software andone year for hardware or a warranty for longer periods under certain customercontracts. In addition, certain customer contracts include warranty-typeprovisions for epidemic or similar product failures, generally for thecontractual period or the life of the product in accordance with publishedtelecommunications standards**.**Sonus accruesfor warranty obligations when the occurrence of such obligation is probable andthe amount of such obligation is reasonably estimable. Sonus has not incurredsignificant costs related to such obligations. Sonus’ customers typicallypurchase maintenance and support contracts, which encompass its warrantyobligations. Sonus’ estimates of warranty obligations are primarily based onhistorical information and future forecasts.

In addition, certain of Sonus’ customer contractsinclude provisions under which Sonus may be obligated to pay penaltiesgenerally for the contractual period or for the life of the product if Sonus’products fail or do not perform in accordance with specifications. Sonusaccrues for such contingent obligations when the occurrence of such obligationis probable and the amount of such obligation is reasonably estimable. Sonushas not incurred significant costs related to such provisions. Sonusperiodically assesses the adequacy of its recorded warranty liabilities andadjusts the amounts as necessary. As of December 31, 2005 andDecember 31, 2004, Sonus had $84,000 and $0 of warranty reserves recorded,respectively.

***Royalty Accrual.******  ***Sonus accruesfor royalties for technology it licenses from vendors based on establishedroyalty rates and usage. In certain cases, Sonus has been contacted by thirdparties who claim that Sonus’ products infringe on certain intellectualproperty of the third party. Sonus evaluates these claims and accrues forroyalties when the amounts are probable and reasonably estimable.

***Reserve forLitigation and Legal Fees.******  ***Sonus issubject to various legal claims, including securities litigation. Sonusreserves for legal contingencies and legal fees when the amounts are probableand reasonably estimable. Sonus’ director and officer liability insurancepolicies provide only limited liability protection relating to the securitiesclass action and derivative lawsuits against Sonus and certain of its officersand directors. Sonus intends to defend these matters vigorously, although theultimate outcome of these items is uncertain and the potential loss, if any,may be significantly different than the amounts Sonus has previously accrued.

***Accounting for Income Taxes.******  ***Sonus providesfor deferred income taxes resulting from temporary differences betweenfinancial and taxable income. Such differences arise primarily fromdepreciation, accruals and reserves, deferred revenue, capitalized softwarecosts, tax carryforwards, and allowances for accounts receivable. Sonus recordsvaluation allowances to reduce deferred tax assets to the amount that is morelikely than not to be realized. Sonus has not provided for U.S. income taxes onthe undistributed earnings of non-U.S. subsidiaries, as these earnings havebeen permanently reinvested or would be principally offset by foreign taxcredits. Cumulative undistributed foreign earnings were approximately $550,000at December 31, 2005.

**(p) Research andDevelopment Costs**

Research and development costs are expensed asincurred.

F-16

----

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

**(1) Operationsand Significant Accounting Policies (Continued)**

**(q) RecentAccounting Pronouncements**

In November 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard(“SFAS”) No. 151, *Inventory Costs, anamendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4.*SFAS 151amends the guidance in ARB No 43, Chapter 4, “Inventory Pricing” to clarifythat abnormal amounts of idle facility expense, freight, handling costs, andwasted material (spoilage) should be recognized as current-periodcharges. In addition, SFAS 151 requires that allocation of fixedproduction overhead to the costs of conversion be based on the normal capacityof the production facilities. The provisions of SFAS 151 are effective forfiscal years beginning after June 15, 2005. The adoption of SFASNo. 151 will not have a material impact on Sonus’ consolidated financialposition, results of operations or cash flows.

In December 2004, the FASB issuedSFAS 123(R), *Share-Based Payment*,which is a revision of SFAS No. 123, *Accountingfor Stock-Based Compensation*. SFAS 123(R) supersedesAPB Opinion No. 25, *Accounting forStock Issued to Employees*, and amends SFAS No. 95, *Statement of Cash Flows*. Generally, theapproach in SFAS 123(R) is similar to the approach described inSFAS 123. However, SFAS 123(R) requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values at the date ofgrant. Pro forma disclosure is no longer an alternative.SFAS 123(R) must be adopted in fiscal periods beginning after June 15,2005. Sonus adopted SFAS 123(R) on January 1, 2006.SFAS 123(R) permits public companies to adopt its requirements usingone of two methods: a “modified prospective” method, in which compensation costis recognized beginning with the effective date (a) based on therequirements of SFAS 123(R) for all share-based paymentsgranted after the effective date, and (b) based on the requirements ofSFAS 123 for all awards granted to employees prior to the effective dateof SFAS 123(R) that remain unvested on the effective date; or a“modified retrospective” method, which includes the requirements of themodified prospective method described above, but also permits entities torestate based on the amounts previously recognized under SFAS 123 forpurposes of pro forma disclosures either (a) all prior periods presentedor (b) prior interim periods of the year of adoption. Sonus will be usingthe modified prospective method in adopting SFAS 123(R). As a result ofthe adoption of SFAS 123(R), Sonus expects stock-based compensation expense toreduce basic and diluted net income per share by approximately $0.03 to $0.05per share for the year ending December 31, 2006. However, Sonus’assessment of the estimated compensation charges is affected by its stock priceas well as assumptions regarding a number of complex and subjective variablesand the related tax impact. These variables include, but are not limited to,the volatility of Sonus’ stock price and employee stock option exercisebehaviors. The adoption of SFAS 123(R) will have no material impacton Sonus’ net cash flows or overall financial position.

**(2) RestructuringCharges**

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

F-17

----

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

**(2) RestructuringCharges (Continued)**

**2002 RestructuringAccrual**

Thefollowing table summarizes the activity relating to Sonus’ accrual for fiscal2002 restructuring actions, in thousands:

| ** **                                   | ** ** | **2003 Activity**             | ** ** | **2004 Activity** | ** ** | **2005 Activity**                    | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **Jan.1,  2003  Accrual  Balance** | ** ** | **Cash  Payments**     | ** ** | **Dec. 31,  2003  Accrual  Balance** | ** ** | **Cash  Payments** | ** ** | **Dec. 31,  2004  Accrual  Balance** | ** ** | **Cash  Payments** | ** ** | **Dec. 31, 2005  Accrual  Balance** | ** ** | **Current  Portion** | ** ** | **Long-term  Portion** | ** ** |
| Workforce  reduction                         |       | $                                  | 534        |                   |       | $                                         | (534       | ) |   | $ | — |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Consolidation of  facilities                 |       | 2,214                              |       |                   | (1,071     | )                                         |       | 1,143 |   |   | (344 | ) |   |   | 799 |   |   |   | (186 | ) |   |   | 613 |   |   |   | 195 |   |   |   | 418 |   |   |
| Sub-total                                    |       | 2,748                              |       |                   | (1,605     | )                                         |       | 1,143 |   |   | (344 | ) |   |   | 799 |   |   |   | (186 | ) |   |   | 613 |   |   |   | 195 |   |   |   | 418 |   |   |
| Write-off  (benefit) of purchase commitments |       | 340                                |       |                   | (300       | )                                         |       | 40 |   |   | (40 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total                                        |       | $                                  | 3,088      |                   |       | $                                         | (1,905     | ) |   | $ | 1,183 |   |   | $ | (384 | ) |   |   | $ | 799 |   |   |   | $ | (186 | ) |   |   | $ | 613 |   |   |   | $ | 195 |   |   |   | $ | 418 |   |   |

 

The remaining cashexpenditures relating to the consolidation of excess facilities are expected tobe paid through 2008.

**(3) Other BalanceSheet Data**

***(a) Accounts Receivable***

Accountsreceivable consists of the following, in thousands:

| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Earned accounts  receivable      |       | $                     | 48,924     |   | $ | 15,919 |   |
| Unearned accounts  receivable    |       | 23,823                |       | 16,976 |   |
| Accounts  receivable, gross      |       | 72,747                |       | 32,895 |   |
| Allowance for  doubtful accounts |       | (426                  | )          | (409 | ) |
| Accounts receivable, net         |       | $                     | 72,321     |   | $ | 32,486 |   |

 

F-18

----

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

**(3) OtherBalance Sheet Data (Continued)**

***(b) Inventory***

Inventoryconsists of the following, in thousands:

| ** **                                             | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **2005**              | ** ** | **2004** | ** ** |
| On-hand  final assemblies and finished goods inventory |       | $                     | 19,457     |   | $ | 18,725 |   |
| Unearned  inventory                                    |       | 21,110                |       | 14,054 |   |
| Evaluation  inventory                                  |       | 4,615                 |       | 6,107 |   |
| Inventory, gross                                       |       | 45,182                |       | 38,886 |   |
| Excess, obsolete  and evaluation reserve               |       | (7,351                | )          | (10,540 | ) |
| Inventory, net                                         |       | $                     | 37,831     |   | $ | 28,346 |   |

 

***(c) Property and Equipment***

Propertyand equipment consists of the following, in thousands:

| ** **                                      | ** ** | **Estimated**        | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **Useful Life** | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Equipment and  software                         |       | 2-3 years            |       | $                     | 67,754     |   | $ | 59,500 |   |
| Furniture and  fixtures                         |       | 3-5 years            |       | 875                   |       | 26 |   |
| Leasehold  improvements                         |       | Life of lease        |       | 1,998                 |       | 484 |   |
|                                            |       |                 |       | 70,627                |       | 60,010 |   |
| Less accumulated  depreciation and amortization |       |                 |       | (55,446               | )          | (51,793 | ) |
| Property and equipment,  net                    |       |                 |       | $                     | 15,181     |   | $ | 8,217 |   |

 

In the fourth quarter of 2005, Sonus determined thatcertain fully-depreciated assets were no longer in service. The write-off ofsuch assets totaled approximately $4.2 million. There was no gain or loss ondisposal of these assets.

As of December 31, 2005, net property andequipment located in United States and foreign locations was $12.9 million and$2.3 million, respectively. As of December 31, 2004, substantially all netproperty and equipment was located in the United States.

***(d) Accrued Expenses***

Accruedexpenses consists of the following, in thousands:

| ** **                               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Employee  compensation and related costs |       | $                     | 9,217      |   | $ | 6,148 |   |
| Employee stock  purchase plan            |       | 1,811                 |       | 2,129 |   |
| Professional fees                        |       | 1,842                 |       | 3,697 |   |
| Royalties                                |       | 3,939                 |       | 3,488 |   |
| Accrued taxes                            |       | 3,829                 |       | 1,849 |   |
| Deferred rent                            |       | 1,021                 |       | 47 |   |
| Other                                    |       | 1,545                 |       | 882 |   |
|                                     |       | $                     | 23,204     |   | $ | 18,240 |   |

 

F-19

----

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

**(3) OtherBalance Sheet Data (Continued)**

***(e) Deferred Revenue***

Deferredrevenue consists of the following, in thousands:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Maintenance and  support contracts |       | $                     | 67,277     |   | $ | 44,859 |   |
| Customer deposits                  |       | 30,952                |       | 29,230 |   |
| Unearned revenue                   |       | 23,823                |       | 16,976 |   |
| Total deferred  revenue            |       | 122,052               |       | 91,065 |   |
| Less current  portion              |       | (88,199               | )          | (65,105 | ) |
|                               |       | $                     | 33,853     |   | $ | 25,960 |   |

 

Maintenance and supportcontracts are recognized ratably over the life of the maintenance and supportperiod. Customer deposits represent payments received in advance of revenuerecognition. Unearned revenue represents billings for which payment has notbeen received and revenue recognition criteria have not been met. As of December 31,2005 and December 31, 2004, deferred revenue and accounts receivableexcluded $5.3 million and $6.5 million related to products shippedand billed to customers which are collectible under extended payment terms orfor which revenue is recognized as cash is collected.

**(4) Valuation andQualifying Accounts**

***(a) Allowance for Doubtful Accounts***

The following table sets forth activity in Sonus’allowance for doubtful accounts, in thousands:

| **Year ended December 31:** | ** ** | ** ** | ** ** | **Balance at  beginning  of year** | ** ** | **Charges  to expense** | ** ** | **Write-offs** | ** ** | **Balance at  end of year** | ** ** |
|--------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| 2005                                       |       |       | $          | 409                                          |       |                         |       | $              | 132        |                                       |       |   | $ | (115 | ) |   |   | $ | 426 |   |   |
| 2004                                       |       |       | 285        |                                         |       |                         | 278        |           |       |                                       | (154       | ) |   |   | 409 |   |   |
| 2003                                       |       |       | 341        |                                         |       |                         | 170        |           |       |                                       | (226       | ) |   |   | 285 |   |   |

 

***(b) Inventory Reserves***

Thefollowing table sets forth activity in Sonus’ inventory reserve, in thousands:

| **Year ended December 31:** | ** ** | ** ** | ** ** | **Balance at  beginning  of year** | ** ** | **Charges  to expense** | ** ** | **Dispositions  and sales** | ** ** | **Balance at  end of year** | ** ** |
|--------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|--------------------------------------------|------------|
| 2005                                       |       |       | $          | 10,540                                       |       |                         |       | $                                | 3,966      |                                       |       |   | $ | (7,155 | ) |   |   | $ | 7,351 |   |   |
| 2004                                       |       |       | 13,814     |                                         |       |                         | 5,478      |                             |       |                                       | (8,752     | ) |   |   | 10,540 |   |   |
| 2003                                       |       |       | 18,306     |                                         |       |                         | 5,806      |                             |       |                                       | (10,298    | ) |   |   | 13,814 |   |   |

 

F-20

----

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

**(4) Valuationand Qualifying Accounts (Continued)**

***(c) Warranty Reserve***

Thefollowing table sets forth activity in Sonus’ warranty reserve accrual,included in accrued expenses, in thousands:

| **Year ended December 31:** | ** ** | ** ** | ** ** | **Balance at  beginning  of year** | ** ** | **Charges  (benefits) to  expense** | ** ** | **Costs  incurred** | ** ** | **Balance at  end of  year** | ** ** |
|--------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------------------|------------|---------------------|------------|----------------------------------------|------------|
| 2005                                       |       |       | $          | —                                       |       |                                     |       | $                   | 809        |                                   |       |   | $ | (725 | ) |   |   | $ | 84 |   |   |
| 2004                                       |       |       | 2,500      |                                         |       |                                     | (1,949     | )                   |       |                                   | (551       | ) |   |   | — |   |   |
| 2003                                       |       |       | 1,300      |                                         |       |                                     | 1,200      |                |       |                                   | —     |   |   |   | 2,500 |   |   |

 

**(5) Income Taxes**

Thefollowing is a summary of the significant components of Sonus' deferred incometax assets and liabilities, in thousands:

| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Net operating  loss carryforwards |       | $                     | 59,272     |   | $ | 63,605 |   |
| Tax credit  carryforwards         |       | 10,234                |       | 8,455 |   |
| Intangible assets                 |       | 1,415                 |       | 1,565 |   |
| Deferred revenue                  |       | 8,784                 |       | 20,611 |   |
| Accrued expenses                  |       | 3,116                 |       | (1,105 | ) |
| Inventory                         |       | 4,802                 |       | 5,240 |   |
| Other temporary  differences      |       | 5,128                 |       | (3,454 | ) |
| Valuation  allowance              |       | (92,232               | )          | (94,917 | ) |
|                              |       | $                     | 519        |   | $ | — |   |

 

As a result of net operating losses incurred prior to2004, operating losses incurred in the first and third fiscal quarters of 2005,and uncertainty as to the extent, jurisdiction and timing of profitability infuture periods, Sonus has continued to record a full valuation allowanceagainst federal and state net deferred tax assets, which was approximately$92 million as of December 31, 2005. We have recorded a foreign deferredincome tax asset of $519,000 with no valuation allowance as of December 31,2005.  In addition, approximately $27million of the valuation allowance relates to tax benefits from stock optioncompensation. A substantial portion of the tax benefit of that item, ifrealized, would result in an increase in additional paid-in capital.  

As of December 31, 2005, Sonus has net operatingloss carryforwards for federal and state income tax purposes of approximately$158,000,000 and $94,000,000, respectively. The federal net operating losscarryforwards expire at various dates from 2019 through 2023. Thestate net operating loss carryforwards expire at various dates from 2006through 2023. Approximately $70,000,000 of the federal net operating lossis attributable to stock option deductions; a substantial portion of thebenefit will be accounted for when used as an increase to capital in excess ofpar value. Sonus also has available research and development creditcarryforwards of approximately $9,855,000 that expire at various datesfrom 2012 through 2025, and an Alternative Minimum Tax Credit carryforwardof $379,000 that has no expiration date. The Internal Revenue Code (IRC)contains provisions that limit the net operating loss and tax credit 

F-21

----

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

**(5) IncomeTaxes (Continued)**

carryforwardsavailable to be used in any given year in the event of certain circumstances,including significant changes in ownership interests. Sonus has completedseveral financings since inception and may have incurred ownership changes asdefined in the IRC. Sonus does not believe that these changes have had amaterial impact on its ability to utilize net operating loss and tax creditcarryforwards.

Incometax (benefit) expense differed from the amounts computed by applying the U.S.statutory income tax rate to pre-tax income as a result of the following:

| ** **                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory income  tax (benefit) expense     |       | 35.0     | %          | 35.0     | %          | (35.0    | )%         |
| State income  taxes, net of federal benefit |       | —   |       | 3.6      |       | (4.5     | )          |
| Foreign income  taxes                       |       | 9.1      |       | —   |       | 1.1      |       |
| Stock-based  compensation                   |       | —   |       | 0.8      |       | 6.5      |       |
| Tax credits                                 |       | (19.8    | )          | 4.9      |       | (9.8     | )          |
| Meals and  entertainment                    |       | 2.1      |       | —   |       | —   |       |
| Valuation  allowance                        |       | (29.9    | )          | (42.9    | )          | 44.0     |       |
| Other, net                                  |       | 10.3     |       | 1.3      |       | (0.3     | )          |
| Effective income tax  rate                  |       | 6.8      | %          | 2.7      | %          | 2.0      | %          |

 

Thecomponents of income (loss) before income taxes and the provision (benefit) forincome taxes consists of the following, in thousands:

| ** **                                 | ** ** | **2005**     | ** ** | **2004**                                 | ** ** | **2003**                                             | ** ** |
|--------------------------------------------|------------|--------------|------------|------------------------------------------|------------|------------------------------------------------------|------------|
| **Income (loss) before income  taxes:**    | ** ** | ** **   | ** ** | ** **                               | ** ** | ** **                                           | ** ** |
| United States                              |       | $            | 7,875      |                                     | $          | 24,770                                               |       | $ | (15,276 | ) |
| Foreign                                    |       | 1,104        |       | 394                                      |       | 442                                                  |       |
|                                       |       | $            | 8,979      |                                     | $          | 25,164                                               |       | $ | (14,834 | ) |
| **Provision (benefit) for income  taxes:** |       |         |       |                                     |       |                                                 |       |
| **Current:**                               | ** ** | ** **   | ** ** | ** **                               | ** ** | ** **                                           | ** ** |
| Federal                                    |       | $            | 59         |                                     | $          | 335                                                  |       | $ | — |   |
| State                                      |       | —       |       | 211                                      |       | 130                                                  |       |
| Foreign                                    |       | 1,071        |       | 141                                      |       | 172                                                  |       |
|                                       |       |   1,130 |       |        687 |       |          302 |       |
| **Deferred:**                              |       |         |       |                                     |       |                                                 |       |
| Foreign                                    |       | (519         | )          | —                                   |       | —                                               |       |
| Total                                      |       | $            | 611        |                                     | $          | 687                                                  |       | $ | 302 |   |

 

F-22

----

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

**(6) Long-term Liabilities**

Long-termliabilities consist of capital lease obligations and restructuringexpenses.  The future minimum annualpayments under capital leases and amounts due for restructuring expenses are asfollows at December 31, 2005, in thousands:

| ** **                                     | ** ** | **Capital  lease** | ** ** | **Restructuring  expense** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|--------------------|------------|----------------------------|------------|-----------|------------|
| 2006                                           |       |               | $          | 55                         |       |      |       | $ | 195 |   |   | $ | 250 |   |
| 2007                                           |       |               | 55         |                       |       |      | 204        |   |   | 259 |   |
| 2008                                           |       |               | 14         |                       |       |      | 214        |   |   | 228 |   |
| 2009                                           |       |               | 3          |                       | * *   | * *  | *—*   |   |   | 3 |   |
| Total minimum lease payments                   |       |               | 127        |                       |       |      | 613        |   |   | 740 |   |
| Less amount representing interest              |       |               | (12        | )                          |       |      | —     |   |   | (12 | ) |
| Present value of minimum lease payments        |       |               | 115        |                       |       |      | 613        |   |   | 728 |   |
| Less current  portion                          |       |               | (48        | )                          |       |      | (195       | ) |   | (243 | ) |
| Long-term  liabilities, net of current portion |       |               | $          | 67                         |       |      |       | $ | 418 |   |   | $ | 485 |   |

 

**(7) ConvertibleSubordinated Note**

In May 2001, Sonusissued a $10,000,000 4.75% convertible subordinated note, due May 1, 2006,to a customer. Interest payments are due semi-annually on May 1 andNovember 1 of each year through May 2006. The note may be convertedby the holder into shares of Sonus' common stock at any time before itsmaturity or prior to its redemption or repurchase by Sonus. The conversion rateis 33.314 shares per each $1,000 principal amount of the note, subject toadjustment in certain circumstances. After May 1, 2004, Sonus has the optionto redeem all or a portion of the note at 100% of the principal amount. Also,at any time if the market price of Sonus' common stock exceeds $60.04 per sharefor 20 trading days in any 30 trading-day period, Sonus may redeem this notethrough the issuance of shares of common stock or for cash. In the event of achange of control in Sonus, the holder at its option may require Sonus toredeem the note through the issuance of common stock or cash. Interest expenserelated to the convertible subordinated note was $475,000 per year for 2005,2004 and 2003.  Accrued interest was$79,000 at December 31, 2005 and 2004, respectively.

**(8) Commitments andContingencies**

***(a) Leases***

Sonus leases its facilities under operating leases,which expire through 2010. Sonus is responsible for certain real estate taxes,utilities and maintenance costs under these leases. In October 2003, Sonusentered into a lease agreement for a new corporate headquarters facility withrent commencing in April 2004 and extending through January 2007. In November 2004,Sonus entered into a lease agreement for a new development center in Bangalore,India, consisting of approximately 16,000 square feet under a lease expiring inJanuary 2008. In July 2005 Sonus entered into a lease agreement at anew location in Richardson, Texas, consisting of approximately 27,000 squarefeet under a lease expiring in October 2010. Rent expense was $3,003,000,$2,716,000 and $2,638,000 for 2005, 2004 and 2003, respectively. The futureminimum payments under operating lease arrangements as of December 31,2005 are as follows: $1,998,000 in 2006; $1,274,000 in 2007; $1,058,000 in2008; $831,000 in 2009 and $621,000 in 2010.

F-23

----

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

**(8) Commitmentsand Contingencies (Continued)**

In February 2006,Sonus entered into a lease to move our corporate headquarters to Westford,Massachusetts. The lease is effective in January 2007 and expires in July 2012.Future contractual obligations under the lease are $1,235,000 annually from 2007-2011and $669,000 in 2012.

***(b) Pending Litigation and Claims***

In November 2001, a purchaser of Sonus’ commonstock filed a complaint in the United States District Court for the SouthernDistrict of New York against Sonus, two of its officers and the lead underwritersalleging violations of the federal securities laws in connection with ourinitial public offering (IPO) and seeking unspecified monetary damages. Thepurchaser seeks to represent a class of persons who purchased Sonus’ commonstock between the IPO on May 24, 2000 and December 6, 2000. Anamended complaint was filed in April 2002. The amended complaint allegesthat Sonus’ registration statement contained false or misleading information oromitted to state material facts concerning the alleged receipt of undisclosedcompensation by the underwriters and the existence of undisclosed arrangementsbetween underwriters and certain purchasers to make additional purchases in theafter market. The claims against Sonus are asserted under Section 10(b) ofthe Securities Exchange Act of 1934 and Section 11 of the Securities Actof 1933 and against the individual defendants under Sections 11 and 15 of theSecurities Act and Sections 10(b) and 20(a) of the Exchange Act.Other plaintiffs have filed substantially similar class action cases againstapproximately 300 other publicly traded companies and their IPO underwriterswhich, along with the actions against Sonus, have been transferred to a singlefederal judge for purposes of coordinated case management. On July 15,2002, Sonus, together with the other issuers named as defendants in thesecoordinated proceedings, filed a collective motion to dismiss the consolidatedamended complaints on various legal grounds common to all or most of the issuerdefendants. The plaintiffs voluntarily dismissed the claims against many of theindividual defendants, including Sonus officers named in the complaint. On February 19,2003, the court granted a portion of the motion to dismiss by dismissing the Section 10(b) claimsagainst certain defendants including Sonus, but denied the remainder of themotion as to the defendants. In June 2003, a special committee of Sonus’Board of Directors authorized Sonus to enter into a proposed settlement withthe plaintiffs on terms substantially consistent with the terms of a Memorandumof Understanding negotiated among representatives of the plaintiffs, the issuerdefendants and the insurers for the issuer defendants. On February 15,2005, the court preliminarily approved the terms of the proposed settlementcontingent on modifications to the proposed settlement. On August 31,2005, the court approved the terms of the proposed settlement, as modified. Thesettlement is subject to class certification and final approval by the court. Ahearing has been scheduled on April 24, 2006 for final approval. Theproposed settlement would not require any settlement payment by Sonus,therefore Sonus does not expect that the settlement would have a materialimpact on its business or financial results.

Beginning in July 2002, several purchasers ofSonus’ common stock filed complaints in the United States District Court forthe District of Massachusetts against Sonus, certain officers and directors anda former officer under Sections 10(b) and 20(a) and Rule 10b-5of the Securities Exchange Act of 1934 (Class Action Complaints). Thepurchasers seek to represent a class of persons who purchased Sonus commonstock between December 11, 2000 and January 16, 2002, and seekunspecified monetary damages. The Class Action Complaints were essentiallyidentical and alleged that Sonus made false and misleading statements about itsproducts and business. On March 3, 2003, the plaintiffs filed aConsolidated Amended Complaint. On April 22, 2003, Sonus filed a motion todismiss the Consolidated Amended Complaint on 

F-24

----

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

**(8) Commitmentsand Contingencies (Continued)**

various grounds. On May 11,2004, the court held oral argument on the motion, at the conclusion of whichthe court denied Sonus’ motion to dismiss. The plaintiffs filed a motion forclass certification on July 30, 2004. On February 16, 2005, the courtcertified the class and appointed a class representative. On March 9,2005, the court appointed lead counsel. After the court requested additionalbriefing on the adequacy of the class representative, the class representativewithdrew. Lead counsel then filed a motion to substitute a new plaintiff as theclass representative. On May 19, 2005, the court held a hearing on themotion and took the matter under advisement. On August 15, 2005, the courtissued an order decertifying the class and requiring the parties to submit ajoint report informing the court whether the cases have been settled andwhether defendants would be seeking to recover attorney’s fees from theplaintiffs. On September 30, 2005, the plaintiffs filed motions tovoluntarily dismiss their complaints with prejudice. On October 5, 2005,the court entered an order dismissing the cases. On October 21, 2005, thedefendants filed a motion seeking the recovery of attorneys’ fees fromplaintiffs. The plaintiffs have opposed the motion. No hearing date has beenscheduled.

On January 6, 2006, a purchaser of Sonus’ commonstock filed a complaint in the United States District Court for the District ofMassachusetts that is essentially identical to the Class Action Complaintspreviously filed against the defendants. Sonus has not yet responded to thecomplaint.  Sonus expects the court toappoint the lead plaintiff within the next month, after which Sonus intends tofile a motion to dismiss the complaint. There is no assurance Sonus willprevail in defending these actions. A judgment or a settlement of the claimsagainst the defendants could have a material impact on Sonus’ financialresults. It is too early to determine the ultimate outcome or potential rangeof loss, if any.

Beginning in February 2004, a number of purportedshareholder class action complaints were filed in the United States DistrictCourt for the District of Massachusetts against Sonus and certain of itscurrent officers and directors. On June 28, 2004, the court consolidatedthe claims. On December 1, 2004, the lead plaintiff filed a consolidatedamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the SecuritiesExchange Act of 1934 and Sections 11, 12(a), and 15 of the Securities Act of1933, relating to Sonus’ restatement of its financial results for 2001, 2002,and the first three quarters of 2003. Specifically, the complaint alleges thatSonus issued a series of false or misleading statements to the marketconcerning our revenues, earnings, and financial position. Plaintiffs contendthat such statements caused Sonus’ stock price to be artificially inflated. Thecomplaint seeks unspecified damages on behalf of a purported class ofpurchasers of Sonus’ common stock during the period from March 28, 2002through March 26, 2004. On January 28, 2005, Sonus filed a motion todismiss the Section 10(b) and 12(a) claims and joined the motionto dismiss the Section 11 claim filed by the individual defendants. On June 1,2005, the court held a hearing on the motion and allowed the plaintiff to filean amended complaint. The plaintiff filed an Amended Complaint that includedthe same claims and substantially similar allegations as set forth in the priorComplaint. On September 12, 2005, the defendants filed motions to dismissthis Amended Complaint. On December 10, 2005, the Court held a hearing onthe motions and took  the matter underadvisement. Sonus believes that it has substantial legal and factual defensesto the claims, which it intends to pursue vigorously. There is no assuranceSonus will prevail in defending these actions. A judgment or a settlement ofthe claims against the defendants could have a material impact of Sonus’financial results. It is too early to determine the ultimate outcome orpotential range of loss, if any.

F-25

----

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

**(8) Commitmentsand Contingencies (Continued)**

In February 2004, three purported shareholderderivative lawsuits were filed in the United States District Court for theDistrict of Massachusetts against Sonus and certain of its officers anddirectors, naming Sonus as a nominal defendant. Also in February 2004, twopurported shareholder derivative lawsuits were filed in the business litigationsession of the superior court of Suffolk County of Massachusetts against Sonusand certain of its directors and officers, also naming Sonus as a nominaldefendant. The suits claim that certain of Sonus’ officers and directorsbreached their fiduciary duties to Sonus’ stockholders and to Sonus. Thecomplaints are derivative in nature and do not seek relief from Sonus. However,Sonus has entered into indemnification agreements in the ordinary course ofbusiness with certain of the defendant officers and directors and may beobligated throughout the pendency of these actions to advance payment of legalfees and costs incurred by the defendants pursuant to Sonus’ obligations underthe indemnification agreements or applicable Delaware law. On September 27,2004, the state court granted Sonus’ motion to dismiss. On October 26,2004, the plaintiffs filed a notice appealing the state court’s dismissal of theactions. On June 24, 2005, the plaintiffs withdrew the appeal anddismissed the case with prejudice. In the federal actions, on June 28,2004, the court consolidated and stayed the three actions. On October 12,2004, the lead plaintiff filed a consolidated amended complaint. On June 1,2005, the court held a hearing on the motion and allowed the plaintiff to filean amended complaint. On July 1, 2005, the plaintiff filed an amendedcomplaint. The defendants renewed their motions to dismiss. On December 10,2005, the court held a hearing on the motions and took the matter underadvisement. There is no assurance Sonus will prevail in defending these actions.Sonus does not expect these shareholder derivative claims will have a materialimpact on its financial results.

In December 2004, a purchaser of Sonus’ commonstock filed a complaint in the circuit court in Will County, Illinois, againstSonus, one of its officers, and a former officer alleging misrepresentation andfraud in connection with the plaintiff’s purchase of Sonus stock. The Complaintseeks unspecified damages. Sonus filed a motion to dismiss the complaint. On May 5,2005, the plaintiff filed an amended complaint. On October 26, 2005, thecourt held a hearing on the motion during which it dismissed the federal claimswithout prejudice and dismissed the state claims without prejudice. On November 23,2005, the plaintiff filed a second amended complaint with essentially the sameallegations as in the prior complaints. The defendants renewed their motions todismiss with respect to the second amended complaint. On March 9, 2006,the court held a hearing on the defendants’ motions during which he entered anorder dismissing the second amended complaint with prejudice. Sonus does notexpect that this claim will have a material impact on its financial results.

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

F-26

----

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

**(9) Stockholders’Equity**

***(a) 1997 Stock Incentive Plan***

On January 1 of each year, the aggregate numberof shares of common stock available for issuance under the 1997 Stock IncentivePlan (Plan) shall increase by the lesser of (i) 5% of the outstandingshares on December 31 of the preceding year or (ii) an amount determinedby the Board of Directors. As of December 31, 2005, 135,227,031 shareswere authorized and 40,401,262 shares were available under the Plan for futureissuance.

Sonus has issued shares of restricted common stock toemployees and consultants which were subject to repurchase agreements andgenerally vested over a four or five-year period. If the employee were to leaveor if the services were not performed, Sonus could repurchase any restrictedshares of common stock held by these individuals at their original purchaseprice ranging from $0.01 to $4.67 per share. All shares of common stock subjectto repurchase restrictions contained the same rights and privileges asunrestricted shares of common stock and are presented as outstanding as of thedate of issuance. As of December 31, 2004, the restrictions on all shareshad lapsed that were subject to Sonus’ right to repurchase.

On October 16, 2002, Sonus commenced its ExchangeOffer for outstanding employee stock options granted under the Plan having an exerciseprice of $0.67 or more per share for new stock options to be granted by Sonus.Outstanding options granted under the telecom technologies, inc. (TTI)Amended and Restated 1998 Equity Incentive Plan were not eligible for exchange.Also, Sonus’ directors, executive officers and non-employees were not eligibleto participate in the exchange. On November 22, 2002, the Exchange Offerexpired. Outstanding options to purchase approximately 8,973,000 shares ofcommon stock were accepted for exchange and cancelled. On May 27, 2003,employees received an option to purchase one share of common stock for eachshare of common stock under the exchanged options. The new options were grantedat an exercise price of $4.08 per share, which represented the fair market valueof Sonus’ common stock on the date of grant.

A summary of activityunder the Plan for the years ended December 31, 2003 and 2004, is asfollows:

**Restricted Common Stock Issuances**

| ** **                                         | ** ** | **Number of  Shares** | ** ** | **Purchase  Price** | ** ** | **Weighted  Average  Purchase  Price** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|---------------------|------------|----------------------------------------|------------|
| Outstanding,  December 31, 2002               |       | 41,715,405                 |       | $                   | 0.01-4.67  |                                   |       | $ | 0.20 |   |   |
| Repurchased                                        |       | (30,100                    | )          | 0.16-0.22           |       |                                   | 0.20       |   |   |
| Outstanding,  December 31, 2003               |       | 41,685,305                 |       | 0.01-4.67           |       |                                   | 0.19       |   |   |
| Repurchased                                        |       | —                     |       | —              |       |                                   | —     |   |   |
| Outstanding  December 31, 2004                |       | 41,685,305                 |       | $                   | 0.01-4.67  |                                   |       | $ | 0.19 |   |   |
| Unrestricted  common stock, December 31, 2004 |       | 41,685,305                 |       | $                   | 0.01-4.67  |                                   |       | $ | 0.19 |   |   |
| Unrestricted common  stock, December 31, 2003 |       | 40,627,260                 |       | $                   | 0.01-4.67  |                                   |       | $ | 0.19 |   |   |

 

F-27

----

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

**(9) Stockholders’ Equity**

**Common Stock Option Grants**

| ** **                        | ** ** | **2003**                   | ** ** | **2004**                                    | ** ** | **2005**                   | ** ** |
|-----------------------------------|------------|----------------------------|------------|---------------------------------------------|------------|----------------------------|------------|
| ** **                        | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise   rice** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise   rice** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Outstanding at  beginning of year |       | 12,412,973                 |       |                                        | $          | 5.42                       |       |   | 28,136,494 |   |   | $ | 4.60 |   |   | 36,893,219 |   |   | $ | 4.71 |   |   |
| Granted                           |       | 20,247,276                 |       |                                        | 4.35       |                       |       | 11,473,300 |   |   | 4.88 |   |   | 10,981,600 |   |   | 4.75 |   |   |
| Cancelled                         |       | (2,329,386                 | )          |                                        | 8.55       |                       |       | (1,492,290 | ) |   | 5.14 |   |   | (1,697,340 | ) |   | 5.16 |   |   |
| Exercised                         |       | (2,194,369                 | )          |                                        | 2.71       |                       |       | (1,224,285 | ) |   | 3.02 |   |   | (843,947 | ) |   | 2.68 |   |   |
| Outstanding at  end of year       |       | 28,136,494                 |       |                                        | $          | 4.60                       |       |   | 36,893,219 |   |   | $ | 4.71 |   |   | 45,333,532 |   |   | $ | 4.74 |   |   |
| Exercisable at end of  year       |       | 9,780,521                  |       |                                        | $          | 4.68                       |       |   | 15,683,511 |   |   | $ | 4.75 |   |   | 42,487,829 |   |   | $ | 4.81 |   |   |

 

Thefollowing table summarizes information relating to currently outstanding andexercisable options as of December 31, 2005:

| **Outstanding**               | ** ** | **Exercisable** | ** ** |
|-------------------------------|------------|-----------------|------------|
| **Exercise Price**       | ** ** | ** **      | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Remaining  Contractual Life  (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $0.07 - $3.99                 |       | 8,715,165       |       |   | 6.1 |   |   |   | $ | 3.13 |   |   | 6,150,582 |   |   | $ | 2.90 |   |   |
| $4.00 - $4.08                 |       | 7,240,062       |       |   | 4.6 |   |   |   | 4.08 |   |   | 7,233,194 |   |   | 4.08 |   |   |
| $4.09 - $4.45                 |       | 3,196,660       |       |   | 9.0 |   |   |   | 4.21 |   |   | 3,177,493 |   |   | 4.21 |   |   |
|  $4.47    |       | 8,925,462       |       |   | 7.5 |   |   |   | 4.47 |   |   | 8,912,337 |   |   | 4.47 |   |   |
| $4.61 - $5.16                 |       | 7,368,183       |       |   | 9.2 |   |   |   | 4.86 |   |   | 7,232,183 |   |   | 4.86 |   |   |
| $5.19 - $5.90                 |       | 7,798,500       |       |   | 8.7 |   |   |   | 5.46 |   |   | 7,715,457 |   |   | 5.46 |   |   |
| $6.60 - $29.00                |       | 2,089,500       |       |   | 5.7 |   |   |   | 12.72 |   |   | 2,066,583 |   |   | 12.78 |   |   |
| Total                         |       | 45,333,532      |       |   | 7.3 |   |   |   | $ | 4.74 |   |   | 42,487,829 |   |   | $ | 4.81 |   |   |

 

***(b) 2000 Employee Stock Purchase Plan***

On January 1 of eachyear, the aggregate number of shares of common stock available for purchaseunder the ESPP shall increase by the lesser of (i) 2% of the outstandingshares on December 31 of the preceding year or (ii) an amountdetermined by the Board of Directors. As of December 31, 2005, 25,290,812shares were authorized and 19,468,485 shares were available under the ESPP forfuture issuance.

***(c) 1998 Equity Incentive Plan***

In January 2001, in connection with thecompletion of the TTI acquisition, Sonus assumed TTI’s 1998 Equity IncentivePlan and all grants of options under this plan. Each outstanding option topurchase shares of TTI Class B common stock granted under the 1998 EquityIncentive Plan immediately prior to the effective time of the acquisition wasconverted into an option to purchase Sonus common stock based on the mergerconsideration, with the exercise price of the options being proportionatelyadjusted.

F-28

----

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

**(9) Stockholders’Equity**

In continuation of a 1997agreement entered into by the TTI founders and other TTI shareholders, thefounders agreed, in exchange for the option exercise proceeds, to transfer toSonus a number of shares of Sonus’ common stock received by them in theacquisition equal to the number of shares of Sonus’ common stock issued uponexercise by former TTI employees of the stock options granted under the TTI1998 Equity Incentive Plan. As a result of this agreement, the aggregate numberof outstanding shares of Sonus’ common stock that will be issued upon exerciseof these stock options will not increase. As of December 31, 2005, alloptions under the TTI 1998 Equity Incentive Plan have expired. The Companyexpects to distribute all remaining shares, approximately 39,000, to the TTIfounders.

***(d) Stock-based Compensation***

Stock-based compensation expenses include theamortization of deferred employee compensation and other equity relatedexpenses for non-employees.

In connection with certain employee stock optiongrants and the issuance of employee restricted common stock during the yearsended December 31, 2000 and 1999, Sonus recorded deferred stock-basedcompensation of $39,433,000 and $20,859,000. This represents the aggregate differencebetween the exercise price or purchase price and the fair value of the commonstock on the date of grant or sale for accounting purposes. The deferredcompensation was recognized as an expense over the vesting period of theunderlying stock options and restricted common stock based on the acceleratedmethod prescribed by FIN 28. This deferred compensation was fully amortized asof December 31, 2004.

Sonus has valued stock options to non-employees basedupon the fair market value of the services rendered where Sonus believes thevalue of these services is more readily determinable than the value of theoptions.

Sonus recorded stock basedcompensation of $20,000, $671,000 and $3,418,000 for the years ended December 31,2005, 2004 and 2003. Stock-based compensation expense for the year ended December 31,2003 is net of $229,000 related to the recapture of expense with respect to unvestedshares held by terminated employees.

***(f) Common Stock Reserved***

Commonstock reserved for future issuance at December 31, 2005 consist of thefollowing:

| Stock incentive  plan                        |   | 82,086,567  |   |
|----------------------------------------------|--------|-------------|--------|
| Employee stock  purchase plan                |   | 19,468,485  |   |
| Conversion of  convertible subordinated note |   | 333,140     |   |
|                                         |   | 101,888,192 |   |

 

**(10) Employee BenefitPlan**

In 1998, Sonus adopted asavings plan for its employees, which has been qualified under Section 401(a) ofthe Internal Revenue Code. Eligible employees are permitted to contribute tothe 401(k) plan through payroll deductions within statutory and planlimits. Contributions from Sonus are made at the discretion of the Board ofDirectors. Sonus has made no contributions to the 401(k) plan to date.

F-29

----

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

**(11) Quarterly Results ofOperations (unaudited)**

Thefollowing table presents Sonus’ quarterly operating results for the years endedDecember 31, 2005 and 2004. The information for each of these quarters isunaudited and has been prepared on the same basis as the audited consolidatedfinancial statements. In the opinion of management, all necessary adjustments,consisting only of normal recurring adjustments, have been included to presentfairly the unaudited consolidated quarterly results when read in conjunctionwith Sonus’ audited consolidated financial statements and related notes. Theseoperating results are not necessarily indicative of the results of any futureperiod.

| ** **                                                 | ** ** | **Three months ended**                                              | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **Dec. 31,  2005**                                                       | ** ** | **Sept. 30,  2005** | ** ** | **June 30,  2005** | ** ** | **March  31  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sept 30,  2004** | ** ** | **June 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| ** **                                                 | ** ** | **(in thousands, except per share data)(unaudited)** | ** ** |
| **Revenues**                                               |       | $                                                                             | 57,250     |   | $ | 45,657 |   | $ | 58,093 |   |   | $ | 33,610 |   |   | $ | 45,083 |   | $ | 46,762 |   | $ | 42,361 |   | $ | 36,532 |   |
| Cost of revenues                                           |       | 20,870                                                                        |       | 23,483 |   | 21,055 |   |   | 12,112 |   |   | 13,757 |   | 10,469 |   | 13,941 |   | 12,400 |   |
| **Gross profit**                                           |       | 36,380                                                                        |       | 22,174 |   | 37,038 |   |   | 21,498 |   |   | 31,326 |   | 36,293 |   | 28,420 |   | 24,132 |   |
| **Income (loss) from operations**                          |       | 2,895                                                                         |       | (5,913 | ) | 7,955 |   |   | (5,346 | ) |   | 4,992 |   | 9,449 |   | 4,381 |   | 2,538 |   |
| **Net income (loss)**                                      |       | $                                                                             | 5,022      |   | $ | (2,704 | ) | $ | 9,745 |   |   | $ | (3,695 | ) |   | $ | 6,261 |   | $ | 10,268 |   | $ | 4,934 |   | $ | 3,014 |   |
| **Net income (loss) per share:**                           |       |                                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                      |       | $                                                                             | 0.02       |   | $ | (0.01 | ) | $ | 0.04 |   |   | $ | (0.01 | ) |   | $ | 0.03 |   | $ | 0.04 |   | $ | 0.02 |   | $ | 0.01 |   |
| Diluted                                                    |       | $                                                                             | 0.02       |   | $ | (0.01 | ) | $ | 0.04 |   |   | $ | (0.01 | ) |   | $ | 0.02 |   | $ | 0.04 |   | $ | 0.02 |   | $ | 0.01 |   |
| **Shares used in computing net  income (loss) per share:** |       |                                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                      |       | 249,390                                                                       |       | 248,801 |   | 248,249 |   |   | 247,877 |   |   | 247,134 |   | 246,198 |   | 245,390 |   | 244,607 |   |
| Diluted                                                    |       | 252,356                                                                       |       | 248,801 |   | 250,651 |   |   | 247,877 |   |   | 256,443 |   | 251,707 |   | 250,127 |   | 255,592 |   |

 

F-30

----

**EXHIBIT INDEX**

| Exhibit No. | ** ** | **Description**                                                                                                                                                                                            |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(d)           |       | Fourth Amended and Restated Certificate of  Incorporation of Sonus Networks, Inc., as amended                                                                                                         |
| 3.2(b)           |       | Amended and Restated By  Laws of Sonus Networks, Inc.                                                                                                                                                      |
| 4.1(b)           |       | Form of Stock Certificate  representing shares of Sonus Networks, Inc. Common Stock                                                                                                              |
| 10.1(a)          |       | Registration Rights  Agreement, dated as of November 2, 2000, by and among Sonus  Networks, Inc. and the Stockholder parties thereto                                                             |
| 10.2(b)+         |       | Amended and Restated  1997 Stock Incentive Plan of the Registrant                                                                                                                                          |
| 10.3(b)+         |       | 2000 Employee Stock  Purchase Plan of the Registrant                                                                                                                                                       |
| 10.4(a)          |       | Lease, dated  September 30, 2000, between the Registrant and BCIA New England Holdings  LLC with respect to property located at 25 Porter Road, Littleton, Massachusetts                              |
| 10.5(c)          |       | Sublease Agreement,  dated October 16, 2003, by and between Cisco Systems, Inc. and  Sonus Networks, Inc. with respect to property located at 250 Apollo  Drive, Chelmsford, Massachusetts  |
| 10.6(d)+         |       | Employment letter dated  April 6, 2004, by and between the Registrant and Albert A. Notini                                                                                                            |
| 10.7(e)+         |       | Employment letter dated  December 23, 2004, by and between the Registrant and Ellen B. Richstone                                                                                                      |
| 10.8(f)+         |       | Summary of 2004  Executive Bonus Plan                                                                                                                                                                      |
| 10.9(g)+         |       | Form of Stock  Option Agreement under the 1997 Stock Incentive Plan                                                                                                                                   |
| 10.10(g)+        |       | Form of Director  and Officer Indemnity Agreement                                                                                                                                                     |
| 10.11(h)+        |       | Employment letter dated  July 6, 2004, by and between the Registrant and Steven Edwards                                                                                                               |
| 10.12(i)+        |       | Summary of 2005  Executive Incentive Plan                                                                                                                                                                  |
| 10.13(i)+        |       | Summary of Director  Compensation Plan                                                                                                                                                                     |
| 10.14(j)         |       | Office Lease Agreement,  dated July 19, 2005, between Sonus Networks, Inc. and Pearson Fund  III, L.P. with respect to property located at 1130 East Arapaho Road,  Richardson, Texas            |
| 10.15(j)+        |       | Employment letter dated  August 11, 2005, by and between the Registrant and Paul K. McDermott                                                                                                         |
| 10.16(k)         |       | Form of Resale  Restriction Agreement                                                                                                                                                                 |
| 10.17(l)         |       | Sublease agreement,  dated February 22, 2006, by and between Teradyne, Inc. and Sonus  Networks, Inc. with respect to property located at 7 Technology Park  Drive, Westford, Massachusetts |
| 14.1(c)          |       | Code of Business Conduct  and Ethics                                                                                                                                                                       |
| 21.1*            |       | Subsidiaries of the  Registrant                                                                                                                                                                            |
| 23.1*            |       | Consent of  Deloitte & Touche LLP                                                                                                                                                                 |
| 23.2*            |       | Consent of  Ernst & Young LLP                                                                                                                                                                     |
| 31.1*            |       | Certificate of Sonus  Networks, Inc. Chief Executive Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002                                                                          |
| 31.2*            |       | Certificate of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002                                                                          |
| 32.1*            |       | Certificate of Sonus  Networks, Inc. Chief Executive Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                                                                          |
| 32.2*            |       | Certificate of Sonus  Networks, Inc. Chief Financial Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                                                                          |

----

(a)           Incorporated byreference to the Registrant’s Registration Statement on Form S-4(file No. 333-52682).

----

(b)          Incorporated byreference to the Registrant’s Registration Statement on Form S-1(file No. 333-32206).

(c)           Attached as Exhibit (a)(1) toTender Offer Statement on Schedule TO (file No. 005-60815), filed October 16,2002 with the SEC, and subsequently amended by Amendment No. 1, filed on October 17,2002, Amendment No. 2, filed on November 12, 2002, and Amendment No. 3,filed on November 26, 2002.

(c)           Incorporated byreference from the Registrant’s Form 10-K (file No. 000-30229),filed March 15, 2004 with the SEC.

(d)          Incorporated byreference from the Registrant’s Amendment No. 1 to Form 10-K/A(file No. 000-30229), filed July 28, 2004 with the SEC.

(e)           Incorporated byreference from the Registrant’s Form 8-K (file No. 000-30229),filed January 12, 2005 with the SEC.

(f)             Incorporated byreference from the Registrant’s Form 10-Q (file No. 000-30229),filed November 9, 2004 with the SEC.

(g)           Incorporated byreference from the Registrant’s Form 10-Q (file No. 000-30229),filed August 20, 2004 with the SEC.

(h)          Incorporated byreference from the Registrant’s Form 10-K/A (file No. 000-30229),filed April 29, 2005 with the SEC.

(i)             Incorporated byreference from the Registrant’s Form 10-Q (file 000-30229),filed August 8, 2005 with the SEC.

(j)              Incorporated byreference from the Registrant’s Form 10-Q (file 000-30229),filed November 8, 2005 with the SEC.

(k)          Incorporated byreference from the Registrant’s Form 8-K (file 000-30229),filed December 28, 2005 with the SEC.

(l)             Incorporated byreference from the Registrant’s Form 8-K (file 000-30229),filed March 9, 2006 with the SEC.

*                    Filedherewith.

+                Managementcontract or compensatory plan or arrangement filed in response to Item 15(a)(3) ofthe Instructions to the Annual Report on Form 10-K.

----