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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended March 31, 2005

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 April 30, 2005, there were 103,615,970 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 March 31, 2005

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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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 share and per share amounts)

Note 1. 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 markets.

Note 2. Basis of Presentation

The accompanying unaudited interim condensed 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. These 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, 2004, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, filed with the Securities and Exchange Commission on March 15, 2005. In the opinion of management, the accompanying unaudited interim condensed 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.

Note 3. 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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TRANSWITCH CORPORATION AND SUBSIDIARIES

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 the above 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.

In December 2004, the FASB released its final revised standard, SFAS No. 123R, Share-Based Payment (SFAS 123R). SFAS 123R requires that a public entity measure the cost of equity based service awards based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award or the vesting period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. A public entity will initially measure the cost of liability based service awards based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The company will implement Statement 123R as of the beginning of fiscal year 2006, as permitted by a Securities and Exchange Commission Rule that was issued in April 2005. The Company is evaluating SFAS 123R and believes that it may have a material effect on the Company’s financial position and results of operations.

Note 4. Loss Per Common Share

Basic and diluted loss per common share is based upon the weighted average common shares outstanding during the periods. All “in-the-money” stock options for the three months ended March 31, 2005 and 2004, respectively, and shares issuable upon the conversion of the 4.50% Convertible Notes due 2005 and 5.45% Convertible Plus Cash Notes_SM due 2007 were anti-dilutive.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

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

Note 5. Change 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 three months ended March 31, 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. In July 2004, the Company informed OptiX that it planned to discontinue funding of OptiX’s operations. Consequently, the Board of Directors of OptiX voted to wind-down its business and operations. The completion of the wind-down took place in the fourth quarter of 2004 resulting in the deconsolidation of OptiX from the Company’s financial statements.

Note 6. Reclassifications

Certain prior year amounts have been reclassified in the Statements of Cash Flows to conform to the current-year presentation. Auction rate securities and certain other investment securities previously reported as cash equivalents, have been reclassified as short-term investments in marketable securities. These reclassifications had no impact on the Company’s results of operations, total assets or changes in shareholders’ equity.

Note 7. Inventories

The components of inventories at March 31, 2005 and December 31, 2004 are as follows:

During the three months ended March 31, 2005 the Company recorded provisions for excess and obsolete inventories of approximately $0.5 million.

In the years ended December 31, 2004, 2003, 2002 and 2001, the Company recorded provisions for excess and obsolete inventories of $0.6 million, $1.5 million, $4.8 million and $39.2 million, respectively. The effect of these inventory provisions was to write this excess inventory down to a new cost basis of zero. During the three months ended March 31, 2005 and 2004, the Company sold certain products that had previously been written down to a cost basis of zero. The following table presents the impact to gross profit of the excess and obsolete inventory charges and benefits for the three months ended March 31, 2005 and 2004:

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

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

Note 8. Comprehensive Loss

The components of comprehensive loss were as follows:

Note 9. Restructuring and Asset Impairment Charges

As a result of the prolonged downturn in the telecom industry, beginning in the third quarter of 2001, the Company has implemented various restructuring programs to reduce the Company’s operating expenses. In the quarter ended March 31, 2005, the Company recorded restructuring charges totaling approximately $1.5 million resulting from the Company’s disengagement from TranSwitch S.A., a wholly owned research and development subsidiary in Toulouse, France, workforce reductions in the Company’s United States locations, as well as related asset impairments and excess facility costs. A summary of the restructuring liabilities and the activity for the three months ended March 31, 2005 is as follows:

In January 2005, the Company implemented an organizational restructuring that included the elimination of 26 positions, primarily in the Company’s Shelton, Connecticut and Boston, Massachusetts locations. The restructuring is expected to reduce the Company’s salary and personnel expenses by approximately $2.5 million annually. As a result, the Company recorded restructuring charges of approximately $0.7 million related to employee termination benefits, $0.2 million related to asset impairments and $0.1 million related to excess facility costs, for a total restructuring charge of approximately $1.0 million.

In March 2005, the Company implemented a plan to disengage from TranSwitch S.A. (formerly ADV Engineering S.A.), a wholly owned research and development subsidiary in France. This action will result in the dismissal of approximately 20 employees and is expected to result in operating savings of approximately $2.0 million annually. As a result of this action, the Company incurred restructuring charges of approximately $1.2 million related to employee termination benefits and $0.3 million related to legal and other transaction costs. These charges were offset by translation and other gains of $0.6 million, for a net restructuring charge of approximately $0.9 million.

In the quarters ended March 31, 2005 and 2004, the Company recorded restructuring benefits of $0.4 million and $0.2 million, respectively, reflecting the Company’s new agreements to sub-lease certain portions of excess facilities that had previously been accrued.

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

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

Note 10. Investments in Non-Publicly Traded Companies

The Company owns convertible preferred stock of Opulan Networks, Inc, and Metanoia Technologies, Inc. (Metanoia). In addition, the Company has a 3% limited partnership interest in Neurone II, a venture capital fund organized as a limited partnership. During the first quarter of 2005, the Company also has advanced Metanoia $0.1 million under a bridge loan. The Company had held an investment in Accordion Networks, Inc., which ceased operations in 2004. The Company accounts for these investments at cost. The financial condition of these companies is subject to significant changes resulting from their operating performance and their ability to obtain financing. The Company continually evaluates its investments in these companies for impairment.

Based upon its evaluations, the Company recorded impairment charges related to investments in non-publicly traded companies of $0.1 million, during the three months ended March 31, 2004. There were no such impairment charges recorded during the three months ended March 31, 2005.

Note 11. 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 March 31, 2005 and December 31, 2004, 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 NotesSM 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. During the year ended December 31, 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 $17.0 million in aggregate original principal amount of the Plus Cash Notes for approximately 12.1 million shares of the Company’s common stock plus approximately $0.1 million cash in lieu of accrued and unpaid interest. No such exchanges were effected in the three months ended March 31, 2005. As of March 31, 2005 and December 31, 2004, the remaining outstanding principal balance of the Plus Cash Notes was $80.5 million.

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

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

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

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 months ended March 31, 2005 and 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 $0.1 million and $0.6 million, respectively. At March 31, 2005 and December 31, 2004, the estimated fair value of the auto-conversion make-whole provision was approximately zero and $0.1 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 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

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TRANSWITCH CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

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

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 months ended March 31, 2005 and 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 $1.50 .million and $0.2 million, respectively. At March 31, 2005 and December 31, 2004, the estimated fair value of the Holder’s Conversion Right was approximately $6.9 million and $8.4 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 months ended March 31, 2005 and 2004, the Company amortized $1.2 million and $1.5 million, respectively of debt discount related to the Plus Cash Notes as discussed above.

Note 12. Supplemental Cash Flow Information

The following represents supplemental cash flow information for the three months ended March 31, 2005 and 2004:

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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 months ended March 31, 2005 and 2004. 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

TranSwitch is 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 communications 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 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 customers.

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 enables 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 the severe downturn in the global telecommunication market in 2001 and 2002, the market showed signs of stability and mild recovery in the latter part of 2003. In 2004, the market for our products continued its recovery, but showed additional

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fluctuations in demand. However, communication service providers, Internet service providers, regional Bell operating companies and interexchange carriers continue to closely monitor their capital expenditures. Spending on voice-only equipment is still slow while spending on equipment providing the efficient transport of data services on existing infrastructure appears to be slowly recovering. Demand for new, high bandwidth applications such as video conferencing, broadband audio and telephone is placing an increased burden on existing public network infrastructure.

Our markets began to stabilize in 2003, and we believe that we are now in the early stages of a market recovery. For the year ended December 31, 2004, our revenues were up $9.9 million or 41% over the previous year, reflecting this strengthening in demand. For the three months ended March 31, 2005, our revenues were $9.0 million compared to $8.2 million in the same period last year. 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 $0.2 million and $0.4 million as of March 31, 2005 and December 31, 2004, 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 March 31, 2005, we had established a liability of $0.2 million against our gross product revenues and an inventory asset of $0.1 million against our product cost of revenues, for a net stock rotation reserve of $0.1 million. This compares to a liability of $0.7 million and an inventory asset of $0.1 million for a net stock rotation reserve of $0.6 million as of December 31, 2004. 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.

Derivative Liability Associated 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.

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During the three months ended March 31, 2005 and 2004, we recorded other income of $1.6 million and $0.8 million, 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 March 31, 2005, the estimated fair value of our derivative liability was $6.9 million, of which $0.0 million and $6.9 million related to the auto-conversion make-whole provision and holder’s conversion right, respectively. As of December 31, 2004, the estimated fair value of our derivative liability was $8.5 million, of which $0.1 million and $8.4 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.

As of March 31, 2005 and December 31, 2004, these embedded derivative financial instruments were recorded and classified as a derivative liability on our consolidated balance sheets because the daily volume weighted average price of our common stock determined according to the voluntary conversion provision contained in the Plus Cash Notes indenture was below the threshold price of $2.61 as set forth in the terms of the Plus Cash Notes. Thus, if any holders of the Plus Cash Notes voluntarily converted their Plus Cash Notes, we would have to pay the plus cash amount in cash. Assuming the daily volume weighted average price of our common stock remains below the threshold price, this embedded derivative related to the holder’s conversion right will continue to be classified as a liability and adjusted quarterly for changes in fair value during the period of time that any such Plus Cash Notes are outstanding, with the corresponding charge or credit to other expense or income.

In subsequent periods, if the daily volume weighted average price of our 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

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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 auto-conversion make-whole provision will be adjusted quarterly for changes in fair value during the first two years that any such Plus Cash Notes are outstanding, with the corresponding charge or credit to other expense or income. The auto-conversion make-whole provision can only be settled with cash and, accordingly, will remain classified as a derivative liability on our consolidated balance sheets.

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 three months ended March 31, 2005 and 2004, we recorded charges for excess and obsolete inventories of approximately $0.5 million and zero, respectively. We also recorded excess inventory charges of approximately $0.6 million, $1.5 million, $4.8 million and $39.2 million in fiscal years ending 2004, 2003, 2002 and 2001, respectively. Most of these products have not been disposed of and remain in our inventory.

During the three months ended March 31, 2005 and 2004, we recorded net product revenues of approximately $2.9 million and $3.2 million, respectively, on shipments of excess inventory that had previously been written down to their estimated net realizable value. This resulted in gross margins of approximately 91% in the first quarter of 2005 and 100% in the first quarter of 2004 on these product revenues. Had these products been sold at our historical average cost basis, a 71% and 60% gross margin would have been recorded on these product shipments for the three months ended March 31, 2005 and 2004, 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.

Estimated Restructuring Reserves. As a result of the prolonged downturn in the telecom industry, beginning in the third quarter of 2001, we have implemented various restructuring programs to reduce our operating expenses. In the quarter ended March 31, 2005, we recorded restructuring charges totaling approximately $1.5 million resulting from our disengagement from TranSwitch S.A., a wholly owned research and development subsidiary in Toulouse, France, workforce reductions in our United States locations, as well as related asset impairments and excess facility costs. In the three months ended March 31, 2004, we recorded a restructuring benefit of $0.2 million, reflecting our agreement to sub-lease certain portions of excess facilities that had previously been reserved. We also recorded restructuring charges and asset impairments totaling $1.1 million, $2.5 million, and $3.9 million in fiscal years ended December 31, 2004, 2003 and 2002, respectively. At March 31, 2005 and December 31, 2004, the restructuring liabilities were $23.4 million and $22.6 million, respectively, on our consolidated balance sheets. Certain assumptions are used by us 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 (revised December 2003), “Consolidation of Variable Interest Entities” (FIN 46R). 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 46R. 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, and review such investments 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 an impairment charge related to our investments in non-publicly traded companies of $0.1 million during the three months ended March 31, 2004. No such charge was recorded in the three months ended March 31, 2005. We used the modified equity method of accounting to determine the impairment loss for certain investments, as it

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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 as its contributed capital is consumed to fund operating losses of the investee from the inception of the investor’s investment.

RESULTS OF OPERATIONS

The results of operations that follow should be read in conjunction with our critical accounting policies and use of estimates summarized above as well as our accompanying unaudited consolidated financial statements and notes thereto contained in Item 1 of this report. The following table sets forth certain unaudited interim consolidated statements of operations data as a percentage of net revenues for the periods indicated.

Net Revenues

The following tables summarizes our net product revenue mix by product line for the three months ended March 31, 2005 and 2004:

The increase in net revenues for the three months ended March 31, 2005 compared to the same period in 2004 is primarily due to increased volume shipments in both our Asynchronous/PDH, primarily the QE1F-Plus product, category and our ATM/IP, primarily the Aspen and Aspen Express products, category. The increase in volume in these product lines can be attributed to overall increased demand as well as inventory depletion in the distribution channel. As inventory is being consumed, customers are placing new orders to meet their end demand.

Included in total net revenues were service revenues consisting of design services performed for third parties on a short-term contract basis. Service revenues are not our primary strategic focus and, as such, will fluctuate up or down from period to period, depending on business priorities.

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International net revenues represented approximately 85% and 60% of net revenues for the three months ended March 31, 2005 and 2004, respectively. The increase in international sales reflects higher sales to Asia as our customers shift manufacturing capacity to that region.

Gross Profit

The following tables present the favorable impact to gross profit from the sale of previously written down inventory for the three months ended March 31, 2005 and 2004:

Total gross profit for the three months ended March 31, 2005 declined by approximately $0.3 million, or 5% from the comparable three months of the prior year. The decline in gross profit reflects the impact of the excess and obsolete inventory charge totaling $0.5 million for the three months ended March 31, 2005. Excluding the benefit from sales of previously written down inventory and the impact of excess and obsolete inventory charges, for the three months ended March 31, 2005, gross profit increased by approximately $0.8 million, or 15%. The fluctuations in gross profit margins are due to changes in the product mix over the prior year and do not indicate a shift in our margin trend, either positive or negative.

We anticipate that gross profit will continue to be impacted by fluctuations in the volume and mix of our product shipments as well as material costs, yield and the fixed cost absorption of our product operations.

Research and Development

Research and development expenses were $6.2 million for the three months ended March 31, 2005, a decrease of $7.5 million or 55% over the same prior year period. This decrease reflects the closure of the Company’s design center in Belgium, the workforce reductions in the Company’s U.S. design locations, reductions in sub-contracting resources, and the Company’s disengagement from development stage entities in Israel. In addition, depreciation costs were down $1.1 million from the first quarter of 2004, reflecting the Company’s reduced capital spending in recent periods and the wind-down of depreciation of assets purchased in 2001 and 2002.

We believe that continued investment in the design and development of future products is vital to maintain a competitive edge. We have monitored our known and forecasted revenue demand and operating expense run rates closely. Furthermore, in 2004, we completed a significant enhancement to our product portfolio which we believe positions us well with our customer base. As a result, commencing in 2004 and continuing through the first quarter of 2005, we completed the restructuring actions described above. We continue to seek opportunities to focus our research and development activities and will continue to closely monitor both our costs and our revenue expectations in future periods. We will continue to concentrate our spending in this area to meet our customer requirements and respond to market conditions.

Marketing and Sales

Marketing and sales expenses consist primarily of personnel-related expenses, trade show expenses, travel expenses and facilities expenses. Marketing and sales expenses decreased by approximately $0.6 million, or 19% for the three months ended March 31, 2005 compared to the same period in the prior year. The decrease is primarily due to workforce reductions completed in the first quarter of 2005. As a percentage of total net revenues, our marketing and sales costs decreased as we continue to monitor our discretionary spending as well as experience an increase in our total net revenue.

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We have monitored our known and forecasted sales demand and operating expense run rates closely and, as a result, have taken five restructuring actions since June 2001. We have added resources in those markets, primarily Asia, where we believe customer requirements warrant the additional operating expense. We will continue to closely monitor both our costs and our revenue expectations in future periods and will take actions as market conditions dictate. There can be no assurances that future acquisitions, market conditions or unforeseen events will not cause our expenses to rise or fall in future periods.

General and Administrative

General and administrative expenses consist primarily of personnel-related expenses, professional and legal fees and facilities expenses. The decrease in general and administrative expenses of approximately $0.7 million, or 36% for the three months ended March 31, 2005 compared to the same period in the prior year is primarily due to the workforce reductions completed in the first quarter of 2005, lower professional service fees, and legal fees. As a percentage of total net revenues, our general and administrative sales costs decreased as we continue to monitor our discretionary spending as well as experience an increase in our total net revenues.

Restructuring Charge (Benefit) and Asset Impairments, net

During the three months ended March 31, 2005, the Company recorded restructuring charges totaling $1.5 million resulting from the Company’s workforce reductions in the United States, the disengagement from the Company’s design center in Toulouse, France and further reductions in the Company’s U.S. facilities expenses. The Company expects to realize annual savings of approximately $4.5 million as a result of these actions. In the three months ended March 31, 2004, restructuring benefits totaled $0.2 million, related to the sub-lease of excess facilities.

Impairment of Investments in Non-Publicly Traded Companies

The Company owns convertible preferred stock of Opulan Networks, Inc, and Metanoia Technologies, Inc. (Metanoia). In addition, the Company has a 3% limited partnership interest in Neurone II, a venture capital fund organized as a limited partnership. During the first quarter of 2005, the Company also has advanced Metanoia $0.1 million under a bridge loan. The Company had held an investment in Accordion Networks, Inc., which ceased operations in 2004. The Company accounts for these investments at cost. The financial condition of these companies is subject to significant changes resulting from their operating performance and their ability to obtain financing. The Company continually evaluates its investments in these companies for impairment.

Based upon its evaluations, the Company recorded impairment charges related to investments in non-publicly traded companies of $0.1 million, during the three months ended March 31, 2004. There were no such impairment charges recorded during the three months ended March 31, 2005.

We will continue to periodically review all of our investments in non-publicly traded companies for impairment in future periods. There can be no assurance that future impairments will not be necessary.

Change in Fair Value of Derivative Liability

For the three months ended March 31, 2005 and 2004, we recorded other income of approximately $1.6 million and $0.8 million, respectively to reflect the change in the fair value of derivative liability resulting from issuance of the Plus Cash Notes (for further discussion, please refer to Item 1, Note 11 – Convertible Notes of our Unaudited Consolidated Financial Statements).

Interest Expense, net

The decrease in interest expense, net for the three months ended March 31, 2005, as compared to the same period in 2004 is primarily due to the reduction of the amortization of debt discount on the Plus Cash Notes. During the year ended December 31, 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 $17.0 million in aggregate original principal amount of the Plus Cash Notes for approximately 12.1 million shares of the Company’s common stock plus approximately $0.1 million cash in lieu of accrued and unpaid interest. As a result of the reduction in the aggregate original principal amount of the Plus Notes, the balance of the debt discount to be amortized has also been reduced. Also contributing to the decrease in interest expense, net is higher interest income due to higher market yields on the Company’s average cash balances during the three months ended March 31, 2005 compared to the three months ended March 31, 2004. At March 31, 2005 and 2004, the effective interest rate on our interest-bearing securities was approximately 2.38% and 1.25%, respectively.

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Income Tax Expense

For the three months ended March 31, 2005 and 2004, income tax expense was $0.02 million and $0.1 million, respectively, reflecting income taxes on the earnings of certain of the Company’s foreign subsidiaries.

During the three months ended March 31, 2005 and 2004, we evaluated our deferred tax assets as to whether it is “more likely than not” that the deferred tax assets will be realized. In our evaluation of the realizability of deferred tax assets, we consider projections of future taxable income, the reversal of temporary differences and tax planning strategies. We have evaluated and determined that it is not “more likely than not” that all of the deferred tax assets will be realized. Accordingly, a valuation reserve was recorded against all of our net deferred tax assets. In future periods, we will not recognize a deferred tax benefit and will maintain a deferred tax valuation allowance until we achieve sustained taxable income. Additionally, in the future, we expect our current income tax expense to be related to taxable income generated by our foreign subsidiaries.

Cumulative Effect on Prior Years of the Application of FIN 46R

We adopted the provisions of FIN 46R and changed our accounting accordingly in the first quarter of 2004. As a result of the adoption of FIN 46R, we consolidated the results of our investment in OptiX and recorded a charge of approximately $0.3 million for the three months ended March 31, 2004 as a cumulative effect of an accounting change.

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LIQUIDITY AND CAPITAL RESOURCES

As of March 31, 2005 and December 31, 2004, we had total cash, cash equivalents and investments in marketable securities of approximately $126.0 million and $134.7 million, respectively. This is our primary source of liquidity, as we are not currently generating positive cash flow from our operations. Details of our cash inflows and outflows for the three months ended March 31, 2005 as well as a summary of our cash, cash equivalents and investments in marketable securities and future commitments are detailed as follows:

Cash, Cash Equivalents and Investments

We have financed our operations and have met our capital requirements since incorporation in 1988 primarily through private and public issuances of equity securities, convertible notes, bank borrowings and cash generated from operations. Our principal sources of liquidity as of March 31, 2005 consisted of $44.7 million in cash and cash equivalents, $64.2 million in short-term investments and $17.2 million in long-term investments in marketable securities, for a total cash, cash equivalents and investment balance of $126.1 million. Cash equivalents are instruments with original maturities of less than 90 days, short-term investments have original maturities of greater than 90 days but remaining maturities of less than one year and long-term investments have remaining maturities of greater than one year. Our cash equivalents and investments consist of U.S. Treasury Bills, corporate debt, taxable municipal securities, money market instruments, overnight repurchase investments, commercial paper and auction rate securities.

We believe that our existing cash, cash equivalents and investments will be sufficient to fund operating losses, capital expenditures and provide adequate working capital for at least the next twelve months. However, there can be no assurance that events in the future will not require us to seek additional capital and, if so required, that capital will be available on terms favorable or acceptable to us, if at all.

Cash Inflows and Outflows