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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended September 30, 2004

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

(Registrant’s telephone number, including area code)

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  x    No  ¨

At October 25, 2004, there were 94,528,578 shares of Common Stock, par value $.001 per share, of the Registrant outstanding.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

FORM 10-Q

For the Quarterly Period Ended September 30, 2004

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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

See accompanying notes to unaudited consolidated financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

Note 1. Summary of Significant Accounting Policies

Description of Business

TranSwitch Corporation 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 variable interest entities for which the Company is the primary beneficiary. 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, 2003, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 3, 2004.

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 full year.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions. Estimates are used in accounting for, among other things, allowances for uncollectible receivables, excess or slow-moving inventories, obsolete inventories, impairment of assets, product warranty reserves, depreciation and amortization, income taxes, sales returns, stock rotation and contingencies. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the financial statements in the period they are determined to be necessary.

Stock-Based Compensation

As permitted by Statement of Financial Accounting Standard (SFAS), No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123), the Company accounts for employee stock-based compensation in accordance with Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and the Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 44, “Accounting for Certain Transactions Involving Stock-Based Compensation, an interpretation of APB Opinion No. 25” (FIN 44) and related interpretations. In addition, the Company provides pro forma disclosure of stock-based compensation, as measured under the fair value requirements of SFAS 123. These pro forma disclosures are provided as required under SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (SFAS 148), which 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.

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

In accordance with SFAS 123, the fair value of options granted to employees, which is amortized to expense over the option vesting period in determining the pro forma impact, is estimated on the date of the grant using the Black-Scholes option-pricing model. The following table illustrates the effect on net loss and loss per common share as if the Black-Scholes fair value method prescribed by SFAS 123 had been applied to the Company’s long-term compensation equity plans:

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

In accordance with SFAS 123, the weighted average fair value of stock options granted to employees was based on a theoretical statistical model using assumptions. However, because our stock options are not traded on any exchange, employees can receive no value or derive any benefit from holding stock options under these plans without an increase in the market price of our common stock relative to the respective dates of the option grants.

(Loss) income Per Common Share

Basic (loss) income per common share is based upon the weighted average common shares outstanding during the period. Diluted (loss) income per common share assumes exercise of all outstanding “in-the-money” stock options for the three and nine months ended September 30, 2004 and 2003, respectively, and the conversion of the 4.50% Convertible Notes due 2005 and 5.45% Convertible Plus Cash Notes_SM due 2007 into common stock at the beginning of the period or the date of issuance, if later, unless they are anti-dilutive.

Recent Accounting Pronouncement

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (FIN 46). The interpretation provided guidance on consolidating variable interest entities and applied immediately to variable interests created after January 31, 2003. The guidelines of the interpretation as revised by FIN 46 (revised December 2003), “Consolidation of Variable Interest Entities” (FIN 46R) became applicable to the Company in the first quarter of 2004 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.

Changes in Accounting Principles

The Company adopted the provisions of FIN 46R and changed its accounting accordingly in the first quarter of 2004. As a result of the adoption of FIN 46R, the Company consolidated the results of its investment in OptiX Networks, Inc. (OptiX) and recorded a charge of $0.3 million for the nine months ended September 30, 2004, as a cumulative effect of an accounting change. This charge has not been presented net of income taxes since the Company continues to maintain a full valuation allowance against net deferred income tax assets. Refer also to Note 5 - Investments in Non-Publicly Traded Companies.

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

As disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, as filed with the Securities and Exchange Commission on March 3, 2004, the Company changed the method of depreciating property and equipment to the straight-line method effective January 1, 2003. Depreciation of property and equipment in prior years was computed using the half-year convention method. 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 was approximately a $0.8 million charge and has been recorded as such on the consolidated statements of operations for the nine months ended September 30, 2003. This charge has not been presented net of income taxes since the Company continues to maintain a full valuation allowance against net deferred income tax assets.

Note 2. Inventories

The components of inventories at September 30, 2004 and December 31, 2003 are as follows:

During the three months ended September 30, 2004 and 2003, the Company recorded provisions for excess and obsolete inventories of approximately $0.6 million and zero, respectively. The Company recorded provisions for excess and obsolete inventories totaling approximately $0.6 million and $1.5 million for the nine months ended September 30, 2004 and 2003 respectively, and $1.5 million, $4.8 million and $39.2 million during the years ended December 31, 2003, 2002 and 2001, respectively. The effect of these inventory provisions was to write this excess inventory down to a new cost basis of zero. During the three and nine months ended September 30, 2004 and 2003, the Company 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 and nine months ended September 30, 2004 and 2003:

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

Note 3. Comprehensive (Loss) Income

The components of comprehensive (loss) income for the three and nine months ended September 30, 2004 and 2003 are as follows:

Note 4. Restructuring Liabilities

During the three months ended September 30, 2004, the Company recorded restructuring charges totaling $0.5 million resulting from the Company’s liquidation of its investment in TeraOp (USA), Inc. (TeraOp) and the wind-down of the business and operations of OptiX, two Israeli development stage companies consolidated in the Company’s financial statements under FIN 46R.

In July 2004, The Company informed OptiX that it planned to discontinue its ongoing funding of OptiX’s operations. Consequently, the OptiX Board of Directors voted to wind-down its business and operations. OptiX expects to have the wind-down completed and to permanently close its operations by December 31, 2004. In the three months ended September 30, 2004, the Company recorded a provision of $0.2 million related to the wind-down of OptiX, of which $0.1 million was to reserve for severance costs and $0.1 million was to record the impairment of certain OptiX assets. The Company expects to record additional charges in the fourth quarter of 2004 for severance and lease buy-out costs. Upon the completion of the wind-down, OptiX will be deconsolidated from the Company’s financial statements.

In September 2004, the Company entered an agreement with TeraOp under which the Company converted its promissory notes issued and payable by TeraOp into shares of TeraOp common stock. The Company then sold all of its common share holdings in TeraOp to an independent third party for a nominal amount. In addition, the Company paid TeraOp $0.3 million for a royalty on future revenues of TeraOp. Currently TeraOp has no revenue and may never have revenue in the future. As a result of these transactions, the Company no longer holds any equity or debt interest in TeraOp and has no influence over the operations of TeraOp. Accordingly, TeraOp was deconsolidated from the Company’s financial statements upon the completion of these transactions, resulting in a net restructuring charge of $0.2 million.

In the nine months ended September 30, 2004, restructuring charges totaled $0.3 million, reflecting the charges totaling $0.5 million resulting from the Company’s liquidation of its investment in TeraOp and the wind-down of the business and operations of OptiX, partially offset by changes in the estimated fair value of the liability for future excess facility costs recorded in 2003.

In January 2003, the Company announced a restructuring plan in order to lower its operating expense run-rate due to then current and anticipated business conditions. This plan resulted in a workforce reduction of approximately 24% of existing personnel. Also, the Company announced the closing of its South Brunswick, New Jersey (formerly known as Systems On Silicon, Inc. and referred to as SOSi) design center and the reduction of staff in its Boston, Massachusetts and Shelton, Connecticut offices. This workforce reduction also impacted the Company’s Switzerland and Belgium locations. In addition, the Company has postponed the completion of the Integrated Access Device (IAD) product line and archived the related intellectual property until that market returns, if ever. During the nine months ended September 30, 2003, the Company incurred approximately $3.4 million in restructuring expenses related to employee termination benefits and $0.5 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 for the nine months ended September 30, 2003. This resulted in a total restructuring charge and asset impairment for the nine months ended September 30, 2003 totaling $4.4 million. This restructuring charge was reduced by $1.3 million as the Company was able to sub-lease portions of its excess facilities and by adjustments to original estimates of severance costs related to previously announced restructuring programs.

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

The Company adopted SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146) as of January 1, 2003. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than being recognized at the date of the Company’s commitment to an exit plan. SFAS 146 also requires that the liability be established at estimated fair value and adjusted in future periods for changes in estimated cash flows. Accordingly, the liability for future excess facility costs recorded in 2003 was recorded net of estimated future sub-lease income (although there were no firm sub-lease commitments) and discounted to current net present value resulting in a net liability of $0.1 million. This liability is adjusted quarterly based upon actual cash flows and changes to estimates. Quarterly adjustments to this liability are recorded as restructuring expenses on the consolidated statements of operations.

A summary of the restructuring liabilities and the activity from December 31, 2003 through September 30, 2004 is as follows:

At September 30, 2004 and December 31, 2003, the Company has classified approximately $21.8 million and $22.7 million, respectively of this restructuring liability as long-term, representing net lease commitments that are not due in the succeeding twelve-month period.

During the three months ended September 30, 2004, the Company began the process of exploring alternatives to disengage from its research and development subsidiary in Belgium. Alternatives under consideration include permanent closure of the unit as well as the sale of all or part of the unit. At this time, the Company is in the early stages of this evaluation process and has not committed to any plan.

Note 5. Investments in Non-Publicly Traded Companies

Variable Interest Entities

In January 2003, FIN 46, “Consolidation of Variable Interest Entities” (FIN 46) was issued. The interpretation provided guidance on consolidating variable interest entities and applied to all variable interests created after January 31, 2003. The interpretation required variable interest entities to be consolidated if the equity investment at risk was 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.

During the first quarter of 2003, the Company loaned TeraOp $0.5 million under a new convertible loan agreement, which provided the Company with additional contractual rights over existing debt or equity investors. In addition, the Company also was in a position, as a result of the loan, to negotiate a more favorable conversion price of the equity securities of TeraOp and acquired the ability to control the operations of TeraOp. None of the existing debt or equity investors, other than the Company, was expected to absorb any additional losses from their investment given that the value of the equity in TeraOp was negative as of January 31, 2003. As a result, the convertible loan was determined to be a variable interest and TeraOp was considered a variable interest entity, as defined by FIN 46. The Company 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 for the nine months ended September 30, 2003, as the fair value of TeraOp’s liabilities exceeded its assets by this amount. All significant intercompany balances, including the Company’s investments in TeraOp, have been eliminated in consolidation. In September 2004, the Company liquidated its investment in TeraOp and deconsolidated TeraOp from the Company’s financial statements. For further discussion, please refer to Note 4 – Restructuring Liabilities.

The Company adopted the provisions of FIN 46R and changed its accounting accordingly in the first quarter of 2004. As a result of the adoption of FIN 46R, the Company consolidated the results of its investment in OptiX and recorded a charge of

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

approximately $0.3 million for the nine months ended September 30, 2004 as a cumulative effect of this accounting change. As disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, the Company restated prior period results to reflect the change from the cost to the equity method of accounting for its investment in 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. This investment restatement reduced the investment balance in OptiX (included in investments in non-publicly traded companies on the consolidated balance sheets), as if accounted for on the equity method, since inception. The Board of Directors of OptiX has voted to wind-down its business and operations and upon the completion of the wind-down, OptiX will be deconsolidated from the Company’s financial statements. For further discussion, please refer to Note 4 – Restructuring Liabilities.

Cost Method Investments

The Company owns shares of convertible preferred stock in Accordion Networks, Inc. (Accordion) and Opulan Networks, Inc. (Opulan). In addition, the Company has a 3% limited partnership interest in Neurone Ventures II, L.P., a venture capital fund organized as a limited partnership. 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 September 30, 2004 and December 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.

During the first quarter of 2004, the Company advanced $0.1 million to Metanoia Technologies, Inc (“Metanoia”) under a bridge loan agreement. During the second quarter ended June 30, 2004, the Company purchased shares of Metanoia’s Series A Preferred Stock through the conversion of the $0.1 million bridge loan and the payment of an additional $0.5 million to Metanoia. During the three months ended September 30, 2004, the Company made an additional $0.4 million investment in Metanoia by purchasing additional shares of Metanoia’s Series A Preferred Stock for a total investment of $1.0 million. The Company’s holdings represent less than 10% of Metanoia’s outstanding voting stock. Accordingly, the Company is accounting for this investment under the cost method.

Impairment of Investments in Non-Publicly Traded Companies

For the three and nine months ended September 30, 2004 and 2003, as a result of Company-specific and industry conditions, the Company determined that there were indicators of impairment to the carrying value of its investments in non-publicly traded companies. 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, the Company carefully considers 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 the Company requests 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. During the nine months ended September 30, 2004 and 2003, the Company used the modified equity method of accounting to measure the impairment loss for its investments in Accordion and Intellectual Capital for Integrated Circuits, Inc. (IC4IC), as the Company determined that no better current evidence of the value of its cost method investments existed and it believes that this measurement process gives the Company the best basis for an estimate given the negative cash flows of these companies. The modified equity method of accounting results in recording an impairment loss on a cost method investment equal to the investor’s proportionate share of the investee’s losses as its contributed capital is consumed to fund operating losses of the investee from the inception of the investor’s investment.

In addition, the Company also evaluated all outstanding bridge loans under SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” (SFAS 114) which it had not already impaired under the modified equity method of accounting. Under SFAS 114, a loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.

Based on our evaluations, we recorded impairment charges related to our remaining investments in convertible debt in Accordion of $0.1 million during the nine months ended September 30, 2004. During the first quarter of 2004, the Company decided to stop funding the operations of Accordion. The Board of Directors of Accordion voted to discontinue the operations of Accordion in March 2004.

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

In February 2003, the Company made a convertible bridge loan investment in IC4IC totaling $0.05 million. It was determined in March 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 April 2003, IC4IC’s Board of Directors made the decision to discontinue operations.

Note 6. Property and Equipment, Net

The components of property and equipment, net at September 30, 2004 and December 31, 2003 are as follows:

Depreciation and amortization expense related to property and equipment components above was $2.3 million and $2.1 million for the three months ended September 30, 2004 and 2003, respectively and was $7.3 million and $6.5 million for the nine months ended September 30, 2004 and 2003, respectively.

Note 7. Convertible Notes

4.50% Convertible Notes due 2005

In September 2000, the Company issued $460.0 million of 4.50% Convertible Notes due September 12, 2005 (the 4.50% Notes), and received proceeds of $444.0 million, net of debt issuance costs. The 4.50% Notes are convertible, at the option of the holder, at any time on or prior to maturity, into shares of common stock at a conversion price of $61.9225 per share.

On February 11, 2002, the Company’s Board of Directors approved a tender offer to purchase up to $200.0 million aggregate principal of the Company’s then outstanding 4.50% Notes at a price not greater than $700 nor less than $650 per $1,000 principal amount, plus accrued and unpaid interest thereon to, but not including, the date of the purchase. As a result of this offer, the Company repurchased $199.9 million face value of the then outstanding 4.50% Notes at the price of $700 per $1,000 principal amount for a cash payment of $139.9 million. During 2001, the Company repurchased some of its outstanding 4.50% Notes on the open market.

On September 30, 2003, the Company completed its exchange offer with and new money offering to the holders of the Company’s 4.50% Notes with the issuance of 5.45% Convertible Plus Cash Notes_SM due September 30, 2007. As of September 30, 2004 and December 31, 2003, the remaining outstanding principal balance of the 4.50% Notes was $24.4 million.

The 4.50% Notes are unsecured and unsubordinated obligations and rank on parity in right of payment with all existing and future unsecured and unsubordinated indebtedness.

5.45% Convertible Plus Cash Notes_SM due 2007

On September 30, 2003, the Company completed its exchange offer with and new money offering to holders of the 4.50% Notes. The Company issued $98.0 million aggregate principal amount of 5.45% Convertible Plus Cash Notes_SM due September 30, 2007 (the Plus Cash Notes), which represented $74.0 million of Plus Cash Notes issued in exchange for the 4.50% Notes tendered in the exchange offer and $24.0 million of additional Plus Cash Notes sold for cash to holders of existing 4.50% Notes. The net proceeds from the new money offering are being used for general corporate purposes, including working capital and research and development. In the second quarter of 2004, the Company exchanged, in privately negotiated transactions with holders of the Plus Cash Notes pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended, approximately $5.5 million

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

in aggregate original principal amount of the Plus Cash Notes for approximately 3.3 million shares of the Company’s common stock. No such exchanges were effected in the three months ended September 30, 2004 . Approximately $92.0 million and $97.6 million of the Plus Cash Notes remained outstanding as of September 30, 2004 and December 31, 2003, respectively.

The following description provides a brief overview of the terms and conditions of the Plus Cash Notes. Each Plus Cash Note may be converted by the holders thereof into 182.71 shares of the Company’s common stock (the base shares) plus $500 in cash (the plus cash amount), which the Company may elect to pay with shares of its common stock subject to the terms and conditions of the Plus Cash Notes indenture. Interest on the Plus Cash Notes is payable at a rate of 5.45% per year, payable on March 31 and September 30 of each year, commencing on March 31, 2004. The Company may elect to pay interest in cash or common stock, subject to the terms and conditions of the Plus Cash Notes. At any time prior to maturity, the Company may, at its option, elect to automatically convert (an auto-conversion) the Plus Cash Notes if the closing price of its common stock exceeds $5.47 for 20 trading days during any consecutive 25 trading day period, subject to the terms and conditions of the Plus Cash Notes. The Company may elect to satisfy the plus cash amount issuable in connection with any auto-conversion in cash or common stock, subject to the terms and conditions of the Plus Cash Notes. If the Company effects an auto-conversion prior to September 30, 2005, the Company will pay the additional interest that would be payable pursuant to the terms of the Plus Cash Notes, as described under “Auto-Conversion Make Whole Provision” below in cash.

The notes are unsecured and unsubordinated obligations and rank in parity in right of payment with all existing and future unsecured and unsubordinated indebtedness.

Derivative Liability Related to 5.45% Convertible Plus Cash Notes_SM due 2007

In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (SFAS 133), the auto-conversion make-whole provision and the holder’s conversion right (collectively, the features) contained in the terms governing the Plus Cash Notes were not clearly and closely related to the characteristics of the Plus Cash Notes. Accordingly, the features qualified as embedded derivative instruments at issuance and, because they do not qualify for any scope exception within SFAS 133, they are required by SFAS 133 to be accounted for separately from the debt instrument and recorded as derivative financial instruments.

Auto-Conversion Make-Whole Provision

Pursuant to the terms of the Plus Cash Notes, the Company will pay additional interest equal to two full years of interest on the Plus Cash Notes (the auto-conversion make-whole provision), less any interest actually paid or provided for on the Plus Cash Notes if the Plus Cash Notes are automatically converted by the Company on or prior to September 30, 2005. The auto-conversion make-whole provision represents an embedded derivative that is required to be accounted for apart from the underlying Plus Cash Notes. At issuance of the Plus Cash Notes, the auto-conversion make-whole provision had an estimated initial fair value of $3.0 million, which was recorded as a discount to the Plus Cash Notes and a derivative liability on the consolidated balance sheets. The discount on the Plus Cash Notes will be accreted to par value through quarterly interest charges over the four-year term of the Plus Cash Notes. The auto-conversion make-whole provision can only be settled in cash, and accordingly, will remain classified as a derivative liability in the consolidated balance sheets as long as the provision is available. The auto-conversion make-whole provision will be adjusted to its fair value on a quarterly basis for the first two years that any such Plus Cash Notes are outstanding, with the corresponding charge or credit to other expense or income. The estimated fair value of the auto-conversion make-whole provision was determined using the Monte Carlo simulation model. The model uses several assumptions including: historical stock price volatility, risk-free interest rate, remaining maturity, and the closing price of the Company’s common stock to determine estimated fair value of the derivative liability. For the three and nine months ended September 30, 2004, the Company recorded other income on the consolidated statements of operations for the change in fair value of the auto-conversion make-whole provision of approximately $0.5 million and $2.1 million, respectively. At September 30, 2004 and December 31, 2003, the estimated fair value of the auto-conversion make-whole provision was approximately $0.1 million and $2.2 million, respectively. The recorded value of the auto-conversion make-whole provision related to the Plus Cash Notes can fluctuate significantly based on fluctuations in the fair value of the Company’s common stock and the time remaining of this feature.

Holder’s Conversion Right

Pursuant to the terms of the Plus Cash Notes, these notes are convertible at the option of the holder, at anytime on or prior to maturity, other than on an auto-conversion date or a redemption date (Holder’s Conversion Right). The Holder’s Conversion Right represents an embedded derivative that is required to be accounted for apart from the underlying Plus Cash Notes. At

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Notes to Unaudited Consolidated Financial Statements

(Tabular dollars in thousands, except share and per share amounts)

issuance of the Plus Cash Notes, the Holder’s Conversion Right had an estimated initial fair value of $20.3 million, which was recorded as a discount to the Plus Cash Notes and a derivative liability on the consolidated balance sheets. The discount on the Plus Cash Notes will be accreted to par value through quarterly interest charges over the four-year term of the Plus Cash Notes. Assuming the daily volume weighted average price determined according to the voluntary conversion provision in the Plus Cash Notes indenture is or remains below the threshold price of $2.61, the derivative related to the Holder’s Conversion Right will be adjusted quarterly for changes in fair value during the period of time that any such Plus Cash Notes are outstanding and classified as a derivative liability, with the corresponding charge or credit to other expense or income. In subsequent periods, if the daily volume weighted average price of the Company’s common stock determined according to the voluntary conversion provision equals or exceeds the threshold price of $2.61, the embedded derivative financial instrument related to the Holder’s Conversion Right will be adjusted to fair value with the corresponding charge or credit to other expense or income and then reclassified from total liabilities to stockholders’ equity. Changes in fair value during the period of time that any such Plus Cash Notes are outstanding and classified within stockholders’ equity, will be made by a corresponding charge or credit to additional paid-in-capital. The estimated fair value of the Holder’s Conversion Right was determined using the Black-Scholes option-pricing model. The model uses several assumptions including: historical stock price volatility, risk-free interest rate, remaining maturity, and the closing price of the Company’s common stock to determine estimated fair value of the derivative liability. For the three and nine months ended September 30, 2004, the Company recorded other income on the consolidated statements of operations for the change in fair value of the Holder’s Conversion Right of approximately $4.6 million and $10.8 million, respectively. At September 30, 2004 and December 31, 2003, the estimated fair value of the Holder’s Conversion Right was approximately $7.7 million and $18.5 million, respectively. The recorded value of the Holder’s Conversion Right related to the Plus Cash Notes can fluctuate significantly based on fluctuations in the fair value of the Company’s common stock.

For the three and nine months ended September 30, 2004, the Company amortized $1.4 million and $4.2 million, respectively of debt discount related to the Plus Cash Notes as discussed above.

Exchanges of the Plus Cash Notes for Shares of Common Stock

During the nine months ended September 30, 2004, the Company issued an aggregate of 3,278,940 shares of the Company’s common stock plus approximately $0.06 million cash in lieu of accrued and unpaid interest in exchange for $5.5 million in aggregate original principal amount of the Plus Cash Notes. The shares issued were exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. No commission or other remuneration was paid or given directly or indirectly for soliciting these transactions. As a result of the exchange, the Company incurred a non-cash loss of approximately $1.2 million due to the write-off of the unamortized debt discount and deferred financing costs related to the exchanged Plus Cash Notes. The Company did not effect any such exchanges during the three months ended September 30, 2004.

Note 8. Supplemental Cash Flow Information

The following represents supplemental cash flow information for the nine months ended September 30, 2004 and 2003:

Note 9. Shelf Registration

On April 6, 2004, the Company filed a shelf registration statement on Form S-3 (Registration No. 333-114238) with the Securities and Exchange Commission (SEC) providing for the offer, from time to time, of common stock, preferred stock, debt securities and warrants up to an aggregate of $60.0 million. On April 19, 2004, the SEC declared effective the shelf registration statement. This enables the Company to, at any time in the subsequent two-year period, make an offering of any individual security covered by the shelf registration statement as well as any combination thereof, subject to market conditions and the Company’s capital needs. The Company may use the net proceeds from the sale of these securities for general corporate purposes, which may include repayment or refinancing of existing indebtedness, acquisitions, investments, capital expenditures, repurchase of its capital stock and for any other purposes that the Company may specify in any prospectus supplement.

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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 unaudited consolidated financial statements and footnotes in Item 1 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 this Quarterly Report on Form 10-Q and any documents incorporated by reference into this Quarterly Report on Form 10-Q 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 and nine months ended September 30, 2004 and 2003. 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 related party transactions and recent accounting pronouncements.

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

This Quarterly Report on Form 10-Q contains, and any documents incorporated herein by reference may contain, forward-looking statements that involve risks and uncertainties. When used in this document, 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 the results discussed in the forward-looking statements as a result of risk factors including those set forth under “FACTORS THAT MAY AFFECT FUTURE RESULTS” and elsewhere in this report. You should read this discussion in conjunction with the accompanying unaudited consolidated financial statements and the notes thereto included in this report.

OVERVIEW

We are a Delaware corporation incorporated on April 26, 1988. We design, develop and market highly integrated semiconductor devices, also referred to as very large scale integration (VLSI) 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 relevant communications network standards including Asynchronous/Plesiochronous Digital Hierarchy (Asynchronous/PDH), Synchronous Optical Network/Synchronous Digital Hierarchy (SONET/SDH), Ethernet 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 micro-processors, enabling us to rapidly accommodate new customer requirements or evolving network standards by modifying a function of the device via software instruction.

We bring value to our customers through our communications systems expertise, VLSI design skills and commitment to excellence in customer support. Our emphasis on technical innovation and complete reference solutions 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 for their customers.

After several years of rapid growth, the global telecommunications industry experienced a severe downturn beginning in 2001. In response to this downturn, we have taken steps to restructure our operations and reduce operating costs. However, we have continued to invest in the design and development of future products, which we believe is vital to maintain a competitive edge. As a result, since 2001, the Company has posted significant operating losses.

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Our markets stabilized in 2003 and we believe that we are now in the early stages of a market recovery. For the nine months ended September 30, 2004, our revenues are up $8.9 million or 54% over the same period last year, reflecting this strengthening in demand. As our markets continue to strengthen, we believe that our investment in product development has positioned us to take advantage of this recovery.

Available Information

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports will be made available free of charge through the Investor Relations section of the Company’s Internet website (http://www.transwitch.com) as soon as practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. Material contained on our website is not incorporated by reference in this report. Our executive offices are located at Three Enterprise Drive, Shelton, CT 06484.

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CRITICAL ACCOUNTING POLICIES AND USE OF ESTIMATES

Our unaudited 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 and assumptions. 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.

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

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

Net Revenues, Cost of Revenues and Gross Profit. Net revenues are primarily comprised of product shipments, principally to domestic and international telecommunications and data communications Original Equipment Manufacturers (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. This liability is established based on historical experience and contractually agreed to provisions. We had established liabilities totaling $0.4 million and $0.7 million as of September 30, 2004 and December 31, 2003, respectively, for price protection and sales allowances related to shipments that were recorded as revenue during the preceding twelve 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 September 30, 2004, we had established a liability of $0.5 million against our gross product revenues and an inventory asset of $0.2 million against our product cost of revenues for a net stock rotation reserve of $0.3 million. This compares to a liability of $1.0 million and an inventory asset of $0.5 million for a net stock rotation reserve of $0.5 million as of December 31, 2003. 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 September 30, 2004 and December 31, 2003, we had a warranty liability established in the amounts of $0.3 million and $0.3 million, respectively, which is included in accrued expenses and other current liabilities on the consolidated balance sheets. We had no material warranty claims during the nine months ended September 30, 2004. 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.

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Derivative LiabilityAssociated with our 5.45% Convertible Plus Cash Notes_SM due 2007. In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (SFAS 133), the auto-conversion make-whole provision and the holder’s conversion right (collectively, the Features) contained in the terms governing our 5.45% Convertible Plus Cash Notes_SM due 2007 (the Plus Cash Notes) were not clearly and closely related to the characteristics of the Plus Cash Notes upon issuance. Accordingly, the Features qualified as embedded derivative instruments and, because they do not qualify for any scope exception within SFAS 133, they are required by SFAS 133 to be accounted for separately from the debt instrument and recorded as derivative financial instruments.

During the three months ended September 30, 2004, we recorded other income of $5.1 million of which $0.5 million relates to the auto-conversion make-whole provision and $4.6 million relates to the holder’s conversion right, to reflect the change in fair value of our derivative liability, which is calculated below:

At each balance sheet date, we adjust the derivative financial instruments to their estimated fair value and analyze the holder’s conversion right to determine its classification as a liability or equity. As of September 30, 2004, the estimated fair value of our derivative liability was $7.8 million, of which $0.1 million and $7.7 million related to the auto-conversion make-whole provision and holder’s conversion right, respectively. As of December 31, 2003, the estimated fair value of our derivative liability was $20.7 million, of which $2.2 million and $18.5 million related to the auto-conversion make-whole provision and holder’s conversion right, respectively. The estimated fair value of the auto-conversion make-whole provision and holder’s conversion right were determined using the Monte Carlo simulation model and the Black-Scholes option-pricing model, respectively. These models use several assumptions including: historical stock price volatility, risk-free interest rates, remaining maturity, and the closing price of our common stock to determine estimated fair value of our derivative liability. We believe that the assumption that has the greatest impact on the determination of fair value is the closing price of our common stock during each quarterly period. Accordingly, we have calculated the fair value of the derivative liability as shown in the following different scenarios. We have included the change in the fair value of the derivative liability below based on all assumed estimates remaining the same except for our common stock price.