ADVANCED FIBRE COMMUNICATIONS INC, 10-K405, 1997-01-28

ADVANCED FIBRE COMMUNICATIONS INC
10-K405, 1997-01-28
TELEPHONE & TELEGRAPH APPARATUS

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996

/ / 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: 0000898805

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ADVANCED FIBRE COMMUNICATIONS, INC.

(Exact name of registrant as specified in its charter)

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<S> <C>
DELAWARE 68-0277743
(State or other (I.R.S. Employer
jurisdiction of Identification No.)
incorporation or
organization)
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1445 MCDOWELL BOULEVARD NORTH
PETALUMA, CALIFORNIA 94954
(707) 794-7700

(Address, including zip code, of Registrant's principal executive offices and
telephone number, including area code)

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SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE
ACT: NONE.

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE
ACT: COMMON STOCK.

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

Indicate by check mark 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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of the Form 10-K or any
amendment to this Form 10-K. /X/

As of January 23, 1997, 32,655,362 shares of the registrant's Common Stock,
$.01 par value, were outstanding, and the aggregate market value of the shares
held by non-affiliates was $883,848,559.

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ADVANCED FIBRE COMMUNICATIONS, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1996

TABLE OF CONTENTS

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PART I.

Item 1. Business......................................................... 3
Item 2. Properties....................................................... 17
Item 3. Legal Proceedings................................................ 17
Item 4. Submission of Matters to a Vote of Security Holders.............. 19

PART II.

Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters........................................................ 19
Item 6. Selected Consolidated Financial Data............................. 20
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................... 21
Item 8. Financial Statements and Supplementary Data...................... 36
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure........................................... 54

PART
III.

Item 10. Executive Officers, Key Employees and Directors.................. 54
Item 11. Executive Compensation........................................... 58
Item 12. Security Ownership of Certain Beneficial Owners and Management... 62
Item 13. Certain Relationships and Related Transactions................... 64

PART IV.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K............................................................ 67
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SEE "GLOSSARY OF TERMS" COMMENCING ON PAGE 14 FOR DEFINITIONS OF VARIOUS
ACRONYMS AND TECHNICAL TERMS USED IN THIS ANNUAL REPORT ON FORM 10-K

PART I.

ITEM 1. BUSINESS

COMPANY OVERVIEW

Advanced Fibre Communications, Inc. ("AFC" or the "Company") designs,
develops, manufactures, markets and supports the Universal Modular Carrier
1000-TM- (the "UMC" system), a cost-effective, multi-feature digital loop
carrier system developed to serve small line-size markets. The Company's UMC
system is designed to enable telephone companies, cable companies and other
service providers to connect subscribers to the central office switch for voice
and data communications over copper, fiber, coax and analog radio networks. The
Company believes that the UMC system is the only digital loop carrier that can
operate simultaneously over a variety of transmission media. The UMC system
meets the service needs of domestic and international subscribers including
analog services such as plain old telephone service ("POTS"), universal voice
grade service ("UVG") and analog switched data service, and digital services
such as high speed digital data service, ISDN, asynchronous and synchronous data
channel ("ADU" and "SDU") services. Through a relationship with Tellabs
Operations, Inc. ("Tellabs"), AFC has developed the capability to deliver many
of these same services over cable TV networks.

Although urban markets have experienced the greatest initial demand for
additional lines and high-speed telecommunications services, the Company
believes that demand for these services is increasing in rural and suburban
markets as well. The Company also believes, however, that telecommunications
service providers in suburban and rural markets generally do not have the
resources to completely replace existing copper networks and therefore must
upgrade to fiber in incremental steps. These incremental infrastructure upgrades
result in hybrid networks containing both copper and fiber transmission lines.
In addition, worldwide demand for POTS and, to a lesser extent, high speed
telecommunications services, is creating the need for significant infrastructure
investments to increase the effective capacity of existing copper, replace
deteriorating copper and provide services in new areas. As telecommunications
service providers upgrade to fiber technology, deploy new networks and plan for
future subscriber services, they must determine how to ensure a seamless,
cost-effective connection between copper and fiber facilities within the local
loop.

The UMC system is easily scalable from six to 672 lines through the addition
of plug-in components. Utilizing a single platform and a variety of line cards
supporting specific services, the UMC system is capable of providing a range of
voice and data services. In addition, the UMC system can be installed in a
variety of network configurations to support the varying geographic distribution
of subscriber bases. The Company has designed the UMC system to require a
minimum number of common control units to support transmission over a variety of
media and the delivery of more advanced services and features by telephone
companies. Thus, the UMC system offers a cost-effective solution to the small
line-size market with a wide variety of features and advanced services.

The UMC system has been sold to more than 450 independent telephone
companies in the United States, is being initially deployed by Ameritech and
GTE, and is in laboratory or field trials at Pacific Bell and BellSouth. The
Company has also sold the UMC system to telephone companies in Hong Kong,
France, Brazil, Canada, China, Mexico, the Netherlands Antilles and the
Dominican Republic. The UMC system is distributed and serviced worldwide through
its direct sales force in the domestic market and through its direct sales
force, distributors and agents in international markets. See "--Markets and
Customers" and "--Proprietary Rights and Licenses."

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The Company was incorporated in California in May 1992 and reincorporated in
Delaware in September 1995. The Company's principal executive offices are
located at 1445 McDowell Boulevard North, Petaluma, California 94954, and the
telephone number at that address is (707) 794-7700.

The Company operates on a 13-week fiscal quarter, comprised of four, four
and five week months ending on the last Saturday of the last week of the
five-week month. For presentation purposes only, the Company has shown its first
three fiscal quarters as ending on March 31, June 30, and September 30 and its
fourth fiscal quarter and fiscal year as ending on December 31.

INDUSTRY BACKGROUND

Much of the existing local loop, which connects the subscriber to the
central office switch, was designed to provide analog voice communications, or
POTS, over copper. As a transmission medium, copper suffers from significant
signal degradation, particularly when transmitting signals beyond 10,000 feet.
In addition, the traditional copper infrastructure was designed to support low
speed telecommunications services and offers relatively poor transmission
quality, especially in data communications applications. Before the 1970s,
various solutions were implemented to address these concerns; however, these
solutions were generally costly to maintain and resulted in complex
architectures. In the early 1970s, to decrease the cost and complexity of
extending service beyond 10,000 feet from the central office, telephone
companies began to deploy digital loop carriers ("DLCs"), which convert analog
signals into digital bit streams for transmission to and from the central
office. The resulting improved signal quality enabled telephone companies to
increase transmission distances from the central office to the customer.

Advancements in digital technology have enabled central office switches to
increase by tenfold the number of lines served. While these advancements have
permitted greater centralization of switch resources, they have also resulted in
increased distances between the central office and the subscribers. Rapid
deployment of DLCs was necessary to effectively transmit signals over these
greater distances. However, the copper infrastructures supported by traditional
DLCs lacked the bandwidth for additional lines and the transmission quality for
high speed telecommunications. In response to these limitations as well as the
deterioration of the existing copper infrastructure, telephone companies began
installing fiber in high density urban markets in the late 1980s. Next
generation DLCs ("NGDLCs") were designed and introduced to the market in the
early 1990s to support telecommunications services over fiber-only networks in
densely populated urban markets with 600 to 2,000 lines within the serviceable
area of the NGDLC ("large line-size markets"). NGDLCs address certain of the
limitations inherent in DLCs. However, NGDLCs have high installation costs and
complex, support-intensive characteristics and are optimized for fiber-only
networks and large line-size markets.

THE AFC SOLUTION

The Company has developed the UMC system to provide cost-effective,
multi-feature local loop systems for the small line-size market, incorporating a
modular architecture that supports copper, fiber and

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coax and the evolution from one transmission media to another. The Company
believes that the UMC system is the only digital loop carrier that can operate
simultaneously over a variety of transmission media. The UMC system is easily
scalable from six to 672 lines through the addition of plug-in components.
Utilizing a single platform and a variety of line cards supporting specific
services, the UMC system is capable of providing a range of voice and data
services. In addition, the UMC system can be installed in a variety of network
configurations to support the varying geographic distribution of subscriber
bases. The Company has designed the UMC system to require a minimum number of
common control units to support transmission over a variety of media and the
delivery of more advanced services and features by telephone companies. Thus,
the UMC system offers a cost-effective solution for the small line-size market
with a wide variety of features and advanced services.

AFC'S STRATEGY

AFC's objective is to be the leading provider of cost-effective,
multi-feature local loop systems for small line-size markets worldwide. The key
elements of its strategy to achieve this objective include:

TARGET DOMESTIC SMALL LINE-SIZE MARKETS. The Company sells the UMC system
principally through its direct sales force into domestic small line-size
markets. These markets, which are generally located in rural and suburban areas,
are served by independent telephone companies and by the Regional Bell Operating
Companies ("RBOCs"). The Company intends to expand its direct sales force and
augment its marketing and customer support efforts to further penetrate its
existing customer base of 450 independent telephone companies and penetrate the
balance of the approximately 1,300 independent telephone companies. In addition,
with the satisfactory completion of a Bell Communications Research ("Bellcore")
technical audit, the Company is expanding into the RBOC market by offering the
UMC system as a solution to the small line-size system requirements of the
RBOCs.

PENETRATE INTERNATIONAL MARKETS. The Company markets the UMC system
internationally through local distributors and agents, through strategic
relationships, and directly to local service providers. The Company intends to
enhance its existing international operations with greater sales and marketing
resources to pursue market opportunities in countries currently undergoing
initial infrastructure deployment or upgrades which demand flexible and
cost-effective systems.

PROVIDE COST-EFFECTIVE SOLUTIONS. The UMC system enhances the transmission
quality and capacity of existing copper facilities, enabling telephone companies
to maximize the performance of the existing copper infrastructure while
permitting a cost-effective and easily configurable upgrade solution as
infrastructure is modernized or demands for more advanced communication services
increase. The Company believes that the UMC system is the only digital loop
carrier that can operate seamlessly over hybrid networks including copper, fiber
and analog radio. The UMC system can also serve as a platform for providing high
speed data transmission and other advanced digital services such as video
teleconferencing. The Company has designed the UMC system to require a minimum
number of common control units to support transmission over a variety of media
and the delivery of more advanced services and features by telephone companies.
The Company's engineering and manufacturing efforts are directed toward
preserving and enhancing the cost-effectiveness of the UMC system as new
features and designs are released.

EXTEND TECHNOLOGY LEADERSHIP. The UMC system contains a proprietary
software and backplane design and modular architecture, which enable telephone
companies to more easily support the varying geographic distribution of
subscriber bases by employing multiple configurations which may be distributed
over any combination of transmission media (including copper, fiber, coax and
analog radio). The proprietary backplane design currently supports a variety of
voice and data services, and the Company is developing improvements to support
higher bandwidth applications. The Company is engaged in ongoing research and
development to leverage its technical expertise and to adapt its technology to
new markets and applications. For example, the Company is engaged in development
efforts to increase the scalability of the UMC system for large line-size
markets.

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DEVELOP STRATEGIC RELATIONSHIPS. The Company has entered into certain
strategic relationships in order to broaden the manufacturing and distribution
of the UMC system into developing international markets, such as China and
India, and to leverage the UMC technology for applications in markets not
directly targeted by the Company, such as the provision of telephone services
over existing cable TV systems. The Company intends to invest in existing
strategic relationships and to seek additional relationships to gain
manufacturing and distribution leverage, to access advanced technologies and to
broaden the acceptance of the UMC system.

TECHNOLOGY AND PRODUCT ARCHITECTURE

The UMC architecture is based upon a modular software and hardware product
platform that can be configured and adapted to the particular requirements of
the customer. Each line card, transceiver and common control unit contains
proprietary application specific integrated circuits ("ASICs") that incorporate
the digital cross-connect function, eliminating the need for a separate digital
cross-connect within the assembly. This design improves efficiency, allowing the
Company to deliver the common control required by telephone companies with fewer
assemblies than most NGDLCs.

A basic UMC system consists of two terminals. Each terminal contains a power
supply, a central processing unit ("CPU"), a transceiver and a line card
providing subscriber service, such as analog voice service. The Local Exchange
Terminal ("LET"), located next to the local exchange switch in the central
office, contains a central processing unit and transmits and receives the
telephone signal from the Remote Service Terminal ("RST") mounted close to the
subscriber group in a weatherproof housing. The RST receives analog signals from
the telephone instruments of subscribers, transforms them into digitally
encoded, time divisioned multiplexed bit streams, and transports them across
either copper, fiber or radio transmission media to a central office. There, the
LET either decodes the signal and converts it back into an analog signal for
connection into the telephone network, or connects the digital signal directly
into the network.

The base UMC system permits telephone companies to offer basic analog voice
service to six subscribers and is priced at approximately $4,000, excluding the
cabinet. The base UMC system can be expanded to accommodate additional
subscribers, to provide advanced services and to operate over different or
multiple transmission media. The UMC system can be configured to accommodate up
to 120 subscribers through the addition of line cards and up to 672 subscribers
through the addition of channel bank assemblies. During 1996, UMC systems with
capacities of 120 and 240 lines of POTS sold for average prices, including the
cabinet, of approximately $25,000 and $40,000, respectively.

MARKETS AND CUSTOMERS

To date, the UMC system has been deployed primarily in the U.S. rural and
suburban markets served by independent telephone companies. While the Company
believes this market has substantial revenue potential and intends to continue
to pursue customers in the U.S. small line-size market, the Company has also
begun to pursue other potential markets and customers for the UMC system, such
as the RBOCs, international telecommunications service providers and competitive
access providers.

DOMESTIC SMALL LINE-SIZE MARKET

The domestic small line-size markets for telecommunications services are
generally located in rural and suburban areas and are served by approximately
1,300 independent telephone companies and the seven RBOCs. The independent
telephone companies range from rural companies with as few as 125 subscribers to
GTE, with approximately 17 million subscribers. The independent companies in
general do not require telephone equipment suppliers to satisfy Bellcore
testing, and typically do not require specific design changes in the product in
order for the equipment to be deployed. As a result, the Company was able to
deploy the UMC system rapidly to independent telephone companies and to build
customer

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acceptance of the UMC system quickly. In addition, independent telephone
companies typically have smaller budgets for telephone equipment than the RBOCs
and demand easily scalable and configurable cost-effective solutions. The UMC
system's ability to improve analog transmission and increase the capacity of
existing networks, together with its ability to operate simultaneously over a
variety of transmission media, enables telephone companies to maximize the
performance of existing copper infrastructure while permitting a cost-effective
and easily configurable upgrade solution as infrastructure is modernized or
demands for more advanced communication services increase. Thus, the Company
believes that the UMC system provides an attractive solution for the independent
telephone companies in small line-size markets. Moreover, with the satisfactory
completion of a Bellcore technical audit, the Company is expanding into the RBOC
market by offering the UMC system as a solution for the small line-size system
requirements of the RBOCs.

The Company has segmented and prioritized the independent telephone company
market into the following: (i) small independents that use consulting
engineering firms to provide network design for service expansion and
modernization; (ii) medium-size independents that perform the network design
internally; and (iii) large independents, such as GTE, that have engineering
committees that approve equipment for standardization and may require testing
and equipment modifications to meet their specific network requirements. The
Company has targeted each of these segments as sources of potential customers
and to date over 450 independents have purchased the Company's products.

INTERNATIONAL MARKETS

The international telephone market is segmented into developing countries
requiring basic telecommunication services, or POTS, and developed countries
which, in addition to POTS, have requirements for more advanced
telecommunication services and which have barriers to entry in the form of
standards or unique domestic network specifications. In most of these
international markets, a single telephone company, which is typically highly
regulated and government-owned, provides service throughout the country.
Typically, these companies are striving to install technology that offers the
opportunity in the future for advanced services, with ease of installation and
servicing at an attractive price. In addition, they are striving to optimize
existing facilities, which typically consist of copper, for a growing subscriber
base. The Company is pursuing selected opportunities to develop these markets
primarily through direct contacts with local distributors and through its
strategic relationships, where the market also requires local manufacturing to
address high import tariffs and where the Company benefits from a local partner
that can assist customer relationships.

As part of its international strategy, the Company is primarily focused on
the substantial market opportunity which the Company believes exists in
developing countries currently undergoing infrastructure deployment.
Telecommunications companies in these markets demand flexible and cost-effective
systems. The Company has sold UMC systems to telephone companies in Brazil,
China, Mexico, the Netherlands Antilles and the Dominican Republic.

Telecommunications companies in more developed countries require that
products have modifications and design specifications that meet local
standardization guidelines. To date, the Company has successfully met these
standards requirements in, and is currently shipping products to, both France
and Hong Kong. The Company was awarded a contract with France Telecom for a
multiplexer subscriber system. The Company was also awarded a three-year
contract with Hongkong Telecommunications Limited to deploy the UMC system.
Although neither of these contracts require the customer to purchase any
specific amount of product from the Company, the Company believes that these
customers present a significant opportunity to the Company.

AFC and Harris Corporation, a stockholder of the Company, entered into an
agreement to form a joint venture to manufacture, distribute and support the UMC
system in India. The joint venture included formation of a holding company in
Mauritius, owned 51% by AFC and 49% by Harris, which in turn

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intends to form a joint venture in India with local Indian partners following
receipt of certain government approvals. To date, the parties have identified
and selected two Indian companies that will collectively own 34% of the Indian
venture to be located in Delhi. In addition, as a means to protect its licensed
technology in India, AFC formed a 100% foreign-owned subsidiary in India, AFC
India Private (Ltd.), which holds the rights to license the UMC technology in
India for manufacturing in the local market. To date, the joint venture
activities have included testing and seeking type approval for the UMC system.

The UMC system has received or is currently undergoing type approval
qualification in a number of countries, including Hungary, Indonesia, the
Philippines and Russia. There can be no assurance that the UMC system will
receive type approval in these or other countries or that receipt of type
approval will lead to product sales. In addition, the Company currently has
outstanding responses to bid requests from telephone companies in India, Panama
and Brazil. The Company's bid responses have been accepted in certain cases and
rejected in others in the past, and there can be no assurance that currently
outstanding or future bid responses will be accepted and, even if accepted,
there can be no assurance that such acceptance will lead to significant sales.

FUTURE MARKET OPPORTUNITIES

REGIONAL BELL OPERATING COMPANIES (RBOCS). The seven RBOCs make up the
largest segment of the U.S. telecommunications equipment market and serve over
80% of all U.S. telephone customers, primarily in urban areas. All of these
companies have stringent testing and approval requirements, known as Bellcore
testing, that must be met before products can be installed in their networks.
Bellcore testing requires significant investments in resources to achieve
compliance. In addition, the RBOCs require that the equipment undergo one or
more field trials to demonstrate that the equipment meets the standards and
satisfies their service and network requirements. The UMC system completed a
Bellcore technical audit, and the Company intends to submit new features for
Bellcore testing as they are released. In addition, the UMC system is being
initially deployed by Ameritech and is in laboratory or field trials at Pacific
Bell and BellSouth.

COMPETITIVE ACCESS PROVIDERS. Deregulation has allowed non-regulated
telephone companies to provide local telephone services. Through better pricing,
faster installation and better customer service, these companies, known as
competitive access providers, hope to attract customers away from the RBOCs and
independent telephone companies. These companies historically have focused on
high density downtown business customers. As these carriers diversify their
sales efforts to include smaller businesses and office parks, an increasing
number will require smaller systems. The companies active in this market segment
are attractive targets for the Company because the UMC system has the capability
to cost-effectively provide a full range of communication services. The Company
intends to address this market primarily through its relationship with Tellabs.
AFC intends to serve this market both over traditional transmission media as
well as over coax media.

CABLE-BASED TELEPHONY. AFC and Tellabs, a stockholder of the Company,
entered into a general partnership in 1994 to design, develop, manufacture and
distribute a new product line derived from the UMC system. This product is
designed to allow telephone services to be provided over existing cable TV
systems as well as other transmission media. AFC contributed a non-exclusive
license to use the UMC technology, Tellabs contributed cash to the joint
venture, and each received defined marketing rights for the developed
technology. In early 1996, upon review of the development of the market for this
product, the Company concluded that the market for transmitting voice and data
over cable systems would develop at a slower pace than originally anticipated.
In the interest of directing its resources towards more immediate market
opportunities, AFC entered into agreements with Tellabs in 1996 that changed the
relationship between the parties. The new relationship provides AFC with
royalties and OEM revenues from Tellabs on its sales into its specified markets
and, in return, AFC works on selected developments of the UMC technology for
Tellabs' markets on a development contract basis. AFC retains all rights in its
technology as well as the market rights previously defined.

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SALES, MARKETING AND CUSTOMER SUPPORT

The Company markets the UMC system worldwide directly to telephone companies
and indirectly through OEMs, distributors and joint ventures to accommodate
specific markets and customer support requirements. The Company's sales force
consists of two groups, one that focuses on U.S. and Canadian telephone
companies and one that focuses on international markets.

The Company's North American sales force focuses on developing relationships
with independent telephone companies in the U.S. and Canada and on understanding
their network deployment strategies and cost requirements. As of December 31,
1996, the Company's domestic sales organization consisted of 17 direct
salespersons, a domestic sales vice president, and technical support personnel.
The Company has sales personnel located in Pittsburgh, Minneapolis, Atlanta,
Denver, Dallas, Chicago, Seattle, Orlando, Birmingham, Tulsa and Santa Clara.
The Company also has sales personnel dedicated to specific customer accounts,
such as Ameritech, BellSouth, GTE and Pacific Bell. In addition to direct calls
on the telephone companies, sales to customers often involve marketing through
consulting engineers who are retained by small independent telephone companies
for engineering, specification and installation services.

The Company employs an international direct sales force consisting of three
salespersons and one vice president. The primary tasks of the international
sales force are to market the UMC system directly to international telephone
companies and to select, manage, and train local distributors. Sales to
international customers are primarily fulfilled through the Company's
distributors and agents. The Company currently has an office in Hong Kong.

The AFC sales organization receives support from the Company's marketing
department, which is responsible, among other things, for product marketing,
advertising and marketing communications. The marketing department works closely
with the planning and engineering departments of telephone companies in order to
provide product proposals that are optimal in terms of both performance and cost
for a specific network configuration.

The Company's customer support organization is responsible for servicing the
Company's products and assisting the Company's sales personnel. In addition to
its own field technical service engineers, the Company uses Point-to-Point
Communications, Inc. ("Point-to-Point"), a third-party support organization,
which provides first-line support for the Company's customers through a
toll-free number open 24 hours per day, 365 days per year, and provides
installation services on a subcontract basis for the Company. Although to date
the Company believes Point-to-Point has provided satisfactory customer
assistance, there can be no assurance that Point-to-Point will be able to
provide the level of customer support demanded by existing or potential
customers. The Company maintains a training organization which is dedicated to
developing training curriculums and materials that are made available to the
customer either through a student training or a train the trainer program.
Internationally, the Company provides customer support either directly or
through authorized distributors or joint venture partners. The Company's
products generally have a warranty period of 24 months.

RESEARCH AND DEVELOPMENT

The Company's research and development efforts have been focused on
developing local loop products with advanced features for small line-size
markets. The Company has developed a modular software and hardware platform that
can be configured and adapted to particular customer requirements. In addition,
development efforts include extensive attention to ease of installation and use
by the customer as evidenced in the menu driven software approach as well as the
compact and efficient hardware design demonstrated in its PCBAs. The Company's
research and development personnel work closely with sales and marketing
personnel to ensure development efforts are targeted at customer needs. In
addition, the Company's development efforts are focused on developing
enhancements to the UMC system, such as a higher bandwidth backplane.

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The current focus of the Company's research and development efforts is
directed at new releases of the UMC system addressing market demands for new
features and services. These efforts include developing new transceivers
incorporating HDSL capabilities, new customer features such as ISDN and new
interfaces such as TR303. The Company is also incorporating MLT remote testing
capabilities into the product in support of the RBOC market. In addition, future
releases are expected to include capabilities to support broader star
configurations, SONET OC3 transceivers and multi-point support for the coax
transceiver version of the product. Finally, the engineering team also
concentrates its attention on numerous projects in the areas of cost and quality
improvements in the UMC system.

In 1995 and 1996, the Company's research and development expenditures were
$5.7 million and $14.4 million, respectively, which represented 10.6% and 11.1%,
respectively, of total revenues in such periods. In 1993 and 1994, the Company's
research and development expenditures were $2.0 million and $2.9 million,
respectively. The Company considers its research and development efforts to be
vital to its future success and anticipates that research and development
expenditures as a percentage of revenues will remain significant for the
foreseeable future. As of December 31, 1996, the Company's research and
development staff consisted of 124 employees.

MANUFACTURING

Manufacturing, system integration and certain testing operations are
performed at the Company's headquarters in Petaluma, California. The Company's
manufacturing operations consist primarily of final assembly and test of
finished goods from components and custom-made subassemblies (primarily printed
circuit boards) purchased from third parties. The Company monitors quality at
each stage of the production process, including the selection of component
suppliers, warehouse procedures, the assembly of finished goods and final
testing, packaging and shipping. The Company also performs functional,
environmental and systems testing and quality assurance procedures on the
subassemblies which are incorporated into the UMC system and with respect to the
final products themselves.

The Company relies on a limited number of independent contractors that
manufacture the subassemblies to the Company's specifications for use in the
Company's products. In particular, the Company relies on: (i) Flextronics
International, Ltd. and Tanon Manufacturing, Inc. (a division of Electronic
Associates, Inc.) to manufacture the Company's printed circuit board assemblies;
(ii) Paragon, Inc. to manufacture backplanes and channel bank assemblies and
(iii) Sonoma Metal Products, Inc. and Cowden Metal San Jose, Inc. to manufacture
the outside cabinets. The Company believes that it has good relations with each
of its suppliers. As the demand for the UMC system has increased, the Company
has begun a program to identify, and potentially qualify at a future date,
additional suppliers to manufacture key product subassemblies. While the Company
believes that the subassemblies manufactured by any of the suppliers could be
procured from alternate suppliers, in the event that the Company's
subcontractors were to experience financial, operational, production, or quality
assurance difficulties that resulted in a reduction or interruption in supply to
the Company or otherwise failed to meet the Company's manufacturing
requirements, the Company's business, financial condition and results of
operations would be adversely affected until the Company established sufficient
manufacturing supply from alternative sources. There can be no assurance that
the Company's current or alternative manufacturers will be able to meet the
Company's future requirements or that such manufacturing services will continue
to be available to the Company at favorable prices.

Certain components used in the Company's products, including the Company's
proprietary ASICs, codecs, certain surface mount technology components and other
components, are only available from a single source or limited number of
suppliers. Some of the Company's sole-source suppliers are companies which from
time to time allocate parts to telephone equipment manufacturers due to market
demand for the telecommunication equipment. Many of the Company's competitors
are much larger and may be able to obtain priority allocations from these shared
suppliers, thereby limiting or making unreliable the sources of supply for these
components. The Company encountered supply delays for codecs in the second
quarter

10
<PAGE>
of 1994 which resulted in delayed shipments of the UMC system, and there can be
no assurance that similar shortages will not occur in the future or will not
result in the Company having to pay a higher price for components. If the
Company is unable to obtain sufficient quantities of these or any other
components, delays or reductions in manufacturing or product shipments could
occur which would have a material adverse effect on the Company's business,
financial condition and results of operations.

COMPETITION

The market for equipment for local telecommunications networks is extremely
competitive. The Company's competitors range from small companies, both domestic
and international, to large multinational corporations. The Company's
competitors include Alcatel Alsthom Compagnie Generale d'Electricite, DSC
Communications Corporation, ECI Telecom, Ltd., E/O Networks, Fujitsu America,
Inc., Hitron Technology, Inc., Lucent Technologies, Inc., NEC America, Inc.,
Northern Telecom Ltd., Opnet Technologies Co. Ltd., RELTEC Corporation, Seiscor
Technologies Inc., Siemens Corporation, Teledata Communications, Ltd. and
Vidar-SMS Co. Ltd. Many of these competitors have more extensive financial,
marketing and technical resources than the Company and enjoy superior name
recognition in the market. In addition, the Company has entered into agreements
with the Industrial Technology Research Institute ("ITRI") to jointly develop
products based on the UMC system. ITRI is a Taiwanese government-sponsored
research and development organization in the telecommunications field. Such
agreements grant ITRI and certain of its member companies certain rights to
manufacture and sell the ETSI version of the UMC system outside of North
America. Such entities currently compete with the Company in international
markets, primarily in China. In addition, upon termination of the agreements
with ITRI in 2002, ITRI will have a worldwide, non-exclusive, royalty-free,
irrevocable license to use the ETSI version of the UMC technology and,
consequently, such member companies will be able to compete with the Company
worldwide at such time. There is an ongoing dispute subject to litigation
between the Company and ITRI and such member companies as to whether, among
other things, ITRI possesses the right to grant such rights to manufacture and
sell the European Telecommunications Standards Institute ("ETSI") version of the
UMC system to new member companies. Depending on the outcome of this dispute,
the Company may face competition from new member companies for the ETSI version
of the UMC system. Such companies may possess substantially greater financial,
marketing and technical resources than the Company. The Company may also face
competition from new market entrants. The principal competitive factors in the
segment of the telecommunications equipment industry in which the Company
operates are total cost of solution, product quality and performance,
scalability, flexibility of configuration and range of system capabilities
available. The Company believes that it competes favorably with respect to these
factors, and that the ability of the UMC system to offer voice and data
communications over a variety of transmission media in a cost-effective package
provides a competitive advantage in the small line-size market. There can be no
assurance that the Company will be able to compete successfully in the future.

COMPLIANCE WITH REGULATORY AND INDUSTRY STANDARDS

The UMC system is required to comply with a large number of voice and data
regulations and standards, which vary domestically versus internationally and
may vary by the specific international market to which the Company sells its
products. The standards in the United States are determined by the Federal
Communications Commission ("FCC"), by Underwriters Laboratories, by independent
telephone companies and by Bellcore. The UMC technology is certified by
Underwriters Laboratories. In international markets, the Company's products must
comply with recommendations by the Consultative Committee on International
Telegraph and Telephony and with requirements established by the individual
regional carriers which specify how equipment that is connected to their local
networks must operate. In addition, the Company's products must comply with
standards issued by ETSI. These standards are implemented and enforced by the
Telecommunications Regulatory Authority of each European nation. Standards for
new services continue to evolve, and the Company will be required to modify its
products or develop and support new versions of its products to meet these
standards. The failure of the Company's products to

11
<PAGE>
comply, or delays in meeting compliance, with the evolving standards both in its
domestic and international markets could have a material adverse affect on the
Company's business, financial condition and results of operations.

In addition, the Company will need to ensure that its products are easily
integrated with the carriers' network management systems. The RBOCs, which
represent a large segment of the U.S. telecommunications market, in many cases
require that equipment integrated into their networks be tested by Bellcore,
indicating that the products are interoperable with the operations,
administration, maintenance and provisioning systems used by the RBOCs to manage
their networks. Bellcore testing requires significant investments in resources
to achieve compliance. The UMC system completed a Bellcore technical audit and
was found to meet applicable requirements. The failure to maintain such
compliance and/or to obtain it on new features released in the future could have
a material adverse affect on the Company's ability to sell the UMC system to the
RBOCs, which represent a large segment of the telecommunications market.

The Company has not received ISO certification, which certifies that design
and manufacturing processes adhere to certain established standards. Many
telecommunications service providers particularly in international markets, will
not purchase products from suppliers that have not received ISO certification.
Accordingly, until it is able to obtain ISO certification, the Company may be
precluded from selling its products to these service providers and its ability
to compete with other suppliers of communications equipment may be adversely
affected. The Company has initiated the formal process of applying for ISO-9001
certification and expects to complete the audit process during 1997. ISO-9001
addresses quality assurance in design, development, production, installation and
service. There can be no assurance as to when or if the Company will receive
such certification. The failure to obtain such certification may preclude the
Company from selling the UMC system in certain markets.

The U.S. Congress recently passed new regulations that affect
telecommunications services, including changes to pricing, access by competitive
suppliers and many other broad changes to the data and telecommunications
networks and services. These changes will have a major impact on the pricing of
existing services, and may affect the deployment of future services. These
changes could cause greater consolidation in the telecommunications industry,
which in turn could disrupt existing customer relationships and have a material
adverse effect on the Company's business, financial condition and results of
operations. There can be no assurance that any regulatory changes will not have
a material adverse effect on the demand for the UMC system. Uncertainty
regarding future policies combined with emerging new competition may also affect
the demand for telecommunications products such as the UMC system.

PROPRIETARY RIGHTS AND LICENSES

The Company attempts to protect its technology through a combination of
copyrights, trade secret laws and contractual obligations. The Company does not
presently hold any patents for its existing products and has no patent
applications pending. There can be no assurance that the Company's intellectual
property protection measures will be sufficient to prevent misappropriation of
the Company's technology or that the Company's competitors will not
independently develop technologies that are substantially equivalent or superior
to the Company's technology. In addition, the laws of many foreign countries do
not protect the Company's intellectual property rights to the same extent as the
laws of the United States. The failure of the Company to protect its proprietary
information could have a material adverse effect on the Company's business,
financial condition and results of operations.

The increasing dependence of the telecommunications industry on proprietary
technology has resulted in frequent litigation based on allegations of the
infringement of patents and other intellectual property. The Company recently
settled litigation with DSC Communications Corporation ("DSC") under which DSC
had claimed proprietary rights in the UMC technology. See "Item 3--Legal
Proceedings-- DSC." In the future the Company may be subject to additional
litigation to defend against claimed infringements of the rights of others or to
determine the scope and validity of the proprietary rights of

12
<PAGE>
others. Future litigation also may be necessary to enforce and protect trade
secrets and other intellectual property rights owned by the Company. Any such
litigation could be costly and cause diversion of management's attention either
of which could have a material adverse effect on the Company's business,
financial condition and results of operations. Adverse determination in such
litigation could result in the loss of the Company's proprietary rights, subject
the Company to significant liabilities, require the Company to seek licenses
from third parties, or prevent the Company from manufacturing or selling its
products, any one of which could have a material adverse effect on the Company's
business, financial condition and results of operations. Furthermore, there can
be no assurance that any necessary licenses will be available on reasonable
terms.

In September 1992, AFC entered into agreements (the "ITRI Agreements") with
the Industrial Technology Research Institute ("ITRI") to jointly develop
products based on the ETSI version of the UMC system. ITRI is a Taiwanese
government-sponsored research and development organization in the
telecommunications field. Under the ITRI Agreements, ITRI has the exclusive
right in Taiwan to use and develop the ETSI version of the UMC technology, and
to manufacture such version of the UMC system through the member companies, but
does not have the right to manufacture and sell the Company's proprietary ASICs
except in circumstances where AFC has failed to provide the ASICs as required.
The ASIC designs were placed in escrow in order to be available to ITRI and the
member companies should the right to manufacture ASICs become effective. ITRI
and the member companies also have a non-exclusive right to sell or lease the
ETSI version of the UMC system in all countries outside of North America. The
ITRI Agreements require ITRI to pay the Company a royalty on sales or leases of
the UMC system made through September 2002, at which time the license becomes
fully-paid, and ITRI will have a worldwide, non-exclusive, royalty free,
irrevocable license to use the ETSI version of the UMC technology. ITRI's member
companies currently compete with the Company in international markets, primarily
in China. The Company is currently involved in litigation with ITRI and certain
of its member companies arising out of disputes over, among other things,
payment of royalties and the supply of ASICs. See "--Competition" and "Item
3--Legal Proceedings--ITRI."

EMPLOYEES

As of December 31, 1996, AFC had 425 full-time employees, including 82 in
marketing, sales and support services, 124 in research and development, 159 in
operations and 60 in general administrative positions. Substantially all of
AFC's employees are based at the Company's headquarters in Petaluma, California.
None of the Company's employees are represented by a labor union. The Company
believes its relationships with its employees are good and has never experienced
a strike or work stoppage.

13
<PAGE>
GLOSSARY OF TERMS

<TABLE>
<S> <C>
Analog....................................... A form of transmission employing a continuous
electrical signal (rather than a pulsed or
digital system) that varies in frequency and
amplitude.

Application Specific Integrated Circuit A broad term that refers to custom or
(ASIC)...................................... semi-custom integrated circuits.

Asynchronous Data Channel Service (ADU)...... A low speed asynchronous data interface for
rates up to 38.4 Kbps.

Backplane Design............................. The design of the circuit board that
interconnects a wide variety of service
types. The interconnection of the traces on
the backplane defines the performance and
flexibility of the system.

Bandwidth.................................... A relative range of frequencies that carry a
signal without distortion on a transmission
medium.

Bellcore..................................... Bell Communications Research. A standards
body funded by the telecommunications
industry that proposes new network
architectures and performs validation testing
and analysis.

Beta Testing................................. A step in the engineering cycle prior to full
manufacturing release.

Central Office............................... A term commonly used to describe the location
of the switching equipment that is used to
re-direct telephone calls.

Central Office Switch........................ Used synonomously with Central Office.

Central Processing Unit (CPU)................ The circuit pack that contains the main
operating software for the system. It is
responsible for co-ordination of all system
level functionality.

Channel Bank................................. A multiplexer that puts many slow speed voice
or data conversations onto one high speed
link and controls the flow of the
conversations.

Coaxial...................................... A type of electrical cable in which one
conductor is wrapped around another and
insulates the inner conductor.

Codec........................................ Electronic circuitry employed to digitize
analog signals and to convert the digital
signals back into analog form.

Digital...................................... The representation of information as discrete
value (i.e., 1s and 0s). These digital values
can be processed, manipulated, exchanged or
stored by electronic systems.

Digital Loop Carrier (DLC)................... A device used to concentrate susbscriber
telephone circuits onto one or more high
speed digital loops in a carrier's central
office by converting analog signals into
digital bit streams.
</TABLE>

14
<PAGE>
<TABLE>
<S> <C>
E1 Transceivers.............................. A transmitter and receiver (transceiver) for
sending digital data at 2.04 Mbps over
twisted pair cabling.

Frequency.................................... The number of identical cycles per second,
measured in hertz, of a periodic oscillation
or wave in radio propagation.

Hertz........................................ One cycle per second. The unit for measuring
frequency signals.

High Speed Digital Subscriber Line (HDSL).... A technology that enables high speed
transmission of data over copper wires.
Utilization of this technology requires
minimal changes to existing copper phone
lines.

Integrated Services Digital Network (ISDN)... An internationally accepted standard for
voice, data and signaling that makes all
transmission circuits end-to-end digital and
defines a standard out-of-band signaling
system.

ISO-9001..................................... ISO is the International Standards
Organisation responsible for drafting quality
procedures. 9001 is the quality procedure for
manufacturing.

Large Line-Size Market....................... Market with 600 to 2,000 lines within the
serviceable area of the NGDLC, generally in
urban areas.

Line Cards................................... A term commonly used to refer to service
interfaces that terminate on plug-in circuit
packs.

Local Exchange Terminal (LET)................ The term the Company uses to describe the
terminal that is housed in the Central
Office. Exchange is the international word
for switch.

Local Loop................................... A term used to describe the copper cables
that connect a customer's phone to the
Central Office.

MLT Remote Testing Capabilities.............. MLT or mechanized loop testing is a technique
the telephone companies use to test a
customer's telephone line. When a DLC is
used, special interfaces must be developed to
provide this test interface.

Next Generation Digital Loop Carrier The next generation of DLC's, designed and
(NGDLC)..................................... introduced in the market in the early 1990s
to support telecommunications services over
fiber-only networks in densely populated
urban markets with 600 to 2,000 lines within
the serviceable area of the NGDLC.

PCBA......................................... Printed Circuit Board Assembly.

Plain Old Telephone Service (POTS)........... Basic telephone service with no enhanced
features such as call waiting, conference
calling or call forwarding.

Printed Circuit Boards....................... A fiberglass laminated board with etched
copper traces.

RBOC......................................... Regional Bell Operating Company.
</TABLE>

15
<PAGE>
<TABLE>
<S> <C>
Remote Service Terminal (RST)................ A term the Company uses to describe its
outside enclosures located at or near the
customers that are being served from it.

Small Line-Size Market....................... Market with less than 600 lines within the
serviceable area of the DLC, generally in
rural and suburban areas.

Synchronous Data Channel Service (SDU)....... A low speed data interface for rates less
than 64 Kbps.

Synchronous Optical Network (SONET).......... A standard designed to establish a digital
hierarchical network that enables the
transmission of data over a consistent
transport scheme at speeds up to 2.4 Gbps.

SONET OC3 Transceivers....................... An optical bi-directional circuit pack
operating at the SONET OC3 rate (155.52 Mbps)
that meets the SONET requirements for
inter-operability.

T1 Transceivers.............................. A transmitter and receiver (transceiver) for
sending digital data at 1.544 Mbps over
twisted pair cabling.

Universal Voice Grade Service (UVG).......... A multipurpose circuit pack that fulfills a
variety of interface requirements for modems,
etc.
</TABLE>

16
<PAGE>
ITEM 2. PROPERTIES

The Company's administrative, sales and marketing, and product development
headquarters are located in Petaluma, California, where the Company leases
approximately 165,000 square feet under leases expiring beginning in March 2005.
The Company believes its facilities are adequate for its current needs and for
its needs in the foreseeable future.

ITEM 3. LEGAL PROCEEDINGS

ITRI

In 1995, a dispute arose among the Company, ITRI and certain of ITRI's
member companies (the "Member Companies") in which the Company claimed that ITRI
and the Member Companies were, among other things, failing to pay royalties when
due. In reliance upon certain provisions of the ITRI Agreements, in April 1996,
the Company ceased delivering to the Member Companies certain proprietary ASICs
used in the manufacture of the UMC system. Pursuant to agreements with ITRI
reached in 1994, design documentation for these ASICs are held in a trust
account, with directions that the designs can be made available to ITRI on the
occurrence of specified conditions. On July 9, 1996, the trustee-custodian of
the ASIC designs filed suit against the Company in the United States District
Court, Eastern District of New York, alleging that the Company had wrongfully
discontinued the sale of the ASICs to the Member Companies. Among other things,
the complaint seeks unspecified damages on behalf of the trustee, and a
determination that the trustee can release the ASIC designs to ITRI. On July 31,
1996, the Company filed a counterclaim against the trustee claiming, among other
things, that the trustee improperly disclosed the design documentation to third
parties.

On July 30, 1996, the Company filed suit against ITRI and others in the
United States District Court, Northern District of California, for breach of the
ITRI Agreements, breach of covenants of good faith, trade secret
misappropriation, tortious interference, and related claims. The complaint
alleges that ITRI breached the ITRI Agreements, among other things, by failing
to collect royalties owed to the Company, by developing UMC-based products not
shared with the Company, by transferring UMC technology to an unauthorized
company, and by misappropriating the Company's trade secrets and that the ITRI
Agreements have been terminated. The Company seeks damages, punitive damages,
and declaratory and injunctive relief. On September 13, 1996, ITRI filed a
demand for arbitration of the dispute and claimed, among other things, that the
Company has breached the ITRI Agreements and is liable for unspecified royalties
and punitive damages, and claiming proprietary rights in certain UMC technology.
On September 30, 1996, the Company amended the complaint in its suit against
ITRI to add the Member Companies and another company as parties to the suit.

On August 27, 1996, the Member Companies filed suit against the Company in
United States District Court, Northern District of California, alleging breach
of contract and unfair competition based on the Company's discontinuation of
ASIC sales to the Member Companies. The complaint filed by the Member Companies
alleges that the Company lacked justification to discontinue the sale of ASICs
and that its failure to sell ASICs to the Member Companies constituted unfair
competition. The complaint seeks court-ordered arbitration, unspecified damages,
punitive damages and an injunction requiring further sales of the ASICs to the
Member Companies. On September 6, 1996, the court granted a temporary
restraining order pursuant to which the Company will be required to supply the
Member Companies with a specified number of ASICs during the ensuing two month
period on the terms and conditions set forth in the ITRI Agreements. The court's
order was granted as an interim measure to preserve the status quo pending
adjudication on the merits. The Company believes that compliance with the
court's order will not have a material adverse effect on the Company's business,
financial condition and results of operations. On September 16, 1996, the
Company filed counterclaims seeking declaratory and injunctive relief and
damages against Member Companies for, among other things, breach of contract,
fraud and misappropriation of trade secrets. On September 23, 1996, the Member
Companies filed a demand for arbitration of the

17
<PAGE>
dispute and claimed, among other things, actual damages in excess of $60
million, legal fees and expenses and punitive damages.

The parties conducted discovery with respect to the royalty and ASIC supply
issues during September and October 1996. A hearing on ITRI's motion for a
preliminary injunction to require the Company to continue supplying ASICs and
ITRI's motion to compel arbitration was held on November 22, 1996. In an order
dated January 9, 1997, the court stayed the litigation and granted the ITRI
parties' motion to compel arbitration. The court has promised, but not yet
issued, an opinion explaining the nature and scope of its arbitration order, and
has issued no ruling on the motion for a preliminary injunction.

The Company believes that it has meritorious defenses to the claims asserted
by ITRI and the Member Companies and it intends to defend the litigation
vigorously. Moreover, the Company believes that the Member Companies' damages
claim is without merit. The Company further believes that its claims against
ITRI and the Member Companies are meritorious and the Company intends to
vigorously pursue such claims. However, due to the nature of the claims and
because the proceedings are in the discovery stage, the Company cannot determine
the total expense or possible loss, if any, that may ultimately be incurred
either in the context of a trial, arbitration or as a result of a negotiated
settlement. Regardless of the ultimate outcome of the proceedings, it could
result in significant diversion of time by the Company's management. After
consideration of the nature of the claims and the facts relating to the
proceedings, the Company believes that the resolution of this matter will not
have a material adverse effect on the Company's business, financial condition
and results of operations; however, the results of these proceedings, including
any potential settlement, are uncertain and there can be no assurance to that
effect.

DSC

From July 1993 until June 1996 the Company was involved in litigation with
DSC. DSC had alleged, among other things, that the UMC technology contained or
was derived from trade secrets and other proprietary technology of DSC. The
parties entered into a Settlement Agreement and Mutual Releases dated as of June
24, 1996 (the "Settlement Agreement"), pursuant to which the litigation was
terminated. Under the terms of the Settlement Agreement, the Company paid DSC an
aggregate of $10.1 million and issued 725,787 shares of Common Stock to DSC. In
addition, under the terms of the Settlement Agreement, AFC maintains all rights
to the UMC technology free and clear of any claim by DSC. In July 1996, the
Company borrowed approximately $7.1 million (representing the present value of
the $8.5 million obligation) under a six-month term loan and repaid its
remaining obligations under the Settlement Agreement. See "Item 6--Selected
Consolidated Financial Data," "Item 7--Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Item 8--Note 10 of Notes to
Consolidated Financial Statements." The Company provided indemnification to
certain stockholders in connection with the settlement of the DSC litigation.
See "Item 13--Certain Relationships and Related Transactions."

OTHER

On June 20, 1995, two investment limited partnerships, Equity-Linked
Investors, L.P. and Equity-Linked Investors, L.P. II (the "Plaintiffs"), filed a
complaint against the Company in the United States District Court for the
Southern District of New York. The Plaintiffs' complaint contains claims for
breach of contract, promissory estoppel, and specific performance related to an
alleged subordinated debt financing agreement. The Plaintiffs are affiliated
with Desai Capital Management Incorporated ("Desai"). From March to June 1995,
the Company was involved in negotiations with Desai regarding a proposed
subordinated debt financing of the Company. On June 13, 1995, the Company's
Board of Directors disapproved the proposed transaction. According to the
Plaintiff's complaint, the Company had a binding commitment to proceed with the
proposed financing. The complaint alleges that the Company committed to accept a
$10 million to $15 million loan from the Plaintiffs in exchange for interest
payments and warrants to purchase 350,000 shares of the Company's Series E
Preferred Stock at $12.50 per share (not

18
<PAGE>
taking into account a two-for-one stock split in September 1995 and the further
two-for-one stock split effected in August 1996). The complaint alleges damages
of "at least the difference between their exercisable $12.50 per share price on
350,000 shares and the per share price of stock sold in any initial public
offering."

On July 12, 1995, and September 8, 1995, the Company filed motions to
dismiss the case for lack of federal jurisdiction and failure to state a claim.
The Company's motions to dismiss the case remain pending and undecided. There
has been no discovery in the case, and no trial date is set.

The Company denies the allegations of the Plaintiffs' complaint,
specifically denies that there was any contract, and intends to contest the
claims vigorously.

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

No matters were submitted to a vote of security holders during the quarter
ended December 31, 1996, through the solicitation of proxies or otherwise.

PART II.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

PRICE RANGE OF COMMON STOCK

The Company's Common Stock has traded on the Nasdaq National Market under
the symbol "AFCI" since October 1, 1996. The Company's initial public offering
price was $25.00 per share. The following table sets forth, for the periods
indicated, the high and low closing sale prices for the Company's Common Stock
as reported by the Nasdaq National Market:

<TABLE>
<CAPTION>
HIGH LOW
----------- -----------

<S> <C> <C>
Year Ending December 31, 1997:

First Quarter (through January 23, 1997)................................... $ 55 5/8 $ 47

Year Ending December 31, 1996:

Fourth Quarter (beginning October 1, 1996)................................. 61 1/4 44 1/2
</TABLE>

On January 23, 1997, the last reported sale price of the Common Stock on the
Nasdaq National Market was $53 1/4 per share. As of December 31, 1996 there were
approximately 211 holders of record of the Company's Common Stock.

DIVIDEND POLICY

The Company has never declared or paid cash dividends on its capital stock.
The Company currently intends to retain all of its earnings, if any, for use in
its business and does not anticipate paying any cash dividends in the
foreseeable future. In addition, the Company's revolving line of credit
agreement requires the prior consent of the bank before payment of dividends by
the Company.

19
<PAGE>
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data should be read in
conjunction with the Company's consolidated financial statements and notes
thereto and the discussion under "Item 7--Management's Discussion and Analysis
of Financial Condition and Results of Operations." The consolidated statement of
operations data for the years ended December 31, 1994, 1995 and 1996 and
consolidated balance sheet data as of December 31, 1995 and 1996 are derived
from audited financial statements included in "Item 8--Financial Statements and
Supplementary Data." The consolidated statement of operations data for the year
ended December 31, 1993 and the consolidated balance sheet data as of December
31, 1993 and 1994 have been derived from audited financial statements not
included herein. The consolidated statement of operations data for the period
from May 29, 1992 to December 31, 1992 and balance sheet data as of December 31,
1992 have been derived from unaudited financial statements that are not
contained herein but which reflect, in management's opinion, all adjustments,
consisting of normal recurring adjustments, necessary for a fair presentation
thereof. These historical results are not necessarily indicative of the results
to be expected in the future.

<TABLE>
<CAPTION>
INCEPTION (MAY
29, 1992) TO
DECEMBER 31, YEAR ENDED DECEMBER 31,
----------------- ------------------------------------------
1992 1993 1994 1995 1996(1)
----------------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:

Revenues...................................................... $ 275 $ 620 $ 18,802 $ 54,287 $ 130,193

Cost of revenues.............................................. 38 2,574 14,124 33,469 73,950
----- --------- --------- --------- ---------

Gross profit (loss)......................................... 237 (1,954) 4,678 20,818 56,243
----- --------- --------- --------- ---------

Operating expenses:

Research and development.................................... 622 2,044 2,867 5,730 14,413

Selling, general and administrative......................... 266 2,509 5,051 9,660 21,188

DSC litigation costs........................................ -- 784 4,551 1,623 18,947
----- --------- --------- --------- ---------

Total operating expenses.................................. 888 5,337 12,469 17,013 54,548
----- --------- --------- --------- ---------

Operating income (loss)....................................... (651) (7,291) (7,791) 3,805 1,695

Gain on dissolution (equity in loss) of joint venture, net.... -- -- -- (1,516) 1,516

Other income (expense), net................................... (25) -- 26 149 872
----- --------- --------- --------- ---------

Income (loss) before income taxes............................. (676) (7,291) (7,765) 2,438 4,083

Income taxes (benefit)........................................ -- -- -- 97 (3,154)
----- --------- --------- --------- ---------

Net income (loss)............................................. $ (676) $ (7,291) $ (7,765) $ 2,341 $ 7,237
----- --------- --------- --------- ---------
----- --------- --------- --------- ---------

Pro forma net income per share (2)............................ $ 0.09 $ 0.21
--------- ---------
--------- ---------

Shares used in per share computations (2)..................... 27,329 34,282
</TABLE>

<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------------------------------------
1992 1993 1994 1995 1996
--------------- --------- --------- --------- ---------
(IN THOUSANDS)

<S> <C> <C> <C> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:

Cash and cash equivalents and marketable securities............. $ -- $ 450 $ 3,858 $ 11,118 $ 108,430

Working capital................................................. 77 466 6,809 18,770 145,338

Total assets.................................................... 458 3,787 14,884 36,680 175,679

Redeemable convertible preferred stock.......................... -- 9,152 23,546 37,777 --

Total stockholders' equity (deficit)............................ (661) (7,952) (15,706) (15,765) 158,023
</TABLE>

- ------------
(1) Includes a charge of $15.8 million to reflect a cash payment of $10.1
million and the issuance of 725,787 shares of Common Stock to DSC in
settlement of outstanding litigation. See "Item 3--Legal Proceedings."
Without this charge, operating income for the year ended December 31, 1996
would have been $17.5 million.

(2) See "Item 8--Note 1 of Notes to Consolidated Financial Statements" for an
explanation of the determination of the number of shares used in computing
pro forma net income per share.

20
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Except for the historical financial information contained herein, the
following discussion and analysis may contain "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Act of 1934, as amended. Such statements include
declarations regarding the intent, belief or current expectations of the Company
and its management. Prospective investors are cautioned that any such
forward-looking statements are not guarantees of future performance and involve
a number of risks and uncertainties; actual results could differ materially from
those indicated by such forward-looking statements. Among the important factors
that could cause actual results to differ materially from those indicated by
such forward-looking statements, as set forth below in "Certain Factors That
Might Affect Future Operating Results," are: (i) the limited history of
operations and profitability of the Company, (ii) potential fluctuations in
future operating results and seasonality, (iii) dependence on the
telecommunications industry and small line-size market, (iv) risks associated
with a concentrated product line, new products and rapid technological change,
(v) dependence on sole-source and other key suppliers, (vi) dependence on a
limited number of third party manufacturers and support organizations, (vii)
risks associated with competition, (viii) risks associated with pending
litigation, (ix) risks associated with limited protection of proprietary
technology and risk of third-party claims of infringement, (x) risk of failure
to manage expanding operations, (xi) customer concentration, (xii) risks
associated with international markets, including currency and economic risks,
(xiii) dependence on key personnel, (xiv) compliance with regulations and
industry standards and (xv) other risks identified from time to time in the
Company's reports and registration statements filed with the Securities and
Exchange Commission.

The following discussion should be read in conjunction with "Item
8--Financial Statements and Supplementary Data."

OVERVIEW

AFC designs develops, manufactures, markets and supports the UMC system, a
cost-effective multi-feature digital loop carrier system developed to serve
small line-size markets. The Company's UMC system is designed to enable
telephone companies, cable companies and other service providers to connect
subscribers to the central office switch for voice and data communications over
copper, fiber, coaxial cable and analog radio networks. The Company was
incorporated in May 1992 and was in the initial startup and development phase
through December 1993. The Company began shipping the UMC in January 1994 and,
accordingly, has a limited operating history.

The Company has incurred substantial expenditures related to the
development, manufacturing startup and marketing of the UMC system. As a result
of these expenditures, combined with $25.9 million of expenses and settlement
amounts recorded in connection with certain litigation with DSC which was
settled in June 1996, the Company had an accumulated deficit of $6.2 million as
of December 31, 1996. Although the Company achieved profitability for the years
ended December 31, 1995 and 1996, there can be no assurance that the Company
will sustain or increase its profitability in the future.

The Company currently derives substantially all of its revenues from the UMC
system and expects that this concentration will continue in the foreseeable
future. As a result, any decrease in the overall level of sales of, or the
prices for, the UMC system due to product enhancements, introductions or
announcements by the Company's competitors, a decline in the demand for the UMC
system, product obsolescence or any other reason would have a material adverse
effect on the Company's business, financial condition and results of operations.
The Company derives a minor amount of revenue from royalties generated from the
Company's various strategic relationships. Support revenues have been negligible
since most systems shipped to date remain under the Company's initial two-year
product warranty period.

21
<PAGE>
The Company sells its products worldwide, primarily through its direct sales
force in the domestic market, and through its direct sales force, distributors
and agents in international markets. In April 1994, the Company and a third
party entered into a joint venture, pursuant to which a Hong Kong-based
subsidiary was formed, 49% of which was owned by the Company and the remaining
51% of which was owned by the third party. In April 1996, the Company acquired
the third party's interest in the subsidiary. As a result of this acquisition,
the Company began consolidating the results of the Hong Kong-based subsidiary
and of a China-based joint venture, 60% of which was owned by the subsidiary and
40% of which was owned by the joint venture partner. The change in accounting
from the equity method to consolidation did not have a material impact on the
Company's financial condition and results of operations in 1996. In August 1996,
the Company and the China-based joint venture partner agreed to liquidate the
joint venture. A charge for liquidation costs of $383,000 was recorded in the
second half of 1996. The liquidation is expected to be completed during the
first quarter of 1997 and is not expected to have a material impact on the
Company's financial condition and results of operations. See "Item 8-- Note 2 of
Notes to Consolidated Financial Statements."

The Company's customers normally install a portion of the UMC system in
outdoor locations. Shipments of the UMC system are subject to the effects of
seasonality, with fewer installation projects scheduled for the winter months.
Accordingly, the Company believes that over time this seasonality will cause its
revenues in the quarter ended March 31 to be lower than revenues in the
preceding quarter ended December 31. In particular, the Company currently
believes that revenues in the quarter ended March 31, 1997 may be lower than
revenues in the quarter ended December 31, 1996. See "--Quarterly Results of
Operations."

RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, the percentage of
revenues represented by certain items reflected in the Company's consolidated
statements of operations:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------------
1994 1995 1996(1)
--------- --------- -----------
<S> <C> <C> <C>
Revenues........................................................................... 100.0% 100.0% 100.0%
Cost of revenues................................................................... 75.1 61.7 56.8
--------- --------- -----
Gross profit..................................................................... 24.9 38.3 43.2
--------- --------- -----
Operating expenses:
Research and development......................................................... 15.2 10.6 11.1
Selling, general and administrative.............................................. 26.9 17.8 16.3
DSC litigation costs............................................................. 24.2 3.0 14.5
--------- --------- -----
Total operating expenses....................................................... 66.3 31.3 41.9
--------- --------- -----
Operating income (loss)............................................................ (41.4) 7.0 1.3
Gain on dissolution (equity in loss) of joint venture, net......................... -- (2.8) 1.2
Other income, net.................................................................. 0.1 0.3 0.6
--------- --------- -----
Income (loss) before income taxes.................................................. (41.3) 4.5 3.1
Income taxes (benefit)............................................................. -- 0.2 (2.4)
--------- --------- -----
Net income (loss).................................................................. (41.3)% 4.3% 5.5%
--------- --------- -----
--------- --------- -----
</TABLE>

- ------------

(1) Includes a charge of $15.8 million to reflect a cash payment of $10.1
million and the issuance of 725,787 shares of Common Stock to DSC in
settlement of outstanding litigation. See "Item 8--Note 10 of the Notes to
the Consolidated Financial Statements." Without this charge, operating
income as a percentage of revenues for the year ended December 31, 1996
would have been 13.4%.

22
<PAGE>
1996 COMPARED WITH 1995

REVENUES. Revenues increased 139.8% from $54.3 million in 1995 to $130.2
million for 1996. International revenues increased 276.7% from $7.2 million in
1995 to $27.1 million in 1996 and represented 13.2% and 20.8% of total revenues
in 1995 and 1996, respectively. No single customer accounted for 10% or more of
revenues in 1996. ALLTEL Supply, Inc. an affiliate of ALLTEL, an independent
domestic telephone company, accounted for 15.7% of total revenues in 1995. No
other single customer accounted for 10% or more of revenues in 1995. Although
the Company's largest customers have varied from period to period, the Company
anticipates that its results of operations in any given period will continue to
depend to a significant extent upon sales to a small number of customers. There
can be no assurance that the Company's principal customers will continue to
purchase product from the Company at current levels, if at all. The loss of one
or more major customers could have a material adverse effect on the Company's
business, financial condition and results of operations.

International and domestic revenues increased as a result of expansion of
the Company's customer base and the introduction of new features in the UMC
system. The increase in international revenues was partially due to higher sales
levels in China resulting from the acquisition in April 1996 of the shares of
the Company's Hong Kong-based subsidiary not previously owned by the Company
(which resulted in the consolidation for financial reporting purposes of the
Company's China-based operations) as well as increased levels of sales activity
in China. The increase in international revenues was also attributable to sales
to France Telecom, Hong Kong Telecom and Promon Electronics (Brazil).

GROSS PROFIT. Gross profit is comprised of revenues less materials,
manufacturing and warranty costs. Gross profit increased 170.2% from $20.8
million in 1995 to $56.2 million in 1996. As a percent of revenues, gross
profits were 38.3% in 1995 and 43.2% in 1996. The improvement in gross margins
was attributable to greater efficiencies in purchasing and manufacturing
activities resulting from higher unit volumes. Also, the Company realized lower
product costs as a result of engineering design improvements. Gross margins were
negatively impacted in 1996 by the increased level of sales in China which
generally have a lower gross margin due to the higher cost of distribution and
price sensitivity as compared with other markets. In the future, gross margins
may fluctuate due to a wide variety of factors, including: the mix between
domestic and international sales; the customer mix; the timing and size of
orders which are received and can be shipped in a quarter; the availability of
adequate supplies of key components and assemblies and the adequacy of
manufacturing capacity; the Company's ability to introduce new products and
technologies on a timely basis; the timing of new product introductions or
announcements by the Company or its competitors; price competition; and unit
volume.

RESEARCH AND DEVELOPMENT. Expenses relating to research and development
activities increased 151.5% from $5.7 million in 1995 to $14.4 million in 1996.
As a percentage of revenues, research and development expenses increased from
10.6% for 1995 to 11.1% in 1996. The increase resulted primarily from the hiring
of additional personnel and the increased use of outside services for certain
development efforts during 1996. The number of employees in research and
development increased from 63 at December 31, 1995 to 124 at December 31, 1996.
The increase in research and development expenses was also attributable to
higher costs for material and test equipment used to develop and test new
products and features. The Company expects that research and development
expenditures generally will continue to increase in absolute dollars to support
the continued development of new features and product cost reduction efforts.
All research and development costs have been expensed as incurred.

SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses increased 119.3% from $9.7 million in 1995 to $21.2 million in 1996. As
a percentage of revenues, selling, general and administrative expenses decreased
from 17.8% in 1995 to 16.3% in 1996. Costs in the sales and marketing area
increased significantly from period to period reflecting the hiring of new
employees, and commissions earned by the Company's sales force and outside
international sales representatives as a result of higher revenue levels. The
Company also increased its advertising and trade show participation in 1996.
General

23
<PAGE>
and administrative expenses increased as a result of the expansion of the
administrative staff in 1996, the legal costs incurred for the ITRI litigation
and the additional costs associated with being a public company.

DSC LITIGATION COSTS. Litigation expenses incurred in connection with the
DSC litigation increased from $1.6 million for 1995 to $18.9 million for 1996.
The increase is primarily attributable to the $15.8 million charge recorded in
the second quarter of 1996 in connection with the final settlement of the DSC
litigation. See "Item 8--Note 10 of Notes to the Consolidated Financial
Statements."

GAIN ON DISSOLUTION (EQUITY IN LOSS) OF JOINT VENTURE, NET. In 1996 and
1995, the Company made advances to a joint venture in which the Company had a
50% ownership interest. In April 1995, the Company made a loan of $1.0 million
to the joint venture. During 1995 and the first quarter of 1996, the Company
recorded its proportionate share of the joint venture's losses to the extent of
the loan and advances. As a result, the loan and intercompany receivables were
reduced to zero on the Company's balance sheet as of December 31, 1995. On
December 23, 1996 the Company and the joint venture partner entered into an
agreement to terminate the joint venture. In connection with the dissolution,
the joint venture partner reimbursed the Company $1,683,000 for all loans and
advances made by the Company to date. The reimbursement was recorded as a gain
in the fourth quarter of 1996 and is reflected in gain on dissolution (equity in
loss) of joint venture, net.

OTHER INCOME, NET. Net other income increased from $149,000 in 1995 to
$872,000 in 1996 and consisted primarily of interest income from the Company's
cash and investments in marketable securities, net of interest expense on the
Company's bank line of credit and short-term bank loan.

INCOME TAXES (BENEFIT). An income tax benefit of $3.2 million was recorded
for 1996 to reflect the benefit of the DSC litigation settlement and the
decrease in the valuation allowance recorded against the Company's deferred tax
assets. As of December 31, 1996, the Company has recorded no valuation allowance
against its deferred tax assets because management believes such assets are
realizable. For the second half of 1996, the Company recorded income taxes at an
effective rate that approximates the combined federal and state statutory rates.

1995 COMPARED WITH 1994

REVENUES. Revenues were $18.8 million and $54.3 million in 1994 and 1995,
respectively. The Company began shipping the UMC 1000 in January 1994. The
revenue level achieved in 1994 reflected initial market acceptance of the
Company's product by independent telephone companies in the United States, as
well as sales to a distributor in Mexico. The 189% increase in revenues in 1995
compared with 1994 resulted from growth in system sales of the UMC to an
expanded customer base. During 1994, shipments to PTI, an independent domestic
telephone company, accounted for approximately 27.0% of revenues. In 1995, the
Company's largest customer, ALLTEL Supply, Inc., accounted for 15.7% of
revenues. No other single customer accounted for 10% or more of revenues in 1994
or 1995. International revenues increased $3.6 million, or 99% from $3.6 million
in 1994 to $7.2 million in 1995, and represented 19.2% and 13.2% of revenues in
1994 and 1995, respectively.

GROSS PROFIT (LOSS). Gross profit increased from $4.7 million in 1994 to
$20.8 million in 1995, respectively, and gross margins increased from 24.9% in
1994 to 38.3% in 1995. Gross margins improved in 1995 due to lower product costs
resulting from engineering design improvements and greater efficiencies achieved
in purchasing and manufacturing activities associated with higher unit volumes.

RESEARCH AND DEVELOPMENT. Research and development expenses were $2.9
million and $5.7 million in 1994 and 1995, respectively. As a percentage of
revenues, research and development expenses were 15.2% and 10.6% in 1994 and
1995, respectively. The Company increased its engineering staff to support
continued product development and cost reductions during these periods from 38
to 63 employees at December 31, 1994 and 1995, respectively. The decrease in
research and development expenses as

24
<PAGE>
a percentage of revenues from 1994 to 1995 was the result of the Company's rapid
growth in revenues. All research and development costs have been expensed as
incurred.

SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses were $5.1 million and $9.7 million in 1994 and 1995, respectively. As a
percentage of revenues, selling, general and administrative expenses were 26.9%
and 17.8% in 1994 and 1995, respectively, with the decrease being the result of
the increased revenue base. The increases in absolute dollars reflects the build
up of the Company's domestic and international direct sales team, investments in
customer support and marketing, costs associated with trade shows and other
marketing efforts, expansion of the Company's administrative staff and
installation of information, manufacturing and financial control systems.

DSC LITIGATION COSTS. DSC litigation costs were $4.6 million and $1.6
million in 1994 and 1995, respectively. DSC litigation costs in 1994 included
reserves for a possible settlement of $2.0 million. See "Item 8--Note 10 of
Notes to Consolidated Financial Statements."

GAIN ON DISSOLUTION (EQUITY IN LOSS) OF JOINT VENTURE, NET. During 1995,
the Company made a loan of $1.0 million and other operating expense advances
totaling approximately $516,000 to a joint venture in which the Company had a
50% ownership interest. In 1995, the Company recorded its proportionate share of
the joint venture's losses to the extent of the loan and advances. As a result,
the loan and intercompany receivables were reduced to zero on the Company's
balance sheet as of December 31, 1995.

OTHER INCOME, NET. Net other income was $26,000 and $149,000 in 1994 and
1995, respectively, and consisted of interest income from the Company's cash
investments, net of interest expense on stockholder loans in 1994 and advances
under the Company's bank line of credit in 1995.

INCOME TAXES. Because of operating losses sustained in 1994, the Company
did not provide for income taxes in that year, other than minimum California
state franchise tax. In fiscal 1995, the provision for income taxes was $97,000
and consisted of the federal alternative minimum tax and the California minimum
state franchise tax. See "Item 8--Note 7 of Notes to Consolidated Financial
Statements."

25
<PAGE>
QUARTERLY RESULTS OF OPERATIONS

The following tables present unaudited quarterly financial information for
the four quarters of 1995 and 1996. In the opinion of the Company's management,
this unaudited information has been prepared on the same basis as the audited
financial statements contained herein and includes all adjustments (consisting
only of normal recurring adjustments) necessary to present fairly the
information set forth therein. The operating results for any quarter are not
necessarily indicative of results for any future period.
<TABLE>
<CAPTION>
QUARTER ENDED
----------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30,
1995 1995 1995 1995 1996 1996 (1)
----------- ----------- ----------- ----------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<S> <C> <C> <C> <C> <C> <C>
Revenues.................................... $ 7,456 $ 11,789 $ 15,548 $ 19,494 $ 24,121 $ 29,651

Cost of revenues............................ 4,633 7,288 9,837 11,711 14,101 16,957
----------- ----------- ----------- ----------- ----------- -----------

Gross profit................................ 2,823 4,501 5,711 7,783 10,020 12,694
----------- ----------- ----------- ----------- ----------- -----------

Operating expenses:

Research and development.................. 1,050 1,214 1,406 2,060 2,619 3,275

Selling, general and administrative....... 1,681 2,281 2,471 3,227 3,545 4,356

DSC litigation costs...................... 358 392 324 549 691 18,256
----------- ----------- ----------- ----------- ----------- -----------

Total operating expenses.............. 3,089 3,887 4,201 5,836 6,855 25,887
----------- ----------- ----------- ----------- ----------- -----------

Operating income (loss)..................... (266) 614 1,510 1,947 3,165 (13,193)

Other income (expense):

Gain on dissolution (equity in loss) of
joint venture, net...................... (202) (340) (526) (448) (167) --

Other income (expense), net............... 26 15 (4) 112 84 (18)
----------- ----------- ----------- ----------- ----------- -----------

Income (loss) before income taxes........... (442) 289 980 1,611 3,082 (13,211)

Income taxes (benefit)...................... -- 2 39 56 910 (9,498)
----------- ----------- ----------- ----------- ----------- -----------

Net income (loss)........................... $ (442) $ 287 $ 941 $ 1,555 $ 2,172 $ (3,713)
----------- ----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- ----------- -----------

AS A PERCENTAGE OF REVENUES
----------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>

Revenues.................................... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Costs of revenues........................... 62.1 61.8 63.3 60.1 58.5 57.2
----------- ----------- ----------- ----------- ----------- -----------

Gross profit................................ 37.9 38.2 36.7 39.9 41.5 42.8
----------- ----------- ----------- ----------- ----------- -----------

Operating expenses:

Research and development.................. 14.1 10.3 9.0 10.6 10.9 11.0

Selling, general and administrative....... 22.5 19.3 15.9 16.6 14.7 14.7

DSC litigation costs...................... 4.8 3.3 2.1 2.8 2.9 61.6
----------- ----------- ----------- ----------- ----------- -----------

Total operating expenses.............. 41.4 33.0 27.0 29.9 28.4 87.3
----------- ----------- ----------- ----------- ----------- -----------

Operating income (loss)..................... (3.6) 5.2 9.7 10.0 13.1 (44.5)

Other income (expense):

Gain on dissolution (equity in loss) of
joint venture, net...................... (2.7) (2.9) (3.4) (2.3) (0.7) --

Other income (expense), net............... 0.3 0.1 -- 0.6 0.3 (0.1)
----------- ----------- ----------- ----------- ----------- -----------

Income (loss) before income taxes........... (5.9) 2.5 6.3 8.3 12.8 (44.6)

Income taxes (benefits)..................... -- -- 0.3 0.3 3.8 (32.1)
----------- ----------- ----------- ----------- ----------- -----------

Net income (loss)........................... (5.9)% 2.5% 6.0% 8.0% 9.0% (12.5)%
----------- ----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- ----------- -----------

SEPT. 30, DEC. 31,
1996 1996
----------- -----------

<S> <C> <C>
Revenues.................................... $ 35,012 $ 41,409
Cost of revenues............................ 19,737 23,155
----------- -----------
Gross profit................................ 15,275 18,254
----------- -----------
Operating expenses:
Research and development.................. 4,141 4,378
Selling, general and administrative....... 5,608 7,679
DSC litigation costs...................... -- --
----------- -----------
Total operating expenses.............. 9,749 12,057
----------- -----------
Operating income (loss)..................... 5,526 6,197
Other income (expense):
Gain on dissolution (equity in loss) of
joint venture, net...................... -- 1,683
Other income (expense), net............... (338) 1,144
----------- -----------
Income (loss) before income taxes........... 5,188 9,024
Income taxes (benefit)...................... 1,984 3,450
----------- -----------
Net income (loss)........................... $ 3,204 $ 5,574
----------- -----------
----------- -----------

<S> <C> <C>
Revenues.................................... 100.0% 100.0%
Costs of revenues........................... 56.4 55.9
----------- -----------
Gross profit................................ 43.6 44.1
----------- -----------
Operating expenses:
Research and development.................. 11.8 10.6
Selling, general and administrative....... 16.0 18.5
DSC litigation costs...................... -- --
----------- -----------
Total operating expenses.............. 27.8 29.1
----------- -----------
Operating income (loss)..................... 15.8 15.0
Other income (expense):
Gain on dissolution (equity in loss) of
joint venture, net...................... -- 4.1
Other income (expense), net............... (1.0) 2.7
----------- -----------
Income (loss) before income taxes........... 14.8 21.8
Income taxes (benefits)..................... 5.6 8.3
----------- -----------
Net income (loss)........................... 9.2% 13.5%
----------- -----------
----------- -----------
</TABLE>

- ------------

(1) Includes a charge of $15.8 million in the quarter ended June 30, 1996 to
reflect a cash payment of $3.0 million paid in June 1996, additional cash
payments of $7.1 million paid in July and the issuance of 725,787 shares of
Common Stock to DSC in settlement of outstanding litigation. See "Item 3 --
Legal Proceedings." Without this charge, operating income for the quarter
ended June 30, 1996 would have been $2.6 million, and as a percentage of
revenues would have been 8.8%.

26
<PAGE>
The Company's operating results have been, and will continue to be, affected
by a wide variety of factors, some of which are outside of the Company's
control, that could have a material adverse effect on revenues and results of
operations during any particular period. These factors include: the mix between
domestic and international sales; the customer mix; the timing and size of
orders which are received and can be shipped in a quarter; the availability of
adequate supplies of key components and assemblies and the adequacy of
manufacturing capacity; the Company's ability to introduce new products and
technologies on a timely basis; the timing of new product introductions or
announcements by the Company or its competitors; price competition; and unit
volume.

The UMC system is sold primarily to telephone companies that install the UMC
system as part of their access networks. Additions to those networks represent
complex engineering projects which can require from three to twelve months from
project conceptualization to completion. The UMC system typically represents
only a portion of a given project and, therefore, the timing of product shipment
and revenue recognition is often difficult to forecast. In developing countries,
delays and reductions in the planned project development can be caused by
additional factors, including reductions in capital availability due to declines
in the local economy, currency fluctuations, priority changes in the
government's budget and delays in receiving government approval for deployment
of the UMC system in the local loop. The Company's expenditures for research and
development, marketing and sales and the general and administrative functions
are based in part on future revenue projections and in the near term are
relatively fixed. The Company may be unable to adjust spending in a timely
manner in response to any unanticipated declines in revenues. Accordingly, any
significant decline in demand for the UMC system relative to planned levels
could have a material adverse effect on the business, financial condition and
results of operations in that quarter or subsequent quarters. All of the above
factors are difficult to forecast, and these or other factors could materially
adversely affect the Company's business, financial condition and results of
operations. As a result, the Company believes that period-to-period comparisons
are not necessarily meaningful and should not be relied upon as indications of
future performance. Fluctuations in the Company's operating results may cause
volatility in the price of the Company's Common Stock. Further, it is likely
that in some future quarter the Company's revenue or operating results will be
below the expectations of public market analysts or investors. In such event,
the market price of the Company's Common Stock would likely be materially
adversely affected.

LIQUIDITY AND CAPITAL RESOURCES

The components of the Company's capital resources and liquidity at December
31, 1995 and 1996 were as follows:

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
--------- ---------

<S> <C> <C>
Cash and cash equivalents............................................... $ 11,118 $ 24,942

Marketable securities................................................... -- 83,488

Non-debt working capital, excluding cash and cash equivalents and
marketable securities.................................................. 7,652 36,908
</TABLE>

On January 24, 1997, the Company filed a Registration Statement on Form S-1
(no. 333-20369) with the Securities and Exchange Commission for the sale of
2,600,000 shares of the Company's Common Stock, of which 2,400,000 shares are
being sold by certain Selling Stockholders and 200,000 shares are being sold by
the Company.

On October 1, 1996, the Company issued 5,175,000 shares of its common stock
pursuant to an underwritten initial public offering which generated
approximately $118.1 million of net proceeds. These

27
<PAGE>
proceeds were used to reduce debt of approximately $14.8 million and to provide
resources for general working capital purposes. The balance was invested in cash
equivalents and marketable securities.

Prior to the Company's initial public offering, the Company had funded its
operations primarily through a series of preferred stock financings. From its
incorporation through September 1995, the Company completed five private
financings of equity securities providing aggregate net proceeds of
approximately $38.1 million. In September 1995, the Company repurchased and
retired approximately $4.2 million of its outstanding preferred stock. Upon the
consummation of the initial public offering, all shares of redeemable
convertible preferred stock were converted into a total of 18,717,463 shares of
Common Stock.

In April 1995, the Company made a loan of $1.0 million to a joint venture
owned 50% by the Company which bears interest at a rate of 5.5%. Beginning in
fiscal 1995, the Company recorded its proportionate share of the joint venture's
losses to the extent of the loan balance and advances made to the joint venture.
As a result, the loan and advances to the joint venture were written off as of
December 31, 1995. On December 23, 1996, the Company and the joint venture
partner entered into an agreement to terminate the partnership. In connection
with the dissolution, the joint venture partner reimbursed the Company
$1,683,000 for all loans and advances made by the Company to date. The
reimbursement was recorded as a gain in the fourth quarter of 1996 and is
reflected in gain on dissolution (equity in loss) of joint venture, net in the
accompanying financial statements.

In April 1996, the Company purchased all of the stock outstanding in a
49%-owned subsidiary that had not previously been owned by the Company in
exchange for 220,000 shares of the Company's Series F Preferred Stock and
approximately $939,000 in cash.

In June 1996, as part of the DSC litigation settlement, the Company paid
$3.0 million in cash to DSC. In July 1996, the Company borrowed approximately
$7.1 million under a six-month term loan with Bank of the West. The proceeds
from the loan were used to pay the remaining obligations under the DSC
litigation settlement. The loan had an interest rate of 5.75% and a $4.0 million
compensating balance requirement. The loan was due in January 1997. In October
1996, the Company repaid the loan with the proceeds of the initial public
offering. See "Item 3--Legal Proceedings" and "Item 8--Note 10 of Notes to
Consolidated Financial Statements."

The $6.2 million of cash used by operating activities during 1996 was
primarily the result of increases in receivables and inventory. Receivables were
higher by $21.4 million in 1996 because of increased revenues. The $5.7 million
growth in inventory is in support of the higher revenue levels.

Investing activities used $91.1 million of cash during 1996, primarily due
to the investment of the proceeds of the Company's initial public offering and
due to $8.4 million of capital expenditures offset by the $1.5 million net
reimbursement from a joint venture. The Company continues to invest in capital
equipment to support employee growth and research and development activities.

Financing activities provided $111.2 million of cash in 1996. The Company's
initial public offering generated $118.1 million of net proceeds. A portion of
the proceeds were used to repay $7.7 million in outstanding balances under a
line of credit agreement and $7.1 million outstanding under a six-month term
loan arrangement with a bank. The Company borrowed under the term loan
arrangement to fund a portion of the DSC litigation settlement.

The Company has a $12.0 million line of credit with a bank bearing interest
at prime plus 0.5%. The line of credit expired on November 15, 1996, but
automatically renews for successive thirty day periods until terminated by
written agreement. The amount available to the Company for borrowing under the
line is based upon the balance of eligible accounts receivable at the time of
borrowing. As part of the bank line, the bank may issue letters of credit up to
$10.0 million and foreign exchange contracts up to $5.0 million. The bank line
requires the Company to comply with certain financial covenants. As of December
31, 1995 and 1996, no borrowings were outstanding under the bank line. At
December 31, 1996, $1.6 million was

28
<PAGE>
reserved under the line for letters of credit and foreign exchange contracts.
The Company also has lease lines totaling $5.2 million that were used to
purchase equipment and furniture. There were no amounts left available under the
lease lines as of December 31, 1996.

The Company believes that its existing cash and short-term investments and
available credit facilities will be adequate to support the Company's financial
resource needs, including working capital requirements, capital expenditures,
operating lease obligations and debt payments for the next twelve months.

CERTAIN FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS

IN ADDITION TO OTHER INFORMATION IN THIS ANNUAL REPORT ON FORM 10-K, THE
FOLLOWING ARE IMPORTANT FACTORS THAT SHOULD BE CONSIDERED IN EVALUATING THE
COMPANY AND ITS BUSINESS.

LIMITED HISTORY OF OPERATIONS AND PROFITABILITY. The Company was
incorporated in May 1992 and was in the initial startup and development phase
through December 1993. The Company began shipping the UMC in January 1994 and,
accordingly, has a limited operating history. The Company has incurred
substantial expenditures related to the development, manufacturing startup and
marketing of the UMC system. As a result of these expenditures, combined with
$25.9 million of expenses and settlement amounts recorded in connection with
certain litigation with DSC Communications Corporation ("DSC") which was settled
in June 1996, the Company had an accumulated deficit of $6.2 million as of
December 31, 1996. Although the Company achieved profitability for the years
ended December 31, 1995 and 1996, there can be no assurance that the Company
will sustain or increase its profitability in the future. See "Item 7--
Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Item 3-- Legal Proceedings."

POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS; SEASONALITY. The
Company's operating results have been, and will continue to be, affected by a
wide variety of factors, some of which are outside of the Company's control,
that could have a material adverse effect on revenues and results of operations
during any particular period. These factors include: the mix between domestic
and international sales; the customer mix; the timing and size of orders which
are received and can be shipped in a quarter; the availability of adequate
supplies of key components and assemblies and the adequacy of manufacturing
capacity; the Company's ability to introduce new products and technologies on a
timely basis; the timing of new product introductions or announcements by the
Company or its competitors; price competition; and unit volume.

The UMC system is sold primarily to telephone companies that install the UMC
system as part of their access networks. Additions to those networks represent
complex engineering projects which can require from three to twelve months from
project conceptualization to completion. The UMC system typically represents
only a portion of a given project and, therefore, the timing of product shipment
and revenue recognition is often difficult to forecast. In developing countries,
delays and reductions in the planned project deployment can be caused by
additional factors, including reductions in capital availability due to declines
in the local economy, currency fluctuations, priority changes in the
government's budget and delays in receiving government approval for deployment
of the UMC system in the local loop. The Company's expenditures for research and
development, marketing and sales, and general and administrative functions are
based in part on future revenue projections and in the near term are relatively
fixed. The Company may be unable to adjust spending in a timely manner in
response to any unanticipated declines in revenues. Accordingly, any significant
decline in demand for the UMC system relative to planned levels could have a
material adverse effect on the Company's business, financial condition and
results of operations in that quarter or subsequent quarters. All of the above
factors are difficult to forecast, and these or other factors could materially
adversely affect the Company's business, financial condition and results of
operations. As a result, the Company believes that period-to-period comparisons
are not necessarily meaningful and should not be relied upon as indications of
future performance. Fluctuations in the Company's operating results may cause
volatility in the price of the Company's Common Stock.

29
<PAGE>
Further, it is likely that in some future quarter the Company's revenues or
operating results will be below the expectations of public market analysts or
investors. In such event, the market price of the Company's Common Stock would
likely be materially adversely affected.

DEPENDENCE ON TELECOMMUNICATIONS INDUSTRY AND SMALL LINE-SIZE MARKET. The
Company's customers are concentrated in the public carrier telecommunications
industry. Accordingly, the Company's future success depends upon the capital
spending patterns of such customers and the continued demand by such customers
for the UMC system. The target markets for the UMC system are the small
line-size markets of the United States and developing countries. Historically,
these markets have had little access to the advanced services that can be made
available through the UMC system and, accordingly, there can be no assurance
that potential customers will consider the near term value of these advanced
services to be sufficient to influence their purchase decisions. Furthermore,
there can be no assurance that the UMC system will find widespread acceptance
among the telephone companies and other potential customers in small line-size
markets or that such customers and potential customers will not adopt
alternative architectures or technologies that are incompatible with the UMC
technology, which would have a material adverse effect on the Company's
business, financial condition and results of operations. In addition, there can
be no assurance that telephone companies, foreign governments or other customers
will pursue infrastructure upgrades that will necessitate the implementation of
advanced products such as the UMC system. Infrastructure improvements requiring
the Company's or similar technology may be delayed or prevented by a variety of
factors, including cost, regulatory obstacles, the lack of consumer demand for
advanced telecommunications services and alternative approaches to service
delivery. See "Item 7-- Management's Discussion and Analysis of Financial
Condition and Results of Operations," "Item 1-- Business--Markets and Customers"
and "--Competition."

CONCENTRATED PRODUCT LINE, NEW PRODUCTS AND RAPID TECHNOLOGICAL CHANGE. The
Company currently derives substantially all of its revenues from the UMC system
and expects that this concentration will continue in the foreseeable future. As
a result, any decrease in the overall level of sales of, or the prices for, the
UMC system due to product enhancements, introductions or announcements by the
Company's competitors, a decline in the demand for the UMC system, product
obsolescence or any other reason could have a material adverse effect on the
Company's business, financial condition and results of operations. See "Item
7--Management's Discussion and Analysis of Financial Condition and Results of
Operations."

The telecommunications equipment market is characterized by rapidly changing
technology, evolving industry standards, changes in end-user requirements, and
frequent new product introductions and enhancements. The introduction of
products embodying new technologies or the emergence of new industry standards
can render existing products obsolete or unmarketable. The Company's success
will depend upon its ability to enhance the UMC technology and to develop and
introduce, on a timely basis, new products and feature enhancements that keep
pace with technological developments and emerging industry standards and address
changing customer requirements in a cost-effective manner. There can be no
assurance that the Company will be successful in identifying, developing,
manufacturing, and marketing product enhancements or new products that respond
to technological change or evolving industry standards, that the Company will
not experience difficulties that could delay or prevent the successful
development, introduction and marketing of these products, or that its new
products and product enhancements will adequately meet the requirements of the
marketplace and achieve market acceptance.

30
<PAGE>
Furthermore, from time to time, the Company may announce new products or product
enhancements, services or technologies that have the potential to replace or
shorten the life cycle of the UMC system and that may cause customers to defer
purchasing the UMC system. There can be no assurance that future technological
advances in the telecommunications industry will not diminish market acceptance
of the UMC system or render the UMC system obsolete and, thereby, materially
adversely affect the Company's business, financial condition and results of
operations.

The Company has experienced delays in completing development and
introduction of new products, product variations and feature enhancements, and
there can be no assurance that such delays will not continue or recur in the
future. Furthermore, the UMC system contains a significant amount of complex
software that may contain undetected or unresolved errors as products are
introduced or as new versions are released. The Company has in the past
discovered software errors in certain UMC system installations. There can be no
assurance that, despite significant testing by the Company, software errors will
not be found in new enhancements of the UMC system after commencement of
shipments, resulting in delays in or loss of market acceptance, either of which
could have a material adverse effect on the Company's business, financial
condition and results of operations. See "Item 1--Business--Competition" and "--
Research and Product Development."

DEPENDENCE ON SOLE-SOURCE AND OTHER KEY SUPPLIERS. Certain components used
in the Company's products, including the Company's proprietary application
specific integrated circuits ("ASICs"), codecs, certain surface mount technology
components and other components, are only available from a single source or
limited number of suppliers. Some of the Company's sole-source suppliers are
companies which from time to time allocate parts to telephone equipment
manufacturers due to market demand for telecommunications equipment. Many of the
Company's competitors are much larger and may be able to obtain priority
allocations from these shared suppliers, thereby limiting or making unreliable
the sources of supply for these components. The Company encountered supply
delays for codecs in the second quarter of 1994 which resulted in delayed
shipments of the UMC system, and there can be no assurance that similar
shortages will not occur in the future or will not result in the Company having
to pay a higher price for components. If the Company is unable to obtain
sufficient quantities of these or any other components, delays or reductions in
manufacturing or product shipments could occur which would have a material
adverse effect on the Company's business, financial condition and results of
operations. See "Item 1-- Business--Manufacturing."

DEPENDENCE ON LIMITED NUMBER OF THIRD PARTY MANUFACTURERS AND SUPPORT
ORGANIZATIONS. The Company relies on a limited number of independent
contractors that manufacture the subassemblies to the Company's specifications
for use in the Company's products. In particular, the Company relies on: (i)
Flextronics International Ltd. and Tanon Manufacturing, Inc. (a division of
Electronic Associates, Inc.) to manufacture the Company's printed circuit board
assemblies; (ii) Paragon, Inc. to manufacture backplanes and channel bank
assemblies and (iii) Sonoma Metal Products, Inc. and Cowden Metal San Jose, Inc.
to manufacture the outside cabinets. In the event that the Company's
subcontractors were to experience financial, operational, production, or quality
assurance difficulties that resulted in a reduction or interruption in supply to
the Company or otherwise failed to meet the Company's manufacturing
requirements, the Company's business, financial condition and results of
operations would be adversely affected until the Company established sufficient
manufacturing supply from alternative sources. There can be no assurance that
the Company's current or alternative manufacturers will be able to meet the
Company's future requirements or that such manufacturing services will continue
to be available to the Company at favorable prices, or at all. See "Item
1--Business--Manufacturing."

The Company also relies on Point-to-Point Communications, Inc.
("Point-to-Point"), a third-party support organization, to provide first-line
technical assistance and post-sales support to AFC customers. There can be no
assurance that Point-to-Point will be able to provide the level of customer
support demanded by the Company's existing or potential customers. See "Item
1--Business--Sales, Marketing and Customer Support."

31
<PAGE>
COMPETITION. The market for equipment for local telecommunications networks
is extremely competitive. The Company's competitors range from small companies,
both domestic and international, to large multinational corporations. The
Company's competitors include Alcatel Alsthom Compagnie Generale d'Electricite,
DSC, ECI Telecom, Inc., E/O Networks, Fujitsu America, Inc., Hitron Technology,
Inc., Lucent Technologies, Inc., NEC America, Inc., Northern Telecom Ltd., Opnet
Technologies Co. Ltd., RELTEC Corporation, Seiscor Technologies Inc., Siemens
Corporation, Teledata Communications Ltd. and Vidar-SMS Co. Ltd. Many of these
competitors have more extensive financial, marketing and technical resources
than the Company and enjoy superior name recognition in the market. In addition,
the Company has entered into agreements with the Industrial Technology Research
Institute ("ITRI") to jointly develop products based on the UMC system. ITRI is
a Taiwanese government-sponsored research and development organization in the
telecommunications field. Such agreements grant ITRI and certain of its member
companies certain rights to manufacture and sell the European Telecommunications
Standards Institute ("ETSI") version of the UMC system outside of North America.
Such entities currently compete with the Company in international markets,
primarily in China. In addition, upon termination of the agreements with ITRI in
2002, ITRI will have a worldwide, non-exclusive, royalty-free, irrevocable
license to use the ETSI version of the UMC technology and, consequently, such
member companies will be able to compete with the Company worldwide at such
time. There is an ongoing dispute subject to litigation between the Company and
ITRI and such member companies as to, among other things, whether ITRI possesses
the right to grant such rights to manufacture and sell the ETSI version of the
UMC system to new member companies and whether AFC has terminated or may
terminate such agreements and the rights, if any, of the member companies
thereunder. Depending on the outcome of this dispute, the Company may face
competition from new member companies for the ETSI version of the UMC system.
Such companies may possess substantially greater financial, marketing and
technical resources than the Company. The Company may also face competition from
new market entrants. There can be no assurance that the Company will be able to
compete successfully in the future. See "Item 1--Business--Competition,"
"--Proprietary Rights and Licenses" and "Item 3--Legal Proceedings."

RISKS ASSOCIATED WITH PENDING LITIGATION. The Company is a party to certain
legal proceedings including the litigation between the Company and ITRI and
certain of its member companies arising primarily out of a dispute regarding the
payment of royalties and the supply of ASICS under the agreements between the
Company and ITRI. The Company is unable to determine the total expense or
possible loss, if any, that may ultimately be incurred in the resolution of
these proceedings. Regardless of the ultimate outcome of these proceedings, they
could result in significant diversion of time by the Company's management. After
consideration of the nature of the claims and the facts relating to these
proceedings, the Company believes that the resolution of these proceedings will
not have a material adverse effect on the Company's business, financial
condition and results of operations; however, the results of these proceedings,
including any potential settlements, are uncertain and there can be no assurance
to that effect. See "Item 1--Business--Competition" and "Item 3--Legal
Proceedings."

LIMITED PROTECTION OF PROPRIETARY TECHNOLOGY; RISK OF THIRD-PARTY CLAIMS OF
INFRINGEMENT. The Company attempts to protect its technology through a
combination of copyrights, trade secret laws and contractual obligations. The
Company does not presently hold any patents for its existing products and has no
patent applications pending. There can be no assurance that the Company's
intellectual property protection measures will be sufficient to prevent
misappropriation of the Company's technology or that the Company's competitors
will not independently develop technologies that are substantially equivalent or
superior to the Company's technology. In addition, the laws of many foreign
countries do not protect the Company's intellectual property rights to the same
extent as the laws of the United States. The failure of the Company to protect
its proprietary information could have a material adverse effect on the
Company's business, financial condition and results of operations.

The increasing dependence of the telecommunications industry on proprietary
technology has resulted in frequent litigation based on allegations of the
infringement of patents and other intellectual

32
<PAGE>
property. In June 1996, the Company settled litigation with DSC under which DSC
had claimed proprietary rights to the UMC technology. See "Item 3--Legal
Proceedings." In the future the Company may be subject to additional litigation
to defend against claimed infringements of the rights of others or to determine
the scope and validity of the proprietary rights of others. Future litigation
also may be necessary to enforce and protect trade secrets and other
intellectual property rights owned by the Company. Any such litigation could be
costly and cause diversion of management's attention, either of which could have
a material adverse effect on the Company's business, financial condition and
results of operations. Adverse determinations in such litigation could result in
the loss of the Company's proprietary rights, subject the Company to significant
liabilities, require the Company to seek licenses from third parties, or prevent
the Company from manufacturing or selling its products, any one of which could
have a material adverse effect on the Company's business, financial condition
and results of operations. Furthermore, there can be no assurance that any
necessary licenses will be available on reasonable terms. See "Item
1--Business-- Proprietary Rights and Licenses."

RISK OF FAILURE TO MANAGE EXPANDING OPERATIONS. The Company has recently
experienced a period of rapid growth, which has placed and could continue to
place, a significant strain on the Company's management, operational, financial
and other resources. The members of the Company's management team have limited
experience in the management of rapidly growing companies. To effectively manage
the recent growth as well as any future growth, the Company will need to
recruit, train, assimilate, motivate and retain qualified managers and
employees. Management of future growth, if such growth occurs, may require the
Company to implement expanded or new management and accounting systems. In
connection with the Company's recent growth, management has begun evaluation of
new management and accounting systems and intends to begin implementing such
systems in 1997. There can be no assurance that the Company will complete such
evaluation or implementation on a timely basis. Information systems expansion or
replacement can be a complex, costly and time-consuming process, and there can
be no assurance that any such activities can be accomplished without disruption
of the Company's business. Any business disruption or other system transition
difficulties could have a material adverse effect on the Company's business,
financial condition and results of operations. The failure of the Company to
effectively manage its domestic and international operations or any current or
future growth could have a material adverse effect on the Company's business,
financial condition and results of operations. The Company's results of
operations will be adversely affected if revenues do not increase sufficiently
to compensate for the increase in operating expenses resulting from any
expansion. See "Item 1--Business-- Employees" and "Item 10--Executive Officers,
Key Employees and Directors."

CUSTOMER CONCENTRATION. Approximately 15.7% and 8.1% of the Company's
revenues in 1995 and 1996, respectively, were derived from sales to ALLTEL
Supply, Inc., an affiliate of ALLTEL, an indepen-
dent domestic telephone company. In 1995 and 1996, the Company's five largest
customers accounted for approximately 37% and 28% of revenues, respectively.
Although the Company's largest customers have varied from period to period, the
Company anticipates that its results of operations in any given period will
continue to depend to a significant extent upon sales to a small number of
customers. None of the Company's customers has entered into an agreement
requiring it to purchase a minimum amount of product from the Company. There can
be no assurance that the Company's principal customers will continue to purchase
product from the Company at current levels, if at all. The loss of one or more
major customers could have a material adverse effect on the Company's business,
financial condition and results of operations. See "Item 7--Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Item 1--Business--Markets and Customers."

RISKS ASSOCIATED WITH INTERNATIONAL MARKETS. International sales
constituted 13.2% and 20.8% of the Company's total revenues in 1995 and 1996,
respectively. International sales have fluctuated in absolute dollars and as a
percentage of revenues, and are expected to continue to fluctuate in future
periods. The Company relies on a number of third-party distributors and agents
to market and sell the UMC system outside of North America. There can be no
assurance that such distributors or agents will provide the

33
<PAGE>
support and effort necessary to service international markets effectively. The
Company intends to expand its existing international operations and enter new
international markets, which will demand significant management attention and
financial commitment. The Company's management has limited experience in
international operations, and there can be no assurance that the Company will
successfully expand its international operations. In addition, a successful
expansion by the Company of its international operations and sales in certain
markets may depend on the Company's ability to establish and maintain productive
strategic relationships. To date, the Company has formed three joint ventures to
pursue international markets, two of which have been or are in the process of
being terminated or liquidated due to differences with the joint venture
partners. There can be no assurance that the Company will be able to identify
suitable parties for joint ventures or strategic relationships or, even if such
parties are identified, that successful joint ventures or strategic
relationships will result. Moreover, there can be no assurance that the Company
will be able to increase international sales of the UMC system through strategic
relationships or joint ventures. The failure to do so could significantly limit
the Company's ability to expand its international operations and could have a
material adverse effect on the Company's business, financial condition and
results of operations.

International telephone companies are in many cases owned or strictly
regulated by local regulatory authorities. Access to such markets is often
difficult due to the established relationships between a government owned or
controlled telephone company and its traditional indigenous suppliers of
telecommunications equipment. In addition, the Company's bids for business in
certain international markets typically will require the Company to post bid and
performance bonds and to incur contract penalties should the Company fail to
meet production and delivery time schedules on large orders. The failure of the
Company to meet these schedules could result in the loss of collateral posted
for the bonds or financial penalties which could adversely affect the Company's
business, financial condition and results of operations.

The Company's international sales currently are primarily U.S.
dollar-denominated. As a result, an increase in the value of the U.S. dollar
relative to foreign currencies could make the Company's products less
competitive in international markets. For example, increases in the value of the
U.S. dollar relative to the Mexican peso in late 1994 resulted in a significant
decrease in sales of the UMC system to Telefonos de Mexico for 1995.
Furthermore, operating in international markets subjects the Company to certain
additional risks, including unexpected changes in regulatory requirements,
political and economic conditions, tariffs or other barriers, difficulties in
staffing and managing international operations, exchange rate fluctuations,
potential exchange and repatriation controls on foreign earnings, potentially
negative tax consequences, longer sales and payment cycles and difficulty in
accounts receivable collection. In addition, any inability to obtain local
regulatory approval could delay or prevent entrance into international markets,
which could materially impact the Company's business, financial condition and
results of operations. In order to compete in international markets, the Company
will need to comply with various regulations and standards. See "Item
3--Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Item 1--Business--Markets and Customers" and "--Sales, Marketing
and Customer Support."

DEPENDENCE ON KEY PERSONNEL. The Company's success depends to a significant
extent upon a number of key technical and management employees. In particular,
the Company's success depends in large part on the knowledge, expertise and
services of its co-founders: Donald Green, Chairman of the Board and Chief
Executive Officer; James T. Hoeck, Vice President, Advanced Development; and
John W. Webley, Vice President, Advanced Development. The loss of the services
of any of these persons or other key employees of the Company could have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company does not have employment agreements with, or
key person life insurance for, any of its employees. Competition for highly
qualified employees is intense and the process of locating key technical and
management personnel with the combination of skills and attributes required to
execute the Company's strategy is often lengthy. There can be no assurance that
the

34
<PAGE>
Company will be successful in retaining its existing key personnel or in
attracting and retaining the additional employees it may require. See "Item
10--Executive Officers, Key Employees and Directors."

COMPLIANCE WITH REGULATIONS AND INDUSTRY STANDARDS. The UMC system is
required to comply with a large number of voice and data regulations and
standards, which vary between domestic and international markets, and may vary
by the specific international market into which the Company sells its products.
The standards in the United States are determined by the Federal Communications
Commission ("FCC"), by Underwriters Laboratories, by independent telephone
companies and by Bell Communications Research ("Bellcore"). In international
markets, the Company's products must comply with recommendations issued by the
Consultative Committee on International Telegraph and Telephony and with
requirements established by the individual regional carriers which specify how
equipment that is connected to their local networks must operate. In addition,
the Company's products must comply with standards issued by the European
Telecommunications Standards Institute. These standards are implemented and
enforced by the Telecommunications Regulatory Authority of each European nation.
Standards for new services continue to evolve, and the Company will be required
to modify its products or develop and support new versions of its products to
meet these standards. The failure of the Company's products to comply, or delays
in meeting compliance, with the evolving standards both in its domestic and
international markets could have a material adverse affect on the Company's
business, financial condition and results of operations.

In addition, the Company will need to ensure that its products are easily
integrated with the carriers' network management systems. The Regional Bell
Operating Companies ("RBOCs"), which represent a large segment of the U.S.
telecommunications market, in many cases require that equipment integrated into
their networks be tested by Bellcore, indicating that the products are
interoperable with the operations, administration, maintenance and provisioning
systems used by the RBOCs to manage their networks. Bellcore testing requires
significant investments in resources to achieve compliance. The UMC system
completed a Bellcore technical audit and was found to meet applicable
requirements. The failure to maintain such compliance or to obtain it on new
features released in the future could have a material adverse affect on the
Company's business, financial condition and results of operations.

The Company has not received ISO certification, which certifies that design
and manufacturing processes adhere to certain established standards. Many
telecommunications service providers, particularly in international markets,
will not purchase products from suppliers that have not received ISO
certification. Accordingly, until it is able to obtain ISO certification, the
Company may be precluded from selling its products to these service providers
and its ability to compete with other suppliers of communications equipment may
be adversely affected. The Company has initiated the formal process of applying
for ISO-9001 certification and expects to complete the audit process during
1997. ISO-9001 addresses quality assurance in design, development, production,
installation and service. There can be no assurance as to when or if the Company
will receive such certification. The failure to obtain such certification may
preclude the Company from selling the UMC system in certain markets.

35
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
---------

<S> <C>
Independent Auditors' Report............................................................................... 37

Consolidated Balance Sheets as of December 31, 1995 and 1996............................................... 38

Consolidated Statements of Operations for the years ended December 31, 1994, 1995 and 1996................. 39

Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders' Equity (Deficit) for
the years ended December 31, 1994, 1995 and 1996......................................................... 40

Consolidated Statements of Cash Flows for the years ended December 31, 1994, 1995 and 1996................. 41

Notes to Consolidated Financial Statements................................................................. 42
</TABLE>

36
<PAGE>
INDEPENDENT AUDITORS' REPORT

The Board of Directors
Advanced Fibre Communications, Inc.:

We have audited the accompanying consolidated balance sheets of Advanced
Fibre Communications, Inc. and subsidiaries (the "Company") as of December 31,
1995 and 1996, and the related consolidated statements of operations, redeemable
convertible preferred stock and stockholders' equity (deficit) and cash flows
for each of the years in the three-year period ended December 31, 1996. 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 in accordance with generally accepted auditing
standards. 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 includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of the Company
as of December 31, 1995 and 1996, and the results of its operations and its cash
flows for each of the years in the three-year period ended December 31, 1996, in
conformity with generally accepted accounting principles.

KPMG PEAT MARWICK LLP

San Francisco, California
January 20, 1997

37
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE DATA)
ASSETS

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1995 1996
---------- ----------
<S> <C> <C>
Current assets:
Cash and cash equivalents, including restricted cash of
$1,730 and $150 in 1995 and 1996, respectively........................................ $ 11,118 $ 24,942
Marketable securities................................................................... -- 83,488
Accounts receivable..................................................................... 10,993 32,779
Inventories............................................................................. 10,149 17,349
Deferred income taxes................................................................... -- 2,889
Prepaid expenses........................................................................ 132 742
---------- ----------
Total current assets.................................................................. 32,392 162,189
Property and equipment, net............................................................... 1,828 9,589
Other assets.............................................................................. 2,460 3,901
---------- ----------
Total assets........................................................................ $ 36,680 $ 175,679
---------- ----------
---------- ----------

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable........................................................................ $ 7,121 $ 8,799
Accrued liabilities..................................................................... 6,501 8,052
---------- ----------
Total current liabilities............................................................. 13,622 16,851
Long-term liabilities..................................................................... 1,046 805
Redeemable convertible preferred stock, $0.01 par value; 35,345,816 shares authorized in
1995; 17,011,204 shares issued and outstanding in 1995.................................. 37,777 --
Stockholders' equity (deficit):
Preferred stock, $0.01 par value; 5,000,000 shares authorized in 1996; no shares issued
and outstanding in 1996............................................................... -- --
Common stock, $0.01 par value; 84,654,184 and 100,000,000 shares authorized in 1995 and
1996, respectively; 5,015,168 and 32,649,607 shares issued and outstanding in 1995 and
1996, respectively.................................................................... 50 326
Additional paid-in capital.............................................................. (2,248) 164,002
Notes receivable from stockholders...................................................... (176) (151)
Accumulated deficit..................................................................... (13,391) (6,154)
---------- ----------
Total stockholders' equity (deficit).................................................. (15,765) 158,023
---------- ----------
Total liabilities, redeemable convertible preferred stock, and stockholders' equity
(deficit)......................................................................... $ 36,680 $ 175,679
---------- ----------
---------- ----------
</TABLE>

See accompanying notes to consolidated financial statements.

38
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1994 1995 1996
--------- --------- ----------
<S> <C> <C> <C>
Revenues........................................................................ $ 18,802 $ 54,287 $ 130,193
Cost of revenues................................................................ 14,124 33,469 73,950
--------- --------- ----------
Gross profit................................................................ 4,678 20,818 56,243
--------- --------- ----------
Operating expenses:
Research and development...................................................... 2,867 5,730 14,413
Selling, general, and administrative.......................................... 5,051 9,660 21,188
DSC litigation costs.......................................................... 4,551 1,623 18,947
--------- --------- ----------
Total operating expenses.................................................... 12,469 17,013 54,548
--------- --------- ----------
Operating income (loss)..................................................... (7,791) 3,805 1,695
Other income (expense):
Gain on dissolution (equity in loss) of joint venture, net.................... -- (1,516) 1,516
Other income, net............................................................. 26 149 872
--------- --------- ----------
Income (loss) before income taxes........................................... (7,765) 2,438 4,083
Income taxes (benefit).......................................................... -- 97 (3,154)
--------- --------- ----------
Net income (loss)........................................................... $ (7,765) $ 2,341 $ 7,237
--------- --------- ----------
--------- --------- ----------
Pro forma net income per share.................................................. $ 0.09 $ 0.21
--------- ----------
--------- ----------
Shares used in per share computations........................................... 27,329 34,282
</TABLE>

See accompanying notes to consolidated financial statements.

39
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE
CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (DEFICIT)

YEARS ENDED DECEMBER 31, 1994, 1995, AND 1996
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
REDEEMABLE
CONVERTIBLE PREFERRED
STOCK COMMON STOCK ADDITIONAL
--------------------- ---------------------- PAID-IN NOTES RECEIVABLE ACCUMULATED
SHARES AMOUNT SHARES AMOUNT CAPITAL FROM STOCKHOLDERS DEFICIT
---------- --------- --------- ----------- ----------- ----------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balances as of December 31,
1993.......................... 10,152,908 $ 9,145 3,006,472 $ 30 $ (15) $ -- $ (7,967)
Issuance of preferred stock..... 3,000,000 7,436 -- -- -- -- --
Conversion of notes payable to
preferred stock............... 200,000 500 -- -- -- -- --
Issuance of preferred stock..... 2,080,000 6,465 -- -- -- -- --
Exercise of common stock
options and warrants.......... -- -- 86,252 1 10 -- --
Net loss........................ -- -- -- -- -- -- (7,765)
---------- --------- --------- ----- ----------- ----- ------------
Balances as of December 31,
1994.......................... 15,432,908 23,546 3,092,724 31 (5) -- (15,732)
Issuance of preferred stock..... 2,193,540 14,539 -- -- -- -- --
Repurchase of preferred stock... (615,244) (308) -- -- (3,848) -- --
Sale of common stock for notes
receivable.................... -- -- 563,600 6 170 (176) --
Exercise of common stock options
and warrants.................. -- -- 1,358,844 13 1,435 -- --
Net income...................... -- -- -- -- -- -- 2,341
---------- --------- --------- ----- ----------- ----- ------------
Balances as of December 31,
1995.......................... 17,011,204 37,777 5,015,168 50 (2,248) (176) (13,391)
Issuance of preferred stock..... 220,000 1,540 -- -- -- -- --
Issuance of common stock in
settlement of litigation...... -- -- 725,787 7 8,986 -- --
Exercise of common stock options
and warrants.................. -- -- 3,016,189 30 112 -- --
Initial public offering of
common stock.................. 5,175,000 52 118,022
Conversion of preferred stock to
common stock.................. (17,231,204) (39,317) 18,717,463 187 39,130 -- --
Payment of notes receivable from
stockholder................... -- -- -- -- -- 25 --
Net income...................... -- -- -- -- -- -- 7,237
---------- --------- --------- ----- ----------- ----- ------------
Balances as of December 31,
1996.......................... -- $ -- 32,649,607 $ 326 $ 164,002 $ (151) $ (6,154)
---------- --------- --------- ----- ----------- ----- ------------
---------- --------- --------- ----- ----------- ----- ------------

TOTAL
STOCKHOLDERS'
EQUITY
(DEFICIT)
-------------
<S> <C>
Balances as of December 31,
1993.......................... $ (7,952)
Issuance of preferred stock..... --
Conversion of notes payable to
preferred stock............... --
Issuance of preferred stock..... --
Exercise of common stock
options and warrants.......... 11
Net loss........................ (7,765)
-------------
Balances as of December 31,
1994.......................... (15,706)
Issuance of preferred stock..... --
Repurchase of preferred stock... (3,848)
Sale of common stock for notes
receivable.................... --
Exercise of common stock options
and warrants.................. 1,448
Net income...................... 2,341
-------------
Balances as of December 31,
1995.......................... (15,765)
Issuance of preferred stock..... --
Issuance of common stock in
settlement of litigation...... 8,993
Exercise of common stock options
and warrants.................. 142
Initial public offering of
common stock.................. 118,074
Conversion of preferred stock to
common stock.................. 39,317
Payment of notes receivable from
stockholder................... 25
Net income...................... 7,237
-------------
Balances as of December 31,
1996.......................... $ 158,023
-------------
-------------
</TABLE>

See accompanying notes to consolidated financial statements.

40
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1994 1995 1996
--------- --------- ---------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)................................................................. $ (7,765) $ 2,341 $ 7,237
Adjustments to reconcile net income (loss) to net cash used in operating
activities:
Noncash portion of litigation settlement........................................ -- -- 12,807
Deferred income taxes........................................................... -- -- (3,679)
Depreciation and amortization................................................... 199 547 956
Equity in loss (gain on dissolution) of joint venture, net...................... -- 1,516 (1,149)
Changes in operating assets and liabilities:
Accounts receivable........................................................... (4,815) (5,802) (21,403)
Inventories................................................................... (2,513) (5,529) (5,714)
Prepaid expenses and other assets............................................. (109) (169) (588)
Accounts payable.............................................................. 1,266 4,516 1,602
Accrued liabilities........................................................... 3,215 1,626 3,442
Long-term liabilities......................................................... (30) (17) 258
--------- --------- ---------
NET CASH USED IN OPERATING ACTIVITIES....................................... (10,552) (971) (6,231)
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net purchases of marketable securities............................................ -- -- (83,488)
Acquisition of technology license................................................. -- (1,000) --
Purchase of property and equipment................................................ (452) (1,084) (8,367)
Reimbursement of loans (advances) to joint venture................................ -- (1,516) 1,516
Business acquisition, net of cash acquired........................................ -- -- (783)
--------- --------- ---------
NET CASH USED IN INVESTING ACTIVITIES....................................... (452) (3,600) (91,122)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from bank borrowings..................................................... -- 1,550 16,806
Repayment of bank borrowings...................................................... -- (1,550) (16,806)
Prepayment of long-term portion of litigation settlement.......................... -- -- (7,064)
Proceeds from stockholder loans................................................... 1,000 -- --
Repayment of stockholder loans.................................................... (500) -- --
Proceeds from initial public offering of common stock............................. -- -- 118,074
Proceeds from issuance of redeemable convertible preferred stock.................. 13,901 14,539 --
Repurchase of redeemable convertible preferred stock.............................. -- (4,156) --
Proceeds from exercise of common stock options and warrants....................... 11 1,448 167
--------- --------- ---------
NET CASH PROVIDED BY FINANCING ACTIVITIES................................... 14,412 11,831 111,177
--------- --------- ---------
INCREASE IN CASH AND CASH EQUIVALENTS............................................... 3,408 7,260 13,824

CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR........................................ 450 3,858 11,118
--------- --------- ---------
CASH AND CASH EQUIVALENTS, END OF YEAR.............................................. $ 3,858 $ 11,118 $ 24,942
--------- --------- ---------
--------- --------- ---------
NONCASH FINANCING AND INVESTING ACTIVITIES:
Conversion of notes payable to redeemable convertible preferred stock............. $ 500 $ -- $ --
Issuance of common stock for notes receivable..................................... -- 176 --
Deferred portion of technology license fee........................................ -- 1,500 --
Issuance of preferred stock for business acquisition.............................. -- -- 1,540
CASH PAID:
Interest.......................................................................... 21 37 398
Income taxes...................................................................... -- -- 265
</TABLE>

See accompanying notes to consolidated financial statements.

41
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Advanced Fibre Communications, Inc. (the "Company") operates in one business
segment and designs, develops, manufactures, markets, and supports the Universal
Modular Carrier 1000-TM- (the UMC system), a cost-effective, multi-feature
digital loop carrier system developed to serve small line-size markets. The
Company's UMC system is designed to enable telephone companies, cable companies,
and other service providers to connect subscribers to the central office switch
for voice and data communications over copper wire, fiber optic cable, coaxial
cable and analog radio networks.

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the Company
and its subsidiaries. All significant intercompany balances and transactions
have been eliminated. The Company's investments in 50% or less owned joint
ventures are accounted for under the equity method.

CASH AND CASH EQUIVALENTS

The Company considers all highly liquid investments with original maturities
of three months or less to be cash equivalents. Cash and cash equivalents are
generally invested in money market funds, are classified as available-for-sales
securities and their cost approximates their market value. Included in cash and
cash equivalents is $833,000 and $150,000 as of December 31, 1995 and 1996,
respectively, held in escrow as collateral for bonds on certain contracts. Also
included in cash and cash equivalents as of December 31, 1995 is $897,000 held
in escrow related to sales to a particular customer pending resolution of the
litigation described in Note 10.

MARKETABLE SECURITIES

All marketable securities are classified as available-for-sale and are
stated at estimated fair value. Unrealized gains and losses were immaterial as
of December 31, 1996, and realized gains and losses were immaterial for the year
ended December 31, 1996.

INVENTORIES

Inventories are valued at the lower of first-in, first-out cost or market.

PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost. Depreciation is computed using
the straight-line method over the estimated useful lives, generally five to
seven years, of the related assets.

REVENUE RECOGNITION

Revenue is generally recognized when products are shipped. Product returns
and uncollectible accounts have been insignificant to date.

WARRANTY

The Company provides for estimated warranty costs at the time of sale.

42
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INCOME TAXES

The Company accounts for income taxes using the asset and liability method.
Deferred tax assets and liabilities are recognized based on the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. The measurement of deferred tax assets is reduced, if necessary, by a
valuation allowance for any tax benefits that are not expected to be realized.

EQUITY-BASED COMPENSATION PLANS

The Company accounts for equity-based compensation plans using the intrinsic
value method.

PRO FORMA NET INCOME PER SHARE

Pro forma net income per share is computed using the weighted average number
of shares of common stock and redeemable convertible preferred stock, on an
as-if converted basis, outstanding and common equivalent shares from options and
warrants to purchase common stock using the treasury stock method, when
dilutive. In accordance with certain Securities and Exchange Commission Staff
Accounting Bulletins, such computations included all common and common
equivalent shares issued within the 12 months preceding the initial public
offering ("IPO") date as if they were outstanding for all prior periods
presented using the treasury stock method and the estimated IPO price.

CONCENTRATION OF CREDIT RISK

Financial instruments potentially exposing the Company to concentrations of
credit risk consist primarily of cash and cash equivalents and trade accounts
receivable. The Company manufactures and sells its products principally to
telephone companies. To reduce credit risk, the Company performs ongoing credit
evaluations of its customers' financial condition. The Company does not
generally require collateral. For international shipments, the Company generally
requires prepayment or letters of credit.

USE OF ESTIMATES

The Company has made a number of estimates and assumptions that affect the
reported amount 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 these estimates.

IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF

The Company adopted the provisions of Statement of Financial Accounting
Standards No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND
LONG-LIVED ASSETS TO BE DISPOSED OF, effective January 1, 1996. This statement
requires long-lived assets to be evaluated for impairment whenever events or
changes in circumstances indicate that the carrying amount of the asset may not
be recoverable. Adoption of this statement did not have a material effect on the
Company's consolidated financial position or results of operations.

43
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 2 -- JOINT VENTURES

ADVANCED ACCESS LABS

During fiscal 1994, the Company entered into a joint venture partnership,
Advanced Access Labs, with a stockholder. The joint venture designed and
developed a product to allow telephone services to be provided over existing
cable TV coaxial systems as well as other transmission media. The Company
contributed the right to use its technology in exchange for a 50% ownership in
the joint venture partnership. During 1995, the Company loaned $1,000,000 to the
joint venture. In addition, during 1995 and 1996, the Company made other net
advances to the joint venture totaling $516,000 and $167,000, respectively. The
Company has recorded its proportionate share of the joint venture's losses to
the extent of the Company's loans and advances therein. As a consequence, the
Company's loans and advances to the joint venture had been reduced to zero.

On December 23, 1996, the Company and the joint venture partner entered into
an agreement to terminate the partnership. In connection with the dissolution,
the joint venture partner reimbursed the Company $1,683,000 for all loans and
advances made by the Company to date. The reimbursement was recorded as a gain
and is reflected in gain on dissolution (equity in loss) of joint venture, net
in the accompanying consolidated financial statements. In addition, the Company
and the joint venture partner entered into a License and Marketing Agreement and
an OEM Agreement.

AFTEK HONG KONG

On April 11, 1996, the Company acquired all of the outstanding shares of
AFTEK Hong Kong, of which the Company had previously been a 49% stockholder.
AFTEK Hong Kong is a holding company that owns 60% of a joint venture, AFTEK
Hangzhou, that is licensed to manufacture and sell the Company's
telecommunications equipment in China. Total consideration consisted of the
following (in thousands):

<TABLE>
<S> <C>
Issuance of Series F preferred stock......................... $ 1,540
Cash paid to retire note payable............................. 939
Acquisition costs incurred................................... 79
---------
$ 2,558
---------
---------
</TABLE>

The acquisition has been accounted for using the purchase method of
accounting, and, accordingly, the purchase price has been allocated to the
assets purchased and the liabilities assumed based upon their fair values at the
date of acquisition. The excess of the purchase price over the fair values of
the net assets acquired was $932,000 and has been recorded as goodwill, which is
being amortized on a straight-line basis over 5 years.

Historical results of AFTEK Hong Kong and pro forma results of operations
giving effect to the acquisition have not been presented because such
information is immaterial in relation to the Company's results of operations.

On August 10, 1996, AFTEK Hong Kong and its joint venture partner agreed to
liquidate AFTEK Hangzhou. The partners appointed a liquidation committee to
facilitate the liquidation procedures and to ensure that the liquidation is
completed in accordance with the relevant stipulations contained in the joint
venture agreement. The Company has recorded a provision of approximately
$383,000 reflecting the reduction in the net realizable value of AFTEK Hong
Kong's interest in the joint venture's net assets to be distributed upon
liquidation.

44
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 2 -- JOINT VENTURES (CONTINUED)
The Company had sales to AFTEK Hong Kong of $2,020,000 in 1995.

NOTE 3 -- MARKETABLE SECURITIES

Marketable securities were comprised of the following as of December 31,
1996 (in thousands):

<TABLE>
<CAPTION>
FAIR
VALUE
---------
<S> <C>
Municipal debt securities....................................................... $ 61,488
Corporate debt securities....................................................... 22,000
---------
Total marketable securities..................................................... $ 83,488
---------
---------
</TABLE>

The fair value of securities maturing in one year or less and those maturing
between one year and five years was $54,128,000 and $29,360,000, respectively.

NOTE 4 -- INVENTORIES

The major components of inventories are as follows (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
--------- ---------
<S> <C> <C>
Raw materials..................................................... $ 5,155 $ 7,631
Work-in-progress.................................................. 899 155
Finished goods.................................................... 4,095 9,563
--------- ---------
$ 10,149 $ 17,349
--------- ---------
--------- ---------
</TABLE>

NOTE 5 -- PROPERTY AND EQUIPMENT

A summary of property and equipment follows (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
--------- ---------
<S> <C> <C>
Furniture and fixtures............................................... $ 375 $ 1,266
Computer and office equipment........................................ 1,204 4,306
Engineering equipment................................................ 865 5,508
--------- ---------
2,444 11,080
Less: accumulated depreciation....................................... 616 1,491
--------- ---------
Net property and equipment......................................... $ 1,828 $ 9,589
--------- ---------
--------- ---------
</TABLE>

45
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 6 -- ACCRUED LIABILITIES

A summary of accrued liabilities follows (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
--------- ---------
<S> <C> <C>
DSC litigation costs................................................. $ 2,674 $ --
Warranty............................................................. 852 2,550
Other................................................................ 2,975 5,502
--------- ---------
$ 6,501 $ 8,052
--------- ---------
--------- ---------
</TABLE>

NOTE 7 -- INCOME TAXES

A summary of the components of income taxes (benefit) follows (in
thousands):

<TABLE>
<CAPTION>
CURRENT DEFERRED TOTAL
----------- --------- ---------
<S> <C> <C> <C>
Year ended December 31, 1995:
Federal...................................................... $ 82 $ -- $ 82
State........................................................ 15 -- 15
----- --------- ---------
$ 97 $ -- $ 97
----- --------- ---------
----- --------- ---------

Year ended December 31, 1996:
Federal...................................................... $ 523 $ (2,764) $ (2,241)
State........................................................ 2 (915) (913)
----- --------- ---------
$ 525 $ (3,679) $ (3,154)
----- --------- ---------
----- --------- ---------
</TABLE>

Income taxes (benefit) differs from the amount computed by applying the U.S.
federal statutory rate of 34% to income (loss) before income taxes as follows
(in thousands):

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1994 1995 1996
--------- --------- ---------
<S> <C> <C> <C>
Income taxes (benefit) at statutory rate........................ $ (2,640) $ 829 $ 1,388
Current losses and temporary differences for which no benefit
was recognized................................................ 2,640 -- 476
Alternative minimum tax......................................... -- 82 --
State taxes net of federal benefit.............................. -- 15 (167)
Change in valuation allowance................................... -- (847) (4,687)
Other........................................................... -- 18 (164)
--------- --------- ---------
$ -- $ 97 $ (3,154)
--------- --------- ---------
--------- --------- ---------
</TABLE>

46
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 7 -- INCOME TAXES (CONTINUED)
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and liabilities are as follows (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------------
1994 1995 1996
--------- --------- ---------
<S> <C> <C> <C>
Deferred tax assets:
Net operating loss carryforwards............................. $ 4,099 $ 3,316 $ --
DSC settlement costs......................................... -- -- 1,257
Allowances and accruals...................................... 1,789 1,914 1,618
Research tax credit carryforwards............................ 374 -- 588
Other........................................................ 52 6 216
--------- --------- ---------
6,314 5,236 3,679
Deferred tax liability -- investment in joint venture.......... -- (549) --
--------- --------- ---------
6,314 4,687 3,679
Less valuation allowance....................................... (6,314) (4,687) --
--------- --------- ---------
Net deferred tax asset......................................... $ -- $ -- $ 3,679
--------- --------- ---------
--------- --------- ---------
</TABLE>

The net change in the valuation allowance for the year ended December 31,
1996 was a decrease of approximately $4,687,000. Management believes that a
valuation allowance is not required, based upon current and projected
profitability of the Company.

The Company has research credit carryforwards for federal income tax return
purposes of approximately $588,000. The federal research credit carryforwards
expire from 2008 through 2011. The Company also has California manufacturing
credits of approximately $276,000; which expire from 2002 through 2004.

The Tax Reform Act of 1986 and the California Conformity Act of 1987 impose
restrictions on the utilization of net operating loss and tax credit
carryforwards in the event of an "ownership change" as defined by the Internal
Revenue Code. The Company's ability to utilize its net operating loss and tax
credit carryforwards is subject to restriction pursuant to these provisions.

NOTE 8 -- BANK BORROWINGS

The Company has a revolving line of credit with a bank providing for
borrowings up to $12,000,000 at an interest rate of prime plus 0.5%. Borrowings
under the line are secured by the Company's accounts receivable. The line of
credit expired on November 15, 1996, but automatically renews for successive
thirty day periods until terminated by written agreement. The line of credit
agreement also contains covenants that require the Company to maintain certain
financial ratios. As of December 31, 1996, the Company was in compliance with
the covenants contained in the agreement. As of December 31, 1995 and 1996, no
borrowings were outstanding under the line of credit, and $1,642,000 was
reserved for letters of credit and foreign exchange contracts.

In July 1996, the Company borrowed approximately $7,106,000 under a
six-month term loan bearing interest at 5.75%. The proceeds from the loan were
used to pay the remaining obligations under the DSC litigation settlement (See
Note 10). The loan had a $4.0 million compensating balance requirement. The loan
was repaid in October 1996 with a portion of the proceeds from the IPO.

47
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 9 -- REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
(DEFICIT)

IPO

In October 1996, the Company issued 5,175,000 shares of its common stock
pursuant to the IPO, which generated approximately $118,074,000 of net proceeds
to the Company.

In conjunction with the IPO, 17,231,204 shares of outstanding redeemable
convertible preferred stock were converted into a total of 18,717,463 shares of
common stock. Prior to the IPO, the Company had outstanding six series of
redeemable convertible preferred stock.

COMMON STOCK WARRANTS

Warrants to purchase shares of common stock were issued to investors as part
of the preferred stock agreements. The warrants expire beginning in 1998 and
ending in 2000 and are summarized as follows:

<TABLE>
<CAPTION>
EXERCISE
NUMBER PRICE
OF SHARES PER SHARE
----------- -----------
<S> <C> <C>
Warrants outstanding as of December 31, 1994....................... 6,496,204 $ 0.03-1.17
Issued........................................................... 30,068 7.00
Exercised........................................................ (1,305,192) 0.03-1.17
-----------
Warrants outstanding as of December 31, 1995....................... 5,221,080 0.03-7.00
Exercised........................................................ (2,599,763) 0.03-1.17
Retired.......................................................... (47,541) 0.03-1.17
-----------
Warrants outstanding as of December 31, 1996....................... 2,573,776 0.03-7.00
-----------
-----------
</TABLE>

COMMON STOCK OPTIONS

The Company's 1996 Stock Incentive Plan (the "1996 Plan") is intended to
serve as the successor equity incentive program to the Company's 1993 Stock
Option/Stock Issuance Plan (the "Predecessor Plan"). As of December 31, 1996, a
total of 7,008,142 shares of Common Stock were authorized for issuance under the
1996 Plan. This share reserve is comprised of (i) the shares which remained
available for issuance under the Predecessor Plan, including the shares subject
to outstanding options thereunder, plus (ii) an additional increase of 1,000,000
shares. In addition, the share reserve will automatically be increased on the
first trading day of each calendar year, beginning with the 1997 calendar year,
by an amount equal to 3% of the number of shares of Common Stock outstanding on
the last trading day of the immediately preceding calendar year. Options
generally vest 20% on the first anniversary date and ratably over the following
48 months. The options expire 10 years from the date of grant and are normally
canceled three months after termination of employment.

48
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 9 -- REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
(DEFICIT) (CONTINUED)
A summary of the Company's stock option plan activity is presented below:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------------------------
1995 1996
----------------------- -----------------------
WEIGHTED WEIGHTED
1994 AVERAGE AVERAGE
---------- EXERCISE EXERCISE
OPTIONS SHARES SHARES PRICE SHARES PRICE
- ------------------------------------------------------ ---------- ---------- ----------- ---------- -----------
<S> <C> <C> <C> <C> <C>
Outstanding at beginning of year...................... 1,608,000 2,734,280 $ 0.14 3,890,016 $ 0.35
Granted............................................... 1,238,080 1,274,036 0.81 1,083,082 12.33
Exercised............................................. (21,780) (53,652) 0.21 (416,426) 0.17
Canceled.............................................. (90,020) (64,648) 0.24 (243,128) 1.21
---------- ---------- ----------
Outstanding at end of year............................ 2,734,280 3,890,016 0.35 4,313,544 3.32
Options exercisable at year end....................... 1,189,402 1,705,659
Weighted average fair value of options granted
during the year..................................... 0.21 5.89
</TABLE>

The following table summarizes information about stock options outstanding
as of December 31, 1996:

<TABLE>
<CAPTION>
WEIGHTED
RANGE AVERAGE WEIGHTED
OF NUMBER REMAINING AVERAGE NUMBER
EXERCISE OUTSTANDING CONTRACTUAL EXERCISE EXCERCISABLE
PRICES AT 12/31/96 LIFE PRICE AT 12/31/96
- ----------------- ----------- ----------- --------- -----------
<C> <C> <S> <C> <C>
$0.03 1,256,600 6.3 years $ 0.03 973,478
0.25 - 0.63 1,665,646 8.1 0.38 598,298
1.50 - 4.70 821,096 9.1 1.63 86,591
12.00 - 25.00 475,402 9.6 14.30 47,292
57.63 - 59.63 94,800 9.9 58.54 --
</TABLE>

EMPLOYEE STOCK PURCHASE PLAN

Under the 1996 Employee Stock Purchase Plan (the "Purchase Plan") adopted on
July 12, 1996, the Company is authorized to issue up to 1,500,000 shares of
Common Stock to eligible employees of the Company and participating
subsidiaries. The Purchase Plan will be implemented in a series of successive
offering periods, each with a maximum duration of 24 months. The initial
offering period commenced on October 4, 1996 and ends on the last business day
in July 1998. Under the terms of the Purchase Plan, eligible employees on the
start date of any offering period can enter the Purchase Plan on that start
date, or on any subsequent semi-annual entry date. Individuals who become
eligible after the start date may join the Purchase Plan on any subsequent
semi-annual entry date within that period. Employees may have up to 10 percent
of their base salary withheld through payroll deductions to purchase the
Company's Common Stock. The purchase price of the stock is the lower of 85
percent of (i) the fair market value of the Common Stock on the participant's
entry date into the offering period or (ii) the fair market value on the
semi-annual purchase date. Under the Purchase Plan, the purchase dates are
January 31 and July 31 of each year.

49
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 9 -- REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
(DEFICIT) (CONTINUED)
PRO FORMA FAIR VALUE INFORMATION

The Company applies the intrinsic value method prescribed by Accounting
Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, in
accounting for its stock-based compensation plans. Had compensation cost for the
Company's stock-based compensation plans been determined consistent with the
fair value approach set forth in SFAS No. 123, ACCOUNTING FOR STOCK-BASED
COMPENSATION, the Company's net income and earnings per share would have been
reduced to the pro forma amounts indicated below (in thousands except per share
amounts):

<TABLE>
<CAPTION>
1995 1996
---------- ----------
<S> <C> <C>
Net income:
As reported......................................................... $ 2,341 $ 7,237
Pro forma........................................................... 2,334 6,638

Fully diluted earnings per share:
As reported......................................................... $ 0.08 $ 0.21
Pro forma........................................................... 0.08 0.19
</TABLE>

The fair value of option grants prior to the IPO is estimated on the date of
grant using the minimum value method with the following weighted average
assumptions: no dividend yield; risk-free interest rates of 6.22% to 6.25%, and
an expected life of 5 years. The fair value of option grants subsequent to the
IPO is estimated on the date of grant using the Black-Scholes option-pricing
model with the following weighted average assumptions: no dividend yield,
expected volatility of 55%; risk-free interest rate of 6.32%; and an expected
life of 5 years. Compensation cost related to the Purchase Plan is recognized
for the fair value of the employees' purchase rights, which are estimated using
the Black-Scholes model. No compensation expense has been disclosed for 1996 and
1995 as the first purchase date will occur on January 31, 1997.

STOCK SPLIT AND REINCORPORATION

In August 1996, the Company's Board of Directors approved a two-for-one
stock split. The accompanying financial statements and notes have been restated
to give effect to the stock split.

NOTE 10 -- COMMITMENTS AND CONTINGENCIES

LEASES

The Company leases office space and certain equipment under operating
leases. Future minimum payments under operating leases with an initial term of
more than one year as of December 31, 1996 are summarized as follows (in
thousands):

<TABLE>
<S> <C>
1997............................................................... $ 3,952
1998............................................................... 4,093
1999............................................................... 3,064
2000............................................................... 2,353
2001............................................................... 2,373
Thereafter......................................................... 9,714
---------
Total minimum lease payments....................................... $ 25,549
---------
---------
</TABLE>

50
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 10 -- COMMITMENTS AND CONTINGENCIES (CONTINUED)
Total rent expense for all operating leases was $462,000, $887,000, and
$3,030,000 for the years ended December 31, 1994, 1995 and 1996, respectively.

EMPLOYEE BENEFIT PLAN

The Company has a 401(k) plan under which employees may contribute a portion
of their compensation on a tax deferred basis to the plan. The Company, at its
discretion, may contribute to the plan on a matching basis up to a maximum of
$5,000 per employee per year. The Company is the plan administrator. During 1995
and 1996, the Company contributed $133,000 and $466,000, respectively, to the
plan.

LITIGATION

DSC:

From July 1993 until June 1996 the Company was involved in litigation with
DSC Communications Corporation ("DSC"). DSC alleged, among other things, that
the Company's Universal Modular Carrier 1000-TM- ("UMC") technology contained or
was derived from trade secrets and other proprietary technology of DSC. The
parties entered into a Settlement Agreement and Mutual Releases dated as of June
24, 1996 (the "Settlement Agreement") pursuant to which the litigation was
terminated. Under the terms of the Settlement Agreement, the Company paid DSC
$3,000,000 in June 1996 and $7,106,000 in July 1996, and issued 725,787 shares
of common stock to DSC. The settlement amount was recorded during the first six
months of 1996 as a charge of $15,807,000. Under the terms of the Settlement
Agreement, the Company maintains all rights to the UMC technology free and clear
of any claim by DSC.

ITRI:

In 1995, a dispute arose among the Company, the Industrial Technology
Research Institute ("ITRI"), a Taiwanese government-sponsored research and
development organization in the telecommunications field, and certain of ITRI's
member companies (the "Member Companies") in which the Company claimed that ITRI
and the Member Companies were, among other things, failing to pay royalties when
due. In reliance upon certain provisions of the ITRI Agreements, in April 1996,
the Company ceased delivering to the Member Companies certain proprietary
application specific integrated circuits ("ASICs") used in manufacturing the UMC
system.

Pursuant to agreements with ITRI reached in 1994, design documentation for
these ASICs are held in a trust account, with directions that the designs can be
made available to ITRI on the occurrence of specified conditions. On July 9,
1996, the trustee-custodian of the ASIC designs filed suit against the Company
in the United States District Court, Eastern District of New York, alleging that
the Company had wrongfully discontinued the sale of the ASICs to the Member
Companies. Among other things, the complaint seeks unspecified damages on behalf
of the trustee, and a determination that the trustee can release the ASIC
designs to ITRI. On July 31, 1996, the Company filed a counterclaim against the
trustee claiming, among other things, that the trustee improperly disclosed the
design documentation to third parties.

51
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 10 -- COMMITMENTS AND CONTINGENCIES (CONTINUED)
by developing UMC-based products not shared with the Company, by transferring
UMC technology to an unauthorized company, and by misappropriating the Company's
trade secrets and that the ITRI Agreements have been terminated. The Company
seeks damages, punitive damages, and declaratory and injunctive relief. On
September 13, 1996, ITRI filed a demand for arbitration of the dispute and
claimed, among other things, that the Company has breached the ITRI Agreements
and is liable for unspecified royalties and punitive damages, and claiming
proprietary rights in certain UMC technology. On September 30, 1996, the Company
amended the complaint in its suit against ITRI to add the Member Companies and
another company as parties to the suit.

The parties conducted discovery with respect to the royalty and ASIC supply
issues during September and October, 1996. A hearing on ITRI's motion for a
preliminary injunction to require the Company to continue supplying ASICs and
ITRI's motion to compel arbitration was held on November 22, 1996. In an order
dated January 9, 1997, the court stayed the litigation and granted the ITRI
parties' motion to compel arbitration. The court has promised, but not yet
issued, an opinion explaining the nature and scope of its arbitration order, and
has issued no ruling on the motion for a preliminary injunction.

The Company believes that it has meritorious defenses to the claims asserted
by ITRI and the Member Companies and it intends to defend the litigation
vigorously. Moreover, the Company believes that the Member Companies' damages
claim is without merit. The Company further believes that its claims against
ITRI and the Member Companies are meritorious and the Company intends to
vigorously pursue such claims. However, due to the nature of the claims and
because the proceedings are in the discovery stage, the Company cannot determine
the total expense or possible loss, if any, that may ultimately be incurred
either in the context of a trial, arbitration or as a result of a negotiated
settlement. After consideration of the nature of the claims and the facts
relating to the proceedings, the Company believes that the resolution of this
matter will not have a material adverse effect on the Company's business,
financial condition and results of operations; however, the results of these
proceedings, including any potential settlement, are uncertain and there can be
no assurance to that effect.

52
<PAGE>
ADVANCED FIBRE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 11 -- COMPANY INFORMATION AND CERTAIN CONCENTRATIONS

During 1994, one customer accounted for 27% of revenues. During 1995, one
customer accounted for approximately 16% of revenues. International sales
constituted 19%, 13% and 21% during 1994, 1995 and 1996, respectively.

The Company currently derives substantially all of its revenue from the UMC,
and expects that this concentration will continue for the foreseeable future. As
a result, any factor adversely affecting the demand for, or pricing of, the UMC
could have a material adverse effect on the Company's business and results of
operations.

The Company's manufacturing operations consist primarily of final assembly
and test of finished goods from components and custom-made subassemblies
purchased from third parties. Although the Company's product designs employ
primarily industry standard hardware, certain components are only available
through limited sources of supply. The Company's proprietary integrated
circuits, codec components, and some surface mount technology components and
other components are available from limited sources. If the Company cannot
obtain essential components as required, the Company may be unable to meet
demand for its products, thereby adversely affecting its operating results. In
addition, scarcity of such components could result in cost increases that
adversely affect the Company's gross margin.

The Company's printed circuit board assemblies and channel bank assemblies
are provided by a limited number of outside turnkey suppliers. In the event
operations of these turnkey suppliers are impaired or they are unable to support
the manufacturing requirements of the Company, the Company's operating results
could be adversely affected.

53
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III.

ITEM 10. EXECUTIVE OFFICERS, KEY EMPLOYEES AND DIRECTORS

The executive officers, key employees and directors of the Company, and
their respective ages as of December 31, 1996, are as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
- ------------------------------------------------ --- ------------------------------------------------
<S> <C> <C>
EXECUTIVE OFFICERS
Donald Green.................................... 65 Chairman of the Board and Chief Executive
Officer
Carl J. Grivner................................. 43 President and Chief Operating Officer and
Director
Karen Godfrey................................... 42 Corporate Controller and Assistant Secretary
Glenn Lillich................................... 49 Vice President, Domestic Sales and Marketing
Dan E. Steimle.................................. 48 Vice President, Chief Financial Officer,
Treasurer and Secretary

KEY EMPLOYEES
James Hoeck..................................... 36 Vice President, Advanced Development
John Webley..................................... 38 Vice President, Advanced Development
David Arnold.................................... 46 Vice President, Engineering Development
Michael Hatfield................................ 34 Vice President, International and Product
Management
Peter Kilkus.................................... 52 Vice President, Quality Assurance
Greg Steele..................................... 35 Vice President, Operations

OUTSIDE DIRECTORS
B.J. Cassin(1).................................. 63 Director
Clifford H. Higgerson(1) (2).................... 57 Director
Brian Jackman(2)................................ 55 Director
Dan Rasdal(1)................................... 63 Director
</TABLE>

- ---------

(1) Member of the Audit Committee.

(2) Member of the Compensation Committee.

DONALD GREEN was a co-founder of the Company and has been the Company's
Chairman of the Board and Chief Executive Officer since May 1992. He founded
Optilink Corporation ("Optilink") in 1987 to develop a fiber NGDLC system called
the Litespan 2000. Mr. Green was the President and Chief Executive Officer of
Optilink from 1987 until its acquisition by DSC in 1990. From 1990 until the
founding of the Company, Mr. Green was Vice President and General Manager of the
Access Products division of DSC. Prior to founding Optilink, Mr. Green served
for 17 years as Chief Executive Officer of Digital Telephone Systems, a company
he founded in 1969 to develop, manufacture and market the D960 Digital Loop
Carrier system. Prior to founding Digital Telephone Systems, Mr. Green served as
Project Engineer and, subsequently, Vice President of Engineering for Lynch
Communication Inc., a telecommunications

54
<PAGE>
company ("Lynch"), as well as Design Engineer for RCA Standard Telephone Cables
(UK), a telecommunications company. Mr. Green began his career with British
Telecom, a telecommunications company, and is a graduate of the British
Institute of Electrical Engineers.

CARL J. GRIVNER has been the Company's President and Chief Operating Officer
since December 1995 and a Director since May 1996. From July 1995 to December
1995 he was the Company's Chief Operating Officer. From September 1994 to July
1995, he was President of Enhanced Business Services of Ameritech, an RBOC. From
1986 to September 1994, Mr. Grivner held various general management positions at
Ameritech, including President of Ameritech's Advertising Services (Yellow
Pages) Unit. From 1977 to 1986, he held a variety of technical and marketing
positions at International Business Machines, Inc. Mr. Grivner holds a Bachelor
of Arts degree in Biology from Lycoming College and an advanced degree from the
University of Pennsylvania, Wharton School of Business.

KAREN GODFREY has been the Company's Corporate Controller since May 1994 and
its Assistant Secretary since February 1995. From September 1992 to May 1994,
Ms. Godfrey was self-employed as a financial management consultant. Ms. Godfrey
was the Chief Financial Officer of Fortune's Almanac, Inc., a catalog company,
from September 1991 to September 1992 and the Chief Financial Officer and Vice
President of Operations of Paracomp, Inc., a software company, from 1989 to
September 1991. Ms. Godfrey held various financial management positions with
WordStar International Corporation, a software company, from 1984 to 1989,
including Corporate Controller. Ms. Godfrey started her professional career with
KPMG Peat Marwick. She is a C.P.A. and holds a Bachelor of Science degree in
Accountancy from the University of Illinois, Champaign-Urbana.

GLENN LILLICH has been the Company's Vice President, Domestic Sales and
Marketing since June 1996. From February 1993 to June 1996, Mr. Lillich was the
Company's Vice President, Sales. From January 1992 to February 1993, he served
as the Western Region Director of Sales for the Telecom Division of Stratus
Company, a manufacturer of computer systems. Mr. Lillich held various sales
positions at DSC from 1984 to December 1991, most recently as Vice President,
Sales; GTE Telenet Systems Corporation, a manufacturer of packet switch
hardware, from 1980 to 1983; and Northern Telecom Systems Corporation, a
manufacturer and distributor of data processing systems, from 1978 to 1979. Mr.
Lillich holds a Bachelor of Science degree in Accounting from Ohio State
University and an MBA in Behavioral Management from Pepperdine University.

DAN E. STEIMLE has been the Company's Vice President and Chief Financial
Officer since December 1993. He has also been the Company's Secretary and
Treasurer since July 1995. He was the Senior Vice President for Operations,
Chief Financial Officer and Treasurer for The Santa Cruz Operations, Inc., a
software company, from 1991 until joining AFC. Mr. Steimle served as Corporate
Director of Business Development at Mentor Graphics Corporation, a company
supplying engineering design software, from 1989 to September 1991 and held
various financial positions at Cipher Data Products, Inc., a manufacturer of
computer peripherals, from 1982 to 1989, including Corporate Vice President,
Chief Financial Officer and Treasurer. Mr. Steimle holds a Bachelor of Science
degree in Accounting from Ohio State University and an MBA in Marketing and
Management from the University of Cincinnati. Mr. Steimle is also a director of
Mitek Systems, Inc., a software company.

JAMES HOECK was a co-founder of the Company and served as Vice President,
Engineering from inception through January 1995 when he became Vice President,
Advanced Development. In November 1990, he co-founded Quadrium Research
Corporation, a design consulting company ("Quadrium"), and served as its
President until May 1992. Previously, Mr. Hoeck served as a manager of firmware
at Optilink and as a member of the technical staff at Teradyne, Inc., a test and
measurement equipment company. Mr. Hoeck holds a Bachelor of Science degree in
Electrical Engineering from Northwestern University.

55
<PAGE>
JOHN WEBLEY was a co-founder of the Company and served as Vice President,
Engineering from inception through January 1995 when he became Vice President,
Advanced Development. In November 1990, he co-founded Quadrium with Mr. Hoeck,
and served as its Vice President until June 1992. Previously, Mr. Webley served
as manager of systems interface hardware at Optilink, as a member of the
technical staff at Rockwell International, a defense contractor, as a senior
engineer at Lynch and as a network systems engineer for the Department of
Telecommunications in Cape Town, South Africa. Mr. Webley holds a Bachelor of
Science degree in Electrical Engineering, an Hon. B.Sc. and a Master of Science
degree in Electrical Engineering from the University of Stellenbosch, South
Africa.

DAVID ARNOLD has been the Company's Vice President, Engineering Development
since April 1996. From November 1993 to November 1995, he was senior director of
telephony products research at Ericsson Raynet, a provider of telecommunications
equipment. From 1989 to November 1993, he served as engineering director for
Alcatel Network Systems, a provider of telecommunications equipment. Previously,
from 1978 to 1983, Mr. Arnold held a variety of engineering positions at Digital
Equipment Corporation, a provider of computer and data processing equipment. Mr.
Arnold holds a Bachelor of Science degree in Computer Science from the
University of California, Berkeley.

MICHAEL HATFIELD has been the Company's Vice President, International and
Product Management since June 1996. From September 1992 to June 1996 he was Vice
President, Marketing. From July 1992 to September 1992, he served as the
director of marketing for the synchronization products division of Telecom
Solutions, Inc., a telecommunications company. Previously, Mr. Hatfield held
various marketing positions at DSC from 1987 to July 1992. Mr. Hatfield holds a
Bachelor of Science degree in Electrical Engineering from the Rose-Hulman
Institute of Technology and an MBA in Finance from Indiana University.

PETER KILKUS has been the Company's Vice President, Quality Assurance since
March 1995. From 1990 to March 1995, he served as the Senior Director, Quality
Assurance, for DSC. From 1988 to 1990, he held various positions at Optilink,
most recently as Vice President; Operations. Mr. Kilkus holds an MA in Physics
from the University of California, Santa Barbara and a Bachelor of Arts degree
in Physics from St. Mary's University of Minnesota.

GREG STEELE has been the Company's Vice President, Operations since April
1995. From November 1994 to March 1995, Mr. Steele was the Company's Director of
Operations. Prior to joining the Company, from 1990 to November 1994, Mr. Steele
held various positions at DSC, including director of account marketing and
senior manager of manufacturing from 1990 to April 1993. Previously, from 1984
to 1990, Mr. Steele held several manufacturing positions at Texas Instruments.
Mr. Steele holds a Bachelor of Science degree in Industrial Engineering from
Oregon State University.

B.J. CASSIN has been a director of the Company since January 1993. Since
1979, he has been a private venture capitalist. Previously, he co-founded Xidex
Corporation, a manufacturer of data storage media, in 1969, and served as Vice
President, Marketing.

CLIFFORD H. HIGGERSON has been a director of the Company since January 1993.
Mr. Higgerson has been a general partner of Vanguard Ventures Partners, a
venture capital firm and a stockholder of the Company, since July 1991 and
managing partner of Communications Ventures, a venture capital firm, since 1987.
Mr. Higgerson is also a director of Digital Microwave Corporation and eight
private companies.

BRIAN JACKMAN has been a director of the Company since September 1993. Mr.
Jackman has been the Executive Vice President of Tellabs, Inc., a
telecommunications equipment company and a stockholder of the Company, and the
President of Tellabs Operations Inc., a subsidiary of Tellabs, Inc., since 1991.
From 1990 to 1993, Mr. Jackman was the Executive Vice President of Business
Operations of Tellabs. From 1989 to 1990, he was the Senior Vice
President/General Manager of the data communications division of Tellabs, Inc.
Mr. Jackman is also a director of Tellabs, Inc. and Universal Electronics, Inc.

56
<PAGE>
DAN RASDAL has been a director of the Company since February 1993. Mr.
Rasdal has been Chairman of the Board of SymmetriComm, Inc., a
telecommunications company, since July 1989, and the President and Chief
Executive Officer of SymmetriComm since 1985. Mr. Rasdal is also a director of
Celeritek, Inc., a semiconductor manufacturer.

The current directors have been elected pursuant to the terms of the
Company's certificate of incorporation and a voting agreement among certain
stockholders of the Company, whereby holders of the Company's Series A and
Series B Preferred Stock of the Company had the right to elect three directors
in the aggregate and the parties to the voting agreement agreed to vote for a
director designated in accordance with the voting agreement. Such arrangements
terminated upon closing of the initial public offering of the Company's Common
Stock on October 4, 1996.

The Company's certificate of incorporation provides for a classified Board
of Directors composed of seven directors. Accordingly, the terms of the office
of the Board of Directors are divided into three classes. Class I will expire at
the annual meeting of the stockholders to be held in 1997; Class II will expire
at the annual meeting of the stockholders to be held in 1998; and Class III will
expire at the annual meeting of the stockholders to be held in 1999. At each
annual meeting of the stockholders, beginning with the 1997 annual meeting, the
successors to directors whose terms will then expire will be elected to serve
from the time of election and qualification until the third annual meeting
following election and until their successors have been duly elected and
qualified, or until their earlier resignation or removal, if any. Carl Grivner
and Clifford Higgerson have been designated as Class I directors. B.J. Cassin
and Brian Jackman have been designated as Class II directors. Donald Green and
Dan Rasdal have been designated as Class III directors. The Company is
continuing to seek to add one additional director to the Board of Directors in
the future. To the extent there is an increase in the number of directors,
additional directorships resulting therefrom will be distributed among the three
classes so that, as nearly as possible, each class will consist of an equal
number of directors.

Each executive officer and key employee serves at the discretion of the
Board of Directors. The Company does not have any existing employment agreements
with any executive officer or key employee. There are no family relationships
among any of the directors, executive officers and key employees of the Company.

BOARD COMMITTEES

The Board of Directors has two standing committees: an Audit Committee and a
Compensation Committee. The Audit Committee, currently consisting of Messrs.
Cassin, Higgerson and Rasdal, meets with the Company's financial management and
its independent accountants at various times during each year and reviews
internal control conditions, audit plans and results, and financial reporting
procedures. The Compensation Committee, currently consisting of Messrs.
Higgerson and Jackman, reviews and approves the Company's compensation
arrangements for key employees and administers the Company's 1996 Stock
Incentive Plan and the Company's Employee Stock Purchase Plan.

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
the Company's directors and executive officers, and persons who own more than
ten percent of a registered class of the Company's equity securities, to file
with the Securities and Exchange Commission initial reports of ownership and
reports of changes in ownership of Common Stock and other equity securities of
the Company. Executive officers, directors and greater than ten percent
stockholders are required by Securities and Exchange Commission regulations to
furnish the Company with copies of all Section 16(a) reports they file.

Based solely upon review of the copies of such reports furnished to the
Company and written representations that no other reports were required, the
Company believes that there was compliance for the fiscal year ended December
31, 1996 with all Section 16(a) filing requirements applicable to the Company's
executive officers, directors and greater than ten percent stockholders.

57
<PAGE>
ITEM 11. EXECUTIVE COMPENSATION

SUMMARY OF CASH AND OTHER COMPENSATION. The following table sets forth the
compensation earned by the Company's Chief Executive Officer and the other four
executive officers of the Company (the ``Named Executive Officers"), each of
whose aggregate compensation for the year ended December 31, 1996 was in excess
of $100,000 for services rendered in all capacities to the Company for such
fiscal year.

<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
-------------
NUMBER OF
ANNUAL COMPENSATION SECURITIES
---------------------- UNDERLYING ALL OTHER
NAME AND PRINCIPAL POSITION SALARY BONUS OPTIONS COMPENSATION
- --------------------------------------------------- ---------- ---------- ------------- -------------
<S> <C> <C> <C> <C> <C>
Donald Green ...................................... 1996 $ 275,000 $ 138,903 184,902 $ --
Chairman of the Board and Chief Executive Officer 1995 185,000 115,625 25,000 --

Carl J. Grivner(1) ................................ 1996 235,000 106,349 -- 74,080(2)
President and Chief Operating Officer 1995 102,115 48,894 212,000 14,690(3)

Karen Godfrey ..................................... 1996 105,000 25,077 -- --
Corporate Controller and Assistant Secretary 1995 101,016 28,935 10,200 --

Glenn Lillich ..................................... 1996 170,000 51,868 -- --
Vice President, Domestic Sales and Marketing 1995 160,000 54,400 12,000 --

Dan E. Steimle .................................... 1996 170,000 51,868 -- --
Vice President, Chief Financial Officer, 1995 160,000 54,400 12,000 --
Treasurer and Secretary
</TABLE>

- ---------

(1) Mr. Grivner joined the Company in July 1995.

(2) Represents $34,377 in relocation expenses paid by the Company and
forgiveness of $39,703 of principal and interest on a note payable to the
Company. See "Item 13--Certain Relationships and Related Transactions."

(3) Represents relocation expenses paid by the Company.

58
<PAGE>
STOCK OPTION GRANTS TO NAMED EXECUTIVE OFFICERS. The following table sets
forth certain information regarding stock option grants made to each of the
Named Executive Officers in 1996. No stock appreciation rights were granted to
the Named Executive Officers during such year.

<TABLE>
<CAPTION>
INDIVIDUAL GRANTS(1)
------------------------------------------------------- POTENTIAL REALIZABLE VALUE
NUMBER OF AT ASSUMED ANNUAL RATES OF
SECURITIES PERCENT OF PER SHARE STOCK PRICE APPRECIATION
UNDERLYING TOTAL GRANTED EXERCISE FOR OPTION TERM(2)
OPTIONS TO EMPLOYEES IN BASE EXPIRATION --------------------------
NAME GRANTED FISCAL YEAR PRICE(3) DATE 5% 10%
- ------------------------------- ----------- --------------- ------------ ----------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Donald Green................... 184,902 17.1% $ 12.50 6/25/06 $ 1,453,548 $ 3,683,577
Carl J. Grivner................ -- -- -- -- -- --
Karen Godfrey.................. -- -- -- -- -- --
Glenn Lillich.................. -- -- -- -- -- --
Dan E. Steimle................. -- -- -- -- -- --
</TABLE>

- ---------

(1) The option shown in the table is immediately exercisable for all the option
shares. However, any shares purchased under the option will be subject to
repurchase by the Company, at the exercise price paid per share, in the
event the optionee terminates employment prior to vesting in those shares.
The shares vest in successive equal monthly installments over 24 months of
service, measured from the date of grant. All the option shares will
immediately vest in the event the Company is acquired by merger or asset
sale, unless the options are assumed by the acquiring entity.

(2) Realizable values are reported net of the option exercise price. The dollar
amounts under these columns are the result of calculations based upon stock
price appreciation at the assumed 5% and 10% compounded annual rates (as
applied to the estimated fair market value of the option shares on the date
of grant, not the current fair market value of those shares) and are not
intended to forecast any actual or potential future appreciation, if any, in
the value of the Company's stock price. Actual gains, if any, on stock
option exercises will be dependent upon the future performance of the Common
Stock as well as the option holder's continued employment through the
vesting period. The potential realizable value calculation assumes that the
option holder waits until the end of the option term to exercise the option.

(3) The exercise price for the shares of Common Stock subject to option grants
made under the Plan may be paid in cash or in shares of Common Stock valued
at fair market value on the exercise date. The option may also be exercised
through a same-day sale program without any cash outlay by the optionee. In
addition, the Plan Administrator may provide financial assistance to one or
more optionees in the exercise of their outstanding options by allowing such
individuals to deliver a full-recourse, interest-bearing promissory note in
payment of the exercise price and any associated withholding taxes incurred
in connection with such exercise.

59
<PAGE>
OPTION EXERCISES AND HOLDINGS. The following table sets forth certain
information with respect to the Named Executive Officers concerning their option
exercises during 1996 and their option holdings as of December 27, 1996. None of
the Named Executive Officers held any stock appreciation rights at the end of
that fiscal year.

<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED
OPTIONS AS OF IN-THE-MONEY OPTIONS
DECEMBER 27, 1996(2) AS OF DECEMBER 27, 1996(3)
SHARES ACQUIRED VALUE -------------------------- ----------------------------
NAME ON EXERCISE REALIZED (1) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------------- --------------- ------------ ----------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Donald Green............. -- $ -- 108,558 181,344 $ 5,193,968 $ 7,892,539
Carl J. Grivner.......... 46,666 2,292,467 12,401 152,933 650,503 8,039,699
Karen Godfrey............ 20,000 170,000 36,440 38,760 1,928,445 2,043,593
Glenn Lillich............ -- -- 160,534 87,466 8,533,982 4,630,868
Dan E. Steimle........... 160,000 236,000 18,400 33,600 971,200 1,767,300
</TABLE>

- ---------

(1) Based upon the difference between the exercise price and the fair market
value of the Company's Common Stock on the date of exercise.

(2) Although each option is immediately exercisable for all the option shares,
any shares purchased under the option are subject to repurchase by the
Company, at the exercise price paid per share, in the event the optionee
terminates employment prior to vesting in those shares. Twenty percent of
the option shares will vest upon optionee's completion of one year of
service measured from the vesting date, and the balance will vest in
successive equal monthly installments over the next 48 months of service
thereafter (other than 184,000 of Mr. Green's options, which vest in
successive equal monthly installments over 24 months of service measured
from the date of grant). All the option shares will immediately vest in the
event the Company is acquired by merger or asset sale, unless the options
are assumed by the acquiring entity. Accordingly, the table reflects such
option shares as to which the repurchase right has lapsed under the
"exercisable" column and such option shares subject to the repurchase right
under the "unexercisable" column.

(3) Based on the last reported sale price of the Company's Common Stock on
December 27, 1996 ($53.25 per share) less the exercise price payable for
such shares.

COMPENSATION, TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL ARRANGEMENTS

The Compensation Committee as Plan Administrator of the 1996 Stock Incentive
Plan has the authority to provide for the accelerated vesting of the shares of
Common Stock subject to outstanding options held by the Chief Executive Officer
and the Company's other executive officers or any unvested shares actually held
by those individuals under the 1996 Stock Incentive Plan, in the event the
Company is acquired by merger or asset sale or there is a hostile change in
control effected by a successful tender or exchange offer for more than 50% of
the Company's outstanding voting securities or a change in the majority of the
Board as a result of one or more contested elections for Board membership.
Alternatively, the Compensation Committee may condition such accelerated vesting
upon the individual's termination of service within a designated period
following the acquisition or hostile change in control.

On May 31, 1995, Mr. Green purchased 167,200 shares of Common Stock from the
Company in exchange for a note payable in the amount of $52,250, the fair market
value of such shares on such date, pursuant to a compensation agreement approved
by the Board of Directors. The Company has the right to repurchase such shares
at the original purchase price per share upon Mr. Green's cessation of service
prior to vesting in such shares. See "Item 13--Certain Relationships and Related
Transactions."

60
<PAGE>
DIRECTOR COMPENSATION

Non-employee Board members do not receive any cash fees for their service on
the Board or any Board committee, but they are entitled to reimbursement of all
reasonable out-of-pocket expenses incurred in connection with their attendance
at Board and Board committee meetings. In addition, non-employee Board members
receive stock options pursuant to the Automatic Option Grant Program in effect
under the Company's 1996 Stock Incentive Plan.

Under the Automatic Option Grant Program, each individual who first joins
the Board after June 30, 1996 as a non-employee Board member will receive an
option grant for 20,000 shares of Common Stock at the time of his or her
commencement of Board service, provided such individual has not otherwise been
in the prior employ of the Company. In addition, at each annual meeting of
stockholders, beginning with the 1997 annual meeting, each individual who is to
continue to serve as a non-employee Board member will receive an option grant to
purchase 6,000 shares of Common Stock, whether or not such individual has been
in the prior employ of the Company and whether or not such individual first
joined the Board after June 30, 1996, provided that such individual has served
as a non-employee Board member for at least six months.

Each automatic grant will have an exercise price equal to the fair market
value per share of Common Stock on the grant date and will have a maximum term
of 10 years, subject to earlier termination following the optionee's cessation
of Board service. Each automatic option will be immediately exercisable;
however, any shares purchased upon exercise of the option will be subject to
repurchase, at the option exercise price paid per share, should the optionee's
service as a non-employee Board member cease prior to vesting in the shares.
Each automatic option grant will vest in a series of installments over the
optionee's period of Board service as follows: one-third of the option shares
upon completion of one year of Board service, and the balance in twenty-four
(24) successive equal monthly installments upon the optionee's completion of
each additional month of Board service thereafter. However, each outstanding
option will immediately vest upon (i) certain changes in the ownership or
control of the Company or (ii) the death or disability of the optionee while
serving as a Board member.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

The Board of Directors established a Compensation Committee in May 1994.
During the last fiscal year, Messrs. Higgerson and Jackman served as members of
the Compensation Committee. Neither of these individuals has served at any time
as an officer or employee of the Company. Prior to the establishment of the
Compensation Committee, all decisions relating to executive compensation were
made by the Company's Board of Directors. For a description of the transactions
between the Company and members of the Compensation Committee and entities
affiliated with such members, see "Item 13-- Certain Relationships and Related
Transactions." No executive officer of the Company serves as a member of the
board of directors or compensation committee of any entity which has one or more
executive officers serving as a member of the Company's Board of Directors or
Compensation Committee.

61
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth certain information regarding the beneficial
ownership of the Company's Common Stock as of December 31, 1996 by (i) each
person (or group of affiliated persons) who is known by the Company to own
beneficially more than 5% of the outstanding shares of the Common Stock of the
Company, (ii) each executive officer of the Company, (iii) each director of the
Company and (iv) all directors and executive officers of the Company as a group.

<TABLE>
<CAPTION>
SHARES BENEFICIALLY OWNED
AS OF DECEMBER 31,
1996(1)
-------------------------
NAME OF BENEFICIAL OWNERS NUMBER PERCENT
- ------------------------------------------------------------------------------------------- ------------ -----------
<S> <C> <C>
Tellabs, Inc.(2) .......................................................................... 3,889,966 11.8%
4951 Indiana Avenue
Lisle, IL 60532

Coral Partners II(3) ...................................................................... 3,308,665 10.1
60 South Sixth Street, Suite 3510
Minneapolis, MN 55402

St. Paul Venture Capital, Inc.(4) ......................................................... 3,252,031 9.7
8500 Normandale Lake Blvd., Suite 1940
Bloomington, MN 55437

Vanguard IV, L.P. ......................................................................... 2,946,397 9.0
525 University Avenue
Palo Alto, CA 94301

Harris Corporation(5) ..................................................................... 1,764,973 5.3
DTS Division
300 Bel Marin Keys Blvd.
Novato, CA 94944-1188

B.J. Cassin(6)............................................................................. 1,342,915 4.1

Donald Green(7)............................................................................ 1,820,101 5.5

Carl J. Grivner(8)......................................................................... 216,000 *

Clifford H. Higgerson(9)................................................................... 2,946,397 9.0

Brian Jackman(10).......................................................................... 3,910,932 11.9

Dan Rasdal(11)............................................................................. 63,000 *

Karen Godfrey(12).......................................................................... 101,586 *

Glenn Lillich(13).......................................................................... 268,000 *

Dan E. Steimle(14)......................................................................... 255,407 *

All executive officers and directors as a group (9 persons)(15)............................ 10,924,338 31.9
</TABLE>

- ---------

* Less than 1%.

(1) Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and generally includes voting or
investment power with respect to securities. Shares of Common Stock subject
to options and warrants currently exercisable within 60 days are deemed to
be outstanding for computing the percentage of the person holding such
options or warrants but are not deemed outstanding for computing the
percentage of any other person. Except as indicated by footnote, and subject
to community property laws where applicable, the persons named in the table
have sole voting and investment power with respect to all shares of Common
Stock shown as beneficially owned by them.

62
<PAGE>
(2) Includes 300,000 shares which may be acquired upon exercise of a warrant.

(3) Includes 4,150 shares held by Yuval Almog and 5,263 shares held in an IRA
by Dain Bosworth, Inc. as a custodian for the benefit of Yuval Almog. Also
includes 4,150 shares held by Peter McNerney. Messrs. Almog and McNerney are
two of the general partners of Coral Management Partners II, which is the
general partner of Coral Partners II, and may be deemed to be the beneficial
owners of such shares. Mr. Almog and Mr. McNerney disclaim beneficial
ownership of such shares.

(4) St. Paul Venture Capital, Inc. is a wholly owned subsidiary of St. Paul
Fire and Marine Insurance Company, which is the record owner of the shares.
Includes 831,880 shares which may be acquired upon exercise of warrants.

(5) Includes 800,000 shares which may be acquired upon exercise of a warrant.

(6) Includes 255,433 shares held by Mr. Cassin as a conservator for Robert
Cassin, 43,380 of which shares may be acquired upon exercise of a warrant,
100,000 shares held in trust by the Cassin Family Foundation and 100,000
shares held in trust by the Cassin Family Charitable Remainder Trust. The
remaining shares are held in trust by B.J. Cassin and Isabel B. Cassin,
Trustees of the Cassin Family Trust U/D/T, dated January 31, 1996.

(7) Includes 289,902 shares issuable upon exercise of options held by Mr.
Green, 127,467 of which shares will be vested as of 60 days from December
31, 1996. Also includes 294,044 shares which may be acquired by Mr. Green
upon exercise of warrants. Excludes shares held by Mr. Green's adult
children.

(8) Includes 165,334 shares issuable upon exercise of options held by Mr.
Grivner, 19,467 of which shares will be vested as of 60 days from December
31, 1996.

(9) Includes 2,946,397 shares held by Vanguard IV, L.P. Mr. Higgerson is a
general partner of Vanguard Venture Partners, L.P., which is the general
partner of Vanguard IV, L.P. and may be deemed to be the beneficial owner of
such shares owned by Vanguard IV, L.P. Mr. Higgerson disclaims beneficial
ownership of such shares.

(10) Includes 3,889,966 shares held by Tellabs, Inc., 300,000 of which shares
may be acquired upon exercise of a warrant. Mr. Jackman is the Executive
Vice President of Tellabs, Inc. and the President of Tellabs Operations,
Inc. and may be deemed to be the beneficial owner of such shares owned by
Tellabs. Mr. Jackman disclaims beneficial ownership of such shares. Also
includes 10,000 shares which may be acquired by Mr. Jackman upon exercise of
a warrant.

(11) Includes 63,000 shares issuable upon exercise of options held by Mr.
Rasdal, 38,400 of which shares will be vested as of 60 days from December
31, 1996.

(12) Includes 75,200 shares issuable upon exercise of options held by Ms.
Godfrey, 40,813 of which shares will be vested as of 60 days from December
31, 1996.

(13) Includes 248,000 shares issuable upon exercise of options held by Mr.
Lillich, 168,800 of which shares will be vested as of 60 days from December
31, 1996. Also includes 20,000 shares which may be acquired upon exercise of
a warrant.

(14) Includes 58,667 shares subject to a right of repurchase by the Company.
Includes 52,000 shares issuable upon exercise of options held by Mr.
Steimle, 20,113 of which shares will be vested as of 60 days from December
31, 1996; 4,800 shares held in an IRA by Alex. Brown & Sons as a custodian
for the benefit of Mr. Steimle; and 4,000 shares held in an IRA by Alex.
Brown & Sons as a custodian for the benefit of Jessica Steimle.

(15) Includes 58,667 shares subject to a right of repurchase by the Company.
Includes 893,436 shares issuable upon exercise of options, 415,080 of which
shares will be vested as of 60 days from December 31, 1996, and 667,424
shares which may be acquired upon exercise of warrants.

63
<PAGE>
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Since its inception, the Company has issued and sold, in private placement
transactions, shares of Preferred Stock and warrants to purchase Common Stock to
the Company's executive officers, directors and/or greater than 5% stockholders
as follows:

<TABLE>
<CAPTION>
COMMON COMMON COMMON COMMON
EQUIVALENT EQUIVALENT EQUIVALENT EQUIVALENT
SHARES OF SHARES OF SHARES OF SHARES OF
SERIES A SERIES B SERIES C SERIES D COMMON
PREFERRED PREFERRED PREFERRED PREFERRED STOCK
INVESTOR(1) STOCK(2) STOCK(3) STOCK(4) STOCK(5) WARRANTS
- ----------------------------------------------------- ---------- ---------- ---------- ---------- ---------------
<S> <C> <C> <C> <C> <C>
B.J. Cassin.......................................... 1,285,458 175,029 109,656 -- 339,908(6)
Coral Partners II.................................... 43,862 6,838 1,353,462 208,487 1,234,280(7)
Donald Green......................................... 681,552 -- -- -- 294,044(8)
Harris Corporation................................... -- -- 877,248 87,725 800,000(9)
Dan E. Steimle....................................... -- -- 5,483 -- 5,000(10)
St. Paul Venture Capital, Inc........................ 1,485,720 231,602 439,655 263,174 831,880(11)
Tellabs, Inc.(12).................................... -- 1,141,322 13,176 1,403,597 1,352,836(13)
Vanguard IV, L.P.(14)................................ 1,485,720 231,602 351,956 87,725 779,464(15)
</TABLE>

- ---------

(1) Shares held by all affiliated persons and entities have been aggregated.
See "Item 12--Security Ownership of Certain Beneficial Owners and
Management" for more detail on shares held by these purchasers.

(2) Shares of Series A Preferred Stock were issued in January and April 1993 at
an effective common equivalent per share price of $0.45597.

(3) Shares of Series B Preferred Stock were issued in October 1993 at an
effective common equivalent per share price of $2.27985.

(4) Shares of Series C Preferred Stock were issued in March and May 1994 at an
effective common equivalent per share price of $2.27985.

(5) Shares of Series D Preferred Stock were issued in October 1994 at an
effective common equivalent per share price of $2.84982.

(6) 80,292 of these Common Stock Warrants were exercised in February 1995, at
the following exercise prices: 6,472 at $0.025 per share and 73,820 at
$0.125 per share. The remaining 259,616 warrants have an exercise price of
$1.165 per share.

(7) An aggregate of 1,207,327 shares of Common Stock were issued upon exercise
of these Common Stock Warrants in October 1996 at an exercise price of
$1.165 per share.

(8) These Common Stock Warrants have the following exercise prices: 255,316 at
$0.025 per share and 38,728 at $0.125 per share.

(9) These Common Stock Warrants have an exercise price of $1.165 per share.

(10) These Common Stock Warrants were exercised in July 1995 at an exercise
price of $1.165 per share.

(11) These Common Stock Warrants have the following exercise prices: 6,472 at
$0.025 per share, 63,260 at $0.125 per share, 150,000 at $0.25 per share and
612,148 at $1.165 per share.

(12) Brian Jackman, an affiliate of Tellabs, is a director of the Company.

(13) 1,042,836 of these Common Stock Warrants were exercised in May 1995 at an
exercise price of $1.165 per share. The remaining 310,000 warrants have the
following exercise prices: 300,000 at $0.25 per share and 10,000 at $1.165
per share.

(14) Clifford H. Higgerson, an affiliate of Vanguard, is a director of the
Company.

(15) An aggregate of 767,463 shares of Common Stock were issued upon exercise of
these Common Stock Warrants in October 1996 at the following exercise
prices: 6,469 at $0.025 per share, 70,666 at $0.125 per share, 149,347 at
$0.25 per share and 540,981 at $1.165 per share.

64
<PAGE>
The foregoing table has been adjusted to reflect the conversion of each
outstanding share of Series A, Series B, Series C and Series D Preferred Stock
of the Company into 1.09656 shares of Common Stock in October 1996. Each holder
of such shares of Common Stock issued upon conversion of Preferred Stock is
entitled to certain registration rights.

In connection with the issuance and sale of Preferred Stock, the Company
entered into an indemnity agreement with its Preferred Stock investors (other
than investors of Series F Preferred Stock) pursuant to which the Company agreed
to indemnify such investors from the financial dilution they may experience as a
result of the costs and potential liabilities of the Company arising in
connection with the DSC litigation. In connection with the settlement of the
litigation with DSC, the Company entered into an Amended and Restated Indemnity
Agreement (the "Amended Indemnity Agreement") with such investors. Pursuant to
the Amended Indemnity Agreement, the indemnification was limited to the costs
and expenses of the litigation and was effected by amending the Company's
Articles of Incorporation in August 1996 to adjust the rate at which each series
of Preferred Stock (other than Series F) converts into Common Stock. The rate at
which each share of Series A, Series B, Series C and Series D Preferred Stock
was adjusted so that each of such shares converted into 1.09656 shares of Common
Stock and each share of Series E Preferred Stock converted into 1.02529 shares
of Common Stock. Such conversion into Common Stock automatically occured in
October 1996. Upon amendment of the Articles of Incorporation in August 1996,
the Amended Indemnity Agreement was terminated and no further indemnification
obligation remains. See "Item 8-- Note 9 of Notes to Consolidated Financial
Statements."

In October 1995, the Company loaned to Carl Grivner, the President and Chief
Operating Officer of the Company, the sum of $100,000 to assist him in
relocating to Northern California. Such loan bears interest at the rate of 6.37%
per annum, with accrued interest due and payable annually on July 19 of each
year, and the principal of such loan is due and payable in three equal
installments on July 19 of 1996, 1997 and 1998. In August 1996, the Company
forgave one-third of the principal balance and interest accrued through July 19,
1996. As of December 31, 1996, two-thirds of the principal balance of this loan
remained outstanding.

In May 1995, the Company issued an aggregate of 563,600 shares of Common
Stock at $0.3125 per share to certain key employees pursuant to compensation
agreements approved by the Company's Board of Directors. In connection with such
issuance, each such employee paid for the restricted stock by issuing a secured
note payable to the Company. The Company has the right to repurchase such stock
at the original purchase price per share upon the purchaser's cessation of
service prior to vesting in such shares. The repurchase right lapses with
respect to the shares, and each purchaser vests in his shares, as follows: 20%
of the shares upon completion of one year of service measured from the date of
issuance, and the balance of the shares in a series of equal successive monthly
installments upon the purchaser's completion of each of the next 48 months of
service thereafter. Such stock is also subject to the Company's right of first
refusal, which is exercisable in the event the purchaser decides to sell or
otherwise transfer any of the shares purchased prior to the initial public
offering of Common Stock. Donald Green, the Company's Chief Executive Officer,
purchased 167,200 shares of Common Stock and issued a note payable to the
Company in the amount of $52,250. The note is secured by shares of Preferred
Stock owned by Mr. Green. Such note bears interest at the rate of 6.5% per annum
with the entire principal balance of the note, together with all accrued or
unpaid interest, due and payable on December 13, 2000.

AFC and Harris, a stockholder of the Company, entered into an agreement in
1995 to form a joint venture to manufacture, distribute and support the UMC
system in India. The joint venture includes formation of a holding company in
Mauritius, owned 51% by AFC and 49% by Harris, which in turn intends to form a
joint venture in India with local Indian partners following receipt of certain
government approvals. To date, the parties have identified and selected two
Indian companies that will collectively own 34% of the Indian venture to be
located in Delhi. See "Item 1--Business--Markets and Customers."

65
<PAGE>
AFC and Tellabs, a stockholder of the Company, entered into a general
partnership in 1994 to design, develop, manufacture and distribute a new product
line derived from the UMC system. AFC contributed a non-exclusive license to use
the UMC technology, Tellabs contributed cash to the joint venture, and each
received defined marketing rights for the developed technology. On December 23,
1996 the Company and the joint venture partner entered into an agreement to
terminate the partnership. In connection with the dissolution, the joint venture
partner reimbursed the Company $1,683,000 for all loans and advances made by the
Company to date. In addition, the Company and the joint venture partner entered
into a License and Marketing Agreement and an OEM Agreement. Under the License
and Marketing Agreement, the Company granted to the joint venture partner a
license to use the UMC technology in the development, manufacture, and
distribution of coaxial systems for specified markets. In return, the Company
will receive royalties from the sale of these systems. Under the OEM Agreement
the Company agreed to manufacture the UMC products for the joint venture
partner. See "Item 1--Business--Markets and Customers."

The Company has granted options to certain of its directors and executive
officers. See ``Item 11-- Executive Compensation" and ``Item--12 Security
Ownership of Certain Beneficial Owners and Management."

The Company believes that all of the transactions set forth above were made
on terms no less favorable to the Company than could have been obtained from
unaffiliated third parties. The Company intends that all future transactions,
including loans, between the Company and its officers, directors, principal
stockholders and their affiliates be approved by a majority of the Board of
Directors, including a majority of the independent and disinterested outside
directors on the Board of Directors, and be on terms no less favorable to the
Company than could be obtained from unaffiliated third parties.

66
<PAGE>
PART IV.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

3(A). EXHIBITS:

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
- --------- --------------------------------------------------------------------------------------------------------
<C> <S>

67
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
- --------- --------------------------------------------------------------------------------------------------------
<C> <S>
10.18 Redwood Business Park Net Lease, dated June 3, 1996, between the Registrant and G & W/ Redwood
Associates Joint Venture, for the premises located at Buildings 1 & 9 of Willowbrook Court.*
10.19 Second Amended and Restated Loan and Security Agreement, dated December 7, 1995, between the Registrant
and Bank of the West.*
10.20 Form of Indemnification Agreement for Executive Officers and Directors of the Registrant.*
10.21 The Registrant's 1993 Stock Option/Stock Issuance Plan as amended (the ``1993 Plan").*#
10.22 Form of Stock Option Agreement pertaining to the 1993 Plan.*#
10.23 Form of Notice of Grant of Stock Option pertaining to the 1993 Plan.*#
10.24 Form of Stock Purchase Agreement pertaining to the 1993 Plan.*#
10.25 The Registrant's 1996 Stock Incentive Plan (the ``1996 Plan").*#
10.26 Form of Stock Option Agreement pertaining to the 1996 Plan.*#
10.26.1 Form of Automatic Stock Option Agreement pertaining to the 1996 Plan.*#
10.27 Form of Notice of Grant of Stock Option pertaining to the 1996 Plan.*#
10.27.1 Form of Notice of Grant of Non-Employee Director Automatic Stock Option pertaining to the 1996 Plan.*#
10.28 Form of Stock Issuance Agreement pertaining to the 1996 Plan.*#
10.29 The Registrant's Employee Stock Purchase Plan.*#
10.30 Termination Agreement of Joint Venture and Partnership Agreement, dated December 23, 1996, between the
Registrant and Tellabs Operations, Inc.**
10.31 License and Marketing Agreement, dated December 23, 1996, between the Registrant and Tellabs Operations,
Inc.**++
10.32 OEM Agreement, dated December 23, 1996, between the Registrant and Tellabs Operations, Inc.**
11.1 Statement regarding computation of per share earnings.
21.1 Subsidiaries of the Registrant.*
23.1 Consent of KPMG Peat Marwick LLP, Independent Auditors.
27.1 Financial Data Schedule.
</TABLE>

- ---------

* Incorporated by reference from the Registrant's Registration Statement on
Form S-1 (no. 333-8921) filed with the Securities and Exchange Commission on
July 26, 1996, as amended, and declared effective September 30, 1996.

** Incorporated by reference from the Registrant's Registration Statement on
Form S-1 (no. 333-20369) filed with the Securities and Exchange Commission
on January 24, 1997.

+ Portions of this Exhibit have been granted Confidential Treatment.

++ Portions of this Exhibit have been deleted pursuant to a Confidential
Treatment Request filed with the Commission.

# Management contract or compensatory plan or arrangement.

3(B). REPORTS ON FORM 8-K: NONE.

68
<PAGE>
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.

ADVANCED FIBRE COMMUNICATIONS, INC.
(Registrant)

By: /s/ DONALD GREEN
-----------------------------------------
Donald Green
CHAIRMAN OF THE BOARD AND
CHIEF EXECUTIVE OFFICER

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

SIGNATURE TITLE DATE
- ------------------------------ -------------------------- -------------------

/s/ DONALD GREEN
- ------------------------------ Chairman of the Board and January 28, 1997
Donald Green Chief Executive Officer

/s/ CARL J. GRIVNER
- ------------------------------ Director, President, and January 28, 1997
Carl J. Grivner Chief Operating Officer

Vice President, Chief
Financial Officer,
/s/ DAN E. STEIMLE Treasurer and Secretary
- ------------------------------ (Principal Financial January 28, 1997
Dan E. Steimle Officer and Principal
Accounting Officer)

/s/ B. J. CASSIN
- ------------------------------ Director January 28, 1997
B. J. Cassin

/s/ CLIFFORD H. HIGGERSON
- ------------------------------ Director January 28, 1997
Clifford H. Higgerson

/s/ BRIAN JACKMAN
- ------------------------------ Director January 28, 1997
Brian Jackman

/s/ DAN RASDAL
- ------------------------------ Director January 28, 1997
Dan Rasdal

69
<PAGE>
EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
- --------- --------------------------------------------------------------------------------------------------------
<C> <S>

3.3 Fourth Amended and Restated Certificate of Incorporation of the Registrant.*
3.5 Amended and Restated Bylaws of the Registrant.*
4.1 Specimen Certificate of Common Stock.*
4.2 Series E Preferred Stock Purchase Agreement, dated September 29, 1995, between the Registrant and
certain purchasers of the Registrant's Series E Preferred Stock.*
4.3 Certificate of Incorporation of the Registrant (included in Exhibit 3.3).*
10.1 Form of Warrant Issued In Connection with the Sale of the Registrant's Series A Preferred Stock on
January 6, 1993.*
10.2 Form of Warrant Issued In Connection with the Sale of the Registrant's Series B Preferred Stock on
October 5, 1993.*
10.3 Form of Warrant Issued in Connection with the Sale of the Registrant's Series C Preferred Stock on March
16, 1994.*
10.4 Form of Performance Warrant Issued in Connection with the Sale of the Registrant's Series C Preferred
Stock on March 16, 1994 and May 4, 1994.*
10.4.1 Form of Amendment to Warrants and Performance Warrants.*
10.5 Warrant Issued in Connection with the Sale of the Registrant's Series E Preferred Stock on September 29,
1995.*
10.6 Restricted Stock Issuance Agreement, dated May 19, 1995, between the Registrant, Donald Green and
Maureen Green.*#
10.7 Compensation Agreement, dated May 19, 1995, between the Registrant and Donald Green.*#
10.8 Promissory Note Secured by Pledge Agreement, dated May 31, 1995, by Donald Green in favor of the
Registrant.*#
10.9 Stock Pledge Agreement, dated June 16, 1995, between the Registrant and Donald Green.*#
10.10 Promissory Note issued by Carl Grivner, dated October 5, 1995, in favor of the Registrant.*#
10.11 Shareholder and Joint Venture Agreement, dated December 28, 1995, between the Registrant and Harris
Corporation, acting for the purposes of the agreement through its Digital Telephone Systems Division.*+
10.12 Joint Venture & Partnership Agreement, dated April 11, 1994, between the Registrant and Tellabs
Operations, Inc.*+
10.13 License, Joint Development, Supply and Authorized Manufacturing Agreement, dated September 25, 1992,
between the Registrant and Industrial Technology Research Institute of the Republic of China.*+
10.14 Hangzhou Aftek Communication Registrant Ltd. Contract, dated June 18, 1994, between Advanced Fibre
Technology Communication (Hong Kong) Limited and Hangzhou Communication Equipment Factory of the MPT.,
HuaTong Branch.*+
10.15 1445 & 1455 McDowell Boulevard North Net Lease, dated February 1, 1993, between the Registrant and G &
W/ Redwood Associates Joint Venture, for the premises located at 1445 McDowell Boulevard North.*
10.16 Redwood Business Park Net Lease, dated July 9, 1995, between the Registrant and G & W/ Redwood
Associates Joint Venture, for the premises located at 1455 McDowell Boulevard North.*
10.17 Redwood Business Park Net Lease, dated July 10, 1995, between the Registrant and G & W/ Redwood
Associates Joint Venture, for the premises located at 1440 McDowell Boulevard North.*
10.18 Redwood Business Park Net Lease, dated June 3, 1996, between the Registrant and G & W/ Redwood
Associates Joint Venture, for the premises located at Buildings 1 & 9 of Willowbrook Court.*
10.19 Second Amended and Restated Loan and Security Agreement, dated December 7, 1995, between the Registrant
and Bank of the West.*
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
- --------- --------------------------------------------------------------------------------------------------------
<C> <S>
10.20 Form of Indemnification Agreement for Executive Officers and Directors of the Registrant.*
10.21 The Registrant's 1993 Stock Option/Stock Issuance Plan as amended (the ``1993 Plan").*#
10.22 Form of Stock Option Agreement pertaining to the 1993 Plan.*#
10.23 Form of Notice of Grant of Stock Option pertaining to the 1993 Plan.*#
10.24 Form of Stock Purchase Agreement pertaining to the 1993 Plan.*#
10.25 The Registrant's 1996 Stock Incentive Plan (the ``1996 Plan").*#
10.26 Form of Stock Option Agreement pertaining to the 1996 Plan.*#
10.26.1 Form of Automatic Stock Option Agreement pertaining to the 1996 Plan.*#
10.27 Form of Notice of Grant of Stock Option pertaining to the 1996 Plan.*#
10.27.1 Form of Notice of Grant of Non-Employee Director Automatic Stock Option pertaining to the 1996 Plan.*#
10.28 Form of Stock Issuance Agreement pertaining to the 1996 Plan.*#
10.29 The Registrant's Employee Stock Purchase Plan.*#
10.30 Termination Agreement of Joint Venture and Partnership Agreement, dated December 23, 1996, between the
Registrant and Tellabs Operations, Inc.**
10.31 License and Marketing Agreement, dated December 23, 1996, between the Registrant and Tellabs Operations,
Inc.**++
10.32 OEM Agreement, dated December 23, 1996, between the Registrant and Tellabs Operations, Inc.**
11.1 Statement regarding computation of per share earnings.
21.1 Subsidiaries of the Registrant.*
23.1 Consent of KPMG Peat Marwick LLP, Independent Auditors.
27.1 Financial Data Schedule.
</TABLE>

- ---------

** Incorporated by reference from the Registrant's Registration Statement on
Form S-1 (no. 333-20369) filed with the Securities and Exchange Commission
on January 24, 1997.

+ Portions of this Exhibit have been granted Confidential Treatment.

++ Portions of this Exhibit have been deleted pursuant to a Confidential
Treatment Request filed with the Commission.

# Management contract or compensatory plan or arrangement.

<PAGE>
EXHIBIT 11.1

ADVANCED FIBRE COMMUNICATIONS, INC.
SCHEDULE RE: COMPUTATION OF PRO FORMA NET INCOME PER SHARE
(In thousands, except per share data)

<TABLE>
<CAPTION>
1995 1996
------------------- -------------------
FULLY FULLY
PRIMARY DILUTED PRIMARY DILUTED
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net income........................................ $ 2,341 $ 2,341 $ 7,237 $ 7,237
-------- -------- -------- --------
Weighted average common shares outstanding........ 4,373 4,373 26,070 26,070
Redeemable convertible preferred stock, on an
as-if converted basis........................... 17,448 17,448 -- --
Common stock equivalents--stock options and
warrants........................................ 3,521 4,003 7,954 8,296

Staff Accounting Bulletin No. 83 issuances and
grants:
Stock options................................... 1,070 1,070 202 203
Redeemable convertible preferred stock issued... 917 917 56 56
-------- -------- -------- --------
Weighted average shares used in per share
computations.................................... 27,329 27,811 34,282 34,625
-------- -------- -------- --------
Pro forma net income per share.................... $ 0.09 $ 0.08 $ 0.21 $ 0.21
-------- -------- -------- --------
-------- -------- -------- --------
</TABLE>

<PAGE>
EXHIBIT 23.1

ADVANCED FIBRE COMMUNICATIONS, INC.
CONSENT OF INDEPENDENT AUDITORS

We consent to incorporation by reference in the registration statement (No.
33-15651) on Form S-8 of Advanced Fibre Communications, Inc. of our report dated
January 20, 1997, relating to the consolidated balance sheets of Advanced Fibre
Communications, Inc. and subsidiaries as of December 31, 1996 and 1995, and the
related consolidated statements of operations, redeemable convertible preferred
stock and stockholders equity (deficit), and cash flows for each of the years in
the three-year period ended December 31, 1996, which report appears in the
December 31, 1996 annual report on Form 10-K of Advanced Fibre Communications,
Inc.

KPMG Peat Marwick LLP

San Francisco, California

January 27, 1997

<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 24,942
<SECURITIES> 83,488
<RECEIVABLES> 32,779
<ALLOWANCES> 0
<INVENTORY> 17,349
<CURRENT-ASSETS> 162,189
<PP&E> 11,080
<DEPRECIATION> 1,491
<TOTAL-ASSETS> 175,679
<CURRENT-LIABILITIES> 16,851
<BONDS> 0
0
0
<COMMON> 326
<OTHER-SE> 157,697
<TOTAL-LIABILITY-AND-EQUITY> 175,679
<SALES> 128,941
<TOTAL-REVENUES> 130,193
<CGS> 69,628
<TOTAL-COSTS> 73,950
<OTHER-EXPENSES> 53,015
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (855)
<INCOME-PRETAX> 4,083
<INCOME-TAX> (3,154)
<INCOME-CONTINUING> 7,237
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 7,237
<EPS-PRIMARY> 0.21
<EPS-DILUTED> 0.21

</TABLE>