UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2006.

OR

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

For the transition period from                      to                     .

Commission File Number: 000-30757

Sunrise Telecom Incorporated

(Exact name of Registrant as specified in its charter)

Delaware	77-0291197
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

302 Enzo Drive, San Jose, California 95138

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (408) 363-8000

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 (“Exchange Act”) 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  ¨    No  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

Large Accelerated Filer  ¨            Accelerated Filer  ¨             Non-accelerated Filer  x             Smaller reporting company  ¨

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)

Yes  ¨    No  x

As of February 1, 2008, there were 51,349,058 shares of the registrant’s Common Stock outstanding, par value $0.001 per share.

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

TABLE OF CONTENTS

		Page Number
	Cautionary Statement	3
	Explanatory Note	3
PART I.	Financial Information
Item 1.	Financial Statements (unaudited)	4
	Condensed Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005	4
	Condensed Consolidated Statements of Operations for the Three-Month Periods Ended March 31, 2006 and 2005 (Restated)	5
	Condensed Consolidated Statements of Cash Flows for the Three-Month Periods Ended March 31, 2006 and 2005	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	31
Item 4.	Controls and Procedures	32
PART II.	Other Information
Item 1.	Legal Proceedings	37
Item 1A.	Risk Factors	38
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	50
Item 3.	Defaults Upon Senior Securities	50
Item 4.	Submission of Matters to a Vote of Security Holders	50
Item 5.	Other Information	50
Item 6.	Exhibits	51
	Signatures	52
	Exhibit Index	53

“3GMaster,” “FTT,” “HTT,” “RealWORX,” “Sunrise Telecom,” “SunSet,” “SunLite,” “STT,” “Sunset MTT,” “Oculist,” “NeTracker,” “Ghepardo,” “CaLan,” and “Lantrend” are trademarks of Sunrise Telecom Incorporated. This Quarterly Report on Form 10-Q also includes references to registered service marks and trademarks of other entities.

2

CAUTION ARY STATEMENT

All statements included or incorporated by reference in this Quarterly Report on Form 10-Q, other than statements or characterizations of historical fact, are forward-looking statements. Examples of forward-looking statements include, but are not limited to: statements concerning projected net revenue, costs and expenses and gross margin; accounting estimates; assumptions and judgments; the impact of the restatement of our financial statements; the effects of our pending litigation; the demand for our products; the effect that seasonality and volume will have on our quarterly operating results; our dependence on a few key customers for a substantial portion of our revenue; our ability to scale our operations in response to changes in demand for existing products and services or the demand for new products requested by our customers; the competitive nature of, and anticipated growth in, our markets; manufacturing, assembly and test capacity; our potential needs for additional capital; and inventory and accounts receivable levels. These forward-looking statements are based on our current expectations, estimates and projections about our industry and business, and certain assumptions we have made, all of which may be subject to change. Forward-looking statements can often be identified by words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions, and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of many factors, including those listed under the section “Risk Factors” contained in Part II, Item 1A of this report. These forward-looking statements speak only as of the date of this report. We undertake no obligation to revise or update any forward-looking statement for any reason, except as otherwise required by law.

Forward-looking statements are not the only statements you should regard with caution. The preparation of our consolidated financial statements for the three months ended March 31, 2006 and prior periods required us to make judgments with respect to the methodologies we selected to calculate the adjustments contained in the restated financial statements for the three months ended March 31, 2005, as well as estimates and assumptions regarding the application of those methodologies. These judgments, estimates and assumptions, which are based on factors that we believe to be reasonable under the circumstances, affected the amounts of additional deferred compensation, additional stock-based compensation expense, additional inventory reserves, and deferred income tax expense that we recorded in 2001, 2002, 2003, 2004, and, 2005. The application of alternative methodologies, estimates and assumptions could have resulted in materially different amounts.

EXPLANATORY NOTE

In this Quarterly Report on Form 10-Q, we are restating our condensed consolidated statements of operations for the quarter ended March 31, 2005. Please refer to Note 2 of Notes to Condensed Consolidated Financial Statements, included in this report, for additional information concerning the restatement. Our decision to restate was the result of our voluntary investigation of historical stock option granting practices that was conducted by our management under the direction of our Audit Committee of our Board of Directors (“Audit Committee”), as well as our identification of an error in the accounting for deferred tax liabilities relating to goodwill.

All financial information contained in this report gives effect to this restatement, unless stated otherwise. You should not rely upon financial information included in any earnings press releases and similar communications issued by us, or any of our previously filed Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, or on the related opinions of our independent registered public accounting firm, for the periods ended March 31, 2001 through June 30, 2005, all of which financial information is superseded in its entirety by the information in this report and our 2005 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on November 2, 2007. This report should be read in conjunction with our 2005 Annual Report on Form 10-K, as well as any Current Reports filed on Form 8-K.

The adjustments did not affect our previously-reported revenue, cash, cash equivalents or marketable securities balances in any of the restated periods.

3

PART I   FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATE MENTS

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

CONDEN SED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data, unaudited)

	March 31, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	17,353		$	18,324
Short-term investments		6,124			6,632
Accounts receivable, net of allowance of $98 and $428, respectively		12,472			17,725
Inventories		14,903			13,298
Prepaid expenses and other assets		2,739			1,185
Deferred tax assets		155			155
Total current assets		53,746			57,319
Property and equipment, net		26,765			26,681
Restricted cash		300			17
Marketable securities		997			818
Goodwill		12,506			12,493
Intangible assets, net		1,414			1,564
Other assets		1,188			888
Total assets	$	96,916		$	99,780
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Short-term borrowings and current portion of notes payable	$	188		$	243
Accounts payable		2,927			2,446
Other accrued expenses		12,409			11,796
Income taxes payable		2,206			1,858
Deferred revenue		1,241			842
Total current liabilities		18,971			17,185
Notes payable, less current portion		549			602
Deferred revenue		19			9
Deferred tax liabilities		1,223			1,135
Total liabilities		20,762			18,931
Stockholders’ equity:
Preferred stock, $0.001 par value per share; 10,000,000 shares authorized; none issued and outstanding		—			—
Common stock, $0.001 par value per share; 175,000,000 shares authorized; 51,349,058 shares issued and outstanding as of March 31, 2006 and December 31, 2005		51			51
Additional paid-in capital		76,654			76,392
Deferred stock-based compensation		—			(8	)
Retained earnings (deficit)		(1,932	)		3,250
Accumulated other comprehensive income		1,381			1,164
Total stockholders’ equity		76,154			80,849
Total liabilities and stockholders’ equity	$	96,916		$	99,780

See accompanying notes to condensed consolidated financial statements.

4

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

CONDENSE D CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data, unaudited)

	Three Months Ended March 31,
	2006			2005
				(Restated)
Net sales	$	16,389		$	11,718
Cost of sales		6,062			4,040
Gross profit		10,327			7,678
Operating expenses:
Research and development		5,269			4,584
Selling and marketing		6,103			4,864
General and administrative		4,069			3,153
Total operating expenses		15,441			12,601
Loss from operations		(5,114	)		(4,923	)
Other income, net		351			202
Loss before income taxes		(4,763	)		(4,721	)
Income tax expense		419			237
Net loss	$	(5,182	)	$	(4,958	)
Loss per share:
Basic and diluted	$	(0.10	)	$	(0.10	)
Shares used in per share computation:
Basic and diluted		51,349			50,758

See accompanying notes to condensed consolidated financial statements.

5

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOL IDATED STATEMENTS OF CASH FLOWS

(In thousands, unaudited)

	Three Months Ended March 31,
	2006			2005
Cash flows from operating activities:
Cash received from customers	$	22,376		$	16,702
Cash paid to suppliers and employees		(22,687	)		(15,863	)
Income taxes refunded (paid)		19			(71	)
Interest and other receipts, net		354			223
Net cash provided by operating activities		62			991
Cash flows from investing activities:
Proceeds from sales of short-term investments		508			2,000
Purchases of short-term investments		—			(2,395	)
Sales of marketable securities		4			—
Capital expenditures		(1,162	)		(732	)
Net cash used in investing activities		(650	)		(1,127	)
Cash flows from financing activities:
(Increase) decrease in restricted cash		(283	)		294
Payments on notes payable		(122	)		(67	)
Dividends paid		—			(2,539	)
Proceeds from exercise of stock options		—			212
Net cash used in financing activities		(405	)		(2,100	)
Effect of exchange rate changes on cash and cash equivalents		22			(167	)
Net decrease in cash and cash equivalents		(971	)		(2,403	)
Cash and cash equivalents at the beginning of the period		18,324			17,758
Cash and cash equivalents at the end of the period	$	17,353		$	15,355
Supplemental Disclosures
Cash paid for interest	$	9		$	9

See accompanying notes to condensed consolidated financial statements.

6

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

(1) Business and Certain Significant Accounting Policies

(a) Business

Sunrise Telecom Incorporated (the “Company”) was incorporated as Sunrise Telecom, Inc. in California in October 1991. In July 2000, the Company reincorporated in Delaware and changed its name to Sunrise Telecom Incorporated. The Company develops, manufactures, and markets service verification equipment that enables service providers to pre-qualify facilities for services, verify newly installed services, and diagnose problems relating to telecommunications, cable broadband, and Internet networks. The Company sells its products on six continents through a worldwide network of manufacturers, sales representatives, distributors, and direct sales people. Due to its international operations, the Company has wholly-owned subsidiaries located outside of the United States in Canada, Italy, Taiwan, Switzerland, South Korea, Japan, China, Germany, France, Spain, and Mexico.

(b) Basis of Presentation

The unaudited condensed consolidated financial statements and notes to the condensed consolidated financial statements included herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by United States generally accepted accounting principles for complete financial statements. In the opinion of management, these financial statements include all adjustments, which are only normal recurring adjustments, necessary for their fair presentation.

All financial information included in the Company’s reports on Form 10-K, Form 10-Q, Form 8-K and amendments to those reports, if any, previously filed by the Company, the related opinions of our independent registered public accounting firm, and all earnings press releases and similar communications issued by us, for the periods ended March 31, 2001 through June 30, 2005, are superseded in their entirety by the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2005 and its Annual Report of Form 10-K for the year ended December 31, 2005. These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 filed with the SEC on November 2, 2007.

The interim results presented are not necessarily indicative of results that may be expected for any subsequent interim period or for the full year.

(c) Net Loss per Share

Basic net loss per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net loss per share is computed using the weighted-average number of common and dilutive potential common equivalent shares outstanding during the period. Potential common equivalent shares consist of common stock issuable upon exercise of stock options using the treasury stock method. Potential common equivalent shares from weighted average outstanding stock options were excluded from the calculation of diluted net loss per share presented in the condensed consolidated statements of operations because their effect would have been anti-dilutive due to the net loss in such periods. Potential common equivalent shares from weighted average outstanding stock options of 4,694,650 and 4,517,831 shares were excluded from the calculation of diluted net loss per share for the three months ended March 31, 2006, and 2005, respectively.

7

The following is a reconciliation of the shares used in the computation of basic and diluted net loss per share (in thousands):

	Three Months Ended March 31,
	2006	2005
Basic net loss per share —weighted-average number of common shares outstanding	51,349	50,758
Effect of dilutive potential common equivalent shares – stock options outstanding	—	—
Diluted net loss per share —weighted-average number of common and common equivalent shares outstanding	51,349	50,758

(d) Share-Based Compensation

The Company has in effect stock incentive plans under which incentive stock options have been granted to employees and non-qualified stock options have been granted to employees and non-employee members of the Board of Directors. The Company also has an employee stock purchase plan for all eligible employees. Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment” (“SFAS 123R”), which requires all share-based payments to employees, including grants of employee stock options, and employee stock purchase rights, to be recognized in the financial statements based on their respective grant date fair values and does not allow the previously permitted pro forma disclosure-only method as an alternative to financial statement recognition. SFAS 123R supersedes Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under previous literature. In March 2005, the SEC issued Staff Accounting Bulleting (“SAB”) No. 107, Share-Based Payment (“SAB 107”), which provides guidance regarding the interaction of SFAS 123R and certain SEC rules and regulations. The Company has applied the provisions of SAB 107 in its adoption of SFAS 123R.

The Company adopted SFAS 123R using the modified-prospective method of recognition of compensation expense related to share-based payments effective January 1, 2006. The Company’s condensed consolidated statements of operations for the three months ended March 31, 2006 reflect the impact of adopting SFAS 123R. In accordance with the modified prospective transition method, the Company’s condensed consolidated statements of operations for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R. See Note 11 for the pro forma illustration of the effect on net loss and net loss per share information for the three months ended March 31, 2005, computed as if the Company had valued stock-based awards to employees using the Black-Scholes option pricing model instead of applying the guidelines provided by APB 25.

SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense ratably over the requisite service periods. The Company has estimated the fair value of each award as of the date of grant or assumption using the Black-Scholes option pricing model. See Note 11 for further disclosures regarding the adoption of SFAS 123R.

(e) Recent Accounting Pronouncements

On July 13, 2006, the FASB issued Interpretation 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109 (“FIN 48”), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold that a tax position must reach before financial statement recognition. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, which is the Company’s fiscal year 2007. The Company does not expect that the adoption of FIN 48 will have a significant impact on the Company’s consolidated financial statements.

8

On September 15, 2006, the FASB issued SFAS 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not expand the use of fair value in any new circumstances. SFAS 157 is effective for fiscal years beginning after November 15, 2007, which is the Company’s fiscal year 2008, for financial assets and liabilities and for fiscal years beginning after November 15, 2008, which is the Company’s fiscal year 2009, for non-financial assets and liabilities. The Company does not expect that the adoption of SFAS 157 will have a significant impact on the Company’s consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 does not change the guidance in SAB No. 99, “Materiality,” when evaluating the materiality of misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. Upon initial application, SAB 108 permits a one-time cumulative effect adjustment to beginning retained earnings. The Company expects to adopt SAB 108 in the fourth quarter of fiscal year 2006. The Company believes at this time that the adoption of SAB 108 will not have a material impact on its consolidated financial statements.

In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007, which is the Company’s fiscal year 2008. The Company is currently assessing the impact of the adoption of SFAS 159 on its consolidated financial statements.

In June 2007, the FASB ratified the consensus on Emerging Issues Task Force (“EITF”) Issue No. 06-11— Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”). EITF 06-11 requires companies to recognize the income tax benefit realized from dividends or dividend equivalents that are charged to retained earnings and paid to employees for non-vested equity-classified employee share-based payment awards as an increase to additional paid-in capital. EITF 06-11 is effective for fiscal years beginning after September 15, 2007, which will be the Company’s fiscal year 2008. The Company does not expect that the adoption of EITF 06-11 will have a significant impact on the Company’s consolidated financial statements.

In June 2007, the FASB ratified the consensus reached on EITF Issue No. 07-3—Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities (“EITF 07-3”), which requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and amortized over the period that the goods are delivered or the related services are performed, subject to an assessment of recoverability. EITF 07-3 will be effective for fiscal years beginning after December 15, 2007, which will be the Company’s fiscal year 2008. The Company does not expect that the adoption of EITF 07-3 will have a significant impact on the Company’s consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007)—Business Combinations (“SFAS 141R”), which replaces SFAS 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. The Company will be required to adopt SFAS 141R in its fiscal year 2009 commencing January 1, 2009.

9

(2) Restatement of Unaudited Consolidated Financial Statements

The Company’s condensed consolidated financial statements as of March 31, 2005 and for the three month period then ended have been restated to correct for errors in the accounting for stock-based compensation expense and income taxes which are further described below.

(a) Stock-Based Compensation Expense

The Company recently completed a voluntary investigation of its historical stock option granting practices. The Audit Committee oversaw the investigation, which commenced in June 2006 and covered all grants of options to purchase shares of our common stock made since our initial public offering in July 2000 through the last stock option grant made in August 2005. Management commenced the investigation under the direction of the Audit Committee to determine whether the Company used appropriate measurement dates for option grants made under our stock option plans. The Audit Committee also evaluated the conduct and performance of the Company’s officers, employees and directors who were involved, directly or indirectly, in the stock option granting process.

Based on the results of the investigation, management concluded that, pursuant to APB 25, the correct measurement dates for stock options granted in January 2001 and June 2002, covering options to purchase 1,377,970 shares of our common stock, differed from the measurement dates previously used for such awards. As a result, revised measurement dates were applied to the affected option grants and the Company recorded a total of $5.6 million in additional stock-based compensation expense for the years 2001 through 2005. This amount is net of forfeitures related to employee terminations. The additional stock-based compensation expense is being amortized over the service period relating to each option, typically four years, with approximately 99% of the expense being recorded in years prior to 2005.

The measurement date for the January 2001 and June 2002 grants were established prior to the completion, review and approval of the final lists of option recipients. For both sets of grants, a preliminary list or budget was developed and approved on the date originally identified as the measurement date, but the lists were subsequently modified, including adding or deleting the names of option recipients and increasing or decreasing the number of shares underlying the options to be granted. The revised measurement dates were based on the date on which all of the required granting actions for a specific grant were final (including any changes to the terms of the option such as the number of shares subject to the options). The Company believes that this is the appropriate way to establish the measurement date.

Notwithstanding the foregoing, the lack of conclusive evidence required the Company’s management to apply significant judgment in establishing revised measurement dates. In those cases where a definitive measurement date could not be determined, the evidence was generally sufficient to establish: (1) a date which was defined as the earliest possible date that met all the conditions that constitute a measurement date under APB 25 (the “Inside Date”) and (2) a date which was defined as the latest possible date that met all the conditions that constitute a measurement date could have existed under APB 25 (the “Outside Date”). These dates, particularly the Inside Date, later became the basis for determination of the revised measurement dates used by the Company in the restatement as the Company determined that this approach is more appropriate in determining when the option grant was determined with finality and no longer subject to change. An example of an Inside Date for an executive officer grant would be the date that the stock option award was formally approved by the Compensation Committee, and for a non-executive officer employee might be the date at which a final list was determined to have been reviewed and approved by the Stock Option Committee or the Compensation Committee. An example of an Outside Date generally was the date on which the option award information was input into our equity award administration system and communicated to employees.

The amounts of the adjustments we recorded for the years 2001 through 2005 were calculated pursuant to APB 25. The adjustments did not affect the Company’s previously reported revenue, cash, cash equivalents or short-term investment balances in any of the restated periods.

The following table summarizes the impact of the additional stock-based compensation expense resulting from the investigation of the Company’s historical stock option granting practices on previously-reported stock-based compensation expense for the three months ended March 31, 2005 (in thousands):

	Stock-Based Compensation Expense
	As Reported		Adjustments		As Restated
Three Months Ended March 31, 2005	$	—	$	37	$	37

10

(b) Income Tax Expense

The Company adopted SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”) on January 1, 2002. In accordance with SFAS No. 142, the Company ceased amortizing goodwill from business acquisitions for financial reporting purposes. Goodwill continues to be amortized for tax reporting, creating a temporary book to tax difference. SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), requires that the Company recognize a deferred tax liability for this taxable temporary difference. The temporary book to tax difference is classified as a long-term deferred tax liability as the timing of any ultimate recognition of expense from the impairment or abandonment of these assets is indeterminate.

In the first quarter of 2004, a valuation allowance was recorded against all of the Company’s net deferred tax assets in most jurisdictions, as the realization of these deferred tax assets was uncertain due to the Company’s recent operating losses. At the time this valuation allowance was recorded, the Company made an error and offset the deferred tax liability associated with the temporary difference in the amortization of goodwill against other deferred tax assets.

The Company failed to recognize the combined impact of the adoption of SFAS 142 in combination with the recording of the valuation allowance against the net deferred tax assets, and, as a result, continued to offset the indeterminate deferred tax liability against deferred tax assets. This error resulted in the failure to recognize $131,000 in deferred tax expense for the three months ended March 31, 2005.

(c) Impact of the Additional Stock-Based Compensation Expense, and Income Tax Expense Errors on the Unaudited Condensed Consolidated Statements of Operations

The following table presents the impact of the financial statement adjustments on the Company’s previously-reported unaudited condensed consolidated statements of operations for the three months ended March 31, 2005 (in thousands, except per share data):

	Three Months Ended March 31, 2005
	As Reported			Adjustments			As Restated
Net sales	$	11,718		$	—		$	11,718
Cost of sales		4,039			1			4,040
Gross profit		7,679			(1	)		7,678
Operating expense:
Research and development		4,569			15			4,584
Selling and marketing		4,851			13			4,864
General and administrative		3,145			8			3,153
		12,565			36			12,601
Loss from operations		(4,886	)		(37	)		(4,923	)
Other income, net		202			—			202
Loss before income taxes		(4,684	)		(37	)		(4,721	)
Income tax expense		106			131			237
Net loss	$	(4,790	)	$	(168	)	$	(4,958	)
Net loss per share, basic and diluted	$	(0.09	)				$	(0.10	)
Shares used in computing net loss per share, basic and diluted		50,758						50,758

11

The following table presents details of the total stock-based compensation expense that is included in each functional line item in the unaudited condensed consolidated statements of operations above (in thousands):

	Three Months Ended March 31, 2005
	As Reported		Adjustments		As Restated
Cost of sales	$	—	$	1	$	1
Research and development		—		15		15
Selling and marketing		—		13		13
General and administrative		—		8		8
	$	—	$	37	$	37

(d) Impact of the Additional Stock-Based Compensation Expense, and Income Tax Expense Adjustments on the Stock-Based Compensation Disclosures in Accordance with SFAS 123

In accordance with the requirements of the disclosure-only alternative of SFAS 123, set forth below is pro forma information as to the effect on net loss and net loss per share information for the three months ended March 31, 2005, computed as if the Company had valued stock-based awards to employees using the Black-Scholes option pricing model instead of applying the guidelines provided by APB 25. In addition, the table below presents the impact of the additional stock-based compensation expense-related adjustments on the Company’s previously-reported pro forma illustrations for the stated periods (in thousands, except per share data):

	Three Months Ended March 31, 2005
	As Reported			Adjustments			As Restated
Net loss	$	(4,790	)	$	(168	)	$	(4,958	)
Add: Stock-based compensation expense included in net loss		—			37			37
Deduct: Stock-based compensation expense determined under the fair value method		(394	)		(319	)		(713	)
Net loss — pro forma	$	(5,184	)	$	(450	)	$	(5,634	)
Net loss per share (basic and diluted)	$	(0.09	)				$	(0.10	)
Net loss per share (basic and diluted) — pro forma	$	(0.10	)				$	(0.11	)

(3) Related Party Transactions

On February 7, 2006, Paul Chang resigned his positions as President and Chief Executive Officer and Chairman and member of the Board of Directors. On that same day, the Company entered into an employment agreement with Mr. Chang, pursuant to which the Company employed Mr. Chang as its Technology Advisor at an annual salary of $400,000. Under the terms of the agreement, if Mr. Chang’s employment was terminated by the Company without cause and Mr. Chang executed a general release of claims, the Company agreed to provide him with certain severance benefits at the time of termination of employment less applicable withholdings.

On March 14, 2006, the Company entered into a separation agreement with Mr. Chang and provided Mr. Chang a severance payment of $300,000, less applicable taxes as well as payment of outstanding salary and benefits, which was recorded as general and administrative expense in the three months ended March 31, 2006.

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(4) Inventories

Inventories consisted of the following (in thousands):

	March 31, 2006		December, 31, 2005
Raw materials	$	7,017	$	5,317
Work in process		4,070		4,402
Finished goods		3,816		3,579
	$	14,903	$	13,298

(5) Comprehensive Loss

Comprehensive loss comprises net loss and other comprehensive income (loss). Other comprehensive income (loss) includes certain changes in the equity of the Company that are excluded from net loss. The components of the Company’s comprehensive loss, net of tax, were as follows (in thousands):

	Three Months Ended March 31,
	2006			2005
				(Restated)
Net loss	$	(5,182	)	$	(4,958	)
Change in unrealized gain on available-for-sale investments, net of any tax effect		181			107
Change in foreign currency translation adjustments, net of tax		36			(167	)
Total comprehensive loss	$	(4,965	)	$	(5,018	)

(6) Short-Term Investments and Marketable Securities

The Company determines the appropriate classification of debt and equity securities at the time of purchase and reevaluates this designation at each balance sheet date. Investments classified as available-for-sale are reported at market value, with unrealized gains and losses, net of tax, reported as a separate component of other comprehensive income (loss) in stockholders’ equity. Realized gains and losses on sales of investments and declines in value determined to be other than temporary are included in other income, net in the condensed consolidated statements of operations. Investment securities available for current operations are classified as current assets, and all other investment securities are classified as non-current assets.

Short-term investments as of March 31, 2006 and December 31, 2005 consisted primarily of market auction rate notes that reset every seven to ninety days, but have an underlying maturity that extends beyond ninety days. The fair value of short-term investments approximates cost as of March 31, 2006 and December 31, 2005.

Non-current marketable securities at March 31, 2006 and December 31, 2005, consisted of common stock of Top Union Electronics Corp. (“Top Union”), a Taiwan R.O.C. corporation. The Company has classified this investment as an available-for-sale security, which is stated at fair value with the unrealized gain presented as a separate component of other comprehensive income (loss) in stockholders’ equity. The market for these securities is limited and the Company believes it may be difficult to sell a substantial number of shares in any given period, and for this reason it is not classified as a current asset.

At March 31, 2006, the Company held 3,300,020 shares of Top Union stock. The Company sold 9,000 shares of Top Union stock for gross proceeds of approximately $4,000, realizing gains of $2,000 during the three month period ended March 31, 2006. The Company sold no shares during the three month period ended March 31, 2005.

As of March 31, 2006, the fair value of the Top Union shares was $997,000. This resulted in an additional unrealized gain of $181,000 for the three-month period ended March 31, 2006, which the Company recorded as other comprehensive income. At March 31, 2006, the cumulative unrealized gain on this investment was $236,000.

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(7) Goodwill and Other Intangible Assets

Acquired intangible assets consisted of the following (in thousands):

	As of March 31, 2006
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Developed technology (five years)	$	6,872	$	(6,199	)	$	673
Non-compete (four years)		215		(163	)		52
License (five years)		637		(513	)		124
Patents and trademarks (two to seventeen years)		668		(103	)		565
	$	8,392	$	(6,978	)	$	1,414

	As of December 31, 2005
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Developed technology (five years)	$	6,871	$	(6,096	)	$	775
Non-compete (four years)		213		(152	)		61
License (five years)		637		(500	)		137
Patents and trademarks (two to seventeen years)		686		(95	)		591
	$	8,407	$	(6,843	)	$	1,564

The Company amortizes intangible assets on a straight-line basis over their estimated useful lives of up to seventeen years. Aggregate amortization expense for the three months ended March 31, 2006 and 2005 was $145,000 and $586,000, respectively. Amortization expense is classified as a general and administrative expense on the Company’s condensed consolidated statements of operations.

Estimated future aggregate annual amortization expense for intangible assets is as follows (in thousands):

Nine months ending December 31, 2006	$	541
Year ending December 31,
2007		241
2008		32
2009		32
2010		32
Thereafter		536
	$	1,414

The changes in the carrying amount of goodwill during the three months ended March 31, 2006 were as follows (in thousands):

Balance as of December 31, 2005	$	12,493
Effect of foreign currency translation		13
Balance as of March 31, 2006	$	12,506

The Company performs its annual impairment test of goodwill, as required by SFAS 142, Goodwill and Other Intangible Assets (“SFAS 142”), as of November 30 of each fiscal year, unless a triggering event occurs before that date.

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(8) Other Assets

Other assets consisted of the following (in thousands):

	March 31, 2006		December 31, 2005
Insurance deposits	$	434	$	313
Rental deposits		441		200
Other deposits		313		375
	$	1,188	$	888

(9) Product Warranties Liability

Changes in the Company’s liability for product warranties during the three month periods ended March 31, 2006 and 2005 were as follows (in thousands):

	Balance at Beginning of Period		Warranty Expense		Warranty Costs			Balance at End of Period
Three months ending March 31, 2006	$	834	$	149	$	(138	)	$	845
Three months ending March 31, 2005, as restated	$	811	$	178	$	(179	)	$	810

The amounts shown in the table above for warranty expense and warranty costs for the three months ending March 31, 2005 have been restated to properly reflect actual warranty expense and warranty costs. The Company determined that certain warranty costs were being charged directly to cost of sales instead of the warranty accrual, which understated both the warranty expense and warranty costs amounts previously reported. The beginning and ending accrued warranty balances were not impacted by these changes.

(10) Short-term Borrowings and Notes Payable

As a result of various acquisitions completed during prior years, as of March 31, 2006, the Company had three non-interest bearing notes payable. The aggregate outstanding balance on these notes at March 31, 2006 was $37,000. In addition, the Company has a loan from the Italian government, which bears interest at 2% per year. As of March 31, 2006, the outstanding balance on this loan was $679,000, which is to be repaid by semi-annual principal payments over an eight-year period which began in July 2003. The Company also has three short-term notes and other borrowings, with an aggregate amount due of $21,000 as of March 31, 2006.

Annual amounts to be repaid under all of these notes are as follows (in thousands):

Nine months ending December 31, 2006	$	135
Year ending December 31,
2007		138
2008		133
2009		133
2010		133
Thereafter		65
	$	737

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(11) Share-Based Compensation

The purpose of the Company’s various share-based compensation plans is to attract, motivate, retain, and reward high-quality employees, directors, and consultants by enabling such persons to acquire or increase their proprietary interest in the Company’s common stock in order to strengthen the mutuality of interests between such persons and its stockholders and to provide such persons with annual and long-term performance incentives to focus their best efforts in the creation of stockholder value. Consequently, share-based compensatory awards issued subsequent to the initial award to the Company’s employees and consultants are determined primarily on the basis of individual performance. The Company’s share-based compensation plans with outstanding awards consist of the 1993 Stock Option Plan, the 2000 Stock Plan, and the 2000 Employee Stock Purchase Plan.

The Company utilizes the Black-Scholes option pricing model to estimate the grant date fair value of certain employee share-based compensatory awards, which requires the input of highly subjective assumptions, including expected volatility and expected life. Historical volatilities were used in estimating the fair value of share-based awards, while the expected life of options was estimated based on historical trends since the Company’s initial public offering. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of the Company’s share-based compensation. Further, as required under SFAS 123R, the Company now estimates forfeitures for share-based awards that are not expected to vest. The Company charges the estimated fair value less estimated forfeitures to earnings on a straight-line basis over the vesting period of the underlying awards, which is generally four years for stock options and up to two years for the employee stock purchase plan. While the Company’s estimate of fair value and the associated charge to earnings materially affects its results of operations, it has no impact on its cash position.

In accordance with SFAS 123R, the Company recognizes tax benefits upon expensing certain share-based awards associated with its share-based compensation plans, including nonqualified stock options, but under current accounting standards the Company cannot recognize tax benefits concurrent with the recognition of share-based compensation expenses associated with incentive stock options and employee stock purchase plan shares (qualified stock options). For qualified stock options that vested after the Company’s adoption of SFAS 123R, it recognizes tax benefits only in the period when disqualifying dispositions of the underlying stock occur, which may be up to several years after vesting and in a period when the Company’s stock price substantially increases. For qualified stock options that vested prior to the Company’s adoption of SFAS 123R, the tax benefit is recorded directly to additional paid-in capital to the extent the Company is able to reduce taxes payable.

On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. SFAS 123R-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards (“FSP 123R-3”). The Company has elected to adopt the alternative transition method provided in FSP 123R-3 for calculating the tax effects of stock-based compensation pursuant to SFAS 123R. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123R. Under paragraph A94 footnote 82 of SFAS 123R, tax benefits associated with excess tax deductions normally creditable to additional paid-in capital are not recognized until the deduction reduces taxes payable. Accordingly, no tax benefit related to excess tax deductions from qualified stock options was recognized during the three month period ended March 31, 2006.

Share-based compensation expense recognized in the Company’s consolidated statements of operations for the three months ended March 31, 2006 as a result of the adoption of SFAS 123R were as follows (in thousands):

Cost of sales	$	17
Research and development		107
Selling and marketing		100
General and administrative		46
Total	$	270

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The impact of adopting SFAS 123R resulted in an increase to the Company’s loss before income taxes and net loss of $264,000 for the three months ended March 31, 2006 but did not impact the reported net loss per share. Application of SFAS 123R had no impact on the Company’s cash position or cash flows from operations.

The Company has historically issued new shares upon the exercise of stock options or employee stock purchase plan purchases.

Stock Options

The Company’s share-based compensation plans with outstanding stock option awards include the 1993 Stock Option Plan and the 2000 Stock Plan (“the Plans”). Under the Plans, the Company may grant employees, consultants, and directors incentive stock options or nonqualified stock options to purchase shares of its common stock at not less than 100% or 85% of the fair market value, respectively, on the date of grant.

Options issued under the Plans generally vest 25% at the end of 12 months from the vesting commencement date and approximately 2% each month thereafter until fully vested at the end of 48 months from the vesting commencement date. Options not exercised ten years after the date of grant are cancelled. Approximately 284,000 shares associated with options granted in prior periods vested in the quarter ended March 31, 2006.

The following table summarizes stock option activity and weighted average exercise prices for the three months ended March 31, 2006, and for options outstanding and options exercisable, the weighted average exercise prices and the aggregate intrinsic value as of March 31, 2006. The aggregate intrinsic value is based on the closing price of the Company’s common stock on March 31, 2006 of $2.25. Outstanding in the money options represented 1,665,364 shares, of which 1,484,858 were exercisable as of March 31, 2006.

	Options Available for Grant	Options Outstanding		Weighted Average Exercise Price		Remaining Contractual Life	Aggregate Intrinsic Value (000’s)
Balance at December 31, 2005	5,822,664	4,882,481		$	3.62
Granted	—	—		$	—
Exercised	—	—		$	—
Forfeited	188,631	(188,631	)	$	3.66
Balance at March 31, 2006	6,011,295	4,693,850		$	3.62	6.02	$	788
Exercisable		3,835,361		$	3.77	5.51	$	729
Exercisable and expected to vest		4,581,446		$	3.63	5.85	$	766

The following table summarizes cash received and the aggregate intrinsic value for stock options exercised during the three months ended March 31, 2006 and 2005 (in thousands):

	Three Months Ended March 31,
	2006		2005
Cash received	$	—	$	212
Aggregate intrinsic value	$	—	$	161

The Company has not granted stock options or other share-based awards since August 2005. Certain of the forfeited and expired options presented in the above table represent options that were not able to be exercised due to the Company not being current in its SEC filings.

Prior to the adoption of SFAS 123R, the Company accounted for stock-based compensation in accordance with APB 25 and related interpretations, and had adopted the disclosure-only alternative of SFAS 123 and SFAS 148, Accounting for Stock-Based Compensation — Transition and Disclosure, an Amendment of FASB Statement No. 123. In accordance with APB 25 and related interpretations, stock-based compensation expense was not recorded in connection with share-based payment awards granted with exercise prices equal to or greater than the fair market value of the Company’s common stock on the measurement date, unless certain modifications were subsequently made. The Company recorded deferred compensation in connection with stock options granted with exercise prices less than the fair market value of the common stock on the measurement date. The amount of such deferred stock-based compensation per share was equal to the excess of the fair market value over the exercise price on such date. Recorded deferred

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stock-based compensation was recognized as stock-based compensation expense ratably over the applicable vesting periods, which are generally deemed to be the applicable service periods. Accordingly, deferred compensation cost was recorded on the date of the grant to the extent that the fair value of the underlying share of common stock exceeded the exercise price for a stock option or the purchase price for a share of common stock. Upon the adoption of SFAS 123R effective January 1, 2006, the Company reversed unrecognized deferred stock-based compensation of $8,000 as of December 31, 2005 and reduced additional paid-in capital by the same amount.

Unrecognized compensation expense as of March 31, 2006 was $1.4 million and will be recognized ratably over the expected remaining term of approximately three years.

If compensation expense for the Company’s stock-based compensation plans had been determined in a manner consistent with the fair value approach described in SFAS 123, the Company’s net loss and loss per share, as reported, would have been increased to the pro forma amounts indicated below (in thousands, except per share data) for the three months ended March 31, 2005:

	Three Months Ended March 31, 2005
	(Restated)
Net loss, as reported	$	(4,958	)
Add: Stock-based employee compensation expense included in reported net loss, net of related tax effects		37
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(713	)
Net loss, pro forma	$	(5,634	)
Loss per share, as reported:
Basic and diluted	$	(0.10	)
Loss per share, pro forma:
Basic and diluted	$	(0.11	)

The Company made no new grants of stock options or other share-based awards, and did not modify any existing awards, in the three months ended March 31, 2006. For purposes of computing pro forma net loss for the three months ended March 31, 2005 under SFAS 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The assumptions used to value the option grants are as follows:

	Three Months Ended March 31,
	2006	2005
Dividend yield	—	1.7	%
Expected term	—	5 Years
Risk-free interest rate	—	4.17	%
Volatility rate	—	0.6485

Employee Stock Purchase Plan

The Company’s 2000 Employee Stock Purchase Plan (the “Purchase Plan”) became effective in April 2000. The Purchase Plan allows employees to designate up to 15% of their base compensation, subject to legal restrictions and limitations, to purchase shares of common stock at 85% of the lesser of the fair market value (“FMV”) at the beginning of the offering period or the exercise date. The offering period extends for up to two years and includes four exercise dates occurring at six month intervals. Under the terms of the plan, if the FMV at an exercise date is less than the FMV at the beginning of the offering period, the current offering period will terminate and a new offering period of up to two years will commence.

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No purchases have been permitted subsequent to November 10, 2005 due to restrictions on the Company’s ability to issue stock as a result of being delinquent with its SEC filings. There were no purchases under the Purchase Plan during the quarter ended March 31, 2006.

The assumptions used to value the shares to be issued under the Purchase Plan are as described in the table below:

	Three Months Ended March 31,
	2006	2005
Dividend yield	—	1.7	%
Expected Term	—	1.25 Years
Risk-free interest rate	—	4.17	%
Volatility rate	—	0.6485

The following table summarizes cash received and the aggregate intrinsic value for purchases under the Purchase Plan during the three months ended March 31, 2006 and 2005 (in thousands):

	Three Months Ended March 31,
	2006		2005
Cash received	$	—	$	—
Aggregate intrinsic value	$	—	$	—

(12) Income Taxes

The Company determines the need for a valuation allowance on deferred tax assets in accordance with the provisions of SFAS 109 which requires that the Company weigh both positive and negative evidence in order to ascertain whether it is more likely than not that deferred tax assets will be realized. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and for the future tax consequences attributable to operating losses and tax credit carry-forwards. The ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which the related temporary differences become deductible. The Company evaluated all significant available positive and negative evidence, including the existence of cumulative net losses in recent periods, benefits that could be realized from available tax strategies, and forecasts of future taxable income, in determining the need for a valuation allowance on its deferred tax assets. Cumulative net losses in recent periods represented sufficient negative evidence that was difficult for positive evidence to overcome under the evaluation guidance of SFAS 109. Accordingly, the Company intends to maintain a valuation allowance against all of the Company’s net deferred tax assets in the United states and most of the foreign jurisdictions until sufficient positive evidence, such as the resumption of a consistent earnings pattern, exists to support its reversal in accordance with SFAS 109.

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(13) Segment Information

Net sales information regarding operations in the different geographic regions is as follows (in thousands):

	Three Months Ended March 31,
	2006		2005
United States	$	7,817	$	4,884
Canada		625		373
Asia/Pacific		3,981		3,004
Europe/Africa/Middle East		3,136		2,873
Latin America		830		584
	$	16,389	$	11,718

Long-lived assets, which consist of property and equipment, were located in the following geographic regions (in thousands):

	March 31, 2006		December 31, 2005
United States	$	22,243	$	23,036
Canada		1,943		1,157
Taiwan and other Asia/Pacific		1,312		1,339
Europe/Africa/Middle East		1,267		1,149
	$	26,765	$	26,681

Net sales information by product category is as follows (in thousands):

	Three Months Ended March 31,
	2006		2005
Wireline access	$	6,180	$	4,790
Cable broadband		5,790		3,930
Fiber optics		3,820		2,366
Signaling		599		632
	$	16,389	$	11,718

No single customer accounted for 10% or more of the Company’s total sales during the three months ended March 31, 2006 or 2005.

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(14) Statements of Cash Flows

The Company presents its condensed consolidated statements of cash flows using the direct method. Following is a reconciliation of net loss to net cash provided by operating activities (in thousands):

	Three Months Ended March 31,
	2006			2005
				(Restated)
Net loss	$	(5,182	)	$	(4,958	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		1,273			1,742
Stock-based compensation expense		270			37
Provision for (recoveries of) losses on accounts receivable		4			(174	)
Loss on disposal of property and equipment		2			6
Gain on sale of marketable securities		(2	)		—
Deferred income taxes		88			124
Changes in operating assets and liabilities :
Accounts receivable		5,249			4,984
Inventories		(1,657	)		(491	)
Prepaid expenses and other assets		(1,837	)		(109	)
Accounts payable and other accrued expenses		1,097			8
Income taxes payable		348			42
Deferred revenue		409			(220	)
Total adjustments		5,244			5,949
Net cash provided by operating activities	$	62		$	991

(15) Legal Proceedings and Contingencies

Certain current and former employees have expired unexercised options, that, but for the Company’s inability to issue stock, may have realized gains from the exercise of those options. The Company may decide, or be required, to provide compensation for the intrinsic value of those expired unexercised options. The Company could elect, or be required, to make cash payments, issue stock, or provide replacement share-based compensation to these option holders to compensate them for the lost intrinsic value from these expired unexercised options. There exists the possibility of a material adverse impact on the Company’s results of operations as a result of the resolution of this matter.

From time to time, the Company may be involved in litigation or other legal proceedings relating to claims arising out of its day-to-day operations or otherwise. Litigation is inherently uncertain, and the Company could experience unfavorable rulings. Should the Company experience an unfavorable ruling, there exists the possibility of a material adverse impact on its financial condition, results of operations, cash flows or on its business for the period in which the ruling occurs and/or future periods.

(16) Subsequent Events

Stockholder Litigation

On December 13, 2006, a stockholder derivative lawsuit was filed in the Superior Court of the State of California on behalf of Chris Stovall, a purported stockholder of the Company, against certain of the Company’s current and former officers, directors, and employees and naming the Company as a nominal defendant. The complaint asserts claims for breach of fiduciary duty, waste, unjust enrichment and other statutory claims arising out of the Company’s stock option grant practices, which plaintiff claims included the “backdating” of stock option grants. The Company had disclosed an internal review of such practices in November 2006 and described the results of that review in its Annual Report on Form 10-K for 2005, filed on November 2, 2007. The court has twice granted the Company’s motions to dismiss the claims based on the insufficiency of the complaint.

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On November 21, 2007, Stovall filed a second amended complaint alleging similar legal claims arising primarily out of the historic stock option grant practices as described in our 2005 Form 10-K. The second amended complaint seeks monetary damages from the individual defendants, restitution, disgorgement of profits, attorneys’ fees, and various corporate governance reforms.

In February 2008, the parties attempted to resolve the litigation through mediation, but were unsuccessful. The parties may continue with their mediation efforts in the future. The Company intends to continue to assert all available defenses.

Litigation Against VeEx, Inc.

On January 22, 2007, the Company filed a complaint in the Superior Court of the State of California against VeEx Inc. (the “VeEx Action”) and certain of its former employees, including its former Chief Executive Officer, Paul Ker-Chin Chang. The VeEx Action alleged misappropriation of trade secrets, conversion, breach of good faith and fair dealing, intentional interference with contractual relationships, intentional interference with prospective economic advantage, and violation of Section 502(c) of the California Penal Code by the defendants.

On March 2, 2007, VeEx filed a cross-complaint against us alleging intentional interference with prospective economic advantage and unfair competition under California Business and Professions Code Section 17200.

On September 27, 2007, the Company reached a settlement with VeEx which terminated all outstanding litigation. The settlement did not have a material impact on the Company’s consolidated financial statements.

B.T.T. Communications Technologies Ltd.

On February 14, 2007, B.T.T. Communications Technologies Ltd. (“BTT”) filed a lawsuit against the Company and RDT Equipment and Systems (1993) Ltd. (“RDT”) in Tel-Aviv Jaffa District Court in Israel. BTT alleged that the Company unlawfully terminated that certain Distribution Agreement by and between the Company and BTT dated December 1, 2000. BTT further alleged that the Company misappropriated BTT’s proprietary and quasi-proprietary rights with respect to certain trade secrets including, but not limited to, customer lists, projects and certain rights of distribution. BTT sought injunctive relief to prohibit the Company from distributing products in Israel through another distributor, namely RDT. On December 31, 2007, the Company reached a settlement with BTT which terminated all outstanding litigation between the parties. The settlement did not have a material impact on the Company’s consolidated financial statements.

Revolving Credit Arrangement

On August 13, 2007, the Company entered into a $10 million secured revolving credit arrangement, as well as a letter of credit facility, with Silicon Valley Bank to improve liquidity and working capital for the Company. The Company may borrow, repay and reborrow under the line of credit facility at any time. The line of credit facility bears interest at the bank’s prime rate (6.0% at February 1, 2008). This line of credit is collateralized by substantially all of the Company’s assets and requires the Company to comply with customary affirmative and negative covenants principally relating to the use and disposition of assets, tangible net worth and the satisfaction of a quick ratio test. In addition, the credit arrangement contains customary events of default. Upon the occurrence of an uncured event of default, among other things, the bank may declare that all amounts owed under the credit arrangement are due and payable. The line of credit and facility expires on August 13, 2008. As of December 28, 2007, the revolving credit arrangement was amended to reduce the Company’s tangible net worth requirement from $57 million to $50 million. As of the date of this report, there are no amounts outstanding under this revolving credit arrangement.

Restructuring

On February 6, 2008, the Company announced a restructuring plan intended to reduce costs and improve operating efficiencies. The plan included a reduction in the Company’s worldwide workforce, across all functional areas, and a shut-down of certain international offices. The restructuring charge is estimated to be approximately $1.4 million and includes employee severance and benefit costs, costs related to leased facilities to be abandoned or subleased, and impairment of owned equipment that will be disposed, and will be recorded in during the first quarter of fiscal 2008.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In addition to the other information in this report, certain statements in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) are forward-looking statements. When used in this report, the word “expects,” “anticipates,” “estimates,” and similar expressions are intended to identify forward-looking statements. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties are set forth below under Part II, Item 1A, “Risk Factors.” The following discussion should be read in conjunction with our consolidated financial statements and notes thereto included elsewhere in this report.

OVERVIEW

We manufacture and market service verification equipment that enables service providers to pre-qualify facilities for services, verify newly installed services, and diagnose problems relating to telecommunications, cable broadband, and internet networks. Our products offer broad functionality, leading edge technology, and compact size to test broadband services. These include wireline access services (including DSL), fiber optics, cable broadband networks, and signaling networks. We design our products to provide rapid answers for technicians in centralized network operations centers. Our customers include incumbent local exchange carriers, cable companies, competitive local exchange carriers, and other service providers, network infrastructure suppliers, and installers throughout North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region.

We assess the overall success of our business primarily through the use of financial metrics. Management considers several factors to be particularly important when assessing past business success and projecting future performance. The first such factor is the maintenance of high levels of working capital and low levels of debt. See “Liquidity and Capital Resources.”

This first factor is enabled by the second factor: the generation of cash flows from our operating activities. Ultimately, the ability to consistently generate substantial positive cash flows is the primary indicator of our business’s success and is imperative for our business’s survival. See “Liquidity and Capital Resources.”

The third factor is profitability. In general, profitability indicates our success in generating present and future cash flows from our operating activities. Key components of our profitability are net sales, cost of sales, and operating expenses. See the discussion directly below and “Comparison of Three-Months Ended March 31, 2006 and 2005.”

For the three months ended March 31, 2006, our net loss was $5.2 million compared with $5.0 million for March 31, 2005. Manufacturing related delays in shipping certain products adversely impacted our net sales for the first quarter of 2005 resulting in a greater than usual seasonal decline than in prior years. Our loss from operations during the three months ended March 31, 2006 was increased substantially due to costs incurred as a result of the investigation of certain business practices at our subsidiaries of $1.6 million and employee termination related payments of $0.4 million, primarily relating to the separation agreement with our former Chief Executive Officer.

Our net sales for the three months ended March 31, 2006 increased to $16.4 million from $11.7 million for the same period during 2005. Our backlog at March 31, 2006 increased to $14.6 million, a $7.0 million increase from backlog of $7.6 million at both December 31, 2005 and March 31, 2005. Variations in the size and delivery schedules of purchase orders that we receive, as well as changes in customers’ delivery requirements, may result in substantial fluctuations in the amount of backlog orders for our products from quarter to quarter.

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Sources of Net Sales

We generate our cash flows primarily from selling telecommunications and broadband cable network testing equipment, and our future cash flows are largely dependent on our continuing ability to sell our products and collect cash for the sales to our customers. Our sales largely depend upon our ability to provide products that test most types of telecommunications network technologies, including those related to twisted-pair copper, cable broadband, and fiber optics networks. Within these technologies, we provide products that test the entire length of the network, from the point of installation in a building or residence through system back-offices and trunk lines, including the signaling processes that set up and tear down phone calls and transmit packets. We consider investment in research and development and selling and marketing activities to be critical to our ability to generate strong sales volume in the future. To that end, we continually offer new products, and update existing products, to meet our customers’ needs.

We sell our products predominantly to large telecommunications service providers. These types of customers generally commit significant resources to the evaluation of our and our competitors’ products and require each vendor to expend substantial time, effort, and cost educating them about the value of the proposed solutions. Delays associated with potential customers’ internal approval and contracting procedures, procurement practices, and testing and acceptance processes are common and may cause potential sales to be delayed or foregone. As a result of these and related factors, the sales cycle of new products for large customers typically ranges from six to twenty-four months. Substantially all of our sales are made on the basis of purchase orders rather than long-term agreements or requirements contracts. As a result, we commit resources to the development and production of products without having received advance or long-term purchase commitments from customers. We anticipate that our operating results for any given period will continue to be dependent, to a significant extent, on purchase orders, which can be delayed or cancelled by our customers.

Historically, a significant portion of our net sales have come from a small number of relatively large orders from a limited number of customers. Overall, we anticipate that our operating results for a given period will be dependent on a small number of customers. These large customers have substantial negotiating leverage and the ability to obtain concessions that may negatively affect our business and products. We have occasionally offered terms and conditions, such as extended payment terms, that can impact our revenue recognition, margins and cash flows.

Currently, competition in the telecommunications equipment market is intense and is characterized by declining prices. Because of these market conditions and potential pricing pressures from large customers in the future, we expect that the average selling price for our products will decline over time. If we fail to reduce our production costs accordingly, or fail to introduce higher margin new products, there will be a corresponding decline in our gross margin percentage. See Part II, Item 1A, “Risk Factors—Competition” and “— Consolidation and Other Risks Within the Telecommunications Industry.”

A portion of our sales are denominated in Euros, as well as small amounts in the Canadian Dollar, Japanese Yen, Korean Won, and other currencies, and we have, in prior years, used derivative financial instruments to hedge our foreign exchange risks. As of March 31, 2006, we had no derivative financial instruments. To date, foreign exchange exposure from sales has not been material to our operations. We have also been exposed to fluctuations in non-U.S. currency exchange rates related to our manufacturing activities in Taiwan. In the future, we expect that a growing portion of international sales may be denominated in currencies other than U.S. dollars, thereby exposing us to gains and losses on non-U.S. currency transactions. See Part II, Item 1A, “Risk Factors—Risks of International Operations.”

Cost of Sales

Our cost of sales consists primarily of the following:

• direct material costs of product components, manuals, product documentation, and product accessories;

• production wages, taxes, and benefits;

• allocated production overhead costs;

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• warranty costs;

• costs of board level assembly by third party contract manufacturers; and

• scrapped and reserved material originally purchased for use in the production process.

We recognize direct cost of sales, wages, taxes, benefits, and allocated overhead costs at the same time we recognize revenue for products sold. We expense scrapped materials as incurred.

Our industry is characterized by limited sources and long lead times for the materials and components that we use to manufacture our products. If we underestimate our requirements, we may have inadequate inventory, resulting in additional product costs for expediting delivery of long lead time components. An increase in the cost of components could result in lower margins. These long lead times have in the past, and may in the future cause us, to purchase larger quantities of some parts, increasing our investment in inventory and the risk of the parts’ obsolescence. Any subsequent write-off of inventory could result in lower margins. See Part II, Item 1A, “Risk Factors—Dependence on Sole and Single Source Suppliers.”

Operating Costs

We classify our operating expenses into three general operational categories: research and development, selling and marketing, and general and administrative. Our operating expenses include stock-based compensation expense and amortization of certain intangible assets. We classify charges to the research and development, selling and marketing, and general and administrative expense categories based on the nature of these expenditures. Although each of these three categories includes expenses that are unique to the category type, each category also includes commonly recurring expenditures that typically relate to all of these categories, such as salaries, amortization of stock-based compensation, employee benefits, travel and entertainment costs, communications costs, rent and facilities costs, and third party professional service fees. The selling and marketing category of operating expenses also includes expenditures specific to the selling and marketing group, such as commissions, public relations and advertising, trade shows, and marketing materials. The research and development category of operating expenses includes expenditures specific to the research and development group, such as design and prototyping costs. The general and administrative category of operating expenses includes expenditures specific to the general and administrative group, such as legal and professional fees and amortization of identifiable intangible assets, such as patents and licenses.

We allocate the total cost of overhead and facilities to each of the functional areas that use overhead and facilities based upon the square footage of facilities used or the headcount in each of these areas. These allocated charges include facility rent, utilities, communications charges, and depreciation expenses for our building, equipment, and office furniture.

We adopted SFAS 123R using the modified-prospective method of recognition of compensation related to share-based payments effective January 1, 2006. During the three months ended March 31, 2006, we made no new grants of stock options or other share-based awards, and did not modify any existing awards. Compensation expense related to options granted prior to the adoption of SFAS 123R that were unvested as of January 1, 2006 has been charged to the departments of the employees who received these option grants using the grant date fair value determined under SFAS 123. During the first three months of 2006, we recognized stock-based compensation expense of $17,000 to cost of sales, $107,000 to research and development expense, $100,000 to selling and marketing expense, and $46,000 to general and administrative expense. The results of operations for the three months ending March 31, 2005, were not restated to reflect the impact of adopting SFAS 123R as the Company adopted SFAS 123R using the modified prospective method.

Also, during the three months ended March 31, 2006 and 2005, we charged $0.1 million and $0.6 million, respectively, to general and administrative expense for amortization of intangible assets obtained through business acquisitions, such as developed technology and non-compete agreements.

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Results of Operations

Comparison of Three-Month Periods Ended March 31, 2006 and 2005

Net Sales. Net sales increased 40% to $16.4 million for the three months ended March 31, 2006, from $11.7 million for the same period of 2005. Sales of our wire line access products increased by $1.4 million, sales of our cable broadband products increased by $1.9 million, sales of our fiber optics products increased by $1.5 million, and sales of our signaling products reflected no significant change. The sales increase in wireline access products was primarily the result of increases in orders for our SSMTT products reflecting the accelerating convergence of voice, data and video in this market. Among cable broadband products, increased sales of our CM product line reflected aggressive VoIP deployment by carriers and demand for high-end central office monitoring devices. Among fiber optics products, sales growth was attributable to increased sales of our STT, MTT and 10G product lines. During the three months ended March 31, 2006, our sales were not significantly affected by changes in prices.

Sales for the three months ended March 31, 2006 increased $3.2 million, or 61%, in North America, $1.0 million, or 33%, in Asia/Pacific, $0.3 million, or 9% in Europe, and by $0.2 million, or 42% in Latin America, compared with the same period of 2005. The increase in sales across all regions, was due to increased sales of our wireline access, fiber optics and cable broadband products. Sales to Latin America remain the smallest region of our business and small changes in order volume from this region can represent large percentage fluctuations, as was the case during the three months ended March 31, 2006. International sales, including sales to Canada, increased to $8.6 million, or 52% of net sales, for the three months ended March 31, 2006, from $6.8 million, or 58% of net sales, for the same period of 2005.

Cost of Sales. Cost of sales for the three months ended March 31, 2006 increased $2.1 million, or 50%, to $6.1 million from $4.0 million for the three months ended March 31, 2005. Cost of sales represented 37% and 34% of net sales for the three months ended March 31, 2006 and 2005, respectively. The increased cost of sales as a percentage of sales was primarily the result of changes in sales mix. Gross margins are expected to be under continued pressure through 2007 as product mix, new product introductions and regulatory impact on components adversely impact margins. Margins are expected to return to historic levels of approximately 65% in 2008.

Research and Development. Research and development expenses increased 15% to $5.3 million for the three months ended March 31, 2006 from $4.6 million for the same period of 2005. This increase was primarily due to increased payroll costs of $0.2 million in response to increased headcount, increased stock-based compensation of $0.1 million and outside services of $0.1 million. Research and development expenses were 32% of net sales during the three months ended March 31, 2006 and 39% of net sales for the corresponding period in 2005. Research and development expenses are expected to remain at current levels, or increase slightly, as a percentage of sales as a result of expanded activity in new product development.

Selling and Marketing. Selling and marketing expenses increased 25% to $6.1 million for the three months ended March 31, 2006 from $4.9 million for the same period of 2005. This increase was primarily due to a $0.2 million increase in commission costs, $0.5 million increase in payroll costs, and a $0.2 million increase in outside services. We have increased headcount and increased our selling and marketing activities to achieve greater sales presence with key accounts. Selling and marketing expenses were 37% and 42% of net sales for the three months ended March 31, 2006 and 2005, respectively.

General and Administrative. General and administrative expenses increased 29% to $4.1 million for the three months ended March 31, 2006 from $3.2 million for the same period of 2005. This increase was primarily from increased legal and professional fees of $1.3 million related to the special investigation by the audit committee of the Board of Directors and from other professional services costs, which were partially offset by decreased intangible asset amortization expense of $0.4 million. General and administrative expenses were 25% and 27% of net sales for the three months ended March 31, 2006 and 2005, respectively. General and administrative expenses are expected to continue at similar levels through the first half of 2008 as decreased legal expenses are offset by increased costs of compliance with Sarbanes-Oxley and continuing significant accounting and audit related expenses.

Other Income, Net. Other income, net primarily consists of interest earned on cash and investment balances, gains and losses on assets, liabilities, and transactions denominated in foreign currencies, and realized investment gains and losses. Other income, net increased to $0.4 million for the three months ended March 31, 2006, from $0.2 million for the same period of 2005. This was primarily due to foreign exchange gains and increased interest income.

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Income Tax Expense. Income tax expense consists primarily of federal, state, and foreign income taxes as well as the impact of indefinite lived deferred tax liabilities that cannot be offset against deferred tax assets. We recorded income tax expense of $0.4 million and $0.2 million for the three months ended March 31, 2006 and 2005, respectively. See Notes to Condensed Consolidated Financial Statements (12) - Income Taxes for additional details on the valuation allowance against deferred tax assets.

Liquidity and Capital Resources

Cash Requirements and Capital Resources

At March 31, 2006, and December 31, 2005, we had working capital of $34.8 million and $40.1 million, respectively, and cash and cash equivalents and short-term investments of $23.5 million and $25.0 million, respectively. The fair value of our investment in non-current marketable securities was $1.0 million and $0.8 million at March 31, 2006, and December 31, 2005, respectively. This investment consisted entirely of the common stock of Top Union, which we consider to be “available-for-sale”, as that term is defined in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. We carry this investment at its fair value on our balance sheet, with the unrealized gain of $0.2 million as of March 31, 2006 deferred as a component of stockholders’ equity. Because our holding is large relative to the normal trading volume in Top Union stock, sale of this investment may take more than twelve months, and therefore, we classify it as a non-current asset.

In addition, in 2001, we obtained a loan from the Italian government, which bears interest at 2% a year. At March 31, 2006, the outstanding balance on this loan was $679,000, which is to be repaid by semi-annual principal payments over an eight-year period which began in July 2003. We also have short-term notes and other borrowings, with an aggregate amount due of $58,000.

On August 13, 2007, we entered into a $10 million secured revolving credit arrangement, as well as a letter of credit facility, with Silicon Valley Bank. We may borrow, repay and reborrow under the line of credit facility at any time. The line of credit facility bears interest at the bank’s prime rate of 6.0% at February 1, 2008. Our line of credit is collateralized by substantially all of our assets and requires us to comply with customary affirmative and negative covenants principally relating to the use and disposition of assets, tangible net worth and the satisfaction of a quick ratio test. In addition, the credit arrangement contains customary events of default. Upon the occurrence of an uncured event of default, among other things, the bank may declare that all amounts owed under the credit arrangement are due and payable. The line of credit and facility expires on August 13, 2008. As of December 28, 2007, the revolving credit arrangement was amended to reduce the Company’s tangible net worth requirement from $57 million to $50 million. As of the date of this report, there are no amounts outstanding under this revolving credit agreement.

On February 6, 2008, we announced a restructuring plan intended to reduce costs and improve operating efficiencies. The plan included a 12% reduction in our worldwide workforce, across all functional areas, and a shut-down of certain international offices. The cost reduction program, when fully implemented, is expected to save approximately $10-12 million per year on a pre-tax basis. We will recognize a one-time charge of approximately $1.4 million associated with employee severance payments, lease terminations, and other miscellaneous charges in the first quarter of fiscal 2008. The restructuring and impairment costs include employee severance and benefit costs, costs related to leased facilities to be abandoned or subleased, and impairment of owned equipment that will be disposed.

As of March 1, 2008, we believe that our current cash balances, future cash flows from operations, and line of credit arrangement will be sufficient to meet our anticipated cash needs for our operations, complete needed business projects, achieve our plans and objectives, meet financial commitments, meet working capital requirements, make capital expenditures, and fund other activities beyond the next twelve months.

Sources and Uses of Cash

In general, we have financed our operations and capital expenditures primarily using cash flows generated by our operating activities.

Cash provided by operating activities was $0.1 million during the three months ended March 31, 2006, compared with $1.0 million during the same period of 2005. The $0.9 million decrease in cash provided by operating activities was primarily due to a $6.8 million increase in cash paid to suppliers and employees partially offset by a $5.7 million increase in cash received from customers. The increase in cash paid to suppliers and employees was primarily the result of increased investment in sales activities and the

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associated increased headcount. The increase in cash received from customers was primarily attributable to increased sales in the three months ended March 31, 2006 over the comparable period in 2005 and from collection of cash from sales made in the fourth quarter of 2005. In general, our ability to continue to generate positive cash flows from operations depends on our ability to generate and collect cash from future sales, while maintaining a cost structure lower than those sales amounts. Therefore, sales volume is the most significant uncertainty in our ability to generate positive cash flows from operations.

Cash used in investing activities was $0.7 million during the three months ended March 31, 2006, compared with $1.1 million during the same period of 2005. During the three months ended March 31, 2006, capital expenditures were $1.2 million offset by proceeds from sales of $0.5 million in short-term investments. During the three months ended March 31, 2005, we made $0.7 million in capital expenditures and invested $2.4 million in short-term investments offset by proceeds from sales of $2.0 million in short-term investments. As of March 31, 2006, we had no plans for large capital expenditures outside the usual course of those needed for our ongoing production, research and development, and selling and marketing activities.

Cash used in financing activities was $0.4 million during the three months ended March 31, 2006, compared with $2.1 million during the same period of 2005. During the first three months of 2006, the primary financing activities that used cash were an increase in restricted cash of $0.3 million and the repayment of $0.1 million on notes payable. During the first three months of 2005, the primary financing activities that used cash were cash dividends of $2.5 million and the repayment of $0.1 million on notes payable. The primary financing activities that provided cash during the first three months of 2005 were $0.2 million in proceeds from employees exercising stock options and a $0.3 million decrease in amounts held in restricted cash.

Debt Instruments, Guarantees, and Related Covenants

On August 13, 2007, we entered into a $10 million secured revolving credit arrangement, as well as a letter of credit facility, with Silicon Valley Bank. It is collateralized by substantially all of our assets. As of the date of this report, there is no amount outstanding under this revolving credit arrangement and we are in compliance with all operating and financial covenants.

Our outstanding debt at March 31, 2006 consisted primarily of a $0.7 million loan from the Italian government for research and development use that is payable in semi-annual payments that started in the second half of 2003 and ends in 2011, three notes payable related to acquisitions, and other short-term borrowings, totaling $0.1 million that are being paid in quarterly installments through 2006. We have not used off-balance sheet financing arrangements, issued or purchased derivative instruments linked to our stock, or used our stock as a form of liquidity. We do not believe that there are any known or reasonably likely changes in credit ratings or ratings outlook, or an inability to achieve such changes, which would have any significant impact on our operations. We are not subject to any debt covenants that we believe might have a material impact on our business.

Off-Balance Sheet Arrangements

As of March 31, 2006, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a material effect on our current or future financial condition, revenues or expenses, results of operations, liquidity, or capital resources.

Contractual Obligations

During the three months ended March 31, 2006, there were no material changes outside the ordinary course of our business in long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations, or any other long-term liabilities reflected on our condensed consolidated balance sheet.

Critical Accounting Policies

The preparation of financial statements in accordance with United States generally accepted accounting principles generally requires us to make estimates, assumptions, and judgments that affect the amounts reported in our condensed consolidated financial statements and the accompanying notes. We base our estimates on historical experience and various other assumptions that we believe to be reasonable. Although these estimates are based on our present best knowledge of the future impact that current events and actions will have on us, actual results may differ from these estimates, assumptions, and judgments.

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We consider “critical” those accounting policies that require our most subjective or complex judgments, which often result from a need to make estimates about the effect of matters that are inherently uncertain, and that are among the most important of our accounting policies to the portrayal of our financial condition and results of operations. These critical accounting policies are the determination of our allowance for doubtful accounts receivable, valuation of excess and obsolete inventory, valuation of goodwill and other intangible assets, accounting for the liability of product warranty, deferred income tax assets and liabilities, revenue recognition, and accounting for stock-based compensation.

Our management has reviewed our critical accounting policies and the related disclosures with our Audit Committee. These policies and our procedures related to these policies are described further in our Annual Report on Form 10-K for the year ended December 31, 2005 in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under the heading “ Critical Accounting Policies.”

Recent Accounting Pronouncements

On July 13, 2006, the FASB issued Interpretation 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109 (“FIN 48”), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold that a tax position must reach before financial statement recognition. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We do not expect that the adoption of FIN 48 will have a significant impact on our consolidated financial statements.

On September 15, 2006, the FASB issued SFAS 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not expand the use of fair value in any new circumstances. SFAS 157 is effective for fiscal years beginning after November 15, 2007 for financial assets and liabilities and for fiscal years beginning after November 15, 2008 for non-financial assets and liabilities. We do not expect that the adoption of SFAS 157 will have a significant impact on our consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 does not change the guidance in SAB No. 99, Materiality, when evaluating the materiality of misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. Upon initial application, SAB 108 permits a one-time cumulative effect adjustment to beginning retained earnings. We expect to adopt SAB 108 in the fourth quarter of fiscal year 2006. We do not expect that the adoption of SAB 108 will have a significant impact on our consolidated financial statements.

In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact of the adoption of SFAS 159 on our consolidated financial statements.

In June 2007, the FASB ratified the consensus on Emerging Issues Task Force (“EITF”) Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”). EITF 06-11 requires companies to recognize the income tax benefit realized from dividends or dividend equivalents that are charged to retained earnings and paid to employees for non-vested equity-classified employee share-based payment awards as an increase to additional paid-in capital. EITF 06-11 is effective for fiscal years beginning after September 15, 2007, which will be the Company’s fiscal year 2008. We do not expect that the adoption of EITF 06-11 will have a significant impact on our consolidated financial statements.

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In June 2007, the FASB ratified the consensus reached on EITF Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities (“EITF 07-3”), which requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and amortized over the period that the goods are delivered or the related services are performed, subject to an assessment of recoverability. EITF 07-3 will be effective for fiscal years beginning after December 15, 2007, which will be the Company’s fiscal year 2008. We do not expect that the adoption of EITF 07-3 will have a significant impact on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141R”), which replaces SFAS 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. The Company will be required to adopt SFAS 141R in its fiscal year 2009 commencing January 1, 2009.

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ITE M 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Risk

We sell our products in North America, the Asia/Pacific region, Latin America, Africa, the Middle East, and Europe and maintain operations in several different countries. Changes in currency exchange rates affect the valuation in our financial statements of the assets and liabilities of these operations. We also have a small amount of sales denominated in Euros, the Canadian Dollar, Japanese Yen, Korean Won, and other currencies, which are also affected by changes in currency exchange rates. To hedge these risks, we have, at certain times, used derivative financial instruments. During the three months ended March 31, 2006, we had no material derivative financial instruments or other foreign exchange risk hedging devices. With or without hedges, our financial results could be affected by changes in foreign currency exchange rates, although foreign exchange risks have not been material to our financial position or results of operations to date.

Interest Rate Risk

We are exposed to the impact of interest rate changes and changes in the market values of our investments. Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We have not held derivative financial instruments in our investment portfolio. We invest our excess cash in depository accounts with financial institutions, in debt instruments of United States governmental agencies, and in debt instruments of high-quality corporate issuers, and, by policy, we limit the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market, and reinvestment risk through portfolio diversification and review of the financial stability of the institutions with which we deposit funds and from whom we purchase debt instruments.

Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates. Because our investment policy restricts us to conservative, interest-bearing investments and because our business strategy does not rely on generating material returns from our investment portfolio, we do not expect our market risk exposure on our investment portfolio to be material.

Equity Price Risk

At March 31, 2006, we owned 3,300,020 shares of the common stock of Top Union Electronics Corp. (“Top Union”), a Taiwan R.O.C. corporation, which we acquired as a strategic investment primarily during the years 1998 through 2000. We consider the Top Union stock to be “available-for-sale,” as that term is defined in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and accordingly we carry our holdings at their fair value on our balance sheet, with the unrealized gain or loss deferred as a component of stockholders’ equity. Because our holding is large relative to the normal trading volume in Top Union stock, we do not consider this to be a liquid investment, and therefore, we classify it as a non-current asset. The carrying amount of this investment as of March 31, 2006 was $997,000 and on December 31, 2005 was $818,000. This carrying amount may be affected by an adverse movement of equity market prices in Taiwan and internationally and would be affected by adverse movement in exchange rates. As of March 31, 2006, we did not have any hedging arrangements to protect our Top Union investment against adverse movements in equity prices or exchange rates.

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IT EM 4. CONTROLS AND PROCEDURES

Evaluation Of Disclosure Controls And Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, as of the end of the period covered in this report, evaluated the effectiveness of our disclosure controls and procedures, as that term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and determined that, as a result of the material weaknesses in internal control over financial reporting described below, as of March 31, 2006, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports that we file or submitted under the Exchange Act was recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

The Public Company Accounting Oversight Board’s Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with An Audit of Financial Statements (“AS 2”), defines a material weakness as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

In October 2005, we identified a material weakness in our internal control over financial reporting relating to business practices at our Korean subsidiary. We identified an inadequate level of detailed review of revenue and inventory, as well as issues related to the overall tone at the top regarding business practices and ethics in some of our foreign operations. In July 2006, we took action designed to remediate this material weakness, but it remained a material weakness as of March 31, 2006.

In July 2006, we identified a material weakness in our internal control over financial reporting relating to our stock option granting practices. We identified a lack of adequate controls over the granting of stock options following the Company’s initial public offering in July 2000 that resulted in errors in the application of APB 25. Specifically, management failed to recognize that changes to a list of grantees after the meeting of the approving body could modify the measurement date for those options. Preventative or detective controls that could have avoided or identified these errors were not in place at the time of the grants and not remediated until October 2002, when the Company instituted enhanced corporate governance procedures. The material weakness that led to these errors was remediated in October 2002 but the associated errors were not identified until June 2006.

In November 2006, we identified a material weakness in our internal control over financial reporting relating to our calculation of reserves for excess and obsolete inventory. We identified system and process failures that allowed previously reserved inventory to be revalued upward based upon increased demand. Controls over the calculation of inventory reserves failed to ensure proper valuation of inventory items and to prevent the release of inventory reserves for inventory items previously reserved. In November 2006, we took action designed to remediate this material weakness, but it remained a material weakness as of March 31, 2006.

During the course of our external audits for fiscal 2005 and 2006, we noted several adjustments identified by our external auditors associated with one of our operating divisions. We identified deficiencies in our staffing requirements and policy regarding the timely replacement of key financial personnel. We have taken actions to remediate this material weakness during 2007, but it remained a material weakness as of March 31, 2006.

In September 2007, we identified a material weakness in our internal control over financial reporting relating to the calculation of our tax provision. We identified failures to properly document the tax impact of SFAS 142 relating to goodwill amortization at the time of adoption on January 1, 2002 and the failure to recognize the impact of indefinite lived deferred tax liabilities during the first quarter of 2004 on our deferred tax balances and tax expense. Controls over the calculation of income tax were inadequate to ensure that intangible assets were appropriately identified and tracked, and that indeterminate lived deferred tax liabilities resulting from timing differences relating to goodwill were clearly identified and not offset against determinate lived deferred tax assets. In September 2007, we took action designed to remediate this material weakness, but it remained a material weakness as of March 31, 2006.

Controls regarding business practices

In October 2005, in the course of preparing our financial statements for the period ended September 30, 2005, management identified a number of unusual transactions in our Korean subsidiary. The Audit Committee retained independent legal counsel and forensic accountants and initiated an investigation into certain transactions and issues involving our sales office in Korea. The investigation expanded to include a review of business practices in other sales offices or regions. The Audit Committee concluded based on the results of the investigation that no restatements to our consolidated financial statements were required. We believe, however, that the investigation identified control deficiencies which when aggregated led to a material weakness in internal control over financial reporting. These deficiencies included an inappropriate tone at the top regarding business and ethical practices and inadequate levels of review of sales and inventory accounts.

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In June 2006, the Audit Committee received and approved a report summarizing findings pertaining to its investigation. The report did not identify any material items that required restatement of our consolidated financial statements, but did highlight the need for additional education and oversight of the business culture and practices at many of our foreign operations. In response to these findings, we have enhanced certain control and review procedures, reinforced our guidelines and policies, and otherwise taken remedial actions to reinforce the internal control environment at all of our locations, with an emphasis on international operations. In September 2006, we informed the staff of the SEC Division of Enforcement about the results of the Audit Committee investigation.

We implemented the following controls over sales office operations in June 2006:

• Each employee is required to attend formal training, directed by our Chief Legal and Compliance Officer and Human Resources personnel, in our Code of Business Ethics and Conduct and other compliance related policies and procedures;

• Ethics policies are translated into the local language for each operation and each employee must acknowledge the receipt and understanding of our ethics policies;

• All material sales transactions require formal review by our Corporate Finance department; and

• Our Corporate Finance department has implemented enhanced internal and operating controls over several areas such as bank accounts, inventory, and international reporting, and conducts periodic reviews of financial practices and financial statements at each entity to ensure these controls are operating effectively and that the entity is acting within the established guidelines.

Controls regarding stock option practices

We recently completed a voluntary investigation of our historical stock option granting practices. The investigation covered all grants of options made since our initial public offering in July 2000 up to the last grant of stock options in August 2005. During the course of the investigation, we identified control deficiencies amounting to a material weakness in our internal control over financial reporting. Management failed to recognize that changes to a list of grantees after the meeting of the approving body could modify the measurement date for those options and changes were made which resulted in errors in the accounting for stock options which were not identified until June 2006.

Prior to our initial public offering in July 2000, the Stock Option Committee of our Board administered our stock option plans. This practice continued through October 2002, and during that period all stock option grants were ratified by the Compensation Committee. Between October 2002 and January 2003, we modified our stock option granting processes and procedures. As a result, the processes were formalized and a consistent procedure for stock option grants was implemented. At that time, the Compensation Committee terminated the delegation of authority previously granted to our Stock Option Committee. Our investigation of our historical stock option granting practices determined that the modified stock option granting practices that were instituted after the hiring of our current Chief Legal and Compliance Officer in December 2002 are sound and have been adhered to consistently. We have not identified any instances of inappropriate equity award practices resulting in revised measurement dates under APB 25 after June 2002.

The restatement covers our consolidated financial statements for the years 2001 through 2004 and for the three and six months ended June 30, 2005. The adjustments to our consolidated financial statements were principally amortization of deferred stock-based compensation resulting from revisions made to measurement dates for certain options granted in January 2001 and June 2002.

In assessing the findings of the investigation and the restatement of our consolidated financial statements, our management concluded that there was a material weakness in our internal control over financial reporting as of October 2002, with respect to the application of accounting principles to the stock option granting process as implemented prior to October 2002 when the Company instituted enhanced corporate governance procedures over stock option grants. As a result of this material weakness, errors were made in the accounting for equity based awards. As a result of these errors, we restated previously issued financial statements, as described in the Explanatory Note and in Note 2 of Notes to Condensed Consolidated Financial Statements.

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We have not issued stock options since August 2005. Our controls over the stock option granting process, as of March 31, 2006, included the following controls:

• Awards to newly hired employees are compiled by our Human Resources department and are submitted to the Compensation Committee for approval only on or after the employee’s commencement of employment. All equity award approvals by the Compensation Committee are communicated to the Human Resources department by the Legal department. The list of equity awards approved by the Compensation Committee includes specific allocations of awards to individuals. Equity awards are entered into our equity award administration system promptly after approval.

• Our Chief Legal and Compliance Officer attends all Compensation Committee meetings, records minutes, and confirms that equity awards comply with our equity plans.

• Except in Italy where local legal and tax rules require otherwise, the exercise price for each option grant is equal to or greater than the closing price of our common stock on the date of approval.

• Formal resolutions approving equity awards are reconciled to the data maintained in the equity award administration system on a quarterly basis. The Human Resources department validates new awards reflected in the equity award administration system.

• Notification of equity awards is sent (electronically or by mail) to employee recipients. The equity awards are uploaded from the equity award administration system to an online brokerage website, at which time grants are available for viewing by employees. Additionally, for members of our Board and our Section 16 officers, a Form 4 is filed with the SEC within two business days after the grant date.

• The equity award administration system is periodically reconciled to reflect the cancellation of awards held by employees whose employment with us has terminated.

• Any proposed modifications to equity awards (such as accelerations and exercise extensions) are communicated by the Legal department to, and such changes are approved by, the Compensation Committee.

• The issuance of shares upon exercise or release of equity awards recorded in our equity award administration system is periodically reconciled with the records of our transfer agent.

In the future, our Compensation Committee intends to hold regular quarterly meetings at which equity awards may be reviewed and approved.

Controls regarding inventory reserves

In the course of analyzing reserves for excess and obsolete inventory in November 2006, the Company identified a control deficiency assessed as a material weakness in internal control over financial reporting related to the methodology used to calculate and track inventory. Inventory that had been determined to be excess or obsolete was properly reserved, but was subsequently released from the reserve based upon changes in demand. As a result of our failure to prevent, or detect and correct, these changes in the inventory reserves, we overstated our inventory amounts. This material weakness was caused by deficiencies in our systems and process that did not maintain an adequate usage history or compare, isolate, or otherwise identify reserved items.

Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins (“ARB 43”), Chapter 4, “Inventory Pricing,” discusses the general principles applicable to the pricing of inventory. We determined that, for the years 2002 through 2004, the methods used to determine reserves for inventory obsolescence did not fully conform to the requirements of ARB 43, as interpreted by SEC Staff Accounting Bulleting No. 100, Restructuring and Impairment Charges (SAB 100). Based on SAB 100’s interpretation ARB 43, footnote 2, a write-down of inventory to the lower of cost or market at the close of a fiscal period creates a new cost basis that subsequently cannot be marked up based on changes in underlying facts and circumstances.

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Our methodology to calculate inventory reserves for the years 2002 through 2004 failed to properly track the cost basis of all items previously reserved, and we improperly reversed an inventory valuation allowance based upon changes in expected customer demand. As a result, we overstated our inventory amounts.

We implemented the following controls over the calculation of excess and obsolete inventory in November 2006:

• System generated demand is compared to inventory on hand to identify inventory that is potentially excess or obsolete.

• System generated excess and obsolete inventory is compared to prior period reserves to identify any reductions in quantities reserved at the item level. All reductions to quantities previously reserved are evaluated to confirm the change is due to the use or disposal of that item.

• Price calculations are reviewed to confirm the system generated values are appropriately calculated.

• Newly reserved items are manually reviewed by production planning to ensure calculated reserves are appropriate and consistent with known requirements.

• Items released from reserve due to the system calculation methodology that are not the result of disposal or use of the items in the manufacturing process are added back to reserves.

Controls at division level

During the course of our external audits for fiscal 2005 and 2006, we noted several adjustments identified by our external auditors associated with one of our operating divisions. In addition, revenue classification errors associated with this division caused a material error in our financial results for the first quarter of 2007 as preliminarily reported in our earnings press release. We believe the reasons for these errors were inadequate levels of training of divisional finance and accounting personnel, and inadequate staffing due to employee promotion and turnover. These errors resulted from a material weakness which consisted of deficiencies in our staffing requirements and policy regarding the timely replacement of key financial personnel. We consider these control deficiencies to be significant and in aggregate led to a material weakness in our internal control over financial reporting as of March 31, 2006. We have taken the following actions during 2007 to remediate this material weakness:

• We have hired an experienced senior financial manager with an appropriate professional accounting certification as division controller.

• We have filled all open positions in the division’s finance organization with personnel with adequate competence to ensure compliance with finance policies and procedures.

• We have refined the job requirements for the division’s finance staff to emphasize familiarity with U.S. generally accepted accounting principles.

• We now require division finance staff to notify corporate finance staff of any leaves of absence or job vacancies that might impact the accuracy and timeliness of financial reporting.

• We have hired corporate finance staff to perform site reviews of finance staff at our various locations to review local financial reporting, evaluate the effectiveness of the local internal control systems and staff performance, and initiate prompt corrective action.

Controls over tax provision calculation

During the course of preparing our 2006 federal tax provisions, we identified incomplete information in the supporting schedules for deferred tax assets and liabilities that revealed an error in the calculation of our tax provision for 2004. This represented a material error in our previously reported financial results for 2004 which continued through March 31, 2006. When we adopted SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), on January 1, 2002, we failed to create proper documentation detailing the impact of SFAS 142 on deferred tax liabilities. This failure to properly document the impact of the adoption of SFAS 142 had no financial statement impact until 2004. In March 2004, as a result of employee turnover combined with this lack of appropriate documentation, we failed to recognize the impact the adoption of SFAS 142 would have on the Company’s income tax

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provision once a full valuation allowance was put in place against the net deferred tax assets, as was required under SFAS 109, Accounting for Income Taxes (“SFAS 109”), due to the uncertainty of the realization of such assets. Consequently, we improperly offset the indeterminate lived deferred tax liability associated with goodwill against definite lived deferred tax assets.

In accordance with SFAS 142, we ceased amortizing goodwill from business acquisitions for financial reporting purposes. Goodwill continues to be amortized for income tax reporting, creating a temporary book to tax difference. SFAS 109 requires that we recognize a deferred tax liability for this temporary book to tax difference. The temporary difference created by the amortization of goodwill is classified as a long-term deferred tax liability as the timing of any ultimate recognition of expense from the impairment or disposal of these assets is indeterminate.

In addition, the ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which the related temporary differences become deductible. In the first quarter of 2004, a valuation allowance was recorded against all of our net deferred tax assets in most jurisdictions, the realization of these deferred tax assets was uncertain due to our recent operating losses. At the time this valuation allowance was recorded, we improperly offset the deferred tax liability associated with the temporary difference in the amortization of goodwill against other deferred tax assets, and as a result understated our valuation allowance.

We have taken the following actions during 2006 which helped us identify this material weakness:

• We have retained outside tax consultants to assist with the analysis and preparation of all tax related entries.

• We have retained a new director of taxation.

In addition, in September 2007, we took the following actions to remediate this material weakness:

• We created appropriate schedules detailing book to tax differences relating to goodwill and the associated tax impact have been created and are utilized in calculating the tax provision.

• We analyze all deferred tax items no less than once each quarter in connection with the preparation of our tax provision.

We will continue to assess whether additional actions or controls will be needed to remediate this material weakness.

While the effectiveness of our internal controls and disclosure controls remains subject to operational assessment and periodic testing, we believe that, as a result of the changes described above, our disclosure controls and procedures will be effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

CHANGES IN INTERNAL CONTROL

During the three months ended March 31, 2006, there were no changes in internal control over financial reporting that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.

INHERENT LIMITATIONS ON INTERNAL CONTROL

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors or mistakes. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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PART II OTHER INFORMATION

I TEM 1. LEGAL PROCEEDINGS

As of March 31, 2006, we were not involved in any material legal proceedings. As of March 1, 2008, we were involved in the following material legal proceeding:

On December 13, 2006, a stockholder derivative lawsuit was filed in the Superior Court of the State of California on behalf of Chris Stovall, a purported stockholder of ours, against certain of our current and former officers, directors, and employees and naming us as a nominal defendant. The complaint asserts claims for breach of fiduciary duty, waste, unjust enrichment and other statutory claims arising out of our stock option grant practices, which plaintiff claims included the “backdating” of stock option grants. We had disclosed an internal review of such practices in November 2006 and described the results of that review in our Annual Report on Form 10-K for 2005, filed on November 2, 2007. The court has twice granted our motions to dismiss the claims based on the insufficiency of the complaint.

On November 21, 2007, Stovall filed a second amended complaint alleging similar legal claims arising primarily out of the historic stock option grant practices as described in our 2005 Form 10-K. The second amended complaint seeks monetary damages from the individual defendants, restitution, disgorgement of profits, attorneys’ fees, and various corporate governance reforms.

In February 2008, the parties attempted to resolve the litigation through mediation, but were unsuccessful. The parties may continue with their mediation efforts in the future. We intend to continue to assert all available defenses.

From time to time, we may be involved in litigation or other legal proceedings, including that noted above, relating to claims arising out of our day-to-day operations or otherwise. Litigation is inherently uncertain, and we could experience unfavorable rulings. Should we experience an unfavorable ruling, there exists the possibility of a material adverse impact on our financial condition, results of operations, cash flows or on our business for the period in which the ruling occurs and/or future periods.

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ITEM 1A. RISK FACTORS

In addition to other information in this report, the following risk factors should be carefully considered in evaluating us and our business because these factors may have a significant impact, on our business, prospects, operating results or financial condition. Actual results could differ materially from those projected in the forward-looking statements contained in this report as a result of the risk factors discussed below and elsewhere in this report.

Stock Option Granting Practices,—Our investigation of our historical stock option granting practices and resulting restatement of our financial statements have had, and may continue to have, a material adverse effect on our financial performance.

We have restated our consolidated balance sheet as of December 31, 2004 and the consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the two-year period ended December 31, 2004, each of the quarters of 2004 and the first two quarters of 2005 as well as our financial statements for fiscal 2001 and 2002 presented in selected financial data in Part II, Item 6, “Selected Financial Data” presented in our 2005 Annual Report on Form 10-K filed with the SEC on November 2, 2007. Accordingly, you should not rely upon financial information included in any earnings press releases and similar communications issued by us, or any of our previously filed Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, or on the related opinions of our independent registered public accounting firm, for the periods ended March 31, 2001 through June 30, 2005.

Based on our investigation of our historical stock option granting practices, we concluded that we had improperly accounted for options to purchase an aggregate of 1,377,970 shares of our common stock that were awarded in January 2001 and June 2002. As a result, we recorded a total of $5.5 million in additional stock-based compensation expense for the years 2001 through 2004, net of forfeitures related to employee terminations. These expenses had the effect of decreasing income from operations, net income and net income per share (basic and diluted) in the affected periods in which we reported a profit, and increasing loss from operations, net loss and net loss per share in the affected periods in which we reported a loss.

Stock Option Issuance and Exercise of Existing Options—We have not issued option grants since August 2005 and option holders have not been permitted to exercise options since December 2005.

The Compensation Committee has not approved any grants of new options since August 2005 as a result of our review of stock option granting practices and our common stock being delisted from the NASDAQ Stock Market as a result of our failure to timely file our periodic reports with the SEC. As of February 1, 2008, management has committed to presenting recommendations to the Compensation Committee for the granting of 437,000 shares at an exercise price to be determined at the date of grant. Additionally, we have historically provided grants to employees annually, typically in the first quarter of the fiscal year, but have not made such grants since January 2005.

We have also been unable to issue stock since December 2005 as a result of our common stock being delisted. As a result, certain options that would otherwise be exercisable have expired unexercised and purchases under the Employee Stock Purchase Plan have been suspended. The Compensation Committee has extended certain options that had not, by their terms, expired.

The purpose of our various share-based compensation plans is to attract, motivate, retain, and reward high-quality employees, directors, and consultants by enabling such persons to acquire or increase their proprietary interest in our common stock in order to strengthen the mutuality of interests between such persons and our stockholders and to provide such persons with annual and long-term performance incentives to focus their best efforts in the creation of stockholder value. The failure to meet expectations of current and previous employees could have an adverse impact on our ability to retain and motivate our employees, directors and consultants. Further, the inability to issue stock to existing option holders reduces the value of such options as a component of our compensation strategy.

Further, current and former employees have expired unexercised options, that, but for our inability to issue stock, may have realized gains from the exercise of those options. We may decide, or be required, to provide compensation for the intrinsic value of those expired unexercised options. We could elect, or be required, to make cash payments, issue stock, or provide replacement share-based compensation to these option holders to compensate them for the lost intrinsic value from these expired unexercised options.

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Material Weaknesses in Internal Control over Financial Reporting—We have identified material weaknesses in our internal control over financial reporting in the past and cannot assure you that additional material weaknesses will not be identified in the future. If our internal controls or disclosure controls and procedures are not effective, there may be material errors in our financial statements that are not identified in a timely manner and that could require restatement, or our filings may not be timely, and investors may lose confidence in our reported financial information, any of which could lead to a decline in our stock price.

In assessing the findings of our investigation into the business practices in certain of our foreign subsidiaries, our historical stock option granting practices, reserves for excess and obsolete inventory and accounting for deferred income taxes, as well as in connection with the preparation of the restatement of our consolidated financial statements, our management concluded that there were material weaknesses in our internal control over financial reporting as of March 31, 2006.

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Controls can be circumvented by the individual acts of some persons, by the collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. In addition, misstatements due to error or fraud may occur and not be detected because of the inherent limitations in a cost-effective control system. As a result, significant deficiencies or material weaknesses in our internal controls may be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, result in material misstatements in our financial statements and/or cause investors to lose confidence in our reported financial information, all of which could lead to a decline in our stock price. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting.

Stockholder Litigation—We have been named as a party to a stockholder derivative action lawsuit arising from our investigation of our historical stock option granting practices and the subsequent restatement of our financial statements and may be named as a party to additional derivative action lawsuits, which could require significant management time and attention and result in significant legal expenses, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

We are currently engaged in civil litigation with a party that claims, among other allegations, that certain of our current and former officers and directors improperly dated stock option grants to enhance their own profits on the exercise of such options or for other improper purposes, and we may become the subject of additional private lawsuits based on our historical stock option granting practices and the subsequent restatement of our financial statements. The expense of defending such litigation may be significant. We have entered into indemnification agreements with each of our present and former officers and directors and if we incur indemnification obligations in connection with the pending stockholder derivative litigation or otherwise, this could affect adversely our financial condition. Moreover, the amount of time to resolve such litigation and potential additional lawsuits is unpredictable and defending the lawsuit may divert management’s attention from the day-to-day operations of our business, which could harm our business, results of operations and cash flows. In addition, an unfavorable outcome in such lawsuits, such as a court judgment against us resulting in monetary damages or penalties, could have a material adverse effect on our business, results of operations and cash flows.

Foreign Corrupt Practices Act—Our international operations are subject to anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and any violations could lead to sanctions against us that could harm our business and our financial condition.

Our operations are subject to the Foreign Corrupt Practices Act (“FCPA”) and similar anti-corruption laws of other countries. The FCPA generally prohibits U.S. companies and their intermediaries from making payments to foreign officials for the purpose of obtaining or maintaining business or otherwise obtaining favorable treatment. The FCPA also requires companies to maintain adequate record-keeping and internal accounting practices to accurately reflect the transactions of the companies. Under the FCPA, U.S. companies may be held liable for actions taken by their strategic or local partners or representatives. The FCPA and similar laws in other countries can impose civil and criminal penalties for violations.

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If we do not properly implement practices and controls with respect to compliance with the FCPA and similar laws, or if we fail to enforce those practices and controls properly, we may be subject to regulatory sanctions. For example, the SEC and the U.S. Department of Justice (the “DOJ”) may assert that we have violated the FCPA, which could lead to fines against us and other penalties or remedies, such as appointment of a monitor or suspension of our ability to contract with U. S. or foreign governmental agencies. Investigations or sanctions by the SEC and DOJ in connection with FCPA enforcement, and internal investigations into whether or not violations have occurred, can be expensive and time-consuming for us. Any of these outcomes may have an adverse effect on our business, and could adversely affect our financial results and financial condition.

Delisting from NASDAQ and Compliance with SEC Reporting Requirements—Our common stock was delisted from the NASDAQ Stock Market, which could adversely affect the price of our stock and the ability of our stockholders to trade in our stock. We have not been in compliance with SEC reporting requirements and if we are unable to remain in compliance with SEC reporting requirements, there may be a material adverse effect on us and our stock price.

Due to our Audit Committee investigation of our business practices, the independent investigation of our historical stock option granting practices, and the restatement activities as a result of the stock option investigation we were unable to timely file our periodic reports with the SEC. As a result, we were not in compliance with the filing requirements for continued listing on the NASDAQ Stock Market and, consequently, our common stock was delisted from the NASDAQ Stock Market in December 2005 and subsequently began trading on the Pink Sheets under the symbol “SRTI.PK.” As a result of the delisting of our common stock from the NASDAQ Stock Market, the price of our stock and the ability of our stockholders to trade in our stock could be adversely affected. To the extent that we attempt to relist our common stock on NASDAQ or another exchange, it would be uncertain when, if ever, our common stock would be relisted. In addition, as a result of our delay in filing periodic reports on a timely basis, we will not be eligible to use a registration statement on Form S-3 to register offers and sales of our securities until all periodic reports have been timely filed for at least twelve months after we have filed all required reports.

Change in SEC Guidance and Disclosure Requirements—Judgments and estimates utilized by us in determining stock option grant dates and related adjustments in connection with the restatement of our consolidated financial statements may be subject to change due to subsequent SEC guidance or other disclosure requirements.

In determining the financial restatement adjustments in connection with our investigation of our historical stock option granting practices, we used all reasonably available relevant information to form conclusions we believe are appropriate as to the most likely option granting actions that occurred, the dates when such actions occurred, and the determination of grant dates for financial accounting purposes based on when the requirements of the accounting standards were met. We considered various alternatives throughout the course of our investigation and the restatement of our financial statements, and we believe the approaches used were the most appropriate, and the choices of measurement dates used in our investigation of stock option grant accounting and restatement of our financial statements were reasonable and appropriate in our circumstances. Nevertheless, the issues surrounding our historical stock option granting practices are complex and the regulatory guidelines or requirements continue to evolve. There can be no assurance that the SEC will not issue additional guidance on disclosure requirements related to the financial impact of past stock option grant measurement date errors and that we will not be required to further amend this report or other filings with the SEC to provide additional disclosures pursuant to such additional guidance. Any such circumstance could also lead to future delays in filing our subsequent SEC reports. Furthermore, if we are subject to adverse findings in any of these matters, we could be required to pay damages or penalties or have other remedies imposed upon us which could harm our business, financial condition, results of operations and cash flows.

Quarterly Fluctuations—Because our quarterly operating results have fluctuated significantly in the past and are likely to fluctuate significantly in the future, our stock price may be volatile.

In the past, we have experienced significant fluctuations in our quarterly results due to a number of factors. In the future, our quarterly operating results may fluctuate significantly and may be difficult to predict given the nature of our business. Many factors could cause our operating results to fluctuate from quarter to quarter, including the following:

• the size and timing of orders from our customers, which may be exacerbated by the increased length and unpredictability of our customers’ buying patterns, and limitations on our ability to ship these orders on a timely basis;

• the degree to which our customers have allocated and spent their yearly budgets;

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• the uneven pace of technological innovation, the development of products responding to these technological innovations by us and our competitors, and customer acceptance of these products and innovations;

• the varied degree of price, product, and technology competition, and our customers’ and competitors’ responses to these changes;

• the relative percentages of our products sold domestically and internationally;

• the mix of the products we sell and the varied margins associated with these products;

• developments relating to our ongoing litigation;

• the timing of our customers’ budget processes; and

• economic downturns reducing demand for telecommunication and cable equipment and services.

The factors listed above may affect our business and stock price in several ways. Given our high fixed costs from overhead, research and development, and selling and marketing, and other activities necessary to run our business, if our net sales are below our expectations in any quarter, we may not be able to adjust spending accordingly. Our stock price may decline and may be volatile, particularly if public market analysts and investors perceive that the factors listed above may contribute to unfavorable changes in operating results. Furthermore, the above factors, taken together, may make it more difficult for us to issue additional equity in the future or raise debt financing to fund future acquisitions and accelerate growth.

Consolidation and Other Risks Within the Telecommunications Industry—Our operating results and financial condition could be adversely affected by several risks related to the telecommunication industry, including the continuing consolidation among our principal customers, the uncertainty of growth of end-user demand for telecommunication services, the possible effects of its unpredictable growth or decline, and the risk that deregulation will slow.

In recent years, the telecommunications industry has experienced rapid growth. The growth led to innovations in technology, intense competition, short product life cycles, and, to some extent, regulatory uncertainty inside and outside the United States. It is difficult for companies operating in this industry to forecast future trends and developments, particularly forecasting customer acceptance of competing technologies. Moreover, the continued growth of end-user demand for telecommunications services is uncertain and difficult to predict. Such uncertainties may lead telecommunications companies to postpone investments in their businesses and purchases of related equipment, such as our products.

Moreover, the telecommunications industry has been experiencing consolidation, such as incumbent local exchange carriers and competitive local exchange carriers, several of whom are our primary customers. For example, in recent years, GTE and Bell Atlantic, both of which were customers of ours, merged to create Verizon Communications Inc. and Southwestern Bell, Pacific Bell, Ameritech, Bell South, and AT&T have consolidated and now operate as AT&T, Inc. Continued consolidation in the telecommunication industry may cause delay or cancellation of orders for our products. The consolidation of our customers will likely provide them with greater negotiating leverage with us and may lead them to pressure us to lower the prices of our products.

Long-term Impact of Cost Controls—The actions we have taken and may take in response to the slowdowns in demand for our products and services could have long-term adverse effects on our business.

From time to time, our business experiences lower revenues due to decreased or cancelled customer orders. To scale back our operations and to reduce our expenses in response to decreased demand for our products and services and lower revenue, we have in the past reduced our workforce, restricted hiring, reduced salaries, restricted pay increases, reduced discretionary spending, and relocated some of our operations abroad.

On February 6, 2008 we announced a restructuring plan intended to reduce costs and improve operating efficiencies. The plan included a 12% reduction in our worldwide workforce, across all functional areas, and a shut-down of certain international offices. The cost reduction program, when fully implemented, is expected to save approximately $10-12 million per year on a pre-tax basis. We will recognize a one-time charge of approximately $1.4 million associated with employee severance payments, lease terminations, and other miscellaneous charges in the first quarter of fiscal 2008. The restructuring and impairment costs include employee severance and benefit costs, costs related to leased facilities to be abandoned or subleased, and impairment of owned equipment that will be disposed.

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There are several risks inherent in any effort to transition to a reduced cost structure. These include the risk that we will not be able to reduce expenditures quickly enough and sustain them at a level necessary to restore profitability, and that we may have to undertake further restructuring initiatives that would entail additional charges. There is also the risk that cost-cutting initiatives will impair our future ability to develop and market products effectively, to manage and control our business, and to remain competitive. Moreover, cost reducing measures are time-consuming, can be costly to implement and can lead to a diminished quality of our products. Each of the above measures could have long-term effects on our business by reducing our pool of employee talent, decreasing or slowing improvements in our products, making it more difficult for us to respond to customers, limiting our ability to increase production quickly if, and when, the demand for our products increases, and limiting our ability to hire and retain key personnel. These circumstances could cause our earnings to be lower than they otherwise might be.

Dependence on Wireline Access Products—A significant portion of our sales has been from our wireline access products, which makes our future sales and overall business vulnerable to product obsolescence and technological change in the wireline field.

Sales of our DSL and other wireline access products represented approximately 35% of our net sales during 2006, 33% during 2005, and 43% during 2004. Currently, our DSL products are primarily used by a limited number of incumbent local exchange carriers, including the regional Bell operating companies, and competitive local exchange carriers who offer DSL services. These parties, and other Internet service providers and users, are continuously evaluating alternative high-speed data access technologies, including cable modems, fiber optics, wireless technology, and satellite technologies, and may, at any time, adopt these competing technologies. These competing technologies may ultimately prove to be superior to DSL services and reduce or eliminate the demand for our DSL products.

Cable Broadband Industry Health—Many companies in the cable broadband industry have incurred significant amounts of debt and operating losses, and face increasing competition from direct broadcast satellite and telecom service providers, which may negatively impact our cable equipment sales.

The cable broadband industry has taken on significant debt as companies aggressively consolidate and build new digital networks to allow them to provide better picture quality, internet access, and voice telephony. As a result, cable companies may reduce their capital expenditures and hiring, either of which could adversely impact our cable business more than we currently anticipate.

Customer Concentration—Our customers are concentrated in the telecommunications and cable broadband industries, which makes our future success dependent on the buying patterns of these customers and their continued demand for our products. In addition, a limited number of customers account for a high percentage of our net sales, and any adverse effect on these customers or our relationship with these customers could cause our net sales to decrease.

Our customers are concentrated in the telecommunications and cable broadband industries. Accordingly, our future success depends on the buying patterns of these customers and the continued demand by these customers for our products. Additionally, the market is characterized by rapidly changing technology, evolving industry standards, changes in end-user requirements and frequent new product introductions and enhancements. See “Risk Factors—Consolidation and Other Risks Within the Telecommunications Industry” for a discussion of risks associated with the telecommunications industry. Our continued success will depend upon our ability to enhance existing products and to develop and introduce, on a timely basis, new products and features that keep pace with technological developments and emerging standards.

Moreover, a relatively small number of customers account for a large percentage of our net sales. Net sales from our top five customers represented approximately 28% of total net sales in 2006, 22% in 2005, and 26% in 2004. In general, our customers are not subject to long-term supply contracts with us and are not obligated to purchase a specific amount of products from us or to provide us with binding forecasts of purchases for any period.

Historically, a significant portion of our net sales have come from a small number of relatively large orders from a limited number of large customers. We anticipate that our operating results for a given period will be dependent on a limited number of customers.

The loss of a major customer or the reduction, delay, or cancellation of orders from one or more of our significant customers could cause our net sales and, therefore, profits to decline. In addition, many of our customers are able to exert substantial negotiating leverage over us. As a result, they may pressure us to lower our prices to them, and they may successfully negotiate other terms and provisions that may adversely affect our business and profits.

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Product Development—If we are unable to develop new products successfully and enhance our existing products, our future success may be threatened.

The market for our products is characterized by rapid technological advances, changes in customer requirements and preferences, evolving industry and customer-specific protocol standards, and frequent new product enhancements and introductions. Our existing products and our products currently under development could be rendered obsolete or otherwise abandoned because of the introduction of products involving competing technologies, by the evolution of alternative technologies or new industry protocol standards, by rival products of our competitors, market timing, or product design flaws. These market conditions are even more complex and challenging because of the high degree to which the telecommunications industry is fragmented.

We believe our future success will depend, in part, upon our ability, on a timely and cost-effective basis, to continue to do the following:

• anticipate and respond to varied and rapidly changing customer preferences and requirements, a process made more challenging by our customers’ buying patterns;

• anticipate and develop new products and solutions for networks based on emerging technologies, such as the asynchronous transfer mode protocol that packs digital information into cells to be routed across a network, and internet telephony, which comprises voice, video, image, and data across the Internet, that are likely to be characterized by continuing technological developments, evolving industry standards and changing customer requirements;

• invest in research and development to enhance our existing products and to introduce new verification and diagnostic products for the telecommunications, internet, cable network and other markets; and

• support our products by investing in effective advertising, marketing, and customer support.

We cannot ensure that we will accomplish these objectives, and our failure to do so could have a material adverse impact on our market share, business, and financial results.

Furthermore, our expenditures devoted to research and development may be considered high for our level of sales. If these efforts do not result in the development of products that generate strong sales for us or if we do not reduce these expenditures, our profit levels will not return to their desired levels. If we reduce this spending, we may not be able to develop needed new products, which could negatively impact our sources of new revenues.

Sales Implementation Cycles—The length and unpredictability of the sales and implementation cycles for our products make it difficult to forecast revenues.

Sales of our products often entail an extended decision-making process on the part of prospective customers. We frequently experience delays following initial contact with a prospective customer and expend substantial funds and management effort pursuing these contacts. Our ability to forecast the timing and amount of specific sales is therefore limited. As a result, the uneven buying patterns of our customers may cause fluctuations in our operating results, which could cause our stock price to decline.

Other sources of delays that lead to long sales cycles, or even to a sales loss, include current and potential customers’ internal budgeting procedures, internal approval and contracting procedures, procurement practices, and testing and acceptance processes. Recently, our customers’ budgeting procedures have lengthened. The sales cycle for larger deployments now typically ranges from six to twenty-four months. The deferral or loss of one or more significant sales could significantly affect our operating results, especially if there are significant selling and marketing expenses associated with deferred or lost sales.

Managing Growth and Slowdowns—We may have difficulty managing expansions and contractions in our operations, which could reduce our chances of maintaining or restoring our profitability.

We experienced rapid growth in revenues and in our business during 1999 and 2000 followed by significant slowdowns in 2001 and 2002, which were then followed by sales increases in subsequent years. In particular, we experienced rapid growth in revenues between 2005 and 2006. These periods of expansion and contraction in our revenues and operations have placed, and may continue to place, a significant strain on our management and operations. As a result of our historical growth and potential future growth or slowdowns, we face several risks, including the following:

• the need to improve our operational, financial, management, informational and control systems;

• the need to hire, train and retain highly skilled personnel; and

• the challenge to manage expense reductions without impacting development strategies or our long-term goals.

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We cannot ensure that we will be able to manage growth or slowdowns successfully, or that we will be able to achieve or sustain profitability.

Manufacturing Capacity—If demand for our products does not match our manufacturing capacity, our earnings may suffer.

We cannot immediately adapt our production capacity and related cost structures to rapidly changing demand for our products. When demand does not meet our expectations or manufacturing capacity exceeds our production requirements, profitability may decline. Conversely, if during a market upturn we cannot increase our manufacturing capacity to meet product demand, we will not be able to fulfill orders in a timely manner, which in turn may have a negative effect on our earnings and overall business.

Competition—Competition could reduce our market share and decrease our net sales.

The market for our products is fragmented and intensely competitive, both inside and outside of the United States, and is subject to rapid technological change, evolving industry standards, regulatory developments, and varied and changing customer preferences and requirements. We compete with a number of United States and international suppliers that vary in size and in the scope and breadth of the products and services offered. Many of these competitors have longer operating histories, larger installed customer bases, longer relationships with customers, wider name recognition and product offerings, and greater financial, technical, marketing, customer service and other resources than we have.

We expect that as our industry and markets evolve, new competitors or alliances among competitors with existing and new technologies may emerge and acquire significant market share. We anticipate that competition in our markets will increase, and we will face continued challenges to our market share and price pressure on our products. Also, over time, our profitability, if any, may decrease. In addition, it is difficult to assess accurately the market share of each of our products and lines of products because of the high degree of fragmentation in the market for service verification equipment. As a result, it may be difficult for us to forecast accurately trends in the market and which of our products will be the most competitive over the longer term, and therefore, what is the best use of our cash, personnel and other forms of resources.

Dependence on Sole and Single Source Suppliers—Because we depend on a limited number of suppliers and some sole and single source suppliers that are not bound by long-term contracts, our future supply of parts is uncertain.

We purchase many key parts, such as microprocessors, field programmable gate arrays, bus interface chips, optical components, and oscillators, from single source or sole suppliers, and we license certain software from third parties. We rely exclusively on third-party subcontractors to manufacture certain sub-assemblies, and we have retained, from time to time, third party design services in the development of our products. We do not have long-term supply agreements with these vendors. In general, we make advance purchases of some products and components to help ensure an adequate supply. In the past, we have experienced supply problems as a result of financial or operating difficulties of our suppliers, shortages, and discontinuations resulting from component obsolescence or other shortages or allocations by suppliers. Our reliance on these third parties involves a number of risks, including the following:

• the unavailability of critical products and components on a timely basis, on commercially reasonable terms, or at all;

• the unavailability of products or software licenses, resulting in the need to qualify new or alternative products or develop or license new software for our use and/or to reconfigure our products and manufacturing process, which could be lengthy and expensive;

• the likelihood that, if these products are not available, we would suffer an interruption in the manufacture and shipment of our products until the products or alternatives become available;

• reduced control over product quality and cost, risks that are exacerbated by the need to respond, at times, to unanticipated changes and increases in customer orders;

• the unavailability of, or interruption in, access to some process technologies; and

• exposure to the financial problems and stability of our suppliers.

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In addition, the purchase of these components on a sole source basis subjects us to risks of price increases and potential quality assurance problems. Long lead-times for delivery of certain sole-sourced components may impact our ability to respond to changes in production demand in a timely fashion to satisfy customers’ orders and we may not be able to ensure customer satisfaction. We cannot ensure that one or more of these factors will not cause delays or reductions in product shipments or increases in product costs, which in turn could have a material adverse effect on our business.

Risks of International Operations—Our plan to expand sales in international markets could lead to higher operating expenses and may subject us to unpredictable regulatory and political systems.

Sales to customers located outside of the United States represented approximately 49% of our net sales in 2006, 47% in 2005 and 2004. We expect international revenues to continue to account for a significant percentage of net sales for the foreseeable future. In addition, an important part of our strategy calls for further expansion into international markets. As a result, we will face various risks relating to our international operations, including the following:

• potentially higher operating expenses, resulting from the establishment of international offices, the hiring of additional local personnel, and the localization and marketing of products for particular countries’ technologies;

• the need to establish relationships with government-owned or subsidized telecommunications providers and with additional distributors;

• fluctuations in foreign currency exchange rates and the risks of using hedging strategies to minimize our exposure to these fluctuations;

• potentially adverse tax consequences related to acquisitions and operations, including the ability to claim goodwill deductions and a foreign tax credit against U.S. federal income taxes; and

• possible disruptions to our customers, sales channels, sources of supply, or production facilities due to wars, terrorist acts, acts of protest or civil disobedience, or other conflicts between or within various nations and due to variations in crime rates and the rule of law between nations.

We cannot ensure that one or more of these factors will not materially and adversely affect our ability to expand into international markets or our revenues and profits.

In addition, the Asia/Pacific and Latin America regions, both high-growth emerging markets for telecommunications equipment, have experienced instability in many of their economies and significant devaluations in local currencies. 22% of our sales in 2005, and 24% of our sales in 2004 were from customers located in these regions. In 2006, our sales to customers in those regions were 22% of our total sales. These instabilities may continue or worsen, which could have a material adverse effect on our results of operations. If international revenues are not adequate to offset the additional expense of expanding international operations, our future growth and profitability could suffer.

Operations in Taiwan—We rely on our subsidiary in Taiwan to manufacture a substantial portion of our products, and our reputation and results of operations could be adversely affected if this subsidiary does not perform as we expect.

We produce a substantial portion of our products at our subsidiary in Taiwan and plan to concentrate more of our production there in the future. We depend on our Taiwan subsidiary to produce a sufficient volume of our products in a timely fashion and at satisfactory quality levels. If we fail to manage our subsidiary so that it produces quality products on time and in sufficient quantities, our reputation and results of operations could suffer. In addition, we rely on our Taiwan subsidiary to place orders with suppliers for the components they need to manufacture our products. If our subsidiary in Taiwan fails to place timely and sufficient orders with its suppliers, our results of operations could suffer.

The cost, quality, and availability of our Taiwan operation are essential to the successful production and sale of our products. Our increasing reliance on this foreign subsidiary for manufacturing exposes us to risks that are not under our immediate control and which could negatively impact our results of operations. For example, a recurrence of the Severe Acute Respiratory Syndrome (SARS) outbreak that occurred in Asia in recent years could result in a quarantine or closure of our manufacturing operation in Taiwan or its local suppliers. In addition, transportation delays and interruptions, political and economic regulations, and natural disasters could also adversely impact our Taiwan operations and negatively impact our results of operations. See “Risk Factors—Dependence on Sole and Single Source Suppliers” and, “—Risks of International Operations” for a discussion of risks associated with concentrating production activities at one facility that is outside the United States.

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Concentration of Control—Our Chief Executive Officer and certain directors retain significant control over us, which may allow them to decide the outcome of matters submitted to stockholders for approval. This influence may not be beneficial to all stockholders.

As of February 26, 2008, Paul A. Marshall, our President and Chief Executive Officer and a member of our Board, and Robert C. Pfeiffer, a member of our Board, beneficially owned approximately 23% and 12%, respectively, of our outstanding shares of common stock. Consequently, these two individuals together control approximately 35% of our outstanding shares of common stock and, to the extent that they act together, may be able to control the election of our directors and the approval of significant corporate transactions that must be submitted to a vote of the stockholders. In addition, Messrs. Marshall and Pfeiffer constitute two of the five members of our Board and have significant influence in directing the actions taken by the Board. Further, to our knowledge, as of February 26, 2008, Paul Ker-Chin Chang, our former Chief Executive Officer, President and Chairman of the Board, continued to hold approximately 10% of our outstanding shares of common stock. To the extent that Mr. Chang acts together with Messrs. Marshall and Pfeiffer, the three individuals together control approximately 45% of our outstanding shares. The interests of these persons may conflict with the interests of other stockholders, and the actions they take or approve may be contrary to those desired by other stockholders. This concentration of ownership and control of the management and affairs of us may also delay or prevent a change in control of us that other stockholders may consider desirable. In addition, conflict among the controlling stockholders may adversely impact their ability to take joint actions in the best interests of us and our other stockholders.

Potential Product Liability—Our products are complex, and our failure to detect errors and defects may subject us to costly repairs and product returns under warranty and product liability litigation.

Our products are complex and may contain undetected defects or errors when first introduced or as enhancements are released. These errors may occur despite our testing and may not be discovered until after a product has been shipped and used by our customers. Many of the products that we ship contain imperfections that we consider to be insignificant at the time of shipment. We may misjudge the seriousness of a product imperfection and allow the product to be shipped to our customers. These risks are compounded by the fact that we offer many products with multiple hardware and software modifications, which makes it more difficult to ensure high standards of quality control in our manufacturing process. The existence of these errors or defects could result in costly repairs and/or returns of products under warranty and, more generally, in delayed market acceptance of the product or damage to our reputation and business.

In addition, the terms of our customer agreements and purchase orders which provide us with protection against unwarranted claims of product defects and errors may not protect us adequately from unwarranted claims against us, unfair verdicts if a claim were to go to trial, settlement of these kinds of claims, or future regulations or laws regarding our products. Our defense against such claims in the future, regardless of their merit, could result in substantial expense to us, diversion of management time and attention, and damage to our business reputation and our ability to retain existing customers or attract new customers.

Intellectual Property Risks—Policing any unauthorized use of our intellectual property by third parties and defending any intellectual property infringement claims against us could be expensive and disrupt our business.

Our intellectual property and proprietary technology is an important part of our business, and we depend on the development and use of various forms of intellectual property and proprietary technology. As a result, we are subject to several risks associated with our intellectual property assets, including the risks of unauthorized use of our intellectual property and the costs of protecting our intellectual property.

Most of our intellectual property and proprietary technology is not protected by patents, and as a result our intellectual property may not be adequately protected. If unauthorized persons were to copy, obtain, or otherwise misappropriate our intellectual property or proprietary technology, the value of our investment in research and development would decline, our reputation and brand could be diminished, and we would likely suffer a decline in revenues. We believe these risks, which are present in any business in which intellectual property and proprietary technology play an important role, are exacerbated by the difficulty in monitoring and detecting the unauthorized use of intellectual property in our business, the increasing incidence of patent infringement in our industry in general, and the difficulty of enforcing intellectual property rights in some foreign countries.

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Although our employees are subject to confidentiality obligations, this protection may be inadequate to deter or prevent the misappropriation of our intellectual property or proprietary technology. Our inability to protect our intellectual property or proprietary technology may adversely affect our competitive business position.

Litigation has in the past been, and may in the future be, necessary to enforce our intellectual property rights and/or defend against the accusations of others. This kind of litigation is time-consuming and expensive to prosecute and resolve and results in a substantial diversion of management resources. We cannot assure you that we will be successful in this type of litigation, that our intellectual property rights will be held valid and enforceable in any litigation, or that we will otherwise be able to protect our intellectual property and proprietary technology.

In the future, we may receive notices from holders of patents that raise issues as to possible infringement by our products. As the number of telecommunications test, measurement, and network management products increases and the functionality of these products further overlap, we believe that we may become subject to allegations of infringement given the nature of the telecommunications industry and the high incidence of these kinds of claims. Questions of infringement and the validity of patents in the field of telecommunications technologies involve highly technical and subjective analyses. These kinds of proceedings are time consuming and expensive to defend or resolve, result in a substantial diversion of management resources, cause product shipment delays, and could force us to enter into royalty or license agreements rather than dispute the merits of the proceedings initiated against us.

Acquisitions—We have in the past acquired multiple companies and lines of business, and we may pursue additional acquisitions in the future. These activities involve numerous risks, including the use of cash, acquired intangible assets, and the diversion of management attention.

We have acquired multiple companies and lines of business in the past. As a result of these acquisitions, we face numerous risks, including the following:

• integrating the existing management, sales force, technicians and other personnel into one culture and business;

• integrating manufacturing, administrative and management information and other control systems into our existing systems;

• developing and implementing an integrated business strategy over what had previously been independent companies;

• developing compatible or complementary products and technologies from previously independent operations; and

• pre-acquisition liabilities associated with the companies or intellectual property acquired, or both.

The risks stated above are increased by the fact that most of the companies and assets that we have acquired are located outside of the United States, which makes integration more difficult and costly. In addition, if we make future acquisitions, these risks will be exacerbated by the need to integrate additional operations at a time when we may not have fully integrated all of our previous acquisitions.

If we pursue additional acquisitions, we will face similar risks as those outlined above and additional risks, including the following:

• the diversion of our management’s attention and the expense of identifying and pursuing suitable acquisition candidates, whether or not an acquisition is consummated;

• negotiating and closing these transactions;

• the possible need to fund these acquisitions by dilutive issuances of equity securities or by incurring debt; and

• the potential negative effect on our financial statements from an increase in other intangibles, write-off of research and development costs, and high costs and expenses from completing acquisitions.

We cannot ensure that we will locate suitable acquisition candidates or that, if we do, we will be able to acquire them and then integrate them effectively, efficiently, and successfully into our business.

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Goodwill Valuation—Our financial results could be materially and adversely affected if it is determined that the book value of goodwill is higher than the fair value.

Our balance sheet at March 31, 2006 included an amount designated as “Goodwill” of $12.5 million. Goodwill arises when an acquirer pays more for a business than the fair value of the acquired tangible and separately measurable intangible net assets. Under accounting pronouncement SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), beginning in January 2002, the amortization of goodwill has been replaced with an “impairment test,” which requires that we compare the fair value of goodwill to its book value at least annually, and more frequently, if circumstances indicate a possible impairment.

Our impairment test is based on a market capitalization analysis. Accordingly, if our market capitalization were to diminish significantly, the book value of goodwill could be higher than the fair value, and we would need to record a non-cash impairment charge for the difference, which could materially and adversely affect our net income or loss.

Dependence on Key Employees—If one or more of our senior managers were to leave, we could experience difficulty in replacing them and our operating results could suffer.

Our success depends to a significant extent upon the continued service and performance of a relatively small number of key senior management, technical, sales, and marketing personnel. If any of our senior managers were to leave us, we would need to devote substantial resources and management attention to replace them. As a result, management attention may be diverted from managing our business, and we may need to pay higher compensation to replace these employees. We do not have employment contracts with, or key person life insurance for, any of our personnel. During 2006, following the loss of a number of key employees, we announced the adoption of a retention bonus program and other inducements to reward long-term employees who remained employed with us as we continued to work our way through our challenges. Competition for skilled employees is intense, especially in the San Francisco Bay Area where our main operations are located, and there can be no assurance that we will be able to recruit and retain such personnel.

Anti-takeover Provisions—Anti-takeover provisions in our charter documents could prevent or delay a change of control and, as a result, negatively impact our stockholders.

Some provisions of our certificate of incorporation and bylaws may have the effect of discouraging, delaying, or preventing a change in control of our company or unsolicited acquisition proposals that a stockholder may consider favorable. These provisions provide for the following:

• authorizing the issuance of “blank check” preferred stock;

• a classified board of directors with staggered, three-year terms;

• prohibiting cumulative voting in the election of directors;

• requiring super-majority voting to effect certain amendments to our certificate of incorporation and by-laws;

• limiting the persons who may call special meetings of stockholders;

• prohibiting stockholder action by written consent; and

• establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon at stockholders meetings.

Some provisions of Delaware law and our stock incentive plans may also have the effect of discouraging, delaying, or preventing a change in control of our company or unsolicited acquisition proposals. These provisions could also limit the price that some investors might be willing to pay in the future for shares of our common stock.

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Sarbanes-Oxley Act of 2002—We will be required to evaluate our system of internal control over financial reporting in 2007 and our independent auditor will be required to attest to the effectiveness of our internal controls in 2008. Any deficiencies found in our internal control over financial reporting or the inability of our independent auditor to conclude on the effectiveness could negatively impact our stock price.

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we will be required, beginning with our fiscal year ending December 31, 2007, to include in our annual report our assessment of the effectiveness of our internal control over financial reporting as of the end of 2007. Furthermore, our independent auditor will be required to separately report on whether it believes we maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008. The Securities and Exchange Commission has proposed a one year delay in the requirement to have our independent auditor separately report on our internal controls over financial reporting, which, if approved, would extend the first audit requirement to December 31, 2009. We have not yet completed our assessment of the effectiveness of our internal controls. If we fail to timely complete this assessment, or if our independent auditor cannot timely complete their audit, we could be subject to regulatory sanctions and a loss of public confidence in our internal controls. In addition, failure to implement any new or improved controls deemed necessary as a result of management or our auditor’s assessments, or difficulties encountered in their implementation, could cause us to fail to timely meet our regulatory reporting obligations. Any of these failures could adversely affect the price of our common stock.

AVAILABLE INFORMATION

Our website is http://www.sunrisetelecom.com. We make available free of charge, on or through our website, our annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the SEC. Information contained on our website is not part of this report.

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5. OTHER INFORMATION

None.

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ITEM 6. EXHIBITS

		Incorporated by Reference
Exhibit Number	Description	Form	Date	Exhibit Number	Filed Herewith
10.1	Employment Agreement between Sunrise Telecom Incorporated and Paul Ker-Chin Chang, dated February 7, 2006. †	8-K	February 8, 2006	10.01
10.2	Description of Director Compensation Arrangements, adopted February 7, 2006. †	8-K	February 8, 2006	10.02
10.3	Separation Agreement between Sunrise Telecom Incorporated and Paul Ker-Chin Chang, dated March 14, 2006. †	8-K	March 20, 2006	10.01
31.1	Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.				X
31.2	Certification of Principal Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.				X
32	Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350.				X

† Indicates management contract or compensatory plan, contract or arrangement.

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SIG NATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		SUNRISE TELECOM INCORPORATED
Date:	March 10, 2008	(Registrant)
		By:	/s/ PAUL A. MARSHALL
			Paul A. Marshall
			President and Chief Executive Officer (Principal Executive Officer)
		By:	/s/ RICHARD D. KENT
			Richard D. Kent
			Chief Financial Officer (Principal Financial Officer)

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EXHIBIT INDEX

		Incorporated by Reference
Exhibit Number	Description	Form	Date	Exhibit Number	Filed Herewith
10.1	Employment Agreement between Sunrise Telecom Incorporated and Paul Ker-Chin Chang, dated February 7, 2006. †	8-K	February 8, 2006	10.01
10.2	Description of Director Compensation Arrangements, adopted February 7, 2006. †	8-K	February 8, 2006	10.02
10.3	Separation Agreement between Sunrise Telecom Incorporated and Paul Ker-Chin Chang, dated March 14, 2006. †	8-K	March 20, 2006	10.01
31.1	Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.				X
31.2	Certification of Principal Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.				X
32	Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350.				X

† Indicates management contract or compensatory plan, contract or arrangement.

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