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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

for the quarterly period ended March 31, 2003

or

for the transition period from              to             

Commission File Number 0-25996

TRANSWITCH CORPORATION

(Exact name of Registrant as Specified in its Charter)

3 Enterprise Drive

Shelton, Connecticut 06484

(Address of Principal Executive Offices)

Telephone (203) 929-8810

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

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

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

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

Common Stock, par value $.001 per share, outstanding at April 30, 2003; 90,136,031

Series A Junior Participating Preferred Stock Purchase Rights

4½% Convertible Notes due 2005 outstanding at April 30, 2003; $114,113,000

Table of Contents

TranSwitch Corporation And Subsidiaries

FORM 10-Q

For the Quarterly Period Ended March 31, 2003

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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

See accompanying notes to unaudited consolidated financial statements

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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share amounts)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

See accompanying notes to unaudited consolidated financial statements.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except per share amounts)

Note 1. Summary of Significant Accounting Policies

Description of Business

TranSwitch Corporation (“TranSwitch” or the “Company”) was incorporated in Delaware on April 26, 1988, and is headquartered in Shelton, Connecticut. The Company and its subsidiaries (collectively, “TranSwitch” or the “Company”) design, develop, market and support highly integrated digital and mixed-signal semiconductor devices for the telecommunications and data communications industries.

Basis of Presentation – Interim Financial Statements

The unaudited interim consolidated financial statements include the accounts of TranSwitch Corporation and its wholly-owned subsidiaries and its majority-controlled variable interest entity. All significant intercompany accounts and transactions have been eliminated. The accompanying unaudited interim consolidated financial statements of TranSwitch have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission for reporting on Form 10-Q. Accordingly, certain information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements are not included herein. The unaudited interim consolidated financial statements are prepared on a consistent basis with, and should be read in conjunction with, the audited consolidated financial statements and the related notes thereto as of and for the year ended December 31, 2002, contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 17, 2003.

In the opinion of management, the accompanying unaudited interim consolidated financial statements include all adjustments, consisting of normal recurring adjustments, which are necessary for a fair presentation for such periods. The results of operations for any interim period are not necessarily indicative of the results that may be achieved for the entire year ending December 31, 2003.

Stock-Based Compensation

As permitted by Statement of Financial Accounting Standard (SFAS), SFAS No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123), the Company accounts for employee stock-based compensation in accordance with Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees”, and the Financial Accounting Standards Board (FASB) Interpretation No. 44, “Accounting for Certain Transactions Involving Stock-Based Compensation, an interpretation of APB Opinion No. 25” (FIN 44) and related interpretations. Stock-based compensation related to non-employees is based on the fair value of the related stock or options in accordance with SFAS 123 and its interpretations. Expense associated with stock-based compensation is amortized over the vesting period of each individual award. The following table illustrates the effect on net (loss) income and (loss) earnings per common share as if the Black-Scholes fair value method described in SFAS 123, had been applied to the Company’s stock purchase and stock option plans:

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing with the following assumptions:

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements—Continued

(Tabular dollars in thousands, except per share amounts)

Restatements

As disclosed in the Company’s Annual Report on Form 10-K, the Company restated prior period results to reflect the change from the cost to the equity method of accounting for its investment in OptiX Networks, Inc. (OptiX) as the Company, during fiscal 2002, obtained the ability to significantly influence the operating and financial policies of OptiX through its investments in convertible preferred stock and a bridge loan.

In addition, the Company adopted SFAS 145 effective January 1, 2003 and, accordingly, reclassified the gain on the early extinguishment of its debt which included the related transaction fees, deferred financing fees and income taxes which was previously recorded in the consolidated statement of operations as an extraordinary item to other (expense) income and income tax expense, respectively.

Reclassifications

Certain prior period amounts have been reclassified to conform to the current period’s presentation.

Recent Accounting Pronouncements

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (SFAS 145). As it applies to the Company, SFAS 145 requires that certain gains and losses on extinguishments of debt be classified as income or loss from continuing operations, rather than as extraordinary items, as previously required under SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt”. The Company adopted SFAS 145 effective January 1, 2003 and, accordingly, reclassified the gain on the early extinguishment of its debt which included the related transaction fees, deferred financing fees and income taxes which was previously recorded in the consolidated statement of operations as an extraordinary item to other (expense) income and income tax expense, respectively.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). The effect of SFAS 146 is to spread out the reporting of expenses related to restructurings initiated after 2002, because commitment to a plan to exit an activity or dispose of long-lived assets is no longer sufficient to record a liability for the anticipated costs. Instead, companies are to record exit and disposal costs when they are “incurred” and can be measured at fair value, and they will subsequently adjust the recorded liability for changes in estimated cash flows. The provisions of SFAS 146 are effective for exit and disposal activities that are initiated after December 31, 2002. In conjunction with the January 2003 restructuring plan, the Company has applied the provisions of SFAS 146. Refer also to Note 5—Restructuring Liabilities for further details on the January 2003 restructuring plan.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (SFAS 148). SFAS 148 amends SFAS 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The additional disclosure requirements of SFAS 148 are effective for fiscal years ending after December 15, 2002. The Company has elected to continue to follow the intrinsic value method of accounting as prescribed by APB 25. The Company has complied with the disclosure requirements of SFAS 148 in the “Stock Based Compensation” paragraph above.

In November 2002, FASB Interpretation FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45) was issued. The interpretation provides guidance on the guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others. The Company has adopted the disclosure requirements of the interpretation as of December 31, 2002. The accounting guidelines are applicable to guarantees issued after December 31, 2002 and require that the Company record a liability for the fair value of such guarantees in the balance sheet. Effective December 31, 2002, the Company adopted FIN 45. The Company determined that it was not necessary to record a liability for potential patent indemnity claims based on past historical experience. However, the Company disclosed information regarding potential patent indemnity claims in Note 14 of the Form 10-K for the year ended December 31, 2002 in accordance with FIN 45.

In January 2003, FIN No. 46, “Consolidation of Variable Interest Entities” (FIN 46) was issued. The interpretation provides guidance on consolidating variable interest entities and applies immediately to variable interests created after January 31, 2003. The guidelines of the interpretation will become applicable for the Company in its third quarter 2003 unaudited interim consolidated financial statements for variable interest entities created before February 1, 2003. The interpretation requires variable interest entities to be consolidated if the equity investment at risk is not sufficient to permit an entity to finance its activities without support from other parties or the equity investors lack certain specified characteristics. The Company adopted FIN No. 46 as of February 1, 2003, which resulted in the Company consolidating the results of TeraOp (USA), Inc. Refer also to Note 6—Investments in Non-Publicly Traded Companies for further details about this adoption.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements—Continued

(Tabular dollars in thousands, except per share amounts)

Note 2.    Inventories

The components of inventories at March 31, 2003 and December 31, 2002 are as follows:

As a result of current and anticipated business conditions, as well as lower than anticipated demand, the Company recorded provisions for excess inventories totaling approximately $4.8 million and $39.2 million during the years ended December 31, 2002 and 2001, respectively. There were no such provisions recorded during the three months ended March 31, 2003 and 2002, respectively. The effect of these inventory provisions was to write this excess inventory down to a new cost basis of zero. During fiscal 2003 and 2002, the Company has sold certain products that had previously been written down to a cost basis of zero. The following tables present the beneficial impact to gross profit from the sale of this previously written down inventory for the three months ended March 31, 2003 and 2002 respectively:

Note 3.    Comprehensive (Loss) Income

The components of comprehensive loss are as follows:

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements—Continued

(Tabular dollars in thousands, except per share amounts)

Note 4.    (Loss) Income Per Common Share

Basic and diluted (loss) income per common share for the three month periods ended March 31, 2003 and 2002 are as follows:

Note 5.    Restructuring Liabilities

In January 2003, the Company announced a restructuring plan in order to lower its operating expense run-rate due to current and anticipated business conditions. This plan resulted in a work-force reduction of approximately 25% of existing personnel. Also, the Company announced that it is closing its South Brunswick, NJ (formerly known as Systems On Silicon, Inc. and referred to as SOSi) design center and is reducing its staff in Boston, MA, and Shelton, CT. This workforce reduction also impacted the Company’s Switzerland and Belgium locations. In addition, the Company has postponed the completion of the IAD product line and archived the related intellectual property until the market returns, if ever. During the three months ended March 31, 2003, the Company incurred approximately $3.4 million in restructuring expenses related to employee termination benefits and $0.2 million related to excess facility costs. In addition, the Company determined that fixed assets with a net book value totaling $0.3 million and a patent on its IAD product line with a net book value of $0.2 million were impaired. This resulted in a total restructuring and asset impairment charge for the three months ended March 31, 2003 totaling $4.1 million. This restructuring charge was reduced by $0.3 million as the Company was able to sub-lease portions of its excess facilities.

The Company adopted SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” as of January 1, 2003. The effect of SFAS 146 is to spread out the reporting of expenses related to restructurings initiated after 2002 because commitment to a plan to exit an activity or dispose of long-lived assets is no longer sufficient to record a liability for the anticipated costs. The Company is now required to record exit and disposal costs when they are “incurred” and can be measured at fair value. The recorded liability will be adjusted in future periods for changes in estimated cash flows. As such, the future excess facility costs incurred in fiscal 2003 have been recorded net of future anticipated lease income (although there are no firm commitments) and discounted to their current present net value resulting in a liability of $0.1 million. This liability will be adjusted quarterly based upon actual cash flows and changes to estimates. Quarterly adjustments to this liability will be recorded as restructuring expenses on the consolidated statement of operations. The liability related to employee termination benefits is short-term in nature and is recorded at its fair value.

During fiscal years 2002 and 2001, the Company announced three restructuring plans due to then current and anticipated business conditions. These plans resulted in the elimination of approximately 130 positions in North America and the closing of six leased facilities in Canada, Massachusetts, North Carolina, California and Connecticut. In addition, the Company discontinued its AsTrix and Sertopia product lines.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements—Continued

(Tabular dollars in thousands, except per share amounts)

A summary of the restructuring liabilities and the activity from December 31, 2002 through March 31, 2003 is as follows:

At March 31, 2003, the Company has classified approximately $25.1 million of this restructuring liability as long-term representing net lease commitments that are not due in the succeeding twelve-month period.

Note 6.    Investments in Non-Publicly Traded Companies

Equity Method Investments

The Company’s venture capital limited partnership investments in GTV Capital, L.P. and Neurone Ventures II, L.P., as well as its investment in OptiX Networks, Inc., are accounted for under the equity method of accounting. Under the equity method of accounting, the Company’s pro-rata share of the net income or loss from the investee companies is recorded in the consolidated statements of operations and, accordingly, the carrying value of the investment is adjusted on the consolidated balance sheets. In February 2003, the Company terminated its limited partnership agreement with GTV Capital, L.P. and was paid the remaining balance of its investment totaling approximately $0.9 million.

Variable Interest Entities

In January 2003, FIN 46, “Consolidation of Variable Interest Entities” was issued. The interpretation provides guidance on consolidating variable interest entities and applies to all variable interests created after January 31, 2003. The interpretation requires variable interest entities to be consolidated if the equity investment at risk is not sufficient to permit an entity to finance its activities without support from other parties or the equity investors lack certain specified characteristics. The Company adopted FIN 46 as of February 1, 2003, which resulted in the Company consolidating the results of TeraOp (USA), Inc. (TeraOp).

        During the first quarter 2003, the Company loaned TeraOp $0.5 million under a new convertible loan agreement, which provides the Company with additional contractual rights over existing debt or equity investors. In addition, the Company also is in a position, as a result of the loan, to negotiate a more favorable conversion price of its interest in TeraOp and has the ability to control the operations of TeraOp. None of the existing debt or equity investors, other than the Company, expects to, or is obligated to, absorb any additional losses from their investment given that the equity in TeraOp is negative as of January 31, 2003. As a result, the convertible loan recently issued has been determined to be a variable interest and TeraOp is now considered a variable interest entity, as defined by FIN 46. The Company has calculated the effect of the initial measurement as of January 31, 2003. As a result of this measurement and consolidation of TeraOp, the Company recognized an extraordinary loss of approximately $0.1 million as the fair value of TeraOp’s liabilities exceeded those of its assets by this amount. All significant intercompany balances, including the Company’s investments in TeraOp, have been eliminated upon consolidation.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements—Continued

(Tabular dollars in thousands, except per share amounts)

Cost Method Investments

The Company has purchased shares of convertible preferred stock in Accordion Networks, Inc. (Accordion) and Intellectual Capital for Integrated Circuits, Inc. (IC4IC). The Company’s direct and indirect voting interest (which include certain board members and employees) is less than 20% of the total ownership of each of these companies as of March 31, 2003 and the Company does not exercise significant influence over the management of these companies as defined by APB Opinion No. 18 “The Equity Method of Accounting for Investments in Common Stock,” and other relevant literature. The Company accounts for these investments at cost and monitors the carrying value of these investments for impairment.

In February 2003, the Company made a convertible bridge loan investment in IC4IC totaling $0.05 million. It was determined in March of 2003 that this investment should be impaired, as it was evident that IC4IC would not have or be able to raise sufficient equity or debt to fund its operations. During early April 2003, IC4IC’s Board of Directors made the decision to discontinue operations.

Summary of Investments in Non-Publicly Traded Companies

The following table summarizes the Company’s investments and changes to investment values as of December 31, 2002 and for the period ended March 31, 2003:

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements—Continued

(Tabular dollars in thousands, except per share amounts)

Note 7.    Property and Equipment, Net

The components of property and equipment, net at March 31, 2003 and December 31, 2002 are as follows:

Depreciation expense was $2.5 million and $2.2 million for the three months ended March 31, 2003 and 2002, respectively.

Effective January 1, 2003, the Company has changed the method of depreciating property and equipment to the straight-line method. Depreciation of property and equipment in prior years was computed using the half-year convention method. The Company has evaluated the use and related consumption of all classes of acquired property and equipment and has determined that many assets are used and consumed on a consistent level over their estimated economic lives. Under the half-year convention method, property and equipment placed in service during the first year of acquisition was subject to six months of depreciation expense regardless of when the asset was acquired, placed in service and consumed. The Company believes that the straight-line method results in a better approximation of the underlying consumption of the asset over its estimated useful life and provides a better matching of revenues and expenses. The effect of the change in depreciation method as of January 1, 2003 was applied retroactively to property and equipment acquisitions of prior years. The cumulative effect of the change with respect to the retroactive application of the straight-line method is an approximately $0.8 million charge (or $0.01 loss per diluted common share) and has been recorded as such on the consolidated statement of operations. This charge has not been presented net of an income tax benefit as the Company continues to maintain a full valuation allowance against its net deferred tax assets. Pro forma amounts have not been presented because the effects of this change in accounting principle were not material to the consolidated financial statements.

Note 8.    Stockholders’ Equity

Nasdaq Listing Requirements

By a letter dated March 4, 2003, the Company received notification from Nasdaq informing the Company that its common stock price had traded below the minimum $1.00 per share requirement for continued inclusion under Marketplace Rule 4310(c)(4). Therefore, in accordance with Marketplace Rule 4310(c)(8)(D), the Company has been provided with 180 calendar days, or until September 2, 2003, to regain compliance. In order to regain compliance, the common stock price must close at $1.00 per share or more, for a minimum of 10 consecutive trading days. If compliance is not regained, the Company may be granted an additional 180 calendar day grace period, should it meet certain other listing criteria for the Nasdaq SmallCap Market. If the Company does not meet this listing criteria, or if it is not granted this additional 180 day grace period and its common stock does not trade at or above $1.00 for 10 consecutive trading days, then Nasdaq will provide notification that TranSwitch’s common stock securities will be delisted. The Company has the right to appeal any delisting notification.

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Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Conditions and Results of Operations (MD&A) is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of our financial condition, changes in our financial condition and results of operations. The MD&A is organized as follows:

Caution concerning forward-looking statements. This section discusses how certain forward-looking statements made by us throughout the MD&A are based on management’s present expectations about future events and are inherently susceptible to uncertainty and changes in circumstances.

Overview. This section provides a general description of our business.

Critical accounting policies and use of estimates. This section discusses those accounting policies that are both considered important to our financial condition and operating results and require significant judgment and estimates on the part of management in their application.

Results of operations. This section provides an analysis of our results of operations for the three months ended March 31, 2003 and 2002, respectively. In addition, a brief description is provided of transactions and events that impact the comparability of the results being analyzed.

Liquidity and capital resources. This section provides an analysis of our cash position and cash flows, as well as a discussion of our financing arrangements. In this section, we also summarize commitments and significant contractual obligations and recent accounting pronouncements.

Certain factors that may affect future results. In this section, we detail certain risk factors that affect our quarterly and annual results, but which are difficult to predict.

CAUTION CONCERNING FORWARD-LOOKING STATEMENTS

Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements that involve risks and uncertainties. When used in this report, the words, “intend”, “anticipate”, “believe”, “estimate”, “plan”, “expect” and similar expressions, as they relate to us, are included to identify forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under “CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS” and elsewhere in this report. You should read this discussion in conjunction with the consolidated financial statements and the notes thereto included in this report.

OVERVIEW

TranSwitch is a Delaware corporation incorporated on April 26, 1988. We design, develop and market highly integrated semiconductor devices that provide core functionality in voice and data communications network equipment deployed in the global network infrastructure. In addition to their high degree of functionality, our products incorporate digital and mixed-signal (analog and digital) processing capabilities, providing comprehensive system-on-a-chip (SOC) solutions to our customers.

Our products are compliant with all of the relevant network standards including Asynchronous/Plesiochronous Digital Hierarchy (Asynchronous/PDH), Synchronous Optical Network/Synchronous Digital Hierarchy (SONET/SDH) and Asynchronous Transfer Mode/Internet Protocol (ATM/IP). We offer several products that combine multi-protocol capabilities on a single chip, enabling our customers to develop network equipment for multi-service (voice, data and video) applications. A key attribute of our products is their inherent flexibility. Many of our products incorporate embedded programmable processors, enabling us to rapidly accommodate new customer requirements or evolving network standards.

We bring value to our customers through our communications systems expertise, VLSI design skills and commitment to excellence in customer support. Our innovative skills and technical capabilities enable us to define and develop products that permit our customers to achieve faster time-to-market and to produce communications systems that offer a host of benefits such as greater functionality, improved performance, lower power dissipation, reduced system size and cost, and greater reliability.

CRITICAL ACCOUNTING POLICIES AND USE OF ESTIMATES

Our consolidated financial statements and related disclosures, which are prepared to conform with accounting principles generally accepted in the United States of America (U.S. GAAP), require us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses during the period reported. We are also required to disclose amounts of contingent assets and liabilities at the date of the consolidated financial statements. Our actual results in future periods could differ from those estimates. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary.

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We consider the most critical accounting policies and uses of estimates in our consolidated financial statements to be those surrounding:

These accounting policies, the basis for these estimates and their potential impact to our consolidated financial statements, should any of these estimates change, are further described as follows:

Revenues, Cost of Revenues and Gross Profit. Net revenues are primarily comprised of product shipments, principally to domestic and international telecommunications and data communications OEMs and to distributors. Net revenues from product sales are recognized at the time of product shipment when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) title and risk of loss transfers to the customer; (3) the selling price is fixed or determinable; and (4) collectibility is reasonably assured. Agreements with certain distributors provide price protection and return and allowance rights. With respect to recognizing revenues from our distributors: (1) the prices are fixed at the date of shipment from our facilities; (2) payment is not contractually or otherwise excused until the product is resold; (3) we do not have any obligations for future performance relating to the resale of the product; and (4) the amount of future returns, allowances, refunds and costs to be incurred can be reasonably estimated and are accrued at the time of shipment. Service revenues are recognized when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) we have performed a service in accordance with our contractual obligations; (3) the fee is fixed or determinable and (4) collectibility is reasonably assured.

At the time of shipment, we record an expense (and related liability) against our gross product revenues for future price protection and sales allowances. This liability is established based on historical experience, contractually agreed to provisions and future shipment forecasts. We had established liabilities totaling $0.9 million and $1.0 million as of March 31, 2003 and December 31, 2002, respectively, for price protection and sales allowances related to shipments that were recorded as revenue during the preceding 12 months. Should our actual experience differ from our estimated liabilities, there could be adjustments (either favorable or unfavorable) to our net revenues, cost of revenues and gross profits.

We also record, at the time of shipment, an expense (and related liability) against our gross product revenues and an inventory asset against product cost of revenues, in order to establish a provision for the gross margin related to future returns under our distributor stock rotation program. As of March 31, 2003, we had established a liability of $0.25 million and an inventory asset of $0.13 million for a stock rotation reserve, for future estimated returns totaling $0.12 million. This compares to a liability of $0.5 million and an inventory asset of $0.25 million for a stock rotation reserve, for future estimated returns totaling $0.25 million as of December 31, 2002. Should our actual experience differ from our estimated liabilities, there could be adjustments (either favorable or unfavorable) to our net revenues, cost of revenues and gross profits.

We warranty our products for up to one year from the date of shipment. A liability is recorded for estimated claims to be incurred under product warranties and is based primarily on historical experience. Estimated warranty expense is recorded as cost of product revenues when products are shipped. As of March 31, 2003 and December 31, 2002, we had a warranty liability established in the amounts of $0.2 million and $0.2 million, respectively, which is included in accrued expenses on the consolidated balance sheets. We had no material warranty claims during the period ended March 31, 2003. Should future warranty claims differ from our estimated current liability, there could be adjustments (either favorable or unfavorable) to our cost of revenues. Any adjustments to cost of revenues could also impact future gross profits.

Estimated Excess Inventories. We periodically review our inventory levels to determine if inventory is stated at the lower of cost or net realizable value. The telecommunications and data communications industries have experienced a significant downturn during the past few years and, as a result, we have had to evaluate our inventory position based on known backlog of orders, projected sales and marketing forecasts, shipment activity and inventory held at our significant distributors. During the year ended December 31, 2002, as a result of current and anticipated business conditions, as well as lower than anticipated demand, we recorded a charge for excess inventories of approximately $4.8 million. Most of these products have not been disposed of and remain in inventory at an adjusted cost basis of zero. There were no charges taken for excess inventory during the three months ended March 31, 2003 and 2002, respectively.

We recorded net product revenues of approximately $1.6 million and $1.7 million on shipments of excess inventory that had previously been written down to their estimated net realizable value of zero for the three months ended March 31, 2003 and 2002, respectively. This resulted in gross margins of approximately 100% on these product revenues. Had these products been

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sold at our historical average cost basis, a 62% and 52% gross margin would have been recorded on these product shipments for the three months ended March 31, 2003 and 2002, respectively. We currently do not anticipate that a significant amount of the excess inventories subject to the write-downs described above will be used in the future based upon our current demand forecast. Should our actual future demand exceed the estimates that we used in writing down our excess inventories, we will recognize a favorable impact to cost of revenues and gross profits. Should demand fall below our current expectations, we may record additional inventory write-downs which will result in a negative impact to cost of revenues and gross profits.

Valuation of Deferred Tax Assets. Income taxes are accounted for under the asset and liability method. Deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities, and their respective tax bases, and operating loss and tax credit carry forwards. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred income tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

We continually evaluate our deferred income tax assets as to whether it is “more likely than not” that the deferred tax assets will be realized. In assessing the realizability of our deferred tax assets, we consider the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies. Based on this assessment, we believe that significant uncertainty exists surrounding the recoverability of the deferred tax assets and we have accordingly recorded a valuation allowance for all of our deferred tax assets.

Estimated Restructuring Reserves. During the three months ended March 31, 2003, we recorded restructuring charges and asset impairments totaling $3.8 million related to employee termination benefits and costs to exit certain facilities, net of sub-lease benefits. We also recorded restructuring charges and asset impairments totaling $3.9 million and $32.5 million in the years ended December 31, 2002 and 2001, respectively. At March 31, 2003, the restructuring liabilities that remain total $27.3 million on our consolidated balance sheets, compared to $27.5 million as of December 31, 2002. The decrease of $0.2 million during the three months ended March 31, 2003 was related to cash payments for severance and lease costs on excess facilities and a non-cash reduction to the remaining restructuring liability as we entered into new sub-lease arrangements with a third party to rent a portion of our excess space, offset by the restructuring charges taken in the first quarter of fiscal 2003. Certain assumptions are used by management to derive this estimate, including future maintenance costs, price escalation and sublease income derived from these facilities. Should we negotiate additional sublease rental income agreements or reach a settlement with our lessors to be released from our existing obligations, we could realize a favorable benefit to our results of future operations. Should future lease, maintenance or other costs related to these facilities exceed our estimates, we could incur additional expenses in future periods.

Valuation of Investments in Non-Publicly Traded Companies. Since 1999, we have been making strategic equity investments in non-publicly traded companies that develop technologies that are complementary to our product road map. We initially evaluate each investment to determine whether a variable interest has been created in a variable interest entity and whether we then should consolidate our investment according to the provisions of FIN 46. Depending on the facts and circumstances surrounding each investment, we make a determination as to the consolidation of the investment based on the specific requirements of FIN 46. If we conclude that consolidation of the investment is not appropriate, then we evaluate each investment based on our level of ownership and whether or not we have the ability to exercise significant influence over the investee company. As a result of this evaluation, we then account for these investments on either the cost or equity method. These investments are reviewed periodically for impairment. The appropriate reductions in carrying values are recorded when, and if, necessary. The process of assessing whether a particular investment’s net realizable value is less than its carrying cost requires a significant amount of judgment. In making this judgment, we carefully consider the investee’s cash position, projected cash flows (both short and long-term), financing needs, most recent valuation data, the current investing environment, management / ownership changes and competition. This evaluation process is based on information that we request from these privately-held companies. This information is not subject to the same disclosure and audit requirements as the reports required of U.S. public companies, and as such, the reliability and accuracy of the data may vary. Based on our evaluations, we recorded impairment charges related to our investments in non-publicly traded companies of $0.1 million during the three months ended March 31, 2003 and $8.7 million during the year ended December 31, 2002. We used the modified equity method of accounting to determine the impairment loss for certain investments accounted for under the cost method. It was determined that no better current evidence of the value of our cost method investments existed and we believe that this gives us the best basis for our estimate given the negative cash flows of these companies. The modified equity method of accounting results in recording an impairment loss for a cost method investment equal to the investor’s proportionate share of the investee’s losses. The impairment loss approximates, from the inception of the investor’s investment, the proportionate reduction in the investor’s contributed capital as it is consumed to fund operating losses of the investee company.

The total investment in non-publicly traded companies was $1.0 and $2.0 million as of March 31, 2003 and December 31, 2002, respectively, on the consolidated balance sheets. During the three months ended March 31, 2003, the Company liquidated its limited partnership investment in GTV Capital, Inc. and received a cash payment of approximately $0.9 million, representing a return of capital. Refer also to Note 6 – Investments in Non-Publicly Traded Companies in our consolidated financial statements for additional details.

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RESULTS OF OPERATIONS

The following table sets forth certain unaudited interim consolidated statements of operations data as a percentage of net revenues for the periods indicated: