Ixia (XXIA) 10-K/A 2005 FY Annual report (amended)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K/A

AMENDMENT NO. 1

(Mark One)

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

For the Fiscal Year Ended December 31, 2005

OR

o 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 000-31523

IXIA

(Exact name of Registrant as specified in its charter)

California	95-4635982
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

26601 West Agoura Road, Calabasas, CA 91302
(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (818) 871-1800

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

Securities registered pursuant to Section 12(g) of the Act: Common Stock, without par value

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yeso Noþ

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yeso Noþ

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.þ

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filerþ Accelerated filero Non-accelerated filero

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

The aggregate market value of the shares of the Registrant’s Common Stock held by nonaffiliates of the Registrant as of June 30, 2005, computed by reference to the closing sales price on the Nasdaq National Market on that date, was approximately $709,560,603.

As of February 22, 2006, the number of shares of the Registrant’s Common Stock outstanding was 66,627,588.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement delivered to shareholders in connection with the Annual Meeting of Shareholders held on May 10, 2006 are incorporated by reference into Part III of this Annual Report.

EXPLANATORY NOTE

We are filing this Amendment No. 1 to our Annual Report on Form 10-K (this “Amendment”) for the year ended December 31, 2005, which was originally filed with the Securities and Exchange Commission on March 13, 2006 (the “Original Filing”) to (i) remove the stock-based compensation subtotals from the table included in the footnote on the face of our consolidated statements of income appearing on page 48 of the Original Filing and (ii) correct a typographical error in Note 4 “Acquisitions” to our consolidated financial statements appearing on page 61 of the Original Filing. The typographical error was in the presentation in Note 4 of the unaudited pro forma amounts for net revenues and net income for the year ended December 31, 2004, had the acquisition of Communication Machinery Corporation occurred on January 1, 2004. The correct amounts of such pro forma net revenues and net income for the year ended December 31, 2004 are $117,807 (in thousands) and $18,764 (in thousands), respectively (replacing the previously reported amounts of $1,430 (in thousands) and $1,169 (in thousands), respectively).

This Amendment contains only Item 15, “Exhibits and Financial Statement Schedules.” This Amendment makes only the changes identified above, does not change any previously reported financial results, and does not reflect events occurring after the date of the Original Filing.

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PART IV

Item 15. Exhibits and Financial Statement Schedules

(a) The following documents are filed as part of this Report:

     (1) Consolidated Financial Statements

          The consolidated financial statements listed in the accompanying Index to Consolidated Financial Statements are filed as part of this report.

     (2) Financial Statement Schedule

          The financial statement schedules have been omitted because they are not applicable or the information required to be set forth therein is included in the consolidated financial statements or notes thereto.

     (3) Exhibits

2.1	Stock Purchase Agreement dated as of February 20, 2004 by and among Ixia, G3 Nova Technology, Mihai Moldovan, Dana Moldovan and Ovidiu Rancu (schedules are omitted from this agreement, and the Registrant agrees to furnish supplementally a copy of any such schedule to the Commission upon request)(1)
3.1	Amended and Restated Articles of Incorporation, as amended(2)
3.2	Bylaws, as amended(3)
10.1*	Amended and Restated 1997 Equity Incentive Plan(4)
10.2*	Amended and Restated Non-Employee Director Stock Option Plan(5)
10.3*	Employee Stock Purchase Plan(6)
10.3.1*	Amendment No. 1, dated May 9, 2003, to Ixia Employee Stock Purchase Plan(7)
10.4*	Officer Severance Plan(8)
10.5*	Form of Indemnity Agreement between Ixia and its directors and executive officers(9)
10.6	Office Lease Agreement dated November 5, 1999 between Malibu Canyon Office Partners, LLC and Ixia First Amendment to Office Lease dated as of March 22, 2000 and Second Amendment to Office Lease dated May 8, 2003(10)
10.6.1	Third Amendment to Office Lease dated September 2004 between Malibu Canyon Office Partners, LLC and Ixia(11)
10.6.2	Fourth Amendment to Office Lease, effective October 27, 2005, between Malibu Canyon Office Partners, LLC and Ixia(12)

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10.7*	Warrants dated August 2, 2000 to Purchase 80,000 Shares of Common Stock issued to Robert W. Bass(13)
10.8	Registration Rights and Stock Transfer Restriction Agreement dated as of September 1, 2000 among Ixia, Technology Capital Group S.A. and Stéphane Ratel(14)
10.10*	Employment offer letter agreement dated October 27, 2001 between Ixia and David Anderson(15)
10.11*	Employment offer letter agreement dated as of February 27, 2003 between Ixia and Robert W. Bass(16)
10.12*	Employment Offer Letter Agreement, effective July 30, 2003, between Ixia and Alan Amrod(17)
10.13	License, Distribution and Option Agreement, dated July 7, 2003, between NetIQ Corporation and Ixia(18)
10.13.1	First Amendment to License, Distribution and Option Agreement dated as of January 6, 2005 between the Registrant and NetIQ Corporation(19)
10.13.2	Second Amendment to License, Distribution and Option Agreement dated as of June 16, 2005 between the Registrant and NetIQ Corporation(20)(21)
10.14*	2004 Employee Bonus Plan(22)
10.15*	2005 Employee Bonus Plan(23)
10.16*	Summary of 2005 Compensation for the Registrant’s Named Executive Officers(24)
10.17*	Summary of Compensation for the Registrant’s Non-Employee Directors(25)
14.1	Code of Ethics for Chief Executive and Senior Financial Officers(26)
21.1	Subsidiaries of the Registrant(25)
23.1	Consent of PricewaterhouseCoopers LLP
31.1	Certificate of Chief Executive Officer of Ixia pursuant to Rule 13a-14(a) under the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certificate of Chief Financial Officer of Ixia pursuant to Rule 13a-14(a) under the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certificate of Chief Executive Officer and Chief Financial Officer of Ixia pursuant to Rule 13a-14(b) under the Exchange Act and Section 906 of the Sarbanes-Oxley Act of 2002.

*	Constitutes a management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K.
(1)	Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q (File No. 000-31523) for the fiscal quarter ended March 31, 2004.
(2)	Incorporated by reference to Exhibit No. 3.1 to Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-42678) filed with the Commission on September 5, 2000.
(3)	Incorporated by reference to Exhibit No. 3.2 to Amendment No. 2 to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-42678) filed with the Commission on September 19, 2000.
(4)	Incorporated by reference to Exhibit 4.1 to the Registrant’s Registration Statement on Form S-8 (Reg. No. 333-117969) filed with the Commission on August 5, 2004.
(5)	Incorporated by reference to Exhibit 4.2 to the Registrant’s Registration Statement on Form S-8 (Reg. No. 333-117969) filed with the Commission on August 5, 2004.
(6)	Incorporated by reference to Exhibit No. 10.3 to Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-42678) filed with the Commission on September 5, 2000.
(7)	Incorporated by reference to Exhibit 4.2 to the Registrant’s Registration Statement on Form S-8 (Registration No. 333-107818) filed with the Commission on August 8, 2003.
(8)	Incorporated by reference to Exhibit No. 10.4 to Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-42678) filed with the Commission on September 5, 2000.
(9)	Incorporated by reference to Exhibit No. 10.5 to Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-42678) filed with the Commission on September 5, 2000.

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(10)	Incorporated by reference to Exhibit No. 10.14 to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-42678) filed with the Commission on July 31, 2000.
(11)	Incorporated by reference to Exhibit 10.6.1 to the Registrant’s Annual Report on Form 10-K (File No. 000-31523) for the fiscal year ended December 31, 2004.
(12)	Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 000-31523) filed with the Commission on December 6, 2005.
(13)	Incorporated by reference to Exhibit No. 10.15 to Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-42678) filed with the Commission on September 5, 2000.
(14)	Incorporated by reference to Exhibit No. 10.17 to Amendment No. 3 to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-42678) filed with the Commission on September 27, 2000.
(15)	Incorporated by reference to Exhibit No. 10.13 to the Registrant’s Annual Report on Form 10-K (File No. 000-31523) for the fiscal year ended December 31, 2001.
(16)	Incorporated by reference to Exhibit No. 10.14 to the Registrant’s Annual Report on Form 10-K (File No. 000-31523) for the fiscal year ended December 31, 2002.
(17)	Incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q (File No. 000-31523) for the fiscal quarter ended September 30, 2003.
(18)	Incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q (File No. 000-31523) for the fiscal quarter ended September 30, 2003.
(19)	Incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q (File No. 000-31523) for the fiscal quarter ended June 30, 2005.
(20)	Incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q (File No. 000-31523) for the fiscal quarter ended June 30, 2005.
(21)	Confidential treatment has been requested with respect to a portion of this exhibit, which portion has been omitted and filed separately with the Commission.
(22)	Incorporated by reference to Exhibit 10.14 to the Registrant’s Annual Report on Form 10-K (File No. 000-31523) for the year ended December 31, 2004.
(23)	Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 000-31523) filed with the Commission on May 19, 2005.
(24)	Incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly Report on Form 10-Q (File No. 000-31523) for the fiscal quarter ended June 30, 2005.
(25)	Previously filed.
(26)	Incorporated by reference to Exhibit 14.1 to the Registrant’s Annual Report on Form 10-K (File No. 000-31523) for the fiscal year ended December 31, 2003.

(b) Exhibits

     See the list of Exhibits under Item 15(a)(3) of this Annual Report on Form 10-K.

(c) Financial Statement Schedules

     See the Schedule under Item 15(a)(2) of this Annual Report on Form 10-K.

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SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) 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.

June 1, 2006	IXIA
	/s/Errol Ginsberg
	Errol Ginsberg
	President and Chief Executive Officer

6

IXIA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

	Page
Report of Independent Registered Public Accounting Firm	8
Consolidated Balance Sheets as of December 31, 2005 and 2004	10
Consolidated Statements of Income for the years ended December 31, 2005, 2004 and 2003	11
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2005, 2004 and 2003	12
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003	13
Notes to Consolidated Financial Statements	14

7

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of Ixia:

We have completed integrated audits of Ixia’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, shareholders’ equity and cash flows present fairly, in all material respects, the consolidated financial position of Ixia and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established inInternal Control — Integrated Frameworkissued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made

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only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP

Los Angeles, California
March 10, 2006

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IXIA

Consolidated Balance Sheets

(in thousands)

	December 31,		December 31,
	2005		2004
Assets
Current assets:
Cash and cash equivalents	$	51,837	$	16,383
Short-term investments in marketable securities		124,456		81,757
Accounts receivable, net		31,565		22,069
Inventories		9,846		6,669
Deferred income taxes		4,401		3,756
Income taxes receivable		9		1,696
Prepaid expenses and other current assets		3,510		2,878
Total current assets		225,624		135,208
Investments in marketable securities		25,392		49,015
Property and equipment, net		19,750		12,268
Deferred income taxes		10,004		4,798
Goodwill		13,468		11,377
Intangible assets, net		20,462		23,031
Other assets		315		612
Total assets	$	315,015	$	236,309
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	2,872	$	1,556
Accrued expenses		12,399		13,181
Deferred revenues		8,338		7,032
Income taxes payable		4,131		4,203
Total current liabilities		27,740		25,972
Deferred revenues		528		—
Deferred income taxes		4,651		3,411
Total liabilities		32,919		29,383
Commitments and contingencies (Note 7)
Shareholders’ equity:
Preferred stock, without par value; 1,000 shares authorized and none outstanding		—		—
Common stock, without par value; 200,000 shares authorized at December 31, 2005 and December 31, 2004, respectively, 66,580 and 62,459 shares issued and outstanding as of December 31, 2005 and December 31, 2004, respectively		126,792		100,144
Additional paid-in capital		68,098		53,247
Retained earnings		87,206		53,535
Total shareholders’ equity		282,096		206,926
Total liabilities and shareholders’ equity	$	315,015	$	236,309

The accompanying notes are an integral part of these consolidated financial statements

10

IXIA

Consolidated Statements of Income

(in thousands, except per share data)

	Year Ended December 31,
	2005		2004		2003
Net revenues	$	159,333	$	116,978	$	83,533
Cost of revenues(1)		24,800		20,716		15,761
Amortization of purchased technology		3,891		3,044		1,183
Gross profit		130,642		93,218		66,589
Operating expenses: (1)
Research and development		32,404		24,960		21,980
Sales and marketing		41,014		31,865		25,050
General and administrative		16,438		12,479		9,179
Amortization of intangible assets		1,278		1,532		1,070
Impairment of goodwill and other intangible assets		—		—		410
Total operating expenses		91,134		70,836		57,689
Income from operations		39,508		22,382		8,900
Interest and other income, net		5,055		2,960		3,062
Income before income taxes		44,563		25,342		11,962
Income tax expense		10,892		6,463		3,258
Net income	$	33,671	$	18,879	$	8,704
Earnings per share:
Basic	$	0.52	$	0.31	$	0.15
Diluted	$	0.49	$	0.29	$	0.14
Weighted average number of common and common equivalent shares outstanding:
Basic		65,168		60,687		58,344
Diluted		69,227		64,745		62,227

⁽¹⁾  Stock-based compensation included in:

Cost of revenues	$	—	$	30	$	157
Research and development		—		271		1,316
Sales and marketing		—		80		166
General and administrative		—		38		280

The accompanying notes are an integral part of these consolidated financial statements

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IXIA

Consolidated Statements of Shareholders’ Equity

(in thousands)

					Additional			Deferred
	Common Stock				Paid-In			Stock-based			Retained
	Shares		Amount		Capital			Compensation			Earnings		Total
Balance as of December 31, 2002		57,595	$	79,206	$	47,045		$	(3,036	)	$	25,952	$	149,167
Net income												8,704		8,704
Exercise of stock options and employee stock purchase plan options		2,047		4,842										4,842
Amortization of deferred stock-based compensation									2,414					2,414
Forfeiture of stock options						(698	)		203					(495	)
Stock option tax benefit						2,422								2,422
Balance as of December 31, 2003		59,642		84,048		48,769			(419	)		34,656		167,054
Net income												18,879		18,879
Exercise of stock options and employee stock purchase plan options		2,510		12,333										12,333
Issuance of common stock in connection with acquisition		307		3,763										3,763
Amortization of deferred stock-based compensation									419					419
Stock option tax benefit						4,478								4,478
Balance as of December 31, 2004		62,459		100,144		53,247			—			53,535		206,926
Net income												33,671		33,671
Exercise of stock options and employee stock purchase plan options		4,121		26,648										26,648
Stock option tax benefit						14,851								14,851
Balance as of December 31, 2005		66,580	$	126,792	$	68,098		$	—		$	87,206	$	282,096

The accompanying notes are an integral part of these consolidated financial statements

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IXIA

Consolidated Statements of Cash Flows
(in thousands)

	Year Ended December 31,
	2005			2004			2003
Cash flows from operating activities:
Net income	$	33,671		$	18,879		$	8,704
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,925			3,418			4,388
Amortization of intangible assets		5,169			4,576			2,255
Allowance for doubtful accounts		12			432			249
Stock-based compensation		—			419			1,919
Deferred income taxes		(4,842	)		719			(1,438	)
Tax benefit from stock option transactions		14,851			4,478			2,422
Impairment of goodwill and other intangible assets		—			—			410
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable		(9,389	)		(5,130	)		(8,019	)
Inventories		(3,156	)		(1,002	)		(464	)
Income taxes receivable		1,687			315			(2,011	)
Prepaid expenses and other current assets		(629	)		(696	)		(85	)
Other assets		297			6			(53	)
Accounts payable		1,312			432			(154	)
Accrued expenses		3,339			(89	)		4,776
Deferred revenues		1,819			1,320			3,478
Income taxes payable		(72	)		1,365			1,311
Net cash provided by operating activities		49,994			29,442			17,688
Cash flows from investing activities:
Purchases of property and equipment		(13,396	)		(8,707	)		(4,233	)
Purchases of available-for-sale securities		(143,336	)		(82,551	)		(27,125	)
Proceeds from available-for-sale securities		109,186			47,750			20,150
Purchases of held-to-maturity securities		(22,030	)		(24,181	)		(53,505	)
Proceeds from held-to-maturity securities		37,104			29,000			36,646
Purchases of technology and other intangible assets		(180	)		(1,447	)		(457	)
Payments in connection with acquisitions		(8,536	)		(6,389	)		(18,138	)
Net cash used in investing activities		(41,188	)		(46,525	)		(46,662	)
Cash flows from financing activities:
Exercise of stock options and employee stock purchase plan options		26,648			12,333			4,842
Net cash provided by financing activities		26,648			12,333			4,842
Net increase (decrease) in cash and cash equivalents		35,454			(4,750	)		(24,132	)
Cash and cash equivalents at beginning of year		16,383			21,133			45,265
Cash and cash equivalents at end of year	$	51,837		$	16,383		$	21,133
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes	$	853		$	2,109		$	2,991
Non-cash activities:
Common stock issued in connection with acquisition	$	—		$	3,763		$	—

The accompanying notes are an integral part of these consolidated financial statements

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IXIA

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Business and Summary of Significant Accounting Policies

     Business

     We were incorporated on May 27, 1997 as a California corporation. We are a leading provider of performance test systems for IP-based infrastructure and services that allow our customers to test and measure the performance, functionality, and conformance of Internet Protocol (IP) equipment and networks, and the applications that run over them. Our solutions generate, capture, characterize, and analyze high volumes of realistic network and application traffic, exposing problems, assessing performance, ensuring functionality and interoperability, and verifying conformance to industry specifications. We offer a hardware platform with interchangeable interfaces, utilizing a single set of applications and Application Programming Interfaces (APIs) that allows our customers to create an integrated, easy-to-use test bed. The networks our systems analyze include Ethernet networks operating at speeds of up to 10 gigabits per second, which carry data traffic over optical fiber or electrical cable. Other networks include Packet over SONET networks operating at speeds of up to 10 gigabits per second, which transmit information over high-speed optical links and Asynchronous Transfer Mode (ATM) networks, operating at speeds of up to 622 megabits per second. We also offer a telephony test suite that is used to test and verify traditional Time-Division Multiplexing (TDM) voice based networks, Voice over IP technology, devices, and systems, as well as the interoperability, troubleshooting, service optimization and call traffic monitoring of Video Telephony. Customers also use our performance applications to test and verify web, internet, security, and business applications.

     Use of Estimates

     In the normal course of preparing financial statements in conformity with accounting principles generally accepted in the United States, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

     Consolidation

     All subsidiaries are consolidated as they are 100% owned by us. All significant intercompany transactions and accounts are eliminated in consolidation.

     Cash and Cash Equivalents

     We consider all highly liquid investments with a maturity of three months or less at the date of purchase to be cash equivalents. Cash and cash equivalents are carried at cost, which approximates fair value. We generally place funds that are in excess of current needs in high credit quality instruments such as money market accounts. There are no restrictions on the use of cash and investments.

     Fair Value of Financial Instruments

     Our financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and other liabilities are carried at cost, which approximates their fair values because of the short-term maturity of these instruments and the relative stability of interest rates.

     We utilize foreign currency forward contracts to hedge certain accounts receivable amounts that are denominated in Japanese Yen. These contracts are used to reduce the risk associated with exchange rate movements, as gains and losses on these contracts are intended to offset exchange losses and gains on underlying exposures. Changes in the fair value of these forward contracts are recorded immediately in earnings. We do not enter into foreign exchange forward contracts for speculative or trading purposes. To date, net gains and losses on the above transactions have not been significant. As of December 31, 2005, we did not have any significant foreign currency forward contracts outstanding.

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     Investments in Marketable Securities

     Management determines the appropriate classification of marketable securities at the time of purchase and reevaluates such designation as of each balance sheet date. Held-to-maturity securities are carried at amortized cost, which approximates fair value. Amortization of the purchase discounts and premiums is included in interest and other income, net. Available-for-sale securities are stated at fair value as determined by the most recently traded market price of each security at the balance sheet date. The net unrealized gains or losses on available-for-sale securities are reported as a separate component of accumulated other comprehensive income, net of tax. The specific identification method is used to compute realized gains and losses on our marketable securities. To date, realized gains and losses on our marketable securities and unrealized gains and losses on our available-for-sale securities have not been significant.

     Our held-to-maturity securities as of December 31, 2005 and 2004 consisted primarily of U.S. government, federal agency and corporate debt securities. As of December 31, 2005 and 2004, our available-for-sale securities consisted primarily of high-grade auction rate securities with reset periods of generally 35 days or less. We regularly monitor and evaluate the realizable value of our marketable securities. Declines in value judged to be other than temporary were not material to our results of operations in any period presented.

     Accounts Receivable and Allowance for Doubtful Accounts

     Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is based on the best estimate of the amount of probable credit losses in existing accounts receivable. The allowance for doubtful accounts is determined based on historical write-off experience, current customer information and other relevant data. We review the allowance for doubtful accounts monthly. Past due balances of 60 days and over are reviewed individually for collectibility. Account balances are charged off against the allowance when management believes it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.

     Inventories

     Inventories are goods held for sale in the normal course of business. Inventories are stated at the lower of cost (first-in, first-out) or market. The inventory balance is segregated between raw materials, work in process (“WIP”) and finished goods. Raw materials are low level components, many of which are purchased from vendors, WIP is partially assembled products and finished goods are products that are ready to be shipped to end customers. Consideration is given to inventory shipped and received near the end of a period and the transaction is recorded when transfer of title occurs. We regularly evaluate inventory for obsolescence and adjust to net realizable value based on inventory that is obsolete or in excess of current demand.

     Property and Equipment

     Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method based upon the estimated useful lives of the assets, ranging from two to seven years. Useful lives are evaluated regularly by management in order to determine recoverability in light of current technological conditions. Repairs and maintenance are charged to expense as incurred while renewals and improvements are capitalized. Upon the sale or retirement of property and equipment, the accounts are relieved of the cost and the related accumulated depreciation, with any resulting gain or loss included in the Statement of Income.

     Amortization of Intangible Assets and Goodwill Impairment

     We apply Statement of Financial Accounting Standards (“SFAS”) 142, “Goodwill and Other Intangible Assets,” to purchased intangible assets, which are carried at cost less accumulated amortization. Cost or purchase price is determined based on amounts paid to the seller (both in cash and the value of our stock), liabilities assumed and transaction costs. The value of intangible assets is determined using valuation techniques such as the discounted cash flow method. In the case of a purchase of a business, the purchase price is allocated to the various identifiable assets, including intangibles, based on their respective fair values, with any remaining amount being assigned to goodwill. In the case of an asset purchase, any excess purchase price is allocated ratably based on the respective

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fair values of the assets. Amortization of purchased technology is computed using the greater of (a) the ratio of current revenues to the total of current and anticipated future revenues or (b) the straight-line method over the remaining estimated economic life. Amortization of other intangible assets is computed using the straight-line method over the economic lives of the respective assets. The economic useful lives are determined based on comparison of similar technologies in the industry, historical experience and management expectations. Goodwill is carried at cost and is tested for impairment annually or whenever events or circumstances occur indicating that goodwill might be impaired in accordance with SFAS 142. Impairment losses are recorded to the extent that the carrying value of the goodwill exceeds the implied fair value of goodwill. Other intangible assets are tested for impairment as circumstances arise in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment loss is recorded to the extent that the carrying value of an intangible asset exceeds its fair value.

     Litigation

     We are currently involved in certain legal proceedings. We accrue for losses when the loss is deemed probable and the liability can reasonably be estimated. Where a liability is probable and there is a range of estimated loss with no best estimate in the range, we record the minimum estimated liability related to the claim. As additional information becomes available, we assess the potential liability related to our pending litigation and revise our estimates.

     Product Warranty Costs

     We generally warrant our products for up to one year after sale and provide for estimated future warranty costs at the time revenue is recognized. Accrued product warranty costs are included as a component of accrued expenses on the accompanying Balance Sheets and are not material.

     Revenue Recognition

     Our revenues consist primarily of hardware and software product sales. In some instances our software products are installed and run on other companies’ hardware. At other times, software products are installed on our hardware products and are an integral part of the functionality of the hardware. As such, we apply the provisions of the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition.”

     Our products are fully functional at the time of shipment and do not require significant production, modification or customization. As such, revenue from product sales is recognized upon shipment provided that (1) a purchase order has been received or a contract has been executed; (2) title and risk of loss have transferred; (3) the sales price is fixed and determinable; and (4) collectibility is deemed probable. When a sale involves multiple elements (typically sales of products that include warranty support and services), the entire sales price of the arrangement is allocated to each respective element based on vendor-specific objective evidence (“VSOE”) of fair value in accordance with SOP 97-2. We determine VSOE based on sales prices charged to customers when the same element is sold separately or based upon renewal pricing. Revenue is recognized on multiple element arrangements as each element is delivered, provided the other revenue recognition criteria noted above have also been met. Warranty support and service revenue is deferred and recognized ratably over the period during which the services are to be performed.

     We use distributors to complement our direct sales and marketing efforts in certain international markets. Due to the broad range of features and options available with our hardware and software products, distributors generally do not stock our products and typically place orders with us after receiving an order from an end customer. These distributors receive business terms of sale generally similar to those received by our other customers.

     Research and Development

     Research and development expenses consist primarily of salaries and other personnel costs related to the design, development, testing and enhancements of our products. Costs related to research and development activities, including those incurred to establish the technological feasibility of a software product, are expensed as incurred. If technological feasibility is established, all development costs incurred until general product release are subject to

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capitalization. To date, the establishment of technological feasibility of our products and general release have substantially coincided. As a result, we have not capitalized any development costs.

     Software Developed for Internal Use

     We capitalize costs of software, consulting services, hardware and payroll-related costs incurred to purchase or develop internal-use software. We expense costs incurred during preliminary project assessment, research and development, re-engineering, training and application maintenance phases. To date, internal costs incurred to develop software for internal use have not been significant.

     Advertising

     Advertising costs are expensed as incurred. Advertising costs were $1.5 million, $918,000 and $867,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

     Stock-Based Compensation

     At December 31, 2005, we have three stock-based employee and director compensation plans which are described more fully in Note 8. We account for our stock option plans in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and the related interpretations of FASB Interpretation (“FIN”) No. 44, “Accounting for Certain Transactions involving Stock Compensation.” Accordingly, compensation expense related to employee stock options is recorded only if, on the date of the grant, the fair value of the underlying stock exceeds the exercise price. We account for stock-based awards issued to non-employees in accordance with the provisions of SFAS 123, “Accounting for Stock-Based Compensation” and Emerging Issues Task Force (“EITF”) 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees.”

     We calculated the fair value of each option grant on the respective dates of grant using the Black-Scholes option pricing model as prescribed by SFAS 123 using the following assumptions:

	Year Ended December 31,
	2005			2004			2003
Expected life (in years)		4.0			3.7			4.0
Risk-free interest rates		4.2	%		3.1	%		3.0	%
Dividend yield		0.0	%		0.0	%		0.0	%
Expected volatility		62.4	%		92.8	%		108.0	%

     The following table illustrates the effect on stock-based compensation, net income and earnings per share on a pro forma basis as if we had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):

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	Year Ended December 31,
	2005		2004		2003
Stock-based compensation:
As reported	$	—	$	419	$	1,919
Additional stock-based compensation expense, net of taxes, determined under the fair value method		8,402		13,612		10,506
Pro forma	$	8,402	$	14,031	$	12,425
Net income (loss):
As reported	$	33,671	$	18,879	$	8,704
Additional stock-based compensation expense, net of taxes, determined under the fair value method		8,402		13,612		10,506
Pro forma	$	25,269	$	5,267	$	(1,802	)
Basic earnings (loss) per share:
As reported	$	0.52	$	0.31	$	0.15
Pro forma	$	0.39	$	0.09	$	(0.03	)
Diluted earnings (loss) per share:
As reported	$	0.49	$	0.29	$	0.14
Pro forma	$	0.37	$	0.08	$	(0.03	)

     In December 2004, the FASB issued SFAS 123R, which is a revision of SFAS 123. SFAS 123R requires all share-based payments to employees, including grants of stock options and employee stock purchase rights, to be recognized in the financial statements based on their fair values for accounting purposes on the grant date and does not allow the previously permitted pro forma disclosure-only method as an alternative to financial statement recognition.

     Effective January 1, 2006, we adopted SFAS 123R which will have a significant adverse impact on our reported results of operations, although it will have no impact on our overall financial position. Had we adopted SFAS 123R in prior periods, the impact would have been similar to the current SFAS 123 pro forma disclosures above. The balance of gross unearned stock-based compensation to be expensed in the periods 2006 through 2009 related to stock-based awards unvested at December 31, 2005, as previously calculated under the requirements of SFAS 123, is approximately $27.2 million. To the extent that we grant additional equity securities to employees, stock-based compensation expense will increase by the additional unearned compensation resulting from those grants. We anticipate we will grant additional employee stock-based awards in 2006 as part of our long-term incentive compensation programs. The impact of these grants cannot be estimated at this time because it will depend on a number of factors, including the amount of stock-based awards granted and the-then current fair values for accounting purposes.

     Income Taxes

     We account for income taxes using the liability method. Deferred taxes are determined based on the differences between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

     Earnings Per Share

     Basic earnings per share is computed using the weighted-average number of common shares outstanding during the period. Diluted earnings per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares primarily consist of employee stock options.

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     Foreign Currency Translation

     Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment are translated to U.S. dollars at exchange rates in effect at the balance sheet date, with the resulting translation adjustments included as a separate component in accumulated other comprehensive income, which have not been significant to date. Income and expense accounts are translated at average exchange rates during the year. Where the U.S. dollar is the functional currency, certain balance sheet and income statement accounts are remeasured at historical exchange rates and translation adjustments from the remeasurement of the local currency amounts to U.S. dollars are included in interest and other income, net. Gains and losses resulting from foreign currency transactions, the amounts of which have not been significant to date, are included in interest and other income, net.

     Comprehensive Income

     We have adopted the provisions of SFAS 130, “Reporting Comprehensive Income.” SFAS 130 establishes standards for reporting comprehensive income and its components in financial statements. Comprehensive income, as defined, includes all changes in equity (net assets) during a period from non-owner sources. To date, there have been no significant transactions that are required to be reported in comprehensive income, other than net income.

     Segments

     We have adopted the provisions of SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” SFAS 131 establishes standards for the way companies report information about operating segments in annual financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. We have determined that we did not have any separately reportable business segments as of, and for the years ended, December 31, 2005, 2004 and 2003.

     Reclassifications

     Certain reclassifications have been made to prior years, financial statements to conform to the current year presentation.

     Recent Accounting Pronouncements

     In December 2004, the FASB issued SFAS 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which replaces SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires all share-based payments to employees, including grants of employee stock options, restricted stock units and employee stock purchase rights, to be recognized in the financial statements based on their respective fair values for accounting purposes on the grant date. The pro forma disclosures previously permitted under SFAS 123, no longer will be an alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. Given that we have historically granted a significant amount of stock options to employees, the adoption of SFAS 123R will have a material adverse impact on our consolidated results of operations and earnings per share. We will adopt the modified prospective transition method and continue to use the Black-Scholes fair value model, where applicable. In addition, had we adopted SFAS 123R in prior periods, the impact would have been similar to the current pro forma disclosures required under SFAS 123. We adopted SFAS 123R effective January 1, 2006.

     In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. The statement provides guidance for determining whether retrospective application of a change in accounting principle is impracticable. The statement also addresses the reporting of a correction of an error by restating previously issued financial statements. SFAS 154 is effective for accounting changes and corrections of

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errors made in fiscal years beginning after December 15, 2005. We will apply the requirements of SFAS 154 on any changes in principle made on or after January 1, 2006.

     In October 2005, FASB issued FASB Staff Position (FSP) No. FAS 123(R)-2, “Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R).” Assuming all other criteria of the grant date definition have been met, grant date is the date the award is approved in accordance with an entity’s corporate governance provisions, provided the award is a unilateral grant, whereby the recipient cannot negotiate the key terms and conditions of the award, and that the key terms and conditions are expected to be communicated to the recipient within a relatively short time from the date of approval. This FSP guidance is effective upon adoption of SFAS 123R. We do not expect this guidance to have a material impact on our consolidated financial position, results of operations or cash flows.

     In November 2005, FASB issued FSP No. FAS 123 (R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards.” This FSP provides a practical transition election related to accounting for the tax effects of share-based payment awards to employees, as an alternative to the transition guidance for the computation of the additional paid-in capital (APIC) pool of SFAS 123R. The guidance in this FSP is effective after November 10, 2005. We may take up to one year from the later of adoption of SFAS 123R or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. We will evaluate this guidance, but we do not expect it to have a material impact on our consolidated financial position, results of operations or cash flows.

     In November 2005, FASB issued FSP Nos. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” This FSP addressees the determination as to when an investment is considered impaired, whether the impairment is ‘other-than-temporary’, and the measurement of an impairment loss. The investment is impaired if the fair value is less than cost. The impairment is ‘other-than-temporary’ for equity securities and debt securities that can contractually be prepaid or otherwise settled in such a way that the investor would not recover substantially all of its cost. If ‘other-than-temporary’, an impairment loss shall be recognized in earnings equal to the difference between the investment’s cost and its fair value. The guidance in this FSP is effective for reporting periods beginning after December 15, 2005. We will review FSP Nos. FAS 115-1 and FAS 124-1, but we do not expect the adoption of this FSP to have a material impact on our consolidated financial position, results of operations or cash flows.

2. Concentrations

     Credit Risk

     Financial instruments that subject us to concentrations of credit risk consist primarily of cash and cash equivalents and trade accounts receivable. We maintain our cash and cash equivalents with reputable financial institutions, and at times, cash balances may be in excess of FDIC insurance limits. We extend differing levels of credit to customers, do not generally require collateral, and maintain reserves for potential credit losses based upon the expected collectibility of accounts receivable.

     Significant Customer

     For the years ended December 31, 2005, 2004 and 2003, only one customer comprised more than 10% of net revenues as follows (in thousands, except percentages):

	Year Ended December 31,
	2005			2004			2003
Amount of net revenues	$	55,498		$	37,165		$	24,316
As a percentage of total net revenues		35	%		32	%		29	%

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

     As of December 31, 2005 and 2004, we had receivable balances from the customer approximating 27% and 22%, respectively, of total accounts receivable.

     International Data

     For the years ended December 31, 2005, 2004 and 2003, net revenues from international product shipments consisted of the following (in thousands, except percentages):

	Year Ended December 31,
	2005			2004			2003
Amount of net revenues	$	43,232		$	30,756		$	25,287
As a percentage of total net revenues		27	%		26	%		30	%

     Long-lived assets are primarily located in the United States. As of December 31, 2005, approximately $4.9 million, or 5.5% of our 2005 total long-lived assets, were located at international locations. As of December 31, 2004, approximately $1.4 million, or 1.4% of our 2004 total long-lived assets, were located at international locations.

     Sources of Supply

     We currently buy a number of key components of our products from a limited number of suppliers. Although there are a limited number of manufacturers of these components, we believe that other suppliers could provide similar components on comparable terms. A change in suppliers, however, could cause a delay in manufacturing and a possible loss of sales, which could adversely affect consolidated operating results.

3. Selected Balance Sheet Data (in thousands)

     Accounts Receivable, Net

     Accounts receivable, net consisted of the following:

	December 31,			December 31,
	2005			2004
Trade accounts receivable	$	32,419		$	22,911
Allowance for doubtful accounts		(854	)		(842	)
	$	31,565		$	22,069

     Allowance for doubtful accounts was adjusted during the years presented as follows:

	Balance at		Charged to and		Reversals to						Balance at
	Beginning		Cost and		Cost and						End of
Year Ended December 31,	of Period		Expenses		Expenses			Deductions			Period
2005	$	842	$	300	$	(150	)	$	(138	)	$	854
2004		410		450		—			(18	)		842
2003		161		300		—			(51	)		410

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

     Investments in Marketable Securities

     Investments in marketable securities as of December 31, 2005 consisted of the following:

	Carrying		Fair
	Value		Value
Available-for-sale — short-term:
Auction rate securities	$	89,526	$	89,526
Held-to-maturity — maturities of less than one year:
U.S. government and federal agency debt securities		20,917		20,759
Corporate debt securities		14,013		13,901
		124,456		124,186
Held-to-maturity — maturities of one to five years:
U.S. government and federal agency debt securities		24,392		24,010
Corporate debt securities		1,000		975
		25,392		24,985
	$	149,848	$	149,171

     Investments in marketable securities as of December 31, 2004 consisted of the following:

	Carrying		Fair
	Value		Value
Available-for-sale — short-term:
Auction rate securities	$	55,376	$	55,376
Held-to-maturity — maturities of less than one year:
U.S. government and federal agency debt securities		2,000		2,005
Corporate debt securities		24,381		24,400
		81,757		81,781
Held-to-maturity — maturities of one to five years:
U.S. government and federal agency debt securities		28,928		28,729
Corporate debt securities		20,087		19,878
		49,015		48,607
	$	130,772	$	130,388

     Inventories

     Inventories consisted of the following:

	December 31,		December 31,
	2005		2004
Raw materials	$	3,574	$	1,665
Work in process		3,426		2,808
Finished goods		2,846		2,196
	$	9,846	$	6,669

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Property and Equipment, Net

Property and equipment, net consisted of the following:

		December 31,			December 31,
	Useful Life	2005			2004
	(in years)
Computer equipment	3	$	5,168		$	3,343
Computer software	3		5,236			2,669
Demonstration equipment	2		9,538			8,318
Development equipment	5		8,416			6,270
Furniture and other equipment	5		10,160			7,447
Leasehold improvements	7		2,024			1,074
			40,542			29,121
Accumulated depreciation			(20,792	)		(16,853	)
		$	19,750		$	12,268

Accrued Expenses

Accrued expenses consisted of the following:

	December 31,		December 31,
	2005		2004
Accrued payroll	$	2,719	$	1,430
Accrued vacation		1,639		1,169
Accrued bonuses		1,533		1,756
Accrued commissions		1,275		966
Accrued legal and professional fees		910		719
Accrued property taxes		887		121
Employee stock purchase plan payroll deductions		644		451
Accrued sales tax		530		332
Accrued royalties		28		542
Accrued G3 Nova earnout (Note 4)		—		1,856
NetIQ purchase option accrual		—		2,500
Other		2,234		1,339
	$	12,399	$	13,181

4. Acquisitions

Communication Machinery Corporation

     On July 15, 2005, we completed the acquisition of all of the outstanding capital stock of Communication Machinery Corporation (“CMC”). CMC developed tools for testing Wi-Fi networks and equipment. This acquisition enabled us to enter the fast growing wireless testing market, expand our product offering to existing customers and gain access to new customers. These factors, among others, contributed to a purchase price in excess of the fair value of CMC’s net tangible and intangible assets acquired, and, as a result, we have recorded goodwill in connection with this transaction. The results of CMC’s operations have been included in the consolidated financial statements since the acquisition date.

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     The CMC purchase price of $4.2 million included $4.0 million in cash payments, and legal and other acquisition costs of approximately $200,000. The following table summarizes the estimated fair values of the tangible and intangible assets acquired and liabilities assumed at the date of acquisition (in thousands):

Current assets	$	144
Property and equipment		11
Deferred taxes		727
Intangible assets		2,420
Goodwill		2,091
Total assets acquired		5,393
Current liabilities assumed		(254	)
Deferred taxes		(958	)
Net assets acquired	$	4,181

     Of the $2.4 million of acquired intangible assets, $1.3 million was assigned to acquired technology, $1.0 million was assigned to customer contracts and relationships, and approximately $100,000 was assigned to a covenant not to compete. These intangible assets will be amortized using a straight-line method over the expected useful lives ranging from two to seven years. Goodwill is not deductible for income tax purposes.

     The following table summarizes the unaudited pro forma net revenues, net income and earnings per share had the acquisition of CMC occurred on January 1, 2005 and 2004, respectively (in thousands, except per share data):

	Year ended December 31,
	2005		2004
Net revenues	$	159,700	$	117,807
Net income		33,549		18,764
Earnings per share:
Basic		0.51		0.31
Diluted		0.48		0.29

     The pro forma results have been prepared for comparative purposes only and include adjustments for amortization of identifiable intangible assets resulting from the acquisition. These results do not purport to be indicative of the results of operations which would have resulted had the acquisition been in effect as of January 1, 2004 or the future results of operations of the combined organization.

G3 Nova Technology, Inc.

     On February 20, 2004, we completed the acquisition of all of the outstanding capital stock of G3 Nova Technology, Inc. (“G3 Nova”). G3 Nova developed and sold Voice over IP test tools for enterprise call centers, communication networks and network devices. This acquisition opened new growth opportunities by allowing us to offer a broader portfolio of products to customers, as well as gain access to new customer segments. These factors, among others, contributed to a purchase price in excess of the fair value of G3 Nova’s net tangible and intangible assets acquired, and, as a result, we have recorded goodwill in connection with this transaction. The results of G3 Nova’s operations have been included in the consolidated financial statements since the acquisition date.

     The G3 Nova purchase price of $9.5 million included $5.5 million in cash, 307,020 shares of our common stock valued at $3.8 million and legal and other acquisition costs of $207,000. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition (in thousands):

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Current assets	$	355
Property and equipment		131
Intangible assets		3,700
Goodwill		7,285
Total assets acquired		11,471
Current liabilities assumed		(722	)
Deferred taxes		(1,279	)
Net assets acquired	$	9,470

     Of the $3.7 million of acquired intangible assets, $2.5 million was assigned to acquired technology, $1.0 million was assigned to customer contracts and relationships, and $200,000 was assigned to a covenant not to compete. These intangible assets will be amortized using a straight-line method over their expected useful lives ranging from three to four-and–one-half years. Goodwill is not deductible for income tax purposes.

     The purchase agreement also provided for a contingent earnout payment of up to $2.5 million to be paid to the sellers based upon sales of G3 Nova products from July 2004 through June 2005. Based on orders received for G3 Nova products from July 2004 through December 2004, management believed that the contingent amount would be earned and accelerated the payment of the earnout; $600,000 of this amount was paid in November 2004 and the remaining $1.9 million was paid in January 2005. We recorded the entire contingent amount of $2.5 million in our December 31, 2004 consolidated financial statements as additional goodwill.

5. Goodwill and Other Intangible Assets

     The following table presents 2005 details of our total purchased intangible assets (in thousands):

			Accumulated
Description	Gross		Amortization			Net
Goodwill	$	13,468	$	—		$	13,468
Other intangible assets:
Technology	$	27,653	$	(10,106	)	$	17,547
Non-compete		862		(699	)		163
Trademark		676		(227	)		449
Workforce		395		(247	)		148
Customer relationships		2,026		(604	)		1,422
Other		1,260		(527	)		733
	$	32,872	$	(12,410	)	$	20,462

     The following table presents 2004 details of our total purchased intangible assets (in thousands):

			Accumulated
Description	Gross		Amortization			Net
Goodwill	$	11,377	$	—		$	11,377
Other intangible assets:
Technology	$	26,352	$	(5,711	)	$	20,641
Non-compete		792		(609	)		183
Trademark		676		(127	)		549
Workforce		395		(148	)		247
Customer relationships		976		(285	)		691
Other		1,081		(361	)		720
	$	30,272	$	(7,241	)	$	23,031

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

     The estimated future amortization expense of purchased intangible assets as of December 31, 2005 is as follows (in thousands):

2006	$	5,441
2007		5,078
2008		4,390
2009		3,520
2010		1,697
Thereafter		336
	$	20,462

6. Income Taxes

     Income tax expense consisted of the following (in thousands):

	Year Ended December 31,
	2005			2004			2003
Current:
Federal	$	13,086		$	4,335		$	3,643
State		2,635			1,571			1,381
Foreign		14			79			195
Deferred:
Federal		(2,319	)		2,233			(668	)
State		(2,540	)		(1,700	)		(1,338	)
Foreign		16			(55	)		45
Income tax expense	$	10,892		$	6,463		$	3,258

     The net effective income tax rate differed from the federal statutory income tax rate as follows (in thousands):

	Year Ended December 31,
	2005			2004			2003
Federal statutory expense	$	15,597		$	8,867		$	4,215
State taxes, net of federal benefit		87			113			328
Research and development credits		(1,937	)		(1,475	)		(901	)
Stock-based compensation		(1,924	)		(968	)		(407	)
Other		(931	)		(74	)		23
Income tax expense	$	10,892		$	6,463		$	3,258
Net effective income tax rate		24.4	%		25.5	%		27.2	%

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

     The primary components of temporary differences that gave rise to deferred taxes were as follows (in thousands):

	December 31,			December 31,
	2005			2004
Deferred tax assets:
Allowance for doubtful accounts	$	353		$	359
Research and development credit carryforward		9,298			4,696
Deferred revenue		430			531
Stock-based compensation		1,220			1,357
Inventory adjustments		1,149			833
Net operating loss carryforward		706			55
Accrued liabilities and other		1,249			723
Total deferred tax assets		14,405			8,554
Deferred tax liabilities:
Depreciation and amortization		(4,651	)		(3,411	)
Net deferred taxes	$	9,754		$	5,143

     Realization of the December 31, 2005 deferred tax assets is dependent on us generating sufficient taxable income in the future. Although realization is not assured, we believe it is more likely than not that the deferred tax assets will be realized. The amount of the deferred tax assets considered realizable, however, could be reduced in the future if estimates of future taxable income are reduced.

     As of December 31, 2005, we have gross federal and state research and development credit carryforwards of approximately $11.7 million, which begin to expire in 2021.

     At December 31, 2005, we have net operating loss (“NOLs”) carryforwards of approximately $1.7 million and $1.8 million for federal and state purposes, respectively. The federal NOLs expire at various dates through 2024, and the state NOLs expire at various dates through 2014. Section 382 of the Internal Revenue Code imposes an annual limitation on the utilization of net operating loss carryforwards related to acquired corporations based on a statutory rate of return (usually the “applicable federal funds rate” as defined in the Internal Revenue Code) and the value of the corporation at the time of a “change in ownership” as defined by Section 382. The annual limitation under Section 382 of the Internal Revenue Code is approximately $183,000.

     Cumulative undistributed earnings of foreign subsidiaries for which no deferred income taxes have been provided approximated $1.0 million at December 31, 2005. Deferred income taxes on these earnings have not been provided as these accounts are considered to be permanent in duration.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

7. Commitments and Contingencies

     Leases

     We lease our facilities under noncancelable operating leases for varying periods through May 2011, excluding options to renew. The following are the future minimum commitments under these leases (in thousands):

Year Ending
December 31,
2006	$	3,390
2007		3,207
2008		1,503
2009		222
2010		200
Thereafter		84
	$	8,606

     Rent expense for the years ended December 31, 2005, 2004 and 2003 was approximately $3.0 million, $2.3 million and $1.8 million, respectively.

     Litigation

     From time to time, certain legal actions may arise in the ordinary course of our business. We believe that the ultimate outcome of our ongoing actions will not have a material adverse effect on our financial position, results of operations or cash flows.

     Indemnifications

     In the normal course of business, we provide indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of our products. Historically, costs related to these indemnification provisions have not been significant and we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations.

8. Shareholders’ Equity

     Stock Options

     Our 1997 Stock Option Plan, as amended (the “1997 Plan”), provides for the issuance of stock-based awards to our qualified employees and consultants. The stock-based awards may include incentive stock options or nonqualified stock options. Options become exercisable over a vesting period as determined by the Board of Directors and expire over terms not exceeding 10 years from the date of grant. The exercise price for options granted under the 1997 Plan may not be granted at less than 100% of the fair market value of our common stock on the date of grant (110% if granted to an employee who owns more than 10% of the voting shares of the outstanding stock). Options generally vest over a four-year period. In the event the holder ceases to be employed by us, all unvested options are forfeited and all vested options may be exercised within a period of up to 30 days after optionee’s termination for cause, up to three months after termination other than for cause or as a result of death or disability, or up to six months after termination as a result of disability or death. As of December 31, 2005, we have reserved 28.5 million shares of our common stock for issuance under the 1997 Plan, 4.8 million shares of which were available for future grant as of such date.

     Our Director Plan, as amended (the “Director Plan”), provides for the issuance of stock-based awards to our non-employee directors. We have reserved a total of 400,000 shares of common stock for issuance under the plan. The option grants under the plan are automatic and non-discretionary, and the exercise price of the options is 100% of the fair market value of our common stock on the grant date. The plan provides for an initial grant to a non-

28

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

employee director of an option to purchase at least 25,000 and up to 35,000 shares of common stock upon the director’s appointment to the board, which vest and become exercisable in eight equal quarterly installments. The plan also provides for each non-employee director to be granted an option to purchase 10,000 shares of common stock upon the director’s re-election to the board at an annual meeting of shareholders, provided the director has served as a non-employee director for at least six months preceding the date of the annual meeting. These subsequent grants vest and become exercisable in four equal quarterly installments commencing on the last day of the calendar quarter in which the option is granted. The plan will terminate in September 2010, unless terminated sooner by the Board of Directors. As of December 31, 2005, the Director Plan had 227,000 shares available for future grant.

     The following table summarizes information relating to stock option activity under the above plans for the years ended December 31, 2005, 2004 and 2003 (in thousands, except per share data):

				Weighted Average
	Number			Exercise Price
	of Options			Per Share
Options Outstanding as of December 31, 2002		11,689		$	6.02
Granted		1,858			7.31
Exercised		(1,603	)		2.13
Canceled		(932	)		8.18
Options Outstanding as of December 31, 2003		11,012			6.62
Granted		3,456			11.21
Exercised		(1,859	)		5.33
Canceled		(663	)		8.49
Options Outstanding as of December 31, 2004		11,946			8.04
Granted		3,166			15.64
Exercised		(3,807	)		6.22
Canceled		(840	)		12.89
Options Outstanding as of December 31, 2005		10,465		$	10.62

     The weighted-average grant-date fair value of options granted during 2005, 2004 and 2003 was $7.75, $7.07 and $5.08 per share, respectively. The fair value was determined using the Black-Scholes option pricing model.

     Additional information with respect to stock options outstanding as of December 31, 2005 is as follows (in thousands, except years and per share data):

					Options Outstanding						Options Exercisable
							Weighted
							Average		Weighted
							Remaining		Average				Weighted
Range of					Number		Contractual		Exercise		Number		Average Exercise
Exercise Price					Outstanding		Life (in years)		Price		Outstanding		Price
$	0.01	to	$	4.10		1,638		3.80	$	2.13		1,423	$	1.85
	4.22	to		8.50		1,699		5.06		7.10		1,066		7.30
	8.58	to		11.31		1,515		4.92		9.94		1,105		9.84
	11.50	to		11.94		1,495		5.46		11.89		553		11.89
	12.00	to		13.98		2,119		6.50		13.47		769		13.15
	14.00	to		19.05		1,697		6.49		16.47		149		16.95
	19.55	to		21.50		302		5.92		20.64		143		20.65
$	0.01	to	$	21.50		10,465		5.45	$	10.62		5,208	$	8.34

29

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

     There were approximately 6.6 million options exercisable with a weighted-average exercise price of $6.82 at December 31, 2004. There were approximately 5.7 million options exercisable with a weighted-average exercise price of $5.77 at December 31, 2003.

     Employee Stock Purchase Plan

     The employee stock purchase plan was adopted and approved in September 2000. The plan became effective upon the closing of our initial public offering in October 2000. We have reserved a total of 2.0 million shares of common stock for issuance under the plan, together with the potential for an annual increase in the number of shares reserved under the plan on May 1 of each year. As of December 31, 2005, 329,000 shares were available for future issuance. For the years ended December 31, 2005 and 2004, 314,000 and 651,000 shares, respectively, were issued under the plan.

     The plan permits eligible employees to purchase common stock, subject to limitations as set forth in the plan, through payroll deductions which may not exceed the lesser of 15% of an employee’s compensation or $25,000 per annum.

     Unless the Board of Directors determines otherwise, the plan is implemented in a series of overlapping 24-month offering periods with new offering periods commencing on May 1 and November 1 of each year. Each offering period is divided into four consecutive six-month purchase periods. All participants in an offering period are granted an option on the first day of the offering period, and the option is automatically exercised on the last day of each purchase period throughout the offering period. The purchase price of our common stock for each purchase period within an offering period is 85% of the lesser of the fair market value per share on the first trading day of the offering period or on the last trading day of the applicable purchase period, whichever is lower. If the fair market value per share on the last trading day of a purchase period is less than on the first day of the offering period, participants are automatically re-enrolled in a new offering period.

     Warrants

     As of December 31, 2005, there were warrants outstanding and exercisable to purchase 50,000 shares of common stock with an exercise price $7.00 per share. The warrants expire in August 2007.

9. Retirement Plan

     We provide a 401(k) Retirement Plan (the “Plan”) to eligible employees who may authorize contributions up to IRS annual deferral limits to be invested in employee elected investment funds. As determined annually by the Board of Directors, we may contribute matching funds of 50% of the employee contributions up to $2,500. These matching contributions vest based on the employee’s years of service with us. For the years ended December 31, 2005, 2004 and 2003, we expensed and made contributions to the Plan in the amount of approximately $770,000, $478,000 and $492,000, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. Earnings Per Share

     The following table sets forth the computation of basic and diluted earnings per share for the periods indicated (in thousands, except per share data):

	Year Ended December 31,
	2005		2004		2003
Basic Presentation
Numerator:
Net income	$	33,671	$	18,879	$	8,704
Denominator:
Weighted average common shares		65,168		60,687		58,363
Adjustment for common shares subject to repurchase		—		—		(19	)
Adjusted weighted average common shares		65,168		60,687		58,344
Basic net income per share	$	0.52	$	0.31	$	0.15
Diluted presentation
Denominator:
Shares used above		65,168		60,687		58,344
Weighted average effect of dilutive securities:
Stock options		4,059		4,058		3,864
Common shares subject to repurchase		—		—		19
Denominator for diluted calculation		69,227		64,745		62,227
Diluted net income per share	$	0.49	$	0.29	$	0.14

     The diluted per share computations for the years ended December 31, 2005, 2004 and 2003, exclude employee stock options to purchase 0.8 million, 3.6 million and 4.6 million shares, respectively, which were antidilutive.

11. Quarterly Financial Summary (Unaudited)

	Three Months Ended
	Dec. 31		Sep. 30		Jun. 30		Mar. 31			Dec. 31		Sep. 30		Jun. 30		Mar. 31
	2005		2005		2005		2005			2004		2004		2004		2004
	(in thousands, except per share data)
Statement of Income Data:
Net revenues	$	37,459	$	42,134	$	41,326	$	38,414	��	$	35,162	$	30,092	$	26,811	$	24,913
Gross profit		30,523		34,458		34,034		31,627			28,253		23,874		21,228		19,863
Income before income taxes		7,045		12,824		13,139		11,555			9,330		6,610		5,142		4,260
Net income		5,506		9,070		9,766		9,329			7,572		4,739		3,546		3,022
Earnings per share:
Basic	$	0.08	$	0.14	$	0.15	$	0.15		$	0.12	$	0.08	$	0.06	$	0.05
Diluted	$	0.08	$	0.13	$	0.14	$	0.14		$	0.11	$	0.07	$	0.06	$	0.05

12. Subsequent Event

     In January 2006, we completed the acquisition of the mobile video and multimedia test product lines of privately-held Dilithium Networks for approximately $5 million in cash.

31

EXHIBIT INDEX

Exhibit Number	Description
23.1	Consent of Independent Registered Public Accounting Firm
31.1	Certificate of Chief Executive Officer of Ixia pursuant to Rule 13a-14(a) under the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certificate of Chief Financial Officer of Ixia pursuant to Rule 13a-14(a) under the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certificate of Chief Executive Officer and Chief Financial Officer of Ixia pursuant to Rule 13a-14(b) under the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002